Insite Vision 10Q 2003 Q3 Quarterly report

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2003

¨	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 0-22332

INSITE VISION INCORPORATED

(Exact name of registrant as specified in its charter)

Delaware		94-3015807
*(State or other jurisdiction)* *of incorporation or organization)*		*(IRS Employer* *Identification No.)*

965 Atlantic Avenue, Alameda, California		94501
*(Address of principal executive offices)*		*(Zip Code)*

Registrant’s telephone number, including area code (510) 865-8800

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

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

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

APPLICABLE ONLY TO CORPORATE ISSUERS:

The number of shares of Registrant’s common stock, $0.01 par value, outstanding as of October 31, 2003: 26,014,146.

QUARTERLY REPORT ON FORM 10-Q

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2003

TABLE OF CONTENTS

		Page
PART I. FINANCIAL INFORMATION

Item 1.	Financial Statements

	Condensed Consolidated Balance Sheets at September 30, 2003 and December 31, 2002	1

	Condensed Consolidated Statements of Operations For the three and nine months ended September 30, 2003 and 2002	2

	Condensed Consolidated Statements of Cash Flows For the nine months ended September 30, 2003 and 2002	3

	Notes to Condensed Consolidated Financial Statements	4

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	9

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	29

Item 4.	Controls and Procedures	29

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	29

Item 2.	Changes in Securities and Use of Proceeds	29

Item 3.	Defaults Upon Senior Securities	31

Item 4.	Submission of Matters to a Vote of Security Holders	31

Item 5.	Other Information	31

Item 6.	Exhibits and Reports on Form 8-K

	Exhibits	31

	Reports on Form 8-K	32

PART I FINANCIAL INFORMATION

Item 1. Financial Statements

InSite Vision Incorporated

Condensed Consolidated Balance Sheets

(in thousands, except share and per share amounts)	September 30, 2003			December 31, 2002
	(Unaudited)
Assets
Current assets:
Cash and cash equivalents	$	150		$	1,179
Inventory		18			19
Prepaid expenses and other current assets		89			124

Total current assets		257			1,322
Property and equipment, at cost:
Laboratory and other equipment		953			1,087
Leasehold improvements		73			73
Furniture & fixtures		3			3

		1,029			1,163
Accumulated depreciation		680			619

		349			544

Deferred debt issuance cost		86			—
Total assets	$	692		$	1,866

Liabilities and stockholders’ equity (deficit)
Current liabilities:
Short-term notes payable to related parties, unsecured	$	296		$	—
Short-term notes payable to related parties, secured		650			—
Accounts payable		889			373
Deferred rent		145			—
Accrued liabilities		569			307
Accrued compensation and related expense		171			289

Total current liabilities		2,720			969

Capital lease obligation, less current portion		3			10
Convertible Notes Payable (net of beneficial conversion feature of $498,000)		2			—
Preferred stock, $0.01 par value, 5,000,000 shares authorized; 4,000 shares issued and outstanding at September 30, 2003; 2,000 shares issued and outstanding at December 31, 2002, value of shares in excess of conversion rights into 4,300,000 shares of common stock		2,059			—
Commitments
Stockholders’ equity:
Preferred stock, $0.01 par value, 5,000,000 shares authorized; 4,000 shares issued and outstanding at September 30, 2003; 2,000 shares issued and outstanding at December 31, 2002		2,150			2,048

Common stockholders’ equity (deficit):
Common stock, $0.01 par value, 60,000,000 shares authorized; 25,136,786 issued and outstanding at September 30, 2003; 25,131,786 issued and outstanding at December 31, 2002		251			251
Additional paid-in-capital		108,128			107,569
Notes receivable from stockholder		(208	)		(231	)
Accumulated deficit		(114,413	)		(108,750	)

Common stockholders’ deficit		(6,242	)		(1,161	)

Total Stockholders’ equity (deficit)		(4,092	)		887

Total liabilities and stockholders’ equity (deficit)	$	692		$	1,866

See accompanying notes to condensed consolidated financial statements.

InSite Vision Incorporated

Condensed Consolidated Statements of Operations

(Unaudited)

	Three months ended September 30						Nine months ended September 30,
(in thousands, except per share amounts)	2003			2002			2003			2002
Revenues	$	4		$	9		$	8		$	26

Cost of goods		5			25			17			57

Operating expenses:
Research and development		793			1,892			3,461			5,686
Cost reimbursement		—			—			—			66

Research and development, net		793			1,892			3,461			5,620
Selling, general and administrative		599			1,192			2,025			3,080

Total		1,393			3,084			5,486			8,700


Loss from operations		(1,393	)		(3,100	)		(5,495	)		(8,731	)

Interest, other income and expense, net		(9	)		10			(7	)		53

Net loss		(1,402	)		(3,090	)		(5,502	)		(8,678	)
Preferred dividends		60			18			161			18

Net loss applicable to common stockholders	$	(1,462	)	$	(3,108	)	$	(5,663	)	$	(8,696	)

Net loss per share applicable to common stockholders, basic and diluted	$	(0.06	)	$	(0.12	)	$	(0.23	)	$	(0.35	)

Shares used to calculate net loss per share applicable to common stockholders, basic and diluted		25,137			25,007			25,136			24,959

No cash dividends were declared or paid during the periods.

See accompanying notes to condensed consolidated financial statements.

InSite Vision Incorporated

Condensed Consolidated Statements of Cash Flows

(Unaudited)

	Nine months ended September 30,
(in thousands)	2003			2002
Operating activities
Net loss	$	(5,502	)	$	(8,678	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		220			224
Stock based compensation		56			156
Changes in:
Prepaid expenses and other current assets		58			40
Current liabilities		812			(343	)

Net cash used in operating activities		(4,356	)		(8,601	)

Investing activities
Purchases of property and equipment		(23	)		(58	)

Net cash used in investing activities		(23	)		(58	)

Financing activities
Issuance of preferred stock		2,000			2,000
Issuance of common stock		3			93
Issuance of convertible notes payable, net of issuance costs		392			—
Note payment received from stockholder		23			26
Issuance of short-term notes payable to related parties		946			—
Payment of capital lease obligation		(14	)		(24	)

Net cash provided by financing activities		3,350			2,095

Net decrease in cash and cash equivalents		(1,029	)		(6,564	)
Cash and cash equivalents, beginning of period		1,179			10,095

Cash and cash equivalents, end of period	$	150		$	3,531

Supplemental disclosure:
Preferred dividends	$	161		$	18

Beneficial conversion feature of convertible notes payable		500			—

See accompanying notes to condensed consolidated financial statements.

InSite Vision Incorporated

Notes to Condensed Consolidated Financial Statements

September 30, 2003

(Unaudited)

Note 1 - Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information pursuant to the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation have been included. Operating results for the three and nine month periods ended September 30, 2003 are not necessarily indicative of the results that may be expected for any future period.

The Company’s consolidated financial statements have been presented on a basis that contemplates the realization of assets and the satisfaction of liabilities in the normal course of business and assumes the Company will continue as a going concern. Except for 1999, the Company has incurred losses since its inception, including a net loss applicable to common stockholders of $5.8 million for the nine months ended September 30, 2003, and the Company expects to incur substantial additional losses, including costs related to clinical trials, marketing and manufacturing expenses. The Company has incurred negative cash flows from operations since inception, including net cash used in operations of $4.5 million for the nine months ended September 30, 2003. As of September 30, 2003, the Company had an accumulated deficit of $114.4 million and $150,000 of cash and cash equivalents. Subsequent to the end of the quarter, the Company obtained $500,000 from the second tranche of a $1.0 million convertible debt issuance. In these circumstances, and notwithstanding any expense reduction measures the Company has undertaken, the Company expects it will not have sufficient funds to meet its various cash needs beyond approximately the beginning of December 2003 unless the Company is able to obtain additional funding from outside sources. The Company continues to actively pursue various sources of additional funds, including debt or equity financing and new license and collaboration agreements and asset sales. There is no assurance that such additional funds will be available for the Company to finance its operations on acceptable terms, if at all. If such funds are not available, management will be required to cease all operations and liquidate its remaining assets. In that case, the Company’s common stock may have no value. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from our inability to obtain funding and resultant ceasing of operations.

The Company has undertaken a number of measures to reduce its short term operating expenses to allow it to continue operations without additional financing through approximately the beginning of December 2003, including: laying-off approximately 42% of its employees, voluntary salary reductions by its senior management team, ceasing work on all non-critical external activities, extending payment terms on its trade payables, working with its landlord to restructure its lease obligations, and other cost containment measures. There is no assurance that these expense reduction efforts will enable the Company to continue operations or that if the Company does survive it has not significantly harmed its business or prospects.

Any person considering an investment in the Company’s securities is urged to consider both the risk that the Company will cease operations at or around the beginning of December 2003, and the risk that its securities will be worthless even if it is successful in raising interim financing. All of the statements set forth in this report are qualified by reference to those facts. Please see “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “—Risk Factors” for a discussion of these and other risk factors relating to the Company and an investment in its securities.

These financial statements and notes should be read in conjunction with our audited financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2002.

Critical Accounting Policies and Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles in the U.S. requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

The following are items in our financial statements that require significant estimates and judgments:

Inventory. Our inventories are stated at the lower of cost or market. The cost of the inventory is based on the first-in first-out method. If the cost of the inventory exceeds the expected market value a provision is recorded for the difference between cost and market. At September 30, 2003, our inventories solely consisted of OcuGene kits.

Property and Equipment. Property and equipment is stated at cost, less accumulated depreciation. Depreciation of property and equipment is provided over the estimated useful lives of the respective assets, which range from three to five years, using the straight-line method. Leasehold improvements are amortized over the lives of the related leases or their estimated useful lives, whichever is shorter, using the straight-line method. It is our policy to write-off our fully depreciated assets.

Additionally, we record impairment losses on long-lived assets used in operations when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amounts of those assets.

Revenue Recognition. We recognize up-front fees over the expected term of the related research and development services using the straight-line method. When changes in the expected term of ongoing services are identified, the amortization period for the remaining fees is appropriately modified.

Revenue related to performance milestones is recognized when the milestone is achieved based on the terms set forth in the related agreements.

We directly reduce expenses for amounts reimbursed due to cost sharing agreements. We recognize the received cost sharing payments when persuasive evidence of an arrangement exists, the services have been rendered, the fee is fixed or determinable and collectibility is reasonably assured.

We receive royalties from licensees based on third-party sales and the royalties are recorded as earned in accordance with contract terms, when third party results are reliably measured and collectibility is reasonably assured.

Revenue related to the sales of our product, the OcuGene glaucoma genetic test, is recognized when all related services have been rendered and collectibility is reasonably assured.

Cost of goods. We recognize the cost of inventory shipped and other costs related to our OcuGene glaucoma genetic test when they are incurred.

Research and Development (R&D) Expenses. R&D expenses include salaries, benefits, facility costs, services provided by outside consultants and contractors, administrative costs and materials for our research and development activities. We also fund research at a variety of academic institutions based on agreements that are generally cancelable. We recognize such costs as they are incurred.

Selling, General and Administrative (SG&A) Expenses. SG&A expenses include salaries, benefits, facility costs, services provided by outside consultants and contractors, advertising and marketing, investor relations, financial reporting, materials and other expenses related to general corporate and sales and marketing activities.

Stock-Based Compensation. We have elected to continue to follow the intrinsic value method of accounting as prescribed by Accounting Principles Board Opinion No. 25 (or APB 25), “Accounting for Stock Issued to Employees,” to account for employee and director stock options. Accordingly, we do not recognize compensation expense for options granted to employees and directors at an exercise price equal to the fair value of the underlying common stock.

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting requirements and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in our opinion, the existing models do not necessarily provide a reliable single measure of the fair value of our employee stock options.

Pro forma information regarding net loss and loss per share is required by Statement of Financial Standards (SFAS) No. 123, “Accounting for Stock Based Compensation,” as amended by SFAS No. 148, and has been determined as if we had accounted for our employee stock options under the fair value method of that Statement. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for the quarter ended September 30, 2003 and 2002, respectively: risk-free interest rates ranging from 0.84% to 4.50%; volatility factors for the expected market price of our common stock of 1.06 and 1.07; and a weighted-average expected life for the options of 4 years. The following weighted-average assumptions were used to estimate the fair value for these options for the nine months ended September 30, 2003 and 2002, respectively: risk-free interest rates ranging from 0.84% to 5.83%; volatility factors for the expected market price of our common stock of 1.06 and 1.14; and a weighted-average expected life for the options of 4 years.

