Avanir Pharmaceuticals

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q/A

Amendment No. 1

(Mark One)


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

For the quarterly period ended June 30, 2007


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

For the transition period from to .

Commission File No. 1-15803

AVANIR PHARMACEUTICALS

(Exact name of registrant as specified in its charter)


California (State or other jurisdiction of incorporation or organization)		33-0314804 (I.R.S. Employer Identification No.)

101 Enterprise Suite 300, Aliso Viejo, California (Address of principal executive offices)		92656 (Zip Code)

(949) 389-6700
(Registrant’s telephone number, including area code)

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

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

Large Accelerated Filer o Accelerated Filer þ Non-accelerated Filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES o NO þ

As of August 6, 2007, the registrant had 43,117,358 shares of common stock issued and outstanding.

PART I. FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

AVANIR PHARMACEUTICALS
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)


	June 30,			September 30,
	2007			2006
	(as restated)
ASSETS

CURRENT ASSETS
Cash and cash equivalents	$	7,538,570		$	4,898,214
Short-term investments in securities		1,982,957			16,778,267
Receivables, net		3,356,157			3,042,468
Inventories		2,561,555			2,835,203
Prepaid expenses		684,905			1,778,918

Total current assets		16,124,144			29,333,070

Investments in securities		246,050			2,216,995
Restricted investments in securities		1,156,597			856,597
Property and equipment, net		2,001,140			6,047,729
Other intangible assets, net		8,826,362			10,113,329
Goodwill		22,042,439			22,110,328
Other assets		426,191			784,289

TOTAL ASSETS	$	50,822,923		$	71,462,337


LIABILITIES AND SHAREHOLDERS’ DEFICIT

CURRENT LIABILITIES
Accounts payable	$	1,222,746		$	10,845,057
Accrued expenses		12,378,411			12,983,501
Assumed liabilities for returns and other discounts		—			3,980,229
Deferred revenues		4,357,655			7,592,563
Notes payable		324,410			670,737
Other current liabilities		607,333			—
Capital lease obligations		—			230,760

Total current liabilities		18,890,555			36,302,847

Other non-current liabilities		1,376,700			230,450
Deferred revenues, net of current portion		13,720,637			15,716,762
Notes payable, net of current portion		22,559,986			24,715,905
Capital lease obligations, net of current portion		—			170,908

Total liabilities		56,547,878			77,136,872


COMMITMENTS AND CONTINGENCIES (Note 14)

SHAREHOLDERS’ DEFICIT
Preferred stock — no par value, 10,000,000 shares authorized, no shares issued and outstanding as of June 30, 2007 and September 30, 2006		—			—
Common stock — no par value, Class A, 200,000,000 shares authorized, 43,031,252 and 31,708,461 shares issued and outstanding as of June 30, 2007 and September 30, 2006, respectively		244,878,756			211,993,249
Accumulated deficit		(250,583,548	)		(217,565,280	)
Accumulated other comprehensive loss		(20,163	)		(102,504	)

Total shareholders’ deficit		(5,724,955	)		(5,674,535	)

TOTAL LIABILITIES AND SHAREHOLDERS’ DEFICIT	$	50,822,923		$	71,462,337

The accompanying notes to condensed consolidated financial statements are an integral part of this statement.

AVANIR PHARMACEUTICALS

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)


	Three months ended						Nine months ended
	June 30,						June 30,
	2007			2006			2007			2006
							(as restated)
PRODUCT SALES
Net revenues	$	4,938,708		$	—		$	15,038,523		$	—
Cost of revenues		1,535,535			260,164			4,190,975			260,164

Product gross margin		3,403,173			(260,164	)		10,847,548			(260,164	)


LICENSES, RESEARCH SERVICES AND GRANTS
Revenues from non-government research services		181,692			1,746,581			2,372,384			6,181,164
Cost of non-government research services		(1,202,476	)		(1,488,363	)		(2,973,715	)		(5,302,796	)
Revenues from government research grant services		122,398			47,345			475,474			208,032
Cost of government research grant services		(201,178	)		(46,402	)		(666,166	)		(214,491	)
Revenues from license agreements		1,443,543			104,174			1,556,827			5,113,516
Revenues from royalties and royalty rights		453,091			465,147			1,955,804			1,474,451