The following table illustrates the effect on net loss and net loss per share as if we had applied the fair value recognition provisions of SFAS 123 to stock based employee compensation (in thousands, except per share amounts):

	Quarter Ended September 30,						Nine Months Ended September 30,
	2003			2002			2003			2002
Net loss applicable to common stockholders-as reported	$	(1,462	)	$	(3,108	)	$	(5,663	)	$	(8,696	)
Deduct: Total stock-based employee compensation expense determined under fair value method for all awards		(42	)		(45	)		(328	)		(86	)

Net loss applicable to common stockholders-pro forma	$	(1,504	)	$	(3,153	)	$	(5,991	)	$	(8,782	)

Loss applicable to common stockholders per share:
Basic and diluted - as reported	$	(0.06	)	$	(0.12	)	$	(0.23	)	$	(0.35	)
Basic and diluted - pro forma	$	(0.06	)	$	(0.13	)	$	(0.24	)	$	(0.35	)

The weighted average grant date fair value of options granted during the quarter ended September 30, 2003 and 2002 were $0.63 and $0.93 respectively. The weighted average grant date fair value of options granted during the nine months ended September 30, 2003 and 2002 were $0.71 and $0.95, respectively.

For purposes of pro forma disclosures pursuant to SFAS 123 as amended by SFAS 148, the estimated fair value of options is amortized to expense over the options’ vesting period.

The pro forma impact of options on the net loss for the quarter ended September 30, 2003 and 2002 is not representative of the effects on net income (loss) for future quarters, as future quarters will include the effects of additional stock grants.

Due to the loss applicable to common stockholders, loss per share for the quarter ended September 30, 2003 and 2002 is based on the weighted average number of common shares only, as the effect of including equivalent shares from stock options would be anti-dilutive. If the Company had recorded net income, the calculation of earnings per share would have been impacted by the dilutive effect of the Series A-1 Preferred Shares and convertible debentures but would not have been materially affected by the minimal number of outstanding stock options and warrants priced below the market price of the common shares at September 30, 2003.

Note 2 - Preferred Stock

In February 2003, the Company received $2.0 million from the sale of 2,000 shares of its Series A-1 Preferred Stock to Bausch & Lomb Incorporated, or Bausch & Lomb, pursuant to a second closing under the August 2002 Preferred Stock Purchase Agreement between it and Bausch & Lomb. The sale was made pursuant to the Company’s achievement of a certain milestone contained in the August 2002 Preferred Stock Purchase Agreement. If the Company achieves certain additional milestones contained in the August 2002 Stock Purchase Agreement, Bausch & Lomb will be required to purchase up to an additional $11.0 million of the Company’s Series A-1 Preferred Stock in various closings from time to time. The August 2002 Preferred Stock Purchase Agreement was entered into contemporaneously with the execution of a Technology License Agreement between the Company and Bausch & Lomb to develop the Company’s ISV-403 product candidate for the treatment of ocular bacterial infections.

As of September 30, 2003, Bausch & Lomb holds a total of 4,000 shares of Series A-1 Preferred Stock. The Series A-1 Preferred Stock does not contain voting rights, except as otherwise provided by the Delaware General Corporation law and each share of Series A-1 Preferred Stock is entitled to a $60 per annum cumulative dividend.

The August 2002 Preferred Stock Purchase Agreement provides for the conversion of the Series A-1 Preferred Stock into shares of Common Stock, and potentially into a note payable, if the Bausch & Lomb License Agreement is terminated by Bausch & Lomb at any time for cause, or without cause prior to the later of the commencement of a Phase 2/3 clinical trial for ISV-403 or January 1, 2004.

If Bausch & Lomb elects to convert any shares of Series A-1 Preferred Stock into common stock, and potentially into a note payable, all shares of Series A-1 Preferred Stock will be converted at the same time. The actual number of shares of common stock issuable upon conversion of the Series A-1 Preferred Stock shall be equal to:

•

the actual purchase price of the Series A-1 Preferred Stock then outstanding plus all accumulated and unpaid dividends on the shares of Series A-1 Preferred Stock then outstanding, divided by

•

the fair market value of the Company’s common stock, up to a maximum of 4,300,000 shares of common stock, as may be adjusted for stock splits, stock dividends, recapitalizations and the like.

Upon the conversion of the Series A-1 Preferred Stock, the excess, if any, of:

•

the actual purchase price of the Series A-1 Preferred Stock outstanding immediately prior to the conversion plus all accumulated and unpaid dividends on the shares of Series A-1 Preferred Stock outstanding immediately prior to the conversion, over

•

the fair market value of 4,300,000 shares of the Company’s common stock shall be converted into a note payable. The note will bear interest at a rate of prime plus 2% per annum and will have a term of 5 years.

have exceeded the 4,300,000 maximum shares under the agreement. The excess amount of the Series A-1 Preferred Stock, of approximately $2.1 million, has been excluded from stockholders’ equity in the Condensed Consolidated Balance Sheet as of September 30, 2003 and has been reported at the mezzanine level. As of the filing of this Form 10-Q, approximately $2.5 million would have been excluded from stockholders’ equity and reported at the mezzanine level.

Note 3 - Short-term Notes Payable

In May and June 2003, the Company issued a series of short-term notes payable totaling $288,500 to members of the Board of Directors, senior management and other stockholders for cash. $100,000 of these notes are Senior Secured Notes, bear a two percent (2%) annual interest rate, were due September 28, 2003 and are secured by a lien on certain pieces of laboratory and other equipment. Prior to September 28, 2003 the due date on these notes was extended to December 31, 2003. The remainder of these notes are unsecured, bear interest rates between two percent (2%) and twelve percent (12%) and were due August 15, 2003. On August 15, 2003 the due date on these notes was extended to November 15, 2003. Prior to November 15, 2003, the due dates on these notes was extended to December 15, 2003.

In July and August 2003, the Company issued $500,000 in short-term Senior Secured Notes payable to an officer who is also a member of the Board of Directors and an affiliate of a member of senior management for cash. These notes bear interest at a rate of between five and one-half percent (5.5%) and twelve percent (12%), were due between September 30, 2003 and October 15, 2003 and are secured by a lien on substantially all of the assets of the Company, including the Company’s intellectual property, other than the equipment secured under the Senior Secured Notes described above and certain other equipment secured by the lessor of such equipment. Prior to September 30, 2003 the due dates of these notes were extended to between November 15, 2003 and December 31, 2003. Subsequently, the November 15, 2003 due date was further extended to December 15, 2003.

Note 4 - Convertible Notes Payable and Subsequent Events

On September 22, 2003, the Company, Arrow Acquisition, Inc., a wholly-owned subsidiary of the Company, and Ophthalmic Solutions, Inc., (“Ophthalmic Solutions”) entered into an Agreement and Plan of Merger (the “Merger Agreement”). The merger contemplated by the Merger Agreement (the “Merger”) was also completed on September 22, 2003. As a result of the Merger, Ophthalmic Solutions became a wholly-owned subsidiary of the Company and all outstanding shares of Ophthalmic Solutions’ capital stock held by its sole stockholder were converted into 100 shares of the Company’s common stock. Ophthalmic Solutions is a private, development stage company with a business plan to pursue opportunities for over-the-counter products in the area of ophthalmology and had immaterial assets and liabilities as of September 22, 2003, other than its obligations under and the proceeds from the debentures described below.

Immediately prior to the Merger, Ophthalmic Solutions entered into a Convertible Debenture Purchase Agreement (the “Purchase Agreement”), dated as of September 22, 2003, with HEM Mutual Assurance LLC, pursuant to which it sold and issued convertible debentures to HEM in an aggregate principal amount of up to $1,000,000 in a private placement pursuant to Rule 504 of Regulation D under the Securities Act of 1933, as amended. Two debentures in the aggregate principal amount of $500,000 were issued for gross proceeds of $500,000 in cash (the “Initial Debentures”) and an additional debenture in the aggregate principal amount of $500,000 (the “Contingent Debenture” and collectively with the Initial Debentures, the “Debentures”) was issued in exchange for a promissory note from HEM in the principal amount of $500,000 (the “Note”). Each of the Debentures has a maturity date of September 21, 2008, subject to earlier conversion or redemption pursuant to its terms, and bears interest at the rate of 1% per year, payable in cash or shares of common stock at the option of the holder of the Debentures. As a result of the Merger, the Company has assumed the rights and obligations of Ophthalmic Solutions in the private placement, including the gross proceeds raised through the sale of the Debentures, the Note issued by HEM to Ophthalmic Solutions, and Ophthalmic Solutions’ obligations under the Debentures and the Purchase Agreement.

As a result of the Merger as of September 30, 2003, $492,750 and $3,625 in principal amount of the Initial Debentures were convertible into unrestricted shares of the Company’s common stock at a conversion price that is the lower of $0.30 or the average of the three lowest closing per share bid prices for the common stock during the 40 trading days prior to conversion and $0.01 per share, respectively. An additional $3,625 in principal amount of the Initial Debentures will become convertible into unrestricted shares of Common Stock at a conversion price $0.01 per share if and when the Note is paid in full and the Contingent Debenture becomes convertible into Common Stock. The merger has been accounted for as an acquisition of assets. The assets acquired and liabilities assumed include: convertible debentures, cash and the related promissory note(s). Ophthalmic Solutions had no other assets or liabilities at the time of the merger. This asset acquisition has been, in substance, reflected as a financing transaction in the accompanying financial statements, including the receipt of cash, the issuance of debentures, and the issuance of a right to exercise the contingent debenture for an additional $500,000 of convertible debentures at an exercise price of $500,000.

The debenture conversion price of $0.30 and $0.01 per share, respectively was lower than the per share price of the Company’s common stock on the issuance date of September 22, 2003. In accordance with the provisions of EITF 00-27,Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios to Certain Convertible Instruments, the Company recorded a beneficial conversion feature of $500,000 related to the initial debenture. The Company will accrete the $500,000 discount recorded from the beneficial conversion feature from the September 22, 2003 issuance date to the stated redemption date of September 21, 2008. The accretion will be reported as interest expense with a corresponding increase to convertible debentures. Further, as amounts are converted into common stock, all of the remaining unamortized discount associated with those shares will be immediately recognized as interest expense. As of September 30, 2003 approximately $2,000 of the beneficial conversion feature had been expensed as interest. As of September 30, 2003 the $500,000 convertible debentures reported on the face of the balance sheet are net of related unamortized debt discount of $498,000. In connection with the convertible debt financing the Company captialized approximately $108,000 of debt issuance costs which are included in prepaid expenses and other current assets and other assets. These costs will be amortized over the life of the convertible debentures.

On November 10, 2003, $200,000 in principal and the related interest was converted into 667,561 shares of the Company’s common stock. On October 30, 2003, $200,000 in principal and the related interest was converted into 667,360 shares of the Company’s common stock. On October 15, 2003 $3,625 and the related interest was converted into 362,718 shares of the Company’s common stock.

On November 12, 2003 the $500,000 Contingent Debenture became convertible and subject to repayment when the related Note from HEM was paid in full to the Company in cash. This contingent Debenture is convertible into unrestricted shares of the Company’s common stock at a conversion price that is the lower of $0.375 or the average of the three lowest closing per share bid prices for the Common Stock during the 40 trading days prior to conversion.

The conversion price and number of shares of Common Stock issuable upon conversion of the Debentures is subject to adjustment for stock splits and combinations and other dilutive events. To satisfy its conversion obligations under the Debentures, we have placed 5,000,000 shares of common stock into escrow for potential issuance to HEM upon conversion of the Debentures. Unless and until the debentures are converted, HEM has no voting or other ownership rights in any of the shares of our common stock held in escrow and the shares in escrow are not treated by us as being issued and outstanding.

The Debentures may never be converted into an aggregate of more than 5,000,000 shares of our common stock unless we elect to increase the number of shares held in escrow in accordance with and subject to any applicable rules or regulations of The American Stock Exchange or such other exchange, market or system on which our common stock is then listed requiring stockholder approval prior to such additional issuance. In the event that the conversion rate of the Debentures would require us to issue more than an aggregate of 5,000,000 shares of our common stock upon conversion of the Debentures and we elect not to increase the number of shares held in escrow (or we fail to obtain any required stockholder approval for such proposed increase), we will be required to redeem the unconverted amount of the Debentures for 140% of the principal amount thereof, plus accrued and unpaid interest.

In addition to the foregoing, the Debentures may not be converted if and to the extent that after such conversion the holder would beneficially own more than 5% of our then outstanding common stock, unless the holder waives this limitation by providing us 75 days prior notice of the waiver.