License, research services, and grants gross margin		797,070			828,482			2,720,608			7,459,876


Total gross margin		4,200,243			568,318			13,568,156			7,199,712

OPERATING EXPENSES
Research and development		3,906,024			8,426,870			16,468,878			21,788,150
Selling, general and administrative		10,647,281			10,105,474			31,154,904			23,366,332

Loss from operations		(10,353,062	)		(17,964,026	)		(34,055,626	)		(37,954,770	)

OTHER INCOME (EXPENSE)
Interest expense		(415,861	)		(191,302	)		(1,334,399	)		(236,143	)
Interest income		88,916			551,948			425,254			1,444,536
Other		1,537,725			(15,029	)		1,968,004			(10,009	)

Loss before income taxes		(9,142,282	)		(17,618,409	)		(32,996,767	)		(36,756,386	)

Provision for income taxes		(8,097	)		(809	)		(21,501	)		(3,230	)


NET LOSS BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE		(9,150,379	)		(17,619,218	)		(33,018,268	)		(36,759,616	)
Cumulative effect of change in accounting principle		—			—			—			(3,616,058	)

NET LOSS	$	(9,150,379	)	$	(17,619,218	)	$	(33,018,268	)	$	(40,375,674	)


Basic and diluted net loss per share
Loss before cumulative effect of change in accounting principle	$	(0.23	)	$	(0.56	)	$	(0.93	)	$	(1.21	)
Cumulative effect of change in accounting principle		—			—			—			(0.12	)

Net loss per share	$	(0.23	)	$	(0.56	)	$	(0.93	)	$	(1.33	)

Basic and diluted weighted average number of common shares outstanding		40,580,326			31,419,394			35,546,976			30,352,690

The accompanying notes to condensed consolidated financial statements are an integral part of this statement.

AVANIR PHARMACEUTICALS

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)


	Nine Months Ended
	June 30,
	2007			2006
	(as restated)
OPERATING ACTIVITIES
Net loss	$	(33,018,268	)	$	(40,375,674	)
Adjustments to reconcile net loss to net cash used in operating activities:
Cumulative effect of change in accounting principle		—			3,616,058
Depreciation and amortization		4,719,632			1,863,379
Amortization of debt discount		182,999			—
Share-based compensation expense		2,055,625			1,977,133
Purchased in-process research and development		—			2,600,000
(Gain) loss on disposal of assets		(229,829	)		17,339

Changes in operating assets and liabilities:
Receivables		2,949			(1,062,860	)
Inventories		621,072			(373,496	)
Prepaid expenses and other assets		1,088,323			815,521
Accounts payable		(9,622,311	)		(732,277	)
Accrued expenses and other liabilities		1,148,493			3,564,523

Assumed liabilities, net of non-cash adjustment of purchase price		87,660			—
Deferred revenues		(5,231,033	)		413,527

Net cash used in operating activities		(38,194,688	)		(27,676,827	)


INVESTING ACTIVITIES
Investments in securities		(351,404	)		(59,231,954	)
Proceeds from sales and maturities of investments in securities		16,900,000			41,950,275
Acquisition of businesses, net of cash acquired		—			(4,617,694	)
Proceeds from the sale of property and equipment		457,420			—
Purchases of property and equipment		(130,760	)		(1,391,987	)

Net cash provided by (used in) investing activities		16,875,256			(23,291,360	)


FINANCING ACTIVITIES
Proceeds from issuance of common stock, net		30,829,882			44,797,440
Payments on notes and capital lease obligations		(6,870,094	)		(290,524	)

Net cash provided by financing activities		23,959,788			44,506,916


Net increase (decrease) in cash and cash equivalents		2,640,356			(6,461,271	)
Cash and cash equivalents at beginning of period		4,898,214			8,620,143

Cash and cash equivalents at end of period	$	7,538,570		$	2,158,872


SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Interest paid	$	1,151,361		$	236,143
Income taxes paid	$	21,501		$	3,230
NON-CASH INVESTING AND FINANCING ACTIVITIES:
Purchase price adjustment of assumed liabilities	$	4,067,889		$	—
Issuance of notes payable as additional consideration for the Alamo acquisition	$	4,000,000		$	—
Accounts payable and accrued expenses for purchases of property and equipment	$	—		$	109,516
Elimination of unearned compensation against common stock	$	—		$	3,477,144
Issuance of promissory notes as consideration for the Alamo acquisition	$	—		$	25,075,000
Accrued expenses for acquisition related transaction costs	$	—		$	130,570

The accompanying notes to condensed consolidated financial statements are an integral part of this statement.

AVANIR PHARMACEUTICALS

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. RESTATEMENT OF CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Background Information

In December 2004, the FASB issued Statement of Financial Accounting Standards “(SFAS”) No. 123(R). “Share-Based Payment” SFAS No. 123(R) requires all share-based payments to employees, including stock awards, to be recognized as expenses in the issuer’s financial statements based on the fair values of those payments, reduced as appropriate based on any estimated forfeitures. Share-based compensation expense recognized during a period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. However, SFAS No. 123R requires that compensation cost recognized at any date must be at least equal to the amount attributable to awards that are vested at that date.

The Company uses a software system that is widely used by many public companies for the calculation of share-based compensation expense under FASB Statement No. 123 (revised 2004) (“FAS 123R”). The Company installed a newly released version of this software in October 2007, after which the Company discovered a material difference in the application of weighted average forfeiture rates to the calculation of share-based compensation expense between the previous version and the new version. Weighted average forfeiture rates, as applied by this software system prior to October 2007, applied a forfeiture rate to each vesting tranche of an award to estimate the number of shares that will vest over the term of the award. The estimated number of underlying shares expected to vest for all tranches is divided by the total shares granted. This is the expected vesting rate. The cumulative expected forfeiture amount is equal to 100% minus the expected vesting rate. This amount is referred to as the “weighted average forfeiture rate”.

The old version consistently applied the weighted average forfeiture rate throughout the vesting period and computed a true-up of unrecognized share-based compensation expense once the award had fully vested. The true-up was necessary because the old method did not properly attribute the cost over the vesting period. Because of the use of this method, the old version failed to properly account for the full amount of share-based compensation expense of the vested awards during the interim periods prior to the award reaching its final vested date.

Under the new version of this software (installed in October 2007) estimated forfeiture rates are applied only for those tranches that are not fully vested. As each tranche vests, the new version properly recognizes 100% of share-based compensation expense over the attribution period related to these fully vested tranches.

Following extensive analysis performed by the Company and its consultants, the Company determined that share-based compensation expense under the old version was understated by $2.4 million from October 1, 2005 (the adoption date of FAS 123R) through June 30, 2007. The Company identified that $2.2 million of the understatement was attributed to the second fiscal quarter ended March 31, 2007, during which quarter the Company had re-assessed its estimated forfeiture rates and increased the estimated forfeiture rate from an average of 8.5% to 30% due to changes in the employee base related to restructuring activities. These restructuring activities resulted in a significant increase in the number of actual equity award forfeitures.

As a result of the increase in the estimated forfeiture rate previously used, the Company had recorded a decrease to total share-based compensation expense of $2.6 million in the second fiscal quarter of 2007. Subsequently, the Company’s in-depth analysis of share-based compensation expense determined that this $2.6 million adjustment was overstated principally due to the pre-October 2007 software version issue discussed above combined with a data input error when the forfeiture rate was adjusted to 30% in the second fiscal quarter of 2007. Specifically, during the data input process the Company increased the forfeiture rate by 26% for fiscal 2007; however, the system had already recognized an increase of approximately 20% for fiscal 2007, based on data previously input for fiscal 2006. This data input error resulted in an overstated forfeiture rate adjustment for fiscal 2007.

As a result of the foregoing, on November 19, 2007, following consultation with, and upon the recommendation of, the Company’s management, the board of directors of the Company determined that it was necessary to restate the Company’s previously issued condensed consolidated financial statements for the nine months ended June 30, 2007 in order to correct the amount of share-based compensation expense recorded by the Company for that period.

Restatement

The restatement has been accounted for in accordance with SFAS No. 154, “Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3,” as a revision of previously issued financial statements to reflect the correction of an error.