We have the right to redeem the Debentures, in whole or in part, at any time on 30 days advanced notice for 140% of the principal amount of the outstanding Debentures being redeemed, plus accrued and unpaid interest. In addition, if at any time any of the Debentures are outstanding, we receive debt or equity financing in an amount equal to or exceeding Five Million dollars ($5,000,000) in a single transaction or series of related transactions (excluding any portion of such financing consisting of forgiveness of debt or other obligations), we are required to redeem the Debentures for 150% of the amount of the then outstanding Debentures. If trading in our common stock is suspended (other than suspensions of trading on such market or exchange generally or temporary suspensions pending the release of material information) for more than ten trading days, or if our common stock is delisted from the exchange, market or system on which it is then traded and not relisted on another exchange, market or the Over the Counter Bulletin Board within 10 trading days, HEM may elect to require us to redeem all then outstanding Debentures and any shares of our common stock held by HEM through prior conversions at a price equal to the sum of the aggregate market value of the common stock then held by HEM through prior conversions plus the value of all unconverted Debentures then held by HEM, calculated in each case in the manner set forth in the Purchase Agreement. We would owe an interest penalty of 8% per year on any payments not made within 7 business days of a redemption request made pursuant to the preceding sentence.

Pursuant to the Purchase Agreement, until December 22, 2003, we are prohibited from offering or issuing any floorless convertible security or any equity line of credit, although we may enter into any other debt or equity financing during such period. In addition, HEM has the right to participate in any debt or equity financing offered by us during the 30-day period following December 22, 2003.

Until such time as it no longer holds any Debentures, neither HEM nor its affiliates may engage in any short sales of our common stock if there is no offsetting long position in our common stock then held by HEM or such affiliates.

On October 20, 2003 the Company entered into a private placement of 210,000 shares of its common stock to two accredited investors and received $84,000 in proceeds.

Note 5 - Legal Proceedings

On June 23, 2003 Xmark Funds, L.P. et al, filed a complaint in the United States District Court, Southern District of New York against the Company alleging that the Company breached the terms of the term sheet signed between Xmark Funds and the Company in May 2003, by not accepting an investment from Xmark Funds. The complaint seeks monetary damages. On July 14, 2003, we filed an answer to the complaint. Legal fees related to this litigation are expensed as incurred. The outcome of this matter cannot be determined at this time and therefore no other contingent liabilities have been recorded.

On or about October 8, 2003, Thai Nguyen filed a complaint in the Superior Court of California, County of San Francisco, against us, our chief executive officer, Kumar Chandrasekaran, the Regents of the University of California, or “Regents,” and two individuals associated with the Regents. Mr. Nguyen alleges that InSite Vision breached an obligation to continue supporting his research; he has also made a variety of other related claims and allegations against us and the other defendants. The Complaint seeks both monetary and injunctive relief. Mr. Nguyen has filed a motion to enjoin InSite Vision during the pendency of the litigation from alienating the license rights held by InSite Vision relating to the subject of Mr. Nguyen’s research, and hawse have opposed such motion. Neither we nor Dr. Chandrasekaran have yet filed a response to the complaint. A preliminary hearing on this matter is scheduled for November 20, 2003.

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

Except for the historical information contained herein, the discussion in this Quarterly Report on Form 10-Q contains certain forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. The cautionary statements made in this document should be read as applicable to all related forward-looking statements wherever they appear in this document. Our actual results could differ materially from those discussed herein. Factors that could cause or contribute to such differences include our ability to raise significant and immediate additional financing and other factors those discussed below in “Risk Factors,” as well as those discussed elsewhere herein. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to update any forward- looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

The following discussion should be read in conjunction with the financial statements and notes thereto included in this Quarterly Report and in our Annual Report on Form 10-K for the year ended December 31, 2002.

Overview

As of September 30, 2003, our accumulated deficit was approximately $114.4 million. Absent additional funding from private or public equity or debt financings, collaborative or other partnering arrangements, or other sources, as of November 14, 2003 we expect that our cash on hand, anticipated cash flow from operations and current cash commitments to us will only be sufficient to fund our operations until approximately the beginning of December 2003. See “ —Liquidity and Capital Resources.” There is no assurance that such additional funds will be available for us to finance our operations on acceptable terms, if at all. If such funds are not available, management will be required to cease all operations and liquidate our remaining assets, most of which are secured by a note to an officer who is also a board member. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from our inability to obtain funding and resultant ceasing of operations. There can be no assurance that we will ever achieve or be able to maintain either significant revenues from product sales or profitable operations.

We are an ophthalmic product development company focused on developing genetically-based technology, for the diagnosis, prognosis and management of glaucoma, as well as ophthalmic pharmaceutical products based on our proprietary DuraSite® eyedrop-based drug delivery technology. In addition, we have a retinal program that includes both a therapeutic agent and a retinal drug delivery technology.

We are focusing our commercial efforts and research and development on the following:

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targeted market introduction of our OcuGene® glaucoma genetic test based on our ISV-900 technology;

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expanding our ISV-900 technology for the diagnosis, prognosis and management of glaucoma;

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ISV-205, a DuraSite formulation for the treatment of glaucoma;

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ISV-401, a DuraSite formulation of azithromycin, an antibiotic not currently used in ophthalmology;

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ISV-403, a DuraSite formulation of a fourth generation fluoroquinolone;

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ISV-014, a retinal drug delivery device; and

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treatments for diabetic retinopathy and macular degeneration.

Glaucoma Genetics. Our glaucoma genetics program, which has been pursued in collaboration with academic researchers, is focused on discovering genes that are associated with glaucoma, and the mutations on these genes that cause and regulate the severity of the disease. This genetic information then may be applied to develop new glaucoma diagnostic, prognostic and management tools. The first of these new tools, OcuGene, our genetic test to determine if an individual has a higher risk of developing a more aggressive form of glaucoma, is being introduced into targeted markets and was first introduced to the medical community at the end of 2001. Development of additional clinical data will be necessary to clarify the market utility of OcuGene.

In June 2003, a peer-reviewed study was published in Clinical Genetics titled “Association of the Myocilin mt.1 Promoter Variant with the Worsening of Glaucomatous Disease Over Time,” (2003: 64: 18-27). The study is based on information gathered at Philadelphia-based Wills Eye Hospital from 147 patients with primary open-angle glaucoma (POAG) who were followed for an average of approximately 15 years. Investigators conducted analyses that were controlled for various relevant disease-related baseline risk factors, including age, family history, initial drug treatment, initial surgical treatment, diabetes, gender, myopia and initial disease severity.

“The results of this study indicate substantial evidence that the TIGR/MYOC mt.1(+) variant provides a strong marker for accelerated worsening of both optic disc and visual field measures of glaucoma progression above and beyond other baseline risk factors,” stated one of the authors of the study, Jon Polansky, M.D., University of California, San Francisco. Our OcuGene glaucoma genetic test screens for the TIGR/MYOC mt.1(+) variant.

In December 2002, we entered into an agreement with Società Industria Farmaceutica Italiana, or SIFI, that grants them the exclusive right to manufacture/perform, distribute and market OcuGene in Italy for eight years. We believe that SIFI intends to launch the OcuGene test before the end of 2003.

To date, our academic collaborators have identified genes associated with POAG (the most prevalent form of glaucoma in adults), normal tension glaucoma, juvenile glaucoma and primary congenital glaucoma, or PCG. Our academic collaborators for our glaucoma genetics program include: the University of California, San Francisco, or UCSF; the University of Connecticut Health Center, or UCHC; Institute National de la Sante et de la Recherche Medicale, or INSERM, which is the French equivalent of US National Institutes of Health; Okayama University in Japan; and other institutions in North America and Europe. This research, other than what has been incorporated into our OcuGene test, still must be converted into commercial products.

DuraSite-Based Product and Candidates. Our DuraSite delivery system is a patented eyedrop formulation comprising a cross-linked carboxyl-containing polymer that incorporates the drug to be delivered to the eye. The formulation is instilled in the cul-de-sac of the eye as a small volume eyedrop and remains in the eye for up to several hours during which time the active drug ingredient is gradually released. This increased residence time is designed to permit lower concentrations of a drug to be administered over a longer period of time, thereby minimizing the inconvenience of frequent dosing and reducing potential related adverse side effects. Eyedrops delivered in the DuraSite system contrast to conventional eyedrops, which typically only last a few minutes in the eye and, thus, require delivery of a highly concentrated burst of drug and frequent administration to sustain therapeutic levels. DuraSite can be customized to deliver a variety of compounds with a broad range of molecular weights and other properties.

The development of our ISV-205 product candidate, containing diclofenac, a non-steroidal anti-inflamatory

drug currently used to treat ocular inflammation, is another result of our glaucoma genetics research. This DuraSite formulation contains a drug that has been shown in cell and organ culture systems to inhibit the production of a protein that appears to block the outflow of fluid from the eye, which is believed to be related to glaucoma. The ISV-205 product candidate delivers concentrations of diclofenac necessary in cell cultures to inhibit the production of the TIGR protein.

A Phase 2a clinical study of ISV-205 was successfully completed in 1999 to evaluate the efficacy of two concentrations of diclofenac. Analysis of the data from this study indicates that ISV-205 was safe and associated with a 75% reduction in the number of subjects with clinically significant intraocular pressure elevation following steroid use.

In 2001 we completed a Phase 2b clinical study of ISV-205 in 233 subjects with ocular hypertension. Genetic information was collected on the subjects using our ISV-900 technology and the subjects were dosed twice daily with ISV-205 for six months. Our ISV-900 technology detected the TIGR mt-1 or mt-11 mutations in approximately 70% of the ocular hypertensives participating in the study. In patients with the TIGR mutations, a 0.1% formulation of ISV-205 was statistically significantly more effective than placebo in lowering intraocular pressure (p=0.008). These effects were not seen to the same extent in patients without the TIGR mutations. ISV-205 was similar to placebo in ocular safety and comfort in all patients. Further clinical studies must be completed before we file for product approval with the U.S. Food and Drug Administration, or FDA. However, we cannot assure you that similar clinical results will be achieved. We are currently seeking a partner for this product candidate and have placed further development on hold until additional financing is obtained.

ISV-401 is an ophthalmic formulation of azithromycin, a broad-spectrum antibiotic that has not previously been used in ophthalmology. The antibiotic has a proven safety and efficacy record in both adult and pediatric populations when used orally. Depending on the indication, current ophthalmic antibiotics must be dosed as often as every 15 to 30 minutes on the first day and then tapered off to a maintenance dose of four times a day for the remainder of the treatment period, which may be up to fourteen days. This may result in patient compliance issues that could be minimized with an improved product. The clinical dosing frequency for ISV-401 appears to be significantly less than that for currently available treatments.

In September 2001, we conducted a Phase 1 clinical trial of ISV-401 that indicated the formulation was safe and well tolerated when used in the eye. In September 2002, we announced the results of our Phase 2 clinical trial using a 1.0% formulation of ISV-401, compared to a placebo, to treat bacterial conjunctivitis. The study results indicated that ISV-401 achieved both clinical resolution, (i.e. absence of redness and discharge) and bacterial eradication over both gram-positive and gram-negative strains of acute bacterial conjunctivitis. This study demonstrated that a total of six drops of ISV-401 administered over five consecutive days produced comparable clinical results to those achieved with currently marketed drugs, which require dosing of approximately thirty-five drops administered over seven consecutive days. Based on the analysis of data from the Phase 2 clinical trial, we have presented plans for Phase 3 clinical trials to the FDA.

ISV-403 is a formulation of a fluoroquinolone in the DuraSite system. Fluoroquinolones are effective against gram-positive and gram-negative bacteria including Pseudomonas, and are often used as prophylaxis during ophthalmic surgery. Based on recently conducted preclinical testing, it was determined that this is a fourth-generation fluoroquinolone, which has expanded bacterial sensitivities and may be effective against the bacteria that have developed resistance to prior generation fluoroquinolones and other antibiotics. In addition, based on preclinical studies, we believe the ISV-403 formulation may allow for reduced dosing frequency compared to other fluoroquinolone formulations currently on the market. In February 2003 we filed an Investigational New Drug Application, or IND, with the FDA and in April 2003 we began a Phase 1 clinical trial of ISV-403. In June 2003 the dosing for the study was completed and the data is being compiled and analyzed.

ISV-403 was licensed to Bausch & Lomb in August 2002. Under the terms of the Bausch & Lomb License Agreement, we are responsible for the clinical development of ISV-403 through New Drug Approval from the FDA, and Bausch & Lomb is responsible for subsequent commercial manufacturing and marketing. Bausch & Lomb is required to make preferred equity investments in us as product milestones are achieved. The Bausch & Lomb License Agreement grants Bausch & Lomb rights to market ISV-403, subject to payment of royalties, in all

geographies except Japan (which were retained by SSP Co., Ltd., or SSP, in connection with a separate license agreement between us and SSP), with such rights being shared with SSP in Asia (except Japan) and exclusive elsewhere.

The first product utilizing our DuraSite technology is AquaSite^®, a DuraSite formulation containing demulcents for the systematic treatment of dry eye. CIBA Vision Ophthalmics, or CIBA Vision launched AquaSite in the U.S. as an over-the-counter medication in October 1992, pursuant to certain co-exclusive licensing arrangements with us. We receive a royalty on sales of AquaSite by CIBA Vision. In March 1999, we granted Global Damon Pharm, a Korean company, rights to be the exclusive distributor of AquaSite in the Republic of Korea under a ten-year royalty-bearing license. In August 1999, we entered into a ten year royalty-bearing license with SSP for the manufacture and distribution of AquaSite in Japan. In addition, we will be the sole supplier to SSP of some of the key ingredients necessary for the manufacture of AquaSite.

Retinal Delivery Device. ISV-014 is a device designed to provide controlled, non-surgical delivery of ophthalmic drugs to the retina and surrounding tissues. We have enhanced the device by collaborating with various academic researchers to perform in vivo experiments delivering products with a variety of molecular sizes to retinal tissues. The combination of this device technology with polymer-based drug platforms may permit long-term delivery of therapeutic agents to treat several retinal diseases, most of which cannot be effectively treated at the present time.

Business Strategy. Our business strategy is to license promising product candidates and technologies from academic institutions and other companies, to conduct preclinical and clinical testing, if necessary, and to partner with pharmaceutical companies to complete clinical development and regulatory filings as needed and to manufacture and market our products. We also have internally developed DuraSite-based product candidates using either non-proprietary drugs or compounds developed by others for non-ophthalmic indications. As with in-licensed product candidates, we either have or plan to partner with pharmaceutical companies to complete clinical development and commercialization of our own product candidates.

Since our inception through the end of 2001, we had not received any revenues from the sale of our products, although we have received a small amount of royalties from the sale of our AquaSite product by CIBA Vision and Global Damon. In the fourth quarter of 2001, we commercially launched our OcuGene glaucoma genetic test and early in 2002 we began to receive a small amount of revenues from the sale of this test. With the exception of 1999, we have been unprofitable on an annual basis since our inception due to continuing research and development efforts, including preclinical studies, clinical trials and manufacturing of our product candidates. We have financed our research and development activities and operations primarily through private and public placement of our equity securities, issuance of convertible debentures and, to a lesser extent, from collaborative agreements and bridge loans.

Results of Operations

We earned revenues in the third quarter of 2003 and 2002 of $4,000 and $9,000, respectively, and $8,000 and $26,000 for the nine months ended September 30, 2003 and September 30, 2002, respectively, from sales of OcuGene and sales of AquaSite^® by CIBA Vision and Kukje Pharma Ind. Co., Ltd., our AquaSite manufacturing partner in Korea. The decrease in revenue is due to reduced royalties resulting from lower sales of AquaSite during both the third quarter and the first nine months of 2003 compared to the third quarter and first nine months of 2002. We recognize revenue when all services have been performed and collectibility is reasonably assured. Accordingly, revenue for the sales of OcuGene may be recognized in a later period than the associated recognition of costs of the services provided, especially during the initial launch of the product.

Cost of goods of $5,000 and $25,000 in the third quarters of 2003 and 2002, respectively, and $17,000 and $57,000 for the nine months ended September 30, 2003 and 2002, respectively, reflect the cost of OcuGene tests performed as well as the cost of sample collection kits distributed for use. Both in the third quarter, and first nine months, of 2002 a large number of OcuGene test kits were distributed, as the product was made initially available to interested parties. A significantly lower number of units were shipped in both the third quarter, and first nine months of 2003.

Research and development expenses decreased to $0.8 million during the third quarter of 2003 from $1.9 million during the third quarter of 2002. The 58% decrease in research and development expenses reflects cost containment efforts initiated in the second quarter of 2003. In May 2003, we instituted a one-month furlough, which included 70% of our research and development personnel. In June 2003, approximately 70% of the furloughed personnel were laid-off. In the third quarter of 2003 we also continued to reduce our financial support of the research related to our genetics programs by not renewing certain research contracts pending the receipt of additional funding. In a further effort to reduce expenses, we have reviewed, and will continue to review, our patent filings and will discontinue maintenance of patents and patent applications related to programs that we have determined not to pursue.

Research and development expenses decreased to $3.5 million from $5.7 million for the first nine months of 2003 compared to the first nine months of 2002. This 39% decrease reflects the personnel cost containment actions taken in the second quarter of 2003 and the reduction in support for external research which was begun in the first quarter of 2003. Additionally, costs incurred in the first nine months of 2002 for the license of the Optineuron gene from UCHC and the related cost of new patent filings, were not incurred in the first nine months of 2003 as the majority of the initial filings were completed in 2002.

In the first nine months of 2003, we received no cost reimbursement. In the first nine months of 2002 we received $66,000 of cost reimbursement related to a retinal research program, which was completed in 2002.

Selling, general and administrative expenses decreased to $599,000 during the third quarter of 2003 from $1.2 million during the second quarter of 2002. Selling expenses decreased approximately $437,000 related to the scale-back of marketing expenses that had been incurred in the third quarter of 2002 related to the initial market introduction of OcuGene, such as advertising and our limited initial contract sales force. In May 2003, we instituted a one-month furlough, which included approximately 64% of our selling, general and administrative personnel. In June 2003, approximately 43% of the furloughed personnel were laid-off and an additional 29% had their part-time hours reduced. Additionally, voluntary salary reductions taken by senior management at the end of the first quarter of 2003 were continued in effect throughout the third quarter of 2003. These activities resulted in a decrease in personnel expenses of approximately $246,000. Expenses related to our insurance coverage, including directors and officers liability insurance, increased approximately 45% during the third quarter of 2003 compared to the third quarter of 2002, reflecting an increase in premiums that we believe is consistent with increases in such premiums in the industry generally. During the third quarter of 2003 legal and financial service costs increased approximately $198,000 due to fund raising efforts including the acquisition of Ophthalmic Solutions, Inc. Overall, the decline in expenses related to OcuGene and reductions in our personnel-related costs more than offset our increased legal and financial service and insurance coverage expenses and resulted in an overall decrease in selling, general and administrative expenses of approximately 41% in the third quarter of 2003 compared to the third quarter of 2002.

Selling, general and administrative expenses decreased to $2.0 million during the first nine months of 2003 from $3.1 million during the first nine months of 2002. This reflects the approximately 86% decrease in selling expenses related to the initial market introduction of OcuGene, such as advertising and our limited initial contract sales force. The remaining decrease includes the impact of the reductions in personnel-related costs due to the furlough, lay-off and voluntary salary reductions. While our legal costs related to our fund raising efforts and the cost of our insurance coverage, including directors and officers insurance increased approximately 52% for the first nine months of 2003 compared to the first nine months of 2002, these costs were more than offset by the other expense containment measures.

Net interest, other income and expense was an expense of $9,000 in the third quarter of 2003 compared to income of $10,000 in the third quarter of 2002. This decrease is due principally to lower average cash balances, interest expense related to the short-term notes payable and $2,000 of interest expense related to the debt discount of the convertible debentures. As of September 30, 2003 $498,000 of the original debt discount remained and will be amortized over the life of the notes. Any interest earned or paid in the future will be dependent on our ability to raise additional funding and prevailing interest rates.

We incurred net losses applicable to common stockholders of $1.5 million and $3.1 million during the third quarter of 2003 and 2002, respectively. This decrease reflects the 66% decrease in personnel related expense due to

the employee furlough, subsequent lay-off and voluntary salary reduction by senior management, partially offset by the increase in legal costs, financial services and directors and officers insurance costs. It also reflects the decrease in external research activities and selling expenses related to the launch of OcuGene.

We incurred net losses applicable to common stockholders of $5.8 million and $8.7 million during the first nine months of 2003 and 2002, respectively. This 33% decrease was due to the scale-back of 2002 activities, such as our licensing of the Optineuron gene and the related patent activities and the selling, general and administrative expenses we incurred in 2002 as we began the launch of OcuGene. Additionally, personnel related expenses decreased 34% due to the employee furlough, subsequent lay-off and voluntary salary reduction by senior management.

If we are able to obtain funding and continue our operations, we anticipate that our net losses in the fourth quarter will be comparable to third quarter excluding the interest expense impact of our convertible debentures, as the expense reduction measures we have undertaken are continued. The actions we have taken include laying-off approximately 42% of our employees, voluntary salary reductions by our senior management team, ceasing work on all non-critical external activities, extending payment terms on our trade payables, and other cost containment measures. Although it is not possible to anticipate all potential effects the implementation of these expense control activities will have on us or our development, we expect that among other things, these activities will delay the initiation of Phase 3 clinical trials on ISV-401 and will impact our ability to promote OcuGene. The extent and ramifications of these delays will be dependent upon our ability to obtain financing, the timing of the receipt of such financing and the amount of such financing, if any.

Liquidity and Capital Resources

Through 1995, we financed our operations primarily through private placements of preferred stock, totaling approximately $32 million, and an October 1993 public offering of Common Stock, which resulted in net proceeds of approximately $30 million. After 1995, we financed our operations primarily through a January 1996 private placement of Common Stock and warrants resulting in net proceeds of approximately $4.7 million and an April 1996 public offering which raised net proceeds of approximately $8.1 million. In accordance with a July 1996 agreement with B&L, we received a total of $2.0 million from the sale of Common Stock in August 1996 and 1997. In September 1997, we completed a $7.0 million private placement of 7,000 shares of Series A Redeemable Convertible Preferred Stock resulting in net proceeds of approximately $6.5 million. In January 1999, we entered into a transaction with Pharmacia from which we received a total of $3.5 million from the sale of Common Stock in January 1999 and September 1999. In November 1999, we entered into another transaction with Pharmacia from which we received a $5.0 million licensing fee and, in January 2000, received $2.0 million from the sale of Common Stock. In April 2000, we received $0.6 million from the issuance of Common Stock from the exercise of warrants issued as part of the 1995 private placement. In May 2000, we completed a private placement of Common Stock and warrants from which we received net proceeds of approximately $13.0 million. During 2000, 2001, and 2002, we also received $243,000, $71,000, and $123,000 respectively, from the issuance of Common Stock upon the exercise of stock options and sales of Common Stock through our Employee Stock Purchase Plan. In August 2002, we received $2.0 million from the issuance of 2,000 shares of Series A-1 Preferred Stock to Bausch & Lomb in connection with the licensing of our antibiotic program ISV-403. In February 2003, we received $2.0 million for the issuance of an additional 2,000 shares of Series A-1 Preferred Stock to Bausch & Lomb related to reaching the first milestone under the ISV-403 license. In May and June 2003 the Company received $288,500 from the issuance of short-term notes payable from members of the Board of Directors, senior management and other stockholders. In July and August 2003, we received short-term financing of $500,000, which is secured by substantially all of our assets from an officer who is also a member of the Board of Directors and other investors affiliated with a member of senior management. In September 2003, we received $500,000 from the acquisition of Ophthalmic Solutions, Inc. and the related assumption of convertible debentures. In October 2003, we received $84,000 from the issuance of Common Stock from a private placement. In November 2003, we received an additional $500,000 related to the repayment of a promissory note originally issued to Ophthalmic Solutions in connection with the convertible debentures assumed from Ophthalmic Solutions. At September 30, 2003, our cash and cash equivalents balance was $150,000 compared to $1.2 million as of December 31, 2002. It is our policy to invest our cash and cash equivalents, if any, in highly liquid securities, such as interest bearing money market funds, Treasury and federal agency notes and corporate debt.

We are currently engaged in discussions with several institutional investors and potential collaborative partners to obtain sufficient interim funding prior to the beginning of December 2003 that, if obtained, we believe would enable us to continue operations for an additional 90 to 120 days. If we are able to secure such interim funding, we are hopeful that we would be able to secure longer term financing or collaborative arrangements prior to exhausting such interim funding. However, there can be no assurance that we will be able to obtain such interim funding on acceptable terms or at all, or, if we obtain such interim funding, that we will be able to obtain longer term financing or collaborative arrangements to enable us to continue our operations.

We have undertaken a number of measures to reduce our short term operating expenses to allow us to continue operations without additional financing through approximately the beginning of December 2003, including: laying-off approximately 42% of our employees, voluntary salary reductions by our senior management team,

ceasing work on all non-critical external activities, extending payment terms on our trade payables, working with our landlord to restructure our lease obligations, and other cost containment measures. However, even with these expense reductions, as of November 14, 2003, we expect our cash on hand, anticipated cash flow from operations and current cash commitments to us will only be sufficient to fund our operations as currently conducted through approximately the beginning of December 2003. If we are unable to complete an interim financing transaction prior to that time, we will cease operations and liquidate our assets. In addition, there can be no assurance that we will be able to successfully implement these expense reduction plans or that we will be able to do so without significantly harming our business, financial condition or results of operations. In order to continue long-term operations we will require and are seeking additional funding through public or private equity or debt financings, collaborative or other partnering arrangements, and from other sources. However, there can be no assurance that we will obtain interim or longer-term financing or that such funding, if obtained, will be sufficient to continue our operations as currently conducted or in a manner necessary for the long-term success of our company. If we raise funds through the issuance of debt securities, such debt will be secured by a security interest or pledge of all of our assets, will require us to make principal and interest payments, would likely include the issuance of warrants and may subject us to restrictive covenants. In addition, our stockholders may suffer substantial dilution if we raise additional funds by issuing equity securities.