The Company has calculated the amount of the necessary cumulative adjustment resulting from the restatement to be equal to approximately $2,343,000, which amount should have been recorded as an increase in non-cash share-based compensation expense within the Company’s operating expenses in the nine months ended June 30, 2007. Previously, in the Form 10-Q, the Company reported non-cash share-based compensation income of $287,000 for the nine months ended June 30, 2007. As a result, after applying the necessary cumulative adjustment referenced above, the Company’s non-cash share-based compensation expense for the nine months ended June 30, 2007 is equal to approximately$2,056,000.

This restatement did not result in a change in the Company’s previously reported revenues, cash flow from operations or total cash and cash equivalents shown in its condensed consolidated financial statements for the fiscal quarter ended and nine months ended June 30, 2007. Instead, the resulting increase in non-cash share-based compensation expense results in an increase of $2,343,000 in the Company’s net loss for the nine months ended June 30, 2007. In addition, because the amount of increase in non-cash share-based compensation expense had an effect of increasing both the Company’s accumulated deficit and common stock, there was no net effect on the Company’s condensed consolidated balance sheet at June 30, 2007. Further, the restatement has no impact on the Company’s operating results for any periods prior to the fiscal quarter ended March 31, 2007.

There is no difference between the gross adjustment to non-cash share-based compensation described herein and the net effect after taxes as the Company has a history of net losses and a valuation allowance has been recorded to offset the net deferred tax assets at June 30, 2007.

CONDENSED CONSOLIDATED BALANCE SHEET ADJUSTMENTS

The following is a summary of the adjustments to our previously issued condensed consolidated balance sheet as of June 30, 2007 (unaudited).


	June 30, 2007
	(as previously
	reported)			(adjustments)			(as restated)

ASSETS
CURRENT ASSETS
Cash and cash equivalents	$	7,538,570		$	—		$	7,538,570
Short-term investments in securities		1,982,957			—			1,982,957
Receivables, net		3,356,157			—			3,356,157
Inventories		2,561,555			—			2,561,555
Prepaid expenses		684,905			—			684,905

Total current assets		16,124,144			—			16,124,144

Investments in securities		246,050			—			246,050
Restricted investments in securities		1,156,597			—			1,156,597
Property and equipment, net		2,001,140			—			2,001,140
Other intangible assets, net		8,826,362			—			8,826,362
Goodwill		22,042,439			—			22,042,439
Other assets		426,191			—			426,191

TOTAL ASSETS	$	50,822,923		$	—		$	50,822,923


LIABILITIES AND SHAREHOLDERS’ DEFICIT
CURRENT LIABILITIES
Accounts payable	$	1,222,746		$	—		$	1,222,746
Accrued expenses		12,378,411			—			12,378,411
Deferred revenue		4,357,655			—			4,357,655
Notes payable		324,410			—			324,410
Other current liabilities		607,333			—			607,333

Total current liabilities		18,890,555			—			18,890,555

Other non-current liabilities		1,376,700			—			1,376,700
Deferred revenues, net of current portion		13,720,637			—			13,720,637
Notes payable, net of current portion		22,559,986			—			22,559,986

Total liabilities		56,547,878			—			56,547,878


COMMITMENTS AND CONTINGENCIES (Note 14)

SHAREHOLDERS’ DEFICIT
Preferred stock		—			—			—
Common stock		242,535,904			2,342,852			244,878,756
Accumulated deficit		(248,240,696	)		(2,342,852	)		(250,583,548	)
Accumulated other comprehensive loss		(20,163	)		—			(20,163	)

Total shareholders’ deficit		(5,724,955	)		—			(5,724,955	)

TOTAL LIABILITIES AND SHAREHOLDERS’ DEFICIT	$	50,822,923		$	—		$	50,822,923

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS ADJUSTMENTS

The following is a summary of the adjustments to our previously issued condensed consolidated statements of operations for the nine months ended June 30, 2007 (unaudited).


	Nine Months ended June 30, 2007
	(as previously
	reported)			(adjustments)			(as restated)

REVENUES FROM PRODUCT SALES
Net revenues	$	15,038,523		$	—		$	15,038,523
Cost of revenues		4,190,975			—			4,190,975

Product gross margin		10,847,548			—			10,847,548

REVENUES AND COST OF RESEARCH SERVICES AND OTHER
Revenues from non-government research services		2,372,384			—			2,372,384
Cost of non-government research services		(2,973,715	)		—			(2,973,715	)
Revenues from government research grant services		475,474			—			475,474
Cost of government research grant services		(666,166	)		—			(666,166	)
Revenues from license agreements		1,556,827			—			1,556,827
Revenue from royalties and royalty rights		1,955,804			—			1,955,804

Research services and other gross margin		2,720,608			—			2,720,608

Total gross margin		13,568,156			—			13,568,156

OPERATING EXPENSES
Research and development		16,057,310			411,568			16,468,878
Selling, general and administrative		29,223,620			1,931,284			31,154,904


Loss from Operations		(31,712,774	)		(2,342,852	)		(34,055,626	)

OTHER INCOME (EXPENSES)
Interest expense		(1,334,399	)		—			(1,334,399	)
Interest income		425,254			—			425,254
Other		1,968,004			—			1,968,004


Loss before income taxes		(30,653,915	)		(2,342,852	)		(32,996,767	)

Provision for income taxes		(21,501	)		—			(21,501	)

NET LOSS	$	(30,675,416	)	$	(2,342,852	)	$	(33,018,268	)


BASIC AND DILUTED NET LOSS PER SHARE:	$	(0.86	)	$	(0.07	)	$	(0.93	)


Weighted average shares outstanding		35,546,976			—			35,546,976

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS ADJUSTMENTS

The following is a summary of the adjustments to our previously issued condensed consolidated statements of cash flows for the nine months ended June 30, 2007 (unaudited).


	Nine Months Ended June 30, 2007
	(as previously
	reported)			(adjustments)			(as restated)

OPERATING ACTIVITIES
Net loss	$	(30,675,416	)	$	(2,342,852	)	$	(33,018,268	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		4,719,632			—			4,719,632
Amortization of debt discount		182,999			—			182,999
Share-based compensation expense (income)		(287,227	)		2,342,852			2,055,625
(Gain) on disposal of assets		(229,829	)		—			(229,829	)
Change in operating assets and liabilities:
Receivables		2,949			—			2,949
Inventories		621,072			—			621,072
Prepaid expenses and other assets		1,088,323			—			1,088,323
Accounts payable		(9,622,311	)		—			(9,622,311	)
Accrued expenses and other liabilities		1,148,493			—			1,148,493
Assumed liabilities, net of non-cash adjustments to purchase price		87,660			—			87,660
Deferred revenues		(5,231,033	)		—			(5,231,033	)

Net cash used in operating activities		(38,194,688	)		—			(38,194,688	)


INVESTING ACTIVITIES
Investments in securities		(351,404	)		—			(351,404	)
Proceeds from sales and maturities of investments in securities		16,900,000			—			16,900,000
Proceeds from the sale of property and equipment		457,420			—			457,420
Purchases of property and equipment		(130,760	)		—			(130,760	)

Net cash provided by investing activities		16,875,256			—			16,875,256


FINANCING ACTIVITIES
Proceeds from issuance of common stock, net		30,829,882			—			30,829,882
Payments on notes and capital lease obligations		(6,870,094	)		—			(6,870,094	)

Net cash provided by financing activities		23,959,788			—			23,959,788


Net increase in cash and cash equivalents		2,640,356			—			2,640,356
Cash and cash equivalents at beginning of period		4,898,214			—			4,898,214

Cash and cash equivalents at end of period	$	7,538,570		$	—		$	7,538,570

2. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements of Avanir Pharmaceuticals (“Avanir,” “we,” or the “Company”) have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (“SEC”) for interim reporting including the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. These condensed statements do not include all disclosures required by accounting principles generally accepted in the United States of America (“U.S. GAAP”) for annual audited financial statements and should be read in conjunction with the Company’s audited consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended September 30, 2006. We believe these condensed consolidated financial statements reflect all adjustments (consisting only of normal, recurring adjustments) that are necessary for a fair presentation of the financial position and results of operations for the periods presented. Results of operations for the interim periods presented are not necessarily indicative of results to be expected for the year. Certain prior period amounts have been reclassified to conform to the current period presentation.