Net cash used in operating activities was $4.5 million and $8.6 million for the nine months ended September 30, 2003 and 2002, respectively. Operating activities in the third quarter of 2003 related primarily to research and development expenditures for our antibiotic programs ISV-403 and ISV-401, and the expenses incurred related to the on-going launch of OcuGene. The reduction in net cash used in operating activities primarily reflects the termination of certain genetic research programs, reduction in patent maintenance, lower marketing costs related to OcuGene, and reductions in personnel-related costs.

Net cash used in investing activities of $23,000 and $58,000 for the first nine months of 2003 and 2002, respectively, reflected the acquisition of laboratory and other equipment. The expenditures in the first nine months of 2003 primarily related to obtaining equipment related to the manufacture of Phase 1 and Phase 2 clinical units for ISV-403 in our pilot facility.

Cash provided by financing activities was $3.5 million in the first nine months of 2003 compared to $2.1 million in the first nine months of 2002. We received $2.0 million in the first quarter of 2003 from the issuance of 2,000 shares of our Series A-1 preferred stock to Bausch & Lomb under the ISV-403 license agreement. We issued $946,000 of short-term notes payable in the first nine months of 2003 to directors, members of senior management and other stockholders. These notes bear interest at rates from 2% to 12% and are due from December 15, 2003 through December 31, 2003. We received $392,000, net of debt issuance costs of approximately $108,000, from the issuance of convertible debentures. These debentures bear interest at a rate of 1% and are due on September 21, 2008. On September 22, 2003 We received $3,000 in the first nine months of 2003 from the issuance of our common stock from the exercise of stock options by employees compared to $93,000 in the first nine months of 2002. We received payments on a note to a stockholder of $23,000 and $26,000 in the nine months ended September 30, 2003 and 2002, respectively. We also made $14,000 of payments on capital leases for certain laboratory equipment in the first nine months of 2003 compared to $24,000 in the first nine months of 2002.

Assuming we are able to obtain additional financing and continue our operations, our future capital expenditures and requirements will depend on numerous factors, including the progress of our research and development programs and preclinical and clinical testing, the time and costs involved in obtaining regulatory approvals, our ability to successfully commercialize OcuGene and any other products that we may launch in the future, our ability to establish collaborative arrangements, the cost of filing, prosecuting, defending and enforcing patent claims and other intellectual property rights, competing technological and market developments, changes in our existing collaborative and licensing relationships, acquisition of new businesses, products and technologies, the completion of commercialization activities and arrangements, and the purchase of additional property and equipment.

We anticipate no material capital expenditures to be incurred for environmental compliance in fiscal year 2003. Based on our environmental compliance record to date, and our belief that we are current in compliance with applicable environmental laws and regulations, environmental compliance is not expected to have a material adverse effect on our operations.

RISK FACTORS

We Require Immediate Significant Additional Funding to Continue our Operations and If We Do Not Receive Such Funding We Will Cease Operations and Liquidate our Assets, Which are Secured by Notes Payable to an Officer who is also a Board Member.

In their audit report accompanying our Annual Report on Form 10-K for the fiscal year ended December 31, 2002, our auditors included an explanatory paragraph referring to our recurring operating losses and a substantial doubt about our ability to continue as a going concern. Absent additional funding from private or public equity or debt financings, collaborative or other partnering arrangements, asset sales or other sources, our cash on hand, anticipated cash flow from operations and current cash commitments to us will only be adequate to fund our operations until approximately the beginning of December 2003, notwithstanding expense reduction measures we have undertaken. Although we are currently engaged in discussions with several institutional investors and potential collaborative partners to obtain sufficient interim funding prior to the beginning of December 2003 that we believe would enable us to continue operations for an additional 90 to 120 days, we may not be able to obtain such interim funding on acceptable terms or at all. If such funds are not available, management will be required to cease all operations and liquidate our remaining assets. Moreover, even if we obtain sufficient interim funding to enable us to continue our operations beyond the beginning of December 2003, we will require substantial additional funding to enable us to continue long term operations, to develop and conduct testing on our potential products, to support our sales and marketing efforts for our OcuGene glaucoma genetic test and, if we decide to do so, to independently manufacture or market any of our other products. There can be no assurance that we would be able to receive such additional long term financing. If we do not obtain such long term financing we will be unable to pay off any interim financing we receive and would have to cease operations and liquidate our assets. In addition, since the release of the audit report accompanying our Annual Report on Form 10-K for the fiscal year ended December 31, 2002, our financial condition has continued to deteriorate and our stock price has declined and our stock price may continue to decline given our current financial situation.

We are seeking both short term and long term additional funding through public or private equity or debt financings, collaborative or other partnering arrangements, asset sales and from other sources. However, our current financial situation may harm our ability to obtain additional funding and could make the terms of any such funding, if available, significantly less favorable than would otherwise be the case. Our board of directors has the authority to determine the price and terms of any sale of common stock and the rights, preferences and privileges of any preferred stock or debt or other security that is convertible into or exercisable for the common stock. The terms of any securities issued to future investors may be superior to the rights of our common stockholders, could result in substantial dilution and could adversely affect the market price for our common stock.

Our stockholders may suffer substantial dilution if we raise additional funds by issuing equity securities. If we raise funds through the issuance of debt securities, such debt will be secured by a security interest or pledge of all of our assets, will require us to make principal and interest payments, would likely include the issuance of warrants, and may subject us to restrictive covenants. However, if we cannot raise sufficient additional funding, we will be required to cease operations and liquidate our assets.

Assuming we are able to raise additional funding and continue our operations, our future capital requirements will depend upon many factors, including:

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the cost of maintaining or expanding a marketing organization for OcuGene and the related promotional activities;

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the progress of our research and development programs;

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our ability to establish additional corporate partnerships to develop, manufacture and market our potential products;

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the progress of preclinical and clinical testing;

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changes in, or termination of, our existing collaboration or licensing arrangements;

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whether we manufacture and market any of our other products ourselves;

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the time and cost involved in obtaining regulatory approvals;

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the cost of filing, prosecuting, defending and enforcing patent claims and other intellectual property rights;

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competing technological and market developments; and

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the purchase of additional capital equipment.

Our Management has Undertaken a Number of Measures to Reduce our Operating Expenses, but These Measures Will Not Alone be Sufficient to Enable us To Continue Operations Beyond the Beginning of December 2003 and May Have Other Negative Consequences

Our management has implemented plans designed to reduce our cash requirements through reductions in operating expenditures. The actions we have taken include laying-off approximately 42% of our employees, voluntary salary reductions by our senior management team, ceasing work on all non-critical external projects, extending payment terms on our trade payables, working with our landlord to restructure our lease obligations, and other cost containment measures. Although it is not possible to anticipate all potential effects the implementation of these expense control measures will have on us or our development, we expect that among other things, these activities will delay the initiation of Phase 3 clinical trials on ISV-401 and will impact our ability to promote OcuGene. The extent and ramifications of these delays will be dependent upon our ability to raise additional financing, the timing of the receipt of financing and the amount of such financing, if any. However, even with these expense reductions, our current cash on hand, anticipated cash flow from operations and current cash commitments to us are only sufficient to fund our operations through approximately the beginning of December 2003. If we are unable to complete a financing transaction, collaborative arrangement or asset sale prior to that time, we will cease operations and liquidate our assets. In addition, there is no assurance that these expense reduction efforts will enable us to continue operations or that if we do survive we have not significantly harmed our business or prospects.

It Is Difficult to Evaluate Our Business Because We Are in an Early Stage of Development and Our Technology Is Untested

We are in an early stage of developing our business. We have only received an insignificant amount of royalties from the sale of one of our products, an over-the-counter dry eye treatment, and in 2002 we began to receive a small amount of revenues from the sale of our OcuGene glaucoma genetic test. Before regulatory authorities grant us marketing approval for additional products, we need to conduct significant additional research and development and preclinical and clinical testing. All of our products are subject to risks that are inherent to products based upon new technologies. These risks include the risks that our products:

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are found to be unsafe or ineffective;

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fail to receive necessary marketing clearance from regulatory authorities;

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even if safe and effective, are too difficult or expensive to manufacture or market;

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are unmarketable due to the proprietary rights of third parties; or

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are not able to compete with superior, equivalent or more cost-effective products offered by competitors.

Therefore, our research and development activities may not result in any commercially viable products.

We Are dependent Upon Key Employees and We May Not Be Able to Retain or Attract Key Employees, and Our Ability to Attract and Retain Key Employees is Likely to be Harmed by Our Current Financial Situation

We are highly dependent on Dr. Chandrasekaran, who is our chief executive officer, president and chief financial officer, and on other principal members of our scientific and management team. The loss of services from any of these key personnel might significantly delay or prevent the achievement of planned development objectives. Furthermore, a critical factor to our success will be recruiting and retaining qualified personnel. Competition for skilled individuals in the biotechnology business is highly intense, and we may not be able to continue to attract and retain personnel necessary for the development of our business. Our ability to attract and retain such individuals is likely to be significantly reduced by our current financial situation. For example, we have recently layed-off approximately 42% of our employees and our senior management has agreed to accept reduced salaries. These measures and other cost reduction measures we have undertaken make it more likely that such individuals will seek other employment opportunities and may leave our company permanently. The loss of key personnel or the failure to recruit additional personnel or to develop needed expertise could harm our business.

Questions Concerning Our Financial Condition May Cause Customers and Current and Potential Partners to Reduce or Not Conduct Business with Us

Due to our present financial condition and concerns regarding our ability to continue operations, customers and current and potential partners may decide not to conduct business with us, may reduce or terminate the business they conduct with us, or may conduct business with us on terms that are less favorable than those customarily offered by them. In that event, our sales would likely decrease, our product development efforts would suffer and our business will be significantly harmed.

We Have a History of Operating Losses and We Expect to Continue to Have Losses in the Future

We have incurred significant operating losses since our inception in 1986 and have pursued numerous drug development candidates that did not prove to have commercial potential. As of September 30, 2003, our accumulated deficit was approximately $114.4 million. We expect to incur net losses for the foreseeable future or until we are able to achieve significant royalties or other revenues from sales of our products. In addition, we recognize revenue when all services have been performed and collectibility is reasonably assured, accordingly, revenue for the sales of OcuGene may be recognized in a later period than the associated recognition of costs of the services provided, especially during the initial launch of the product.

Attaining significant revenue or profitability depends upon our ability, alone or with third parties, to successfully develop our potential products, conduct clinical trials, obtain required regulatory approvals and successfully manufacture and market our products. We may not ever achieve or be able to maintain significant revenue or profitability.

We Rely on Third Parties to Develop, Market and Sell Our Products, We May Not Be Able to Continue or Enter into Third Party Arrangements, and these Third Parties’ Efforts May Not Be Successful

Following the termination of our ISV-900 agreement with Pharmacia in December 2000, we began to develop a marketing organization focused on the launch of our OcuGene glaucoma genetic test. We do not plan on establishing a dedicated sales force or a marketing organization for our other product candidates and primarily use external marketing and sales resources even for OcuGene. We also rely on third parties for clinical testing or product development. In addition, in May 2001, Pharmacia terminated the licensing agreement we had entered into with them in January 1999, that granted Pharmacia an exclusive worldwide license for ISV-205 for the treatment of glaucoma. We now must enter into another third party collaboration agreement for the development, marketing and sale of our ISV-205 product or develop, market and sell the product ourselves. There can be no assurance that we will be successful in finding a new corporate partner for our ISV-205 program or that any collaboration will be

successful, either of which could significantly harm our business. In addition, we have no experience in marketing and selling products and we cannot assure you that we would be successful in marketing ISV-205 ourselves. If we are to successfully develop and commercialize our product candidates, including ISV-205, we will be required to enter into arrangements with one or more third parties that will:

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provide for Phase 2 and/or Phase 3 clinical testing;

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obtain or assist us in other activities associated with obtaining regulatory approvals for our product candidates; and

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market and sell our products, if they are approved.

In August 2002, we entered into a license agreement with Bausch & Lomb related to our antibiotic program ISV-403. The Bausch & Lomb License Agreement grants Bausch & Lomb rights to market ISV-403, subject to payment of royalties, in all geographies except Japan (which were retained by SSP, in connection with a separate license agreement between us and SSP), with such rights being shared with SSP in Asia (except Japan) and exclusive elsewhere. The foregoing is contingent on our ability to receive the appropriate approvals from the FDA and the other appropriate international regulatory agencies.