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts, and the disclosures of commitments and contingencies in the financial statements and accompanying notes. Actual results could differ from those estimates.

On August 3, 2007, the Company sold its rights to the FazaClo product and the Company’s related assets and operations. The sale was made pursuant to an agreement entered into with Azur Pharma, Inc. (“Azur”) in July 2007. In connection with the sale, the Company transferred certain assets and liabilities related to FazaClo to Azur. In the fourth quarter of fiscal 2007, the Company expects to record a net gain on the sale of FazaClo (see Note 4).

3. NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Business

Since our inception in August 1988, the Company has reported cumulative net losses of approximately $251 million (as restated) and recurring negative cash flows from operations. In July 2007, we signed an agreement to sell the Fazaclo business in August which generated approximately $31 million in available cash after fees and loan repayments. In order to maintain sufficient cash and investments to fund long term future operations, we may seek to raise additional capital through various financing alternatives. The minimum balance of securities available for sale under our existing shelf registration was approximately $28.5 million as of June 30, 2007. We believe that the net proceeds from the sale of FazaClo, plus our cash, cash equivalents and unrestricted investments in securities of approximately $9.8 million at June 30, 2007 will be sufficient to sustain our planned level of operations through the end of the next fiscal year, excluding any costs associated with the development of Zenvia for diabetic peripheral neuropathic pain. However, the Company cannot provide absolute assurances that our plans will not change, or that changed circumstances will not result in the depletion of capital resources more rapidly than anticipated. If we are unable to generate sufficient cash flows from licensed technologies or are unable to raise sufficient capital, management believes that planned expenditures could be curtailed in order to continue operations for the next 12 months.

Revenue recognition

The Company generates revenues from product sales, collaborative research and development arrangements, and other activities such as, royalties, the sale of royalty rights and sales of technology rights. Payments received under such arrangements may include non-refundable fees at the inception of the arrangements, fully burdened funding for services performed under collaborative arrangements, milestone payments for specific achievements designated in the collaborative arrangements, royalties on sales of products resulting from collaborative arrangements, and payments for the sale of rights to future royalties.

We recognize revenue in accordance with the SEC’s Staff Accounting Bulletin Topic 13 (“Topic 13”), “Revenue Recognition.” Revenue is recognized when all of the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) the seller’s price to the buyer is fixed and determinable; and (4) collectibility is reasonably assured. Certain product sales are subject to rights of return. In accordance with Statement of Financial Accounting Standards No. 48, “Revenue Recognition When Right of Return Exists” (“FAS 48”), we recognize such product revenues at the time of sale only if we have met all the criteria of FAS 48, including the ability to reasonably estimate future returns. FAS 48 states that revenue from sales transactions where the buyer has the right to return the product shall be recognized at the time of sale only if (1) the seller’s price to the buyer is substantially fixed or determinable at the date of sale, (2) the buyer has paid the seller, or the buyer is

obligated to pay the seller and the obligation is not contingent on resale of the product, (3) the buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product, (4) the buyer acquiring the product for resale has economic substance apart from that provided by the seller, (5) the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer, and (6) the amount of future returns can be reasonably estimated. We recognize such product revenues when either we have met all the criteria of FAS 48, including that ability to reasonably estimate future returns, when we can reasonably estimate that the return privilege has substantially expired, or when the return privilege has substantially expired, whichever occurs first.

We allocate amounts to separate elements in multiple element arrangements in accordance with Emerging Issues Task Force Issue No. 00-21 (“EITF 00-21”), “Accounting for Revenue Arrangements with Multiple Deliverables.” Revenues are allocated to a delivered product or service when all of the following criteria are met: (1) the delivered item has value to the customer on a standalone basis; (2) there is objective and reliable evidence of the fair value of the undelivered item; and (3) if the arrangement includes a general right of return relative to the delivered item, delivery or performance of the undelivered item is considered probable and substantially in our control. We use the relative fair values of the separate deliverables to allocate revenue. For arrangements with multiple elements that are separated, we recognize revenues in accordance with Topic 13. Revenue is recognized when all of the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) the seller’s price to the buyer is fixed and determinable; and (4) collectibility is reasonably assured. Certain sales transactions include multiple deliverables.

Product Sales

Active Pharmaceutical Ingredient Docosanol (“API Docosanol”). Revenues from the sale of our API Docosanol are recognized when title and risk of loss have passed to the buyer and provided the criteria in SAB Topic 13 are met. We sell the API Docosanol to various licensees upon receipt of a written order for the materials. Shipments generally occur fewer than five times a year. Our contracts for sales of the API Docosanol include buyer acceptance provisions that give our buyers the right of replacement if the delivered product does not meet specified criteria. That right requires that they give us notice within 30 days after receipt of the product. We have the option to refund or replace any such defective materials; however, we have historically demonstrated that the materials shipped from the same pre-inspected lot have consistently met the specified criteria and no buyer has rejected any of our shipments from the same pre-inspected lot to date. Therefore, we recognize revenue at the time of delivery without providing any returns reserve.

FazaClo. We acquired Alamo Pharmaceuticals LLC (“Alamo”) on May 24, 2006, with one marketed product, FazaClo (clozapine, USP), that began shipping to wholesale customers in July 2004 in 48-pill units. At that time, FazaClo had a two-year shelf life. In June 2005, Alamo received FDA approval to extend the product expiration date to three years. In October 2005, Alamo began shipping 96-pill units and accepted returns of unsold or undispensed 48-pill units.

During fiscal 2007, we sold FazaClo to pharmaceutical wholesalers, the three largest of which accounted for approximately 83% of our net wholesale shipments for the quarter ended and nine-months ended June 30, 2007. They resold our product to outlets such as pharmacies, hospitals and other dispensing organizations. We have agreements with our wholesale customers, various states, hospitals, certain other medical institutions and third-party payers throughout the U.S. These agreements frequently contain commercial incentives, which may include pricing allowances and discounts payable at the time the product is sold to the dispensing outlet or upon dispensing the product to patients. Consistent with pharmaceutical industry practice, wholesale customers can return purchased product during an 18-month period that begins six months prior to the product’s expiration date and ends 12 months after the expiration date. Additionally, several of our dispensing outlets have the right to return expired product at any time. Once products have been dispensed to patients the right of return expires.

Beginning in the first quarter of fiscal 2007, we obtained third-party information regarding certain wholesaler inventory levels, a sample of outlet inventory levels and third-party market research data regarding FazaClo sales. The third-party data includes, (i) IMS Health Audit - National Sales Perspective reports (“NSP”), which is a projection of near-census data of wholesaler shipments of product to all outlet types, including retail and non-retail and; (ii) IMS Health National Prescription Audit (“NPA”) Syndicated data, which captures end-user consumption from retail dispensed prescriptions based upon projected data from pharmacies estimated to represent approximately 60% to 70% of the U.S. prescription universe. Further, we analyzed historical rebates and chargebacks earned by State Medicaid, Medicare Part D and managed care customers. Based upon this additional information and analysis obtained, we estimated the amount of product that was shipped that was no longer in the wholesale or outlet channels, and hence no longer subject to a right of return. Therefore, we began recognizing revenues, net of returns, chargebacks, rebates, and discounts, in the first quarter of fiscal 2007, for product that we estimated had been sold to patients and that was no longer subject to a right of return.

We continue to accumulate historical product return data. To date we have accumulated return data for six lots which are within the 18-month return window, which have varying historical return rates. We are continuing to accumulate historical product return information, but at this time believe that we have insufficient information to reasonably estimate future product returns for revenue recognition purposes. Accordingly, we continue to defer recognizing revenues on all estimated in-channel inventories that are subject to the right of return until such time as we can reasonably estimate product returns.

Revenues are recorded net of provisions for estimated product pricing allowances including: State Medicaid base and supplemental rebates, Medicare Part D discounts, managed care contract discounts and prompt payment discounts at an aggregate rate of approximately 25.8% of gross revenues for the quarter ended June 30, 2007. Provisions for these allowances are estimated based upon contractual terms and require management to make estimates regarding customer mix to reach. We considered our current contractual rates with States related to Medicaid base and supplemental rebates, with private organizations for Medicare Part D discounts and contracts with managed care organizations. We review these rates at least quarterly and make adjustments, if necessary.