We are marketing and selling our OcuGene glaucoma genetic test mainly using external marketing and sales resources that include:

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marketing consultants;

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a network of key ophthalmic clinicians; and

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other resources with ophthalmic expertise.

We may not be able to enter into arrangements with third parties with ophthalmic or diagnostic industry experience on acceptable terms or at all. If we are not successful in concluding such arrangements on acceptable terms, or at all, we may be required to establish our own sales force and significantly expand our marketing organization, despite the fact that we have no experience in sales, marketing or distribution. Even if we do enter into collaborative relationships, as we have recently experienced with Pharmacia, these relationships can be terminated forcing us to seek alternatives. We may not be able to build a marketing staff or sales force and our sales and marketing efforts may not be cost-effective or successful.

In addition, we currently contract with a third party to assemble the sample collection kits used in our OcuGene glaucoma genetic test. If our assembler should encounter significant delays or we have difficulty maintaining our existing relationship, or in establishing a new one, our sales of this product could be adversely affected.

Our strategy for research, development and commercialization of our products requires us to enter into various arrangements with corporate and academic collaborators, licensors, licensees and others. Furthermore, we are dependent on the diligent efforts and subsequent success of these outside parties in performing their responsibilities.

Because of our reliance on third parties for the development, marketing and sale of our products, any revenues that we receive will be dependent on the efforts of these third parties, such as our corporate collaborators. These partners may terminate their relationships with us and may not diligently or successfully market our products. In addition, marketing consultants and contract sales organizations, such as those deployed by us currently or in the future for OcuGene, may market products that compete with our products and we must rely on their efforts and ability to effectively market and sell our products. We may not be able to conclude arrangements with other companies to support the commercialization of our products on acceptable terms, or at all. Moreover, our current financial condition may make us a less attractive partner to potential collaborators. In addition, our collaborators may take the

position that they are free to compete using our technology without compensating or entering into agreements with us. Furthermore, our collaborators may pursue alternative technologies or develop alternative products either on their own or in collaboration with others, including our competitors, as a means for developing treatments for the diseases or disorders targeted by these collaborative programs.

Our Business Depends Upon Our Proprietary Rights, and We May Not Be Able to Adequately Protect, Enforce or Secure Our Intellectual Property Rights

Our future success will depend in large part on our ability to obtain patents, protect trade secrets, obtain and maintain rights to technology developed by others, and operate without infringing upon the proprietary rights of others. A substantial number of patents in the field of ophthalmology and genetics have been issued to pharmaceutical, biotechnology and biopharmaceutical companies. Moreover, competitors may have filed patent applications, may have been issued patents or may obtain additional patents and proprietary rights relating to products or processes competitive with ours. Our patent applications may not be approved. We may not be able to develop additional proprietary products that are patentable. Even if we receive patent issuances, those issued patents may not be able to provide us with adequate protection for our inventions or may be challenged by others. Furthermore, the patents of others may impair our ability to commercialize our products. The patent positions of firms in the pharmaceutical and genetic industries generally are highly uncertain, involve complex legal and factual questions, and have recently been the subject of much litigation. Neither the United States Patent and Trademark Office nor the courts has developed, formulated, or presented a consistent policy regarding the breadth of claims allowed or the degree of protection afforded under pharmaceutical and genetic patents. Despite our efforts to protect our proprietary rights, others may independently develop similar products, duplicate any of our products or design around any of our patents. In addition, third parties from which we have licensed or otherwise obtained technology may attempt to terminate or scale back our rights.

A number of pharmaceutical and biotechnology companies and research and academic institutions have developed technologies, filed patent applications or received patents on various technologies that may be related to our business. Some of these technologies, applications or patents may conflict with our technologies or patent applications. Such conflicts could limit the scope of the patents, if any, we may be able to obtain or result in the denial of our patent applications or block our rights to exploit our technology. In addition, if the United States Patent and Trademark Office or foreign patent agencies have issued or issue patents that cover our activities to other companies, we may not be able to obtain licenses to these patents at all, or at a reasonable cost, or be able to develop or obtain alternative technology. If we do not obtain such licenses, we could encounter delays in or be precluded altogether from introducing products to the market.

We may need to litigate in order to defend against or assert claims of infringement, to enforce patents issued to us or to protect trade secrets or know-how owned or licensed by us. Litigation could result in substantial

cost to and diversion of effort by us, which may harm our business. We have also agreed to indemnify our licensees against infringement claims by third parties related to our technology, which could result in additional litigation costs and liability for us. In addition, our efforts to protect or defend our proprietary rights may not be successful or, even if successful, may result in substantial cost to us.

We also depend upon unpatented trade secrets to maintain our competitive position. Others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets. Our trade secrets may also be disclosed, and we may not be able to effectively protect our rights to unpatented trade secrets. To the extent that we or our consultants or research collaborators use intellectual property owned by others, disputes also may arise as to the rights in related or resulting know-how and inventions.

Our Current Financial Situation May Impede Our Ability to Adequately Protect or Enforce Our Legal Rights Under Agreements and to Our Intellectual Property

We currently do not have sufficient funds, anticipated cash flow from operations and current cash commitments to us to continue our operations beyond approximately the beginning of December 2003. Our current financial situation may impede our ability to enforce our legal rights under various agreements we are currently a party to or may become a party to due to our inability to incur the costs associated with such enforcement. Similarly, our lack of financial resources makes it more difficult for us to enforce our intellectual property rights, through the filing or maintenance of patents, taking legal action against those that may infringe on our proprietary rights, defending infringement claims against us, or otherwise. Our inability to adequately protect our legal and intellectual property rights may make us more vulnerable to infringement and could harm our business.

We Have No Experience in Commercial Manufacturing and Need to Establish Manufacturing Relationships with Third Parties, and If Contract Manufacturing Is Not Available to Us or Does Not Satisfy Regulatory Requirements, We Will Have to Establish Our Own Regulatory Compliant Manufacturing Capability

We have no experience manufacturing products for Phase 3 and commercial purposes. We have a pilot facility licensed by the State of California to manufacture a number of our products for Phase 1 and Phase 2 clinical trials but not for late stage clinical trials or commercial purposes. Any delays or difficulties that we may encounter in establishing and maintaining a relationship with qualified manufacturers to produce, package and distribute our finished products may harm our clinical trials, regulatory filings, market introduction and subsequent sales of our products.

We currently contract with a third party to assemble the sample collection kits used in our OcuGene glaucoma genetic test. If our assembler should encounter significant delays or we have difficulty maintaining our existing relationship, or in establishing a new one, our sales of this product could be adversely affected.

Contract manufacturers must adhere to Good Manufacturing Practices regulations that are strictly enforced by the FDA on an ongoing basis through the FDA’s facilities inspection program. Contract manufacturing facilities must pass a pre-approval plant inspection before the FDA will approve a new drug application. Some of the material manufacturing changes that occur after approval are also subject to FDA review and clearance or approval. The FDA or other regulatory agencies may not approve the process or the facilities by which any of our products may be manufactured. Our dependence on third parties to manufacture our products may harm our ability to develop and deliver products on a timely and competitive basis. Should we be required to manufacture products ourselves, we:

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will be required to expend significant amounts of capital to install a manufacturing capability;

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will be subject to the regulatory requirements described above;

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will be subject to similar risks regarding delays or difficulties encountered in manufacturing any such products; and

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will require substantial additional capital than we otherwise may require.

Therefore, we may not be able to manufacture any products successfully or in a cost-effective manner.

We Have No Experience in Performing the Analytical Procedures Related to Genetic Testing and Have Established an Exclusive Commercial Agreement with a Third Party to Perform These Procedures For Our OcuGene Glaucoma Genetic Test. If We Are Unable to Maintain this Arrangement, and Are Unable to Establish New Arrangements with Third Parties, We Will Have to Establish Our Own Regulatory Compliant Analytical Process for Genetic Testing.

We have no experience in the analytical procedures related to genetic testing. We have entered into an agreement with Quest Diagnostics Incorporated under which Quest exclusively performs OcuGene genetic analytical

procedures at a commercial scale in the United States. Accordingly, we are reliant on Quest for all of our OcuGene analytical procedures. If we are unable to maintain this arrangement, we would have to contract with another clinical laboratory or would have to establish our own facilities. We cannot assure you that we will be able to contract with another laboratory to perform these services on a commercially reasonable basis, or at all.

Clinical laboratories must adhere to Good Laboratory Practice regulations that are strictly enforced by the FDA on an ongoing basis through the FDA’s facilities inspection program. Should we be required to perform the analytical procedures for genetic testing ourselves, we:

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will be required to expend significant amounts of capital to install an analytical capability;

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will be subject to the regulatory requirements described above; and

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will require substantial additional capital than we otherwise may require.

We cannot assure you we will be able to successfully enter into another genetic testing arrangement or perform these analytical procedures ourselves on a cost-efficient basis, or at all.

We Rely on a Sole Source for Some of the Raw Materials in Our Products, and the Raw Materials We Need May Not be Available to Us

We are dependent upon SSP for the active drug incorporated into our ISV-403 product candidate. SSP has registered the compound with the FDA and is subject to the FDA’s review and oversight. If SSP is unable to obtain and maintain FDA approval for their production of the drug or is otherwise unable to supply us with sufficient quantities of the drug, our ability to continue with the development, and potentially the commercial sale if the product is approved, would be interrupted and could harm our business.

We have entered into a material supply agreement for azithromycin, the active drug incorporated into our ISV-401 product candidate. The supplier has registered with the FDA and is subject to the FDA’s review and oversight. If the FDA were to identify issues in the production of the drug that the supplier was unable to quickly resolve, or other issues were to arise that impact production, our ability to continue with the development, and potentially the commercial sale if the product is approved, would be interrupted and would harm our business. Additional suppliers for this drug exist, but qualification of an alternative source can be time consuming, expensive and could result in a delay that could harm our business.

We are dependent upon our development partner for the active drug incorporated into our ISV-616 product candidate. ISV-616 is a DuraSite-based formulation of a compound that may inhibit the growth of new blood vessels. This compound may be a treatment for such retinal diseases as diabetic retinopathy or macular degeneration. We have performed limited formulation and pre-clinical testing of ISV-616 in collaboration with the pharmaceutical company that developed the compound. The further development of this product will be dependent upon reaching appropriate agreement with our development partner on future supply of the compound and other development terms.

In addition, certain of the raw materials we use in formulating our DuraSite drug delivery system, and other components of our product candidates, are available from only one source. Any significant interruption in the supply of these raw materials could delay our clinical trials, product development or product sales and could harm our business.

Our Products Are Subject to Government Regulations and Approval Which May Delay or Prevent the Marketing of Potential Products and Impose Costly Procedures Upon Our Activities

The FDA and comparable agencies in state and local jurisdictions and in foreign countries impose substantial requirements upon preclinical and clinical testing, manufacturing and marketing of pharmaceutical products. Lengthy and detailed preclinical and clinical testing, validation of manufacturing and quality control

processes, and other costly and time-consuming procedures are required. Satisfaction of these requirements typically takes several years and the time needed to satisfy them may vary substantially, based on the type, complexity and novelty of the pharmaceutical product. The effect of government regulation may be to delay or to prevent marketing of potential products for a considerable period of time and to impose costly procedures upon our activities. The FDA or any other regulatory agency may not grant approval for any products we develop on a timely basis, or at all. Success in preclinical or early stage clinical trials does not assure success in later stage clinical trials. Data obtained from preclinical and clinical activities are susceptible to varying interpretations that could delay, limit or prevent regulatory approval. If regulatory approval of a product is granted, such approval may impose limitations on the indicated uses for which a product may be marketed. Further, even after we have obtained regulatory approval, later discovery of previously unknown problems with a product may result in restrictions on the product, including withdrawal of the product from the market. Moreover, the FDA has recently reduced previous restrictions on the marketing, sale and prescription of products for indications other than those specifically approved by the FDA. Accordingly, even if we receive FDA approval of a product for certain indicated uses, our competitors, including our collaborators, could market products for such indications even if such products have not been specifically approved for such indications. Additionally, the FDA recently issued an advisory that microarrays used for diagnostic and prognostic testing may need regulatory approval. The need for regulatory approval of multiple gene analysis is uncertain at this time. Delay in obtaining or failure to obtain regulatory approvals would make it difficult or impossible to market our products and would harm our business.

The FDA’s policies may change and additional government regulations may be promulgated which could prevent or delay regulatory approval of our potential products. Moreover, increased attention to the containment of health care costs in the United States could result in new government regulations that could harm our business. Adverse governmental regulation might arise from future legislative or administrative action, either in the United States or abroad. See “—Uncertainties Regarding Healthcare Reform and Third-Party Reimbursement may Impair Our Ability to Raise Capital, Form Collaborations and Sell Our Products.”

We Compete in Highly Competitive Markets and Our Competitors’ Financial, Technical, Marketing, Manufacturing and Human Resources May Surpass Ours and Limit Our Ability to Develop and/or Market Our Products and Technologies

Our success depends upon developing and maintaining a competitive advantage in the development of products and technologies in our areas of focus. We have many competitors in the United States and abroad, including pharmaceutical, biotechnology and other companies with varying resources and degrees of concentration in the ophthalmic market. Our competitors may have existing products or products under development which may be technically superior to ours or which may be less costly or more acceptable to the market. Competition from these companies is intense and is expected to increase as new products enter the market and new technologies become available. Many of our competitors have substantially greater financial, technical, marketing, manufacturing and human resources than we do, particularly in light of our current financial condition. In addition, they may succeed in developing technologies and products that are more effective, safer, less expensive or otherwise more commercially

acceptable than any that we have or will develop. Our competitors may obtain cost advantages, patent protection or other intellectual property rights that would block or limit our ability to develop our potential products. Our competitors may also obtain regulatory approval for commercialization of their products more effectively or rapidly than we will. If we decide to manufacture and market our products by ourselves, we will be competing in areas in which we have limited or no experience such as manufacturing efficiency and marketing capabilities. See “— We Have No Experience in Commercial Manufacturing and Need to Establish Manufacturing Relationships with Third Parties, and if Contract Manufacturing is Not Available to Us or Does Not Satisfy Regulatory Requirements, We Will Have to Establish Our Own Regulatory Compliant Manufacturing Capability.”

If We Engage in Acquisitions, We Will Incur a Variety of Costs, and the Anticipated Benefits of the Acquisition May Never be Realized

We may pursue acquisitions of companies, product lines, technologies or businesses that our management believes are complementary or otherwise beneficial to us. Any of these acquisitions could have negative effects on our business. Future acquisitions may result in substantial dilution to our stockholders, the incurrence of additional debt and amortization expenses related to goodwill, research and development and other intangible assets. Any of these results could harm our financial condition. In addition, acquisitions would involve several risks for us, including:

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assimilating employees, operations, technologies and products from the acquired companies with our existing employees, operation, technologies and products;

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diverting our management’s attention from day-to-day operation of our business;

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entering markets in which we have no or limited direct experience; and

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potentially losing key employees from the acquired companies.

Our Insurance Coverage May Not Adequately Cover Our Potential Product Liability Exposure

We are exposed to potential product liability risks inherent in the development, testing, manufacturing, marketing and sale of human therapeutic products. Product liability insurance for the pharmaceutical industry is extremely expensive. Our present product liability insurance coverage may not be adequate to cover all potential claims we may encounter. In addition, our existing coverage will not be adequate as we further develop, manufacture and market our products, and we may not be able to obtain or afford adequate insurance coverage against potential claims in sufficient amounts or at a reasonable cost.

Uncertainties Regarding Healthcare Reform and Third-Party Reimbursement May Impair Our Ability to Raise Capital, Form Collaborations and Sell Our Products

The continuing efforts of governmental and third-party payers to contain or reduce the costs of healthcare through various means may harm our business. For example, in some foreign markets the pricing or profitability of health care products is subject to government control. In the United States, there have been, and we expect there will continue to be, a number of federal and state proposals to implement similar government control. The implementation or even the announcement of any of these legislative or regulatory proposals or reforms could harm our business by impeding our ability to achieve profitability, raise capital or form collaborations.

In addition, the availability of reimbursement from third-party payers determines, in large part, the demand for healthcare products in the United States and elsewhere. Examples of such third-party payers are government and private insurance plans. Significant uncertainty exists as to the reimbursement status of newly approved healthcare products, and third-party payers are increasingly challenging the prices charged for medical products and services. If we succeed in bringing one or more products to the market, reimbursement from third party payers may not be available or may not be sufficient to allow us to sell our products on a competitive or profitable basis.

Our Use of Hazardous Materials May Pose Environmental Risks and Liabilities Which May Cause Us to Incur Significant Costs

Our research, development and manufacturing processes involve the controlled use of small amounts of radioactive and other hazardous materials. We cannot completely eliminate the risk of accidental contamination or injury from these materials. In the event of such an accident, we could be held liable for any damages that result, and any such liability could exceed our resources. Moreover, as our business develops we may be required to incur significant costs to comply with federal, state and local environmental laws, regulations and policies, especially to the extent that we manufacture our own products.

Management and Principal Stockholders May Be Able to Exert Significant Control On Matters Requiring Approval by Our Stockholders and Security Interests in Our Assets Held by Management May Enable Them to Control the Disposition of Such Assets

As of September 30, 2003, our management and principal stockholders together beneficially owned approximately 18% of our outstanding shares of common stock. As a result, these stockholders, acting together, may be able to effectively control all matters requiring approval by our stockholders, including the election of a majority of our directors and the approval of business combinations.

In May and June 2003, we issued a series of short-term notes payable totaling $288,500 to members of the board of directors, senior management and other stockholders for cash. $100,000 of these notes are senior secured notes, bear a two percent (2%) annual interest rate, are due December 31, 2003 and are secured by a lien on certain pieces of laboratory and other equipment. The remainder of these notes are unsecured, bear interest rates between two percent (2%) and twelve percent (12%) and are due November 15, 2003.

In July and August 2003, we issued $500,000 short-term senior secured notes payable to one of our officers who is also a member of our board of directors and to an affiliate of a member of senior management for cash. These notes bear an interest rate between five and one-half percent (5.5%) and twelve percent (12%), are due between December 15, 2003 and December 31, 2003 and are secured by a lien on substantially all of our assets including our intellectual property, other than the equipment secured under the senior secured notes issued in May 2003, and certain other equipment secured by the lessor of such equipment.

These security interests enable these members of our board of directors and management to control the disposition of these assets in the event of our liquidation. If we are unable to repay the amounts due under these notes, these directors, officers and affiliates of our senior managers could cause us to enter into involuntary liquidation proceedings in the event we default on our obligations.

The Market Prices For Securities of Biopharmaceutical and Biotechnology Companies such as Ours Have Been and Are Likely to Continue to Be Highly Volatile Due to Reasons that Are Related and Unrelated to the Operating Performance and Progress of Our Company

The market prices for securities of biopharmaceutical and biotechnology companies, including ours, have been highly volatile. The market has from time to time experienced significant price and volume fluctuations that are unrelated to the operating performance of particular companies. In addition, future announcements and circumstances, such as our current financial condition, the audit report included in our Annual Report on Form 10-K for the year ended December 31, 2002 that included an explanatory paragraph referring to our recurring operating losses and a substantial doubt about our ability to continue as a going concern, our ability to obtain new financing, the results of testing and clinical trials, the status of our relationships with third-party collaborators, technological innovations or new therapeutic products, governmental regulation, developments in patent or other proprietary rights, litigation or public concern as to the safety of products developed by us or others and general market conditions, concerning us, our competitors or other biopharmaceutical companies, may have a significant effect on the market price of our common stock. Further, conversions of convertible securities and the sale of the shares of our commonstock underlying those convertible securities, such as the debentures issued to HEM, could cause a significant decline in the market price for our common stock. We have not paid any cash dividends on our common stock, and we do not anticipate paying any dividends on our common stock in the foreseeable future.

In addition, the terrorist attacks in the U.S. and abroad, the U.S. retaliation for these attacks, the war in Iraq and continued worldwide economic weakness and the related decline in consumer confidence have had, and may continue to have, an adverse impact on the U.S. and world economy. These events, as well as, fluctuations in our operating results and market conditions for biopharmaceutical and biotechnology stocks in general, could have a significant effect on the volatility of the market price for our common stock and on the future price of our common stock.

We Have Adopted and Are Subject to Anti-Takeover Provisions That Could Delay or Prevent an Acquisition of Our Company

Provisions of our certificate of incorporation and bylaws may constrain or discourage a third party from acquiring or attempting to acquire control of us. Such provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. Our board of directors has the authority to issue up to 5,000,000 shares of preferred stock, 15,000 of which have been designated as Series A-1 Preferred Stock. Our board of directors has the authority to determine the price, rights, preferences, privileges and restrictions of the remaining unissued shares of preferred stock without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of preferred stock, while providing desirable flexibility in connection with possible financings, acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. Provisions of Delaware law applicable to us could also delay or make more difficult a merger, tender offer or proxy contest involving us, including Section 203 of the Delaware General Corporation Law, which prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years unless conditions set forth in the Delaware General Corporation Law are met.

We Have Convertible, Redeemable Securities That Have and May Continue To Result in Dilution for Common Stockholders, and May Be Convertible Into Common Stock or Debt

As a result of our merger with Ophthalmic Solutions Inc. on September 22, 2003, we assumed the rights and obligations in connection with $1,000,000 in principal amount of convertible debentures issued by Ophthalmic Solutions to HEM Mutual Assurance LLC, including the gross proceeds raised through the sale of the debentures and Ophthalmic Solutions’ obligations under the debentures and the related debenture purchase agreement. The debentures are convertible into shares of our common stock, accrue interest at the rate of 1% per year, payable in cash or shares of our common stock, and have a maturity date of September 21, 2008. As of the filing of this Form 10-Q, an aggregate of $403,625 in principal amount of these debentures, along with the associated interest, had been converted into an aggregate of 1,697,639 unrestricted shares of our common stock. Of the remaining $596,375 in principal amount of the debentures:

•

$92,750 is convertible into unrestricted shares of our common stock at a conversion price that is the lower of $0.30 or the average of the three lowest closing per share bid prices for our common stock during the 40 trading days prior to conversion.

•

$3,625 is convertible into unrestricted shares of our common stock at a conversion price $0.01 per share; and.

•

$500,000 is convertible into unrestricted shares of our common stock at a conversion price that is the lower of $0.375 or the average of the three lowest closing per share bid prices for our common stock during the 40 trading days prior to conversion.

In August 2002, we entered into a stock purchase agreement with Bausch & Lomb concurrent with the Bausch & Lomb License Agreement for ISV-403. The stock purchase agreement provides for Bausch & Lomb to purchase up to 15,000 shares of Series A-1 Preferred Stock for a purchase price equal to $1,000 per share for an aggregate investment of up to $15.0 million. The initial investment, which occurred contemporaneously with the execution of the Bausch & Lomb License Agreement, was for 2,000 shares of Series A-1 Preferred Stock, for a total investment of $2.0 million. In February 2003, Bausch & Lomb purchased an additional 2,000 shares of Series A-1 Preferred Stock for $2.0 million under the stock purchase agreement upon our achieving the first milestone set forth in that agreement. If we achieve certain additional milestones, Bausch & Lomb will invest up to an additional $11.0 million in various closings from time to time. The Series A-1 Preferred Stock does not contain voting rights, except as otherwise provided by the Delaware General Corporation law and each share is entitled to a $60 per annum cumulative dividend.

The stock purchase agreement provides for the conversion of the Series A-1 Preferred Stock into shares of common stock, and potentially into a note payable, if the Bausch & Lomb License Agreement is terminated by Bausch & Lomb at any time for cause, or without cause prior to the later of the commencement of a Phase 2/3 clinical trial for ISV-403 or January 1, 2004. If Bausch & Lomb elects to convert any shares of Series A-1 Preferred Stock into common stock, and potentially into a note payable, all shares of Series A-1 Preferred Stock will be converted at the same time.

In addition, in the event of the first commercial sale of the product pursuant to the terms of the Bausch and Lomb License Agreement, the Series A-1 Preferred Stock then outstanding shall be redeemed by us for cash and a pre-paid royalty. See Note 2 to Notes to Condensed Financial Statements contained herein for additional information regarding the Series A-1 Preferred Stock.

The issuance of a substantial number of shares of common stock upon conversion of our Series A-1 Preferred Stock could adversely affect the market value of the common stock, depending upon the timing of such issuance may effect a substantial dilution of the book value per share of our common stock. Furthermore, if a portion of the Series A-1 Preferred Stock is exchanged for a note payable, our debt service expenses would increase and in the event of our bankruptcy, liquidation or reorganization, our assets would be available for distribution to our current stockholders only after the indebtedness has been paid in full. As a result, there may not be sufficient assets remaining to make any distributions to our stockholders.

As of September 30, 2003, if the Series A-1 Preferred Stock had been converted into Common Stock, the number of shares of Common Stock, into which the Series A-1 Preferred Stock would have been converted would have exceeded the 4,300,000 maximum shares under the agreement. The excess amount of the Series A-1 Preferred Stock, of approximately $2.1 million, has been excluded from stockholders’ equity in the Condensed Consolidated Balance Sheet as of September 30, 2003 and has been reported at the mezzanine level. As of the filing of this Form 10-Q, approximately $2.5 million would have been excluded from stockholders’ equity and reported at the mezzanine level.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The following discusses our exposure to market risk related to changes in interest rates.

We invest our excess cash in investment grade, interest-bearing securities. While a hypothetical decrease in market interest rates by 10 percent from the September 30, 2003 levels would cause a decrease in interest income, it would not result in a loss of the principal. Additionally, the decrease in interest income would not be material.

Item 4. Controls and Procedures

(a.) As of the end of the quarter ended September 30, 2003, the Company’s management, including its chief executive officer and chief financial officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures, as such term is defined in Rule 13a-15(e) promulgated under the Securities and Exchange Act of 1934, as amended. Based on that evaluation, the Company’s chief executive officer and chief financial officer concluded that the Company’s disclosure controls and procedures were effective as of September 30, 2003 to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities and Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

(b.) During the quarter ended September 30, 2003, there were no changes in our internal control over financial reporting that materially affected or are reasonably likely to materially affect our internal control over financial reporting.

Part II OTHER INFORMATION

Item 1. Legal Proceedings.

On June 23, 2003, Xmark Funds, L.P. et al, filed a complaint in the United States District Court, Southern District of New York against us alleging that InSite Vision breached the terms of the term sheet signed between Xmark Funds and us in May 2003, by not accepting an investment from Xmark Funds. The complaint seeks monetary damages. On July 14, 2003, we filed an answer to the complaint.

On or about October 8, 2003, Thai Nguyen filed a complaint in the Superior Court of California, County of San Francisco, against us, our chief executive officer, Kumar Chandrasekaran, the Regents of the University of California or “Regents” and two individuals associated with the Regents. Mr. Nguyen alleges that InSite Vision breached an obligation to continue supporting his research; he has also made a variety of other related claims and allegations against us and the other defendants. The complaint seeks both monetary and injunctive relief. Mr. Nguyen has filed a motion to enjoin InSite Vision during the pendency of the litigation from alienating the license rights held by InSite Vision relating to the subject of Mr. Nguyen’s research, and have opposed such motion. Neither we nor Dr. Chandrasekaran have yet filed a response to the complaint. A preliminary hearing on this matter is scheduled for November 20, 2003.

Item 2. Changes in Securities and Use of Proceeds.

In October 2003 we received aggregate proceeds of $84,000 from the sale of an aggregate of 210,000 shares of our common stock in a private placement to two accredited investors. These securities were sold pursuant to an exemption provided by Section 4(2) of the Securities Act of 1933 based on the limited nature of the offering and the purchasers’ status as accredited investors.

On September 22, 2003, pursuant to an Agreement and Plan of Merger dated as of the same date, we completed a triangular merger with Ophthalmic Solutions, Inc., a private, development stage Delaware corporation with a business plan to pursue opportunities for over-the-counter products in the area of ophthalmology, and Arrow Acquisition, Inc., a Delaware corporation and a wholly owned subsidiary of ours. Following the merger, Ophthalmic Solutions became our wholly-owned subsidiary and we issued 100 shares of our common stock to the sole stockholder of Ophthalmic Solutions in exchange for all outstanding shares of Ophthalmic Solutions’ capital stock. These 100 shares of our common stock were issued pursuant to an exemption provided by Section 4(2) of the Securities Act of 1933 based on the nature of the transaction and the sole Ophthalmic Solutions stockholder’s status as an accredited investor and such shares may not be sold, transferred or assigned absent an effective registration statement or an applicable exemption from the registration requirements under the Securities Act of 1933 and applicable state securities laws.

Immediately prior to the merger, Ophthalmic Solutions entered into a Convertible Debenture Purchase Agreement, dated as of September 22, 2003, with HEM Mutual Assurance LLC, or HEM, pursuant to which Ophthalmic Solutions sold and issued convertible debentures to HEM in an aggregate principal amount of $1,000,000 in a private placement pursuant to Rule 504 of Regulation D under the Securities Act of 1933, as amended. Each of the debentures has a maturity date of September 21, 2008, subject to earlier conversion or redemption pursuant to its terms, and bears interest at the rate of 1% per year, payable in cash or shares of common stock at the option of the holder of the Debentures. As a result of the merger, we assumed the rights and obligations of Ophthalmic Solutions in the private placement, including the gross proceeds raised through the sale of the debentures and Ophthalmic Solutions’ obligations under the debentures and the Purchase Agreement. In connection with the Purchase Agreement, 5,000,000 shares of Ophthalmic Solutions’ common stock had been placed into escrow, in the name of HEM, without restrictive legend for possible future conversion under the debentures. Upon completion of the merger, the 5,000,000 shares of Ophthalmic Solutions’ common stock held in escrow were canceled and replaced with 5,000,000 shares of our common stock in the

name of HEM, to be held in escrow without restrictive legend for possible future conversion under the debentures, pursuant to an exemption from registration under Section 3(a)(9) of the Securities Act of 1933. Unless and until the debentures are converted, HEM has no voting or other ownership rights in any of the shares of our common stock held in escrow and the shares in escrow are not treated by us as being issued and outstanding. In connection with the initial placement of the debentures with HEM, we paid aggregate fees of $80,000 to the placement agent.

As of September 30, 2003, $492,750 in principal amount of the debentures were convertible into unrestricted shares of our common stock at a conversion price that is the lower of $0.30 or the average of the three lowest closing per share bid prices for the common stock during the 40 trading days prior to conversion. On November 10, 2003, $200,000 in principal and the related interest was converted into 667,561 shares of our common stock. On October 30, 2003, $200,000 in principal and the related interest was converted into 667,360 shares of our common stock. Additionally, as of September 30, 2003, $3,625 in principal amount of the debentures were convertible into unrestricted shares of our common stock at a conversion price $0.01 per share. On October 15, 2003 this $3,625 and the related interest was converted into 362,718 unrestricted shares of our common stock. An additional $3,625 in principal amount of the debentures became convertible into unrestricted shares of our common stock at a conversion price $0.01 per share when the $500,000 promissory note issued by HEM as partial consideration for the debentures was paid in full by HEM in cash to us on November 12, 2003.

The remaining $500,000 in principal amount of the debentures is convertible into unrestricted shares of our common stock at a conversion price that is the lower of $0.375 or the average of the three lowest closing per share bid prices for our common stock during the 40 trading days prior to conversion.

As of November 12, 2003 a total of $596,375 of debentures remain outstanding and, along with accrued and unpaid interest, may be converted into our common stock. The conversion price and number of shares of our common stock issuable upon conversion of the debentures is subject to adjustment for stock splits and combinations and other dilutive events.

The debentures may never be converted into an aggregate of more than 5,000,000 shares of our common stock unless we elect to increase the number of shares held in escrow in accordance with and subject to any applicable rules or regulations of The American Stock Exchange or such other exchange, market or system on which our common stock is then listed requiring stockholder approval prior to such additional issuance. In the event that the conversion rate of the debentures would require us to issue more than an aggregate of 5,000,000 shares of our common stock upon conversion of the debentures and we elect not to increase the number of shares held in escrow (or if we fail to obtain any required stockholder approval for such proposed increase), we will be required to redeem the unconverted amount of the debentures for 140% of the principal amount thereof, plus accrued and unpaid interest.

In addition to the foregoing, the debentures may not be converted if and to the extent that after such conversion the holder would beneficially own more than 5% of our then outstanding common stock, unless the holder waives this limitation by providing us 75 days prior notice of the waiver.

We have the right to redeem the debentures, in whole or in part, at any time on 30 days advanced notice for 140% of the principal amount of the outstanding debentures being redeemed, plus accrued and unpaid interest. In addition, if at any time any of the debentures are outstanding, we receive debt or equity financing in an amount equal to or exceeding $5,000,000 in a single transaction or series of related transactions (excluding any portion of such financing consisting of forgiveness of debt or other obligations), we are required to redeem the debentures for 150% of the amount of the then outstanding debentures. If trading in our common stock is suspended (other than suspensions of trading on such market or exchange generally or temporary suspensions pending the release of material information) for more than ten trading days, or if our common stock is delisted from the exchange, market or system on which it is then traded and not relisted on another exchange, market or the Over the Counter Bulletin Board within 10 trading days, HEM may elect to require us to redeem all then outstanding debentures and any shares of our common stock then held by HEM through prior conversions at a price equal to the sum of the aggregate market value of the common stock then held by HEM through prior conversions plus the value of all unconverted debentures then held by HEM, calculated in each case in the manner set forth in the Purchase Agreement. We would owe an interest penalty of 8% per year on any payments not made within 7 business days of a redemption request made pursuant to the preceding sentence.

Item 3. Defaults Upon Senior Securities.

None.

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

None.

Item 5. Other Information.

On October 21, 2003, Ernst & Young LLP notified us that it would resign as our independent public accountants effective following the completion of its review of this Quarterly Report on Form 10-Q. On November 19, 2003, Ernst & Young’s completed its review of this Quarterly Report on Form 10-Q and Ernst & Young’s resignation as our independent public accountants became effective. Both we and Ernst & Young agree that InSite Vision would be better served by an independent accounting firm that focuses on meeting the needs of smaller public companies. We have commenced a search for a new independent accounting firm, but have not yet engaged such a firm.

Ernst & Young’s decision to resign as our independent public accountants was not the result of any disagreement between us and Ernst & Young on any matters of accounting principles or practices, financial statement disclosure, or auditing scope or procedure. On October 28, 2003 we filed a Current Report on Form 8-K with the Securities and Exchange Commission regarding the resignation of Ernst & Young as our independent public accountants effective following the completion of its review of this Quarterly Report on Form 10-Q.

Item 6. Exhibits and Reports on Form 8-K.

a)Exhibits

The exhibits listed on the Exhibit Index (following the signatures section of this Quarterly Report) are included, or incorporated by reference, in this Quarterly Report.

b)Reports on Form 8-K on August 13, 2003, we filed a Current Report on Form 8-K reporting under Item 9 a copy of a press release, which, among other things, set forth our results of operations for the quarter ended June 30, 2003.

During the quarter ended September 30, 2003, we filed the following reports on Form 8-K:

On September 23, 2003, we filed a Current Report on Form 8-K reporting under Item 5 the merger with Ophthalmic Solutions, Inc. and the assumption of convertible debentures.

SIGNATURES

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

	INSITE VISION INCORPORATED

Dated: November 19, 2003	by:	/s/ S. Kumar Chandrasekaran, Ph.D.

		S. Kumar Chandrasekaran, Ph.D. Chairman of the Board, Chief Executive Officer, President and Chief Financial Officer (on behalf of the registrant and as principal financial and accounting officer)

EXHIBIT INDEX

Exhibit No.		Description

2.1		Agreement and Plan of Merger, dated as of September 22, 2003, by and among InSite Vision Incorporated, a Delaware corporation, Arrow Acquisition, Inc., a Delaware corporation, and Ophthalmic Solutions, Inc., a Delaware corporation. (previously filed as Exhibit 2.1 to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 23, 2003, and incorporated herein by reference)

4.1		Convertible Debenture Purchase Agreement, dated as of September 22, 2003, by and between Ophthalmic Solutions, Inc. and HEM Mutual Assurance LLC. (previously filed as Exhibit 4.1 to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 23, 2003 and incorporated herein by reference)

4.2		$492,750 1% Convertible Debenture Due September 21, 2008, originally issued by Ophthalmic Solutions, Inc., a Delaware corporation to HEM Mutual Assurance LLC on September 22, 2003. (previously filed as Exhibit 4.2 to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 23, 2003 and incorporated herein by reference)

4.3		$7,250 1% Convertible Debenture Due September 21, 2008, originally issued by Ophthalmic Solutions, Inc., a Delaware corporation to HEM Mutual Assurance LLC on September 22, 2003. (previously filed as Exhibit 4.3 to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 23, 2003 and incorporated herein by reference)

4.4		$500,000 1% Convertible Debenture Due September 21, 2008, originally issued by Ophthalmic Solutions, Inc., a Delaware corporation to HEM Mutual Assurance LLC on September 22, 2003. (previously filed as Exhibit 4.4 to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 23, 2003 and incorporated herein by reference)

10.1 *		Form of Common Stock Purchase Agreement, dated October 20, 2003, for an aggregate 210,000 shares of InSite Vision Incorporated Common Stock.

31.1*		Certification of Chief Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended.

31.2*		Certification of Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended.

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

99.1		Promissory Note, in the amount of $500,000, originally issued by HEM Mutual Assurance LLC to Ophthalmic Solutions, Inc., a Delaware corporation on September 22, 2003. (previously filed as Exhibit 99.1 to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 23, 2003 and incorporated herein by reference)

*	filed herewith

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	H.S. junior Avg

Insite Vision (INSV) Inactive 10-Q2003 Q3 Quarterly report

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