Multiple Element Arrangements.

We have arrangements whereby we deliver to the customer multiple elements including technology and/or services. Such arrangements have generally included some combination of the following: antibody generation services; licensed rights to technology, patented products, compounds, data and other intellectual property; and research and development services. In accordance with EITF 00-21, we analyze our multiple element arrangements to determine whether the elements can be separated. We perform our analysis at the inception of the arrangement and as each product or service is delivered. If a product or service is not separable, the combined deliverables will be accounted for as a single unit of accounting.

When a delivered element meets the criteria for separation in accordance with EITF 00-21, we allocate amounts based upon the relative fair values of each element. We determine the fair value of a separate deliverable using the price we charge other customers when we sell that product or service separately; however if we do not sell the product or service separately, we use third-party evidence of fair value. We consider licensed rights or technology to have standalone value to our customers if we or others have sold such rights or technology separately or our customers can sell such rights or technology separately without the need for our continuing involvement.

License Arrangements. License arrangements may consist of non-refundable upfront license fees, data transfer fees, research reimbursement payments, exclusive licensed rights to patented or patent pending compounds, technology access fees, various performance or sales milestones and future product royalty payments. These arrangements are often multiple element arrangements.

Non-refundable, up-front fees that are not contingent on any future performance by us, and require no consequential continuing involvement on our part, are recognized as revenue when the license term commences and the licensed data, technology and/or compound is delivered. Such deliverables may include physical quantities of compounds, design of the compounds and structure-activity relationships, the conceptual framework and mechanism of action, and rights to the patents or patents pending for such compounds. We defer recognition of non-refundable upfront fees if we have continuing performance obligations without which the technology, right, product or service conveyed in conjunction with the non-refundable fee has no utility to the licensee that is separate and independent of our performance under the other elements of the arrangement. In addition, if we have required continuing involvement through research and development services that are related to our proprietary know-how and expertise of the delivered technology, or can only be performed by us, then such up-front fees are deferred and recognized over the period of continuing involvement.

Payments related to substantive, performance-based milestones in a research and development arrangement are recognized as revenues upon the achievement of the milestones as specified in the underlying agreements when they represent the culmination of the earnings process.

Research Services Arrangements. Revenues from research services are recognized during the period in which the services are performed and are based upon the number of full-time-equivalent personnel working on the specific project at the agreed-upon rate. Reimbursements from collaborative partners for agreed upon direct costs including direct materials and outsourced services, or subcontracted, pre-clinical studies are classified as revenues in accordance with EITF Issue No. 99-19, “Reporting Revenue

Gross as a Principal versus Net as an Agent,” and recognized in the period the reimbursable expenses are incurred. Payments received in advance are deferred until the research services are performed or costs are incurred. These arrangements are often multiple element arrangements.

Royalty Arrangements. We recognize royalty revenues from licensed products when earned in accordance with the terms of the license agreements. Net sales amounts generally required to be used for calculating royalties include deductions for returned product, pricing allowances, cash discounts, freight and warehousing. These arrangements are often multiple element arrangements.

When we sell our rights to future royalties under license agreements and also maintain continuing involvement in earning such royalties, we defer recognition of any upfront payments and recognize them as revenues over the life of the license agreement. We recognize revenues for the sale of an undivided interest of our Abreva^® license agreement to Drug Royalty USA under the “units-of-revenue method.” Under this method, the amount of deferred revenues to be recognized in each period is calculated by multiplying the ratio of the royalty payments due to Drug Royalty USA by GlaxoSmithKline for the period to the total remaining royalties that is expected GlaxoSmithKline will pay Drug Royalty USA over the remaining term of the agreement by the unamortized deferred revenues.

Government Research Grant Revenues. We recognize revenues from federal research grants during the period in which the related expenditures are incurred.

Cost of Revenues

Cost of product revenues includes direct and indirect costs to manufacture, manufacturer royalties, write-off of obsolete inventories, and the amortization of the acquired FazaClo product rights. The cost of research and grant services includes the direct and indirect cost to provide such services.

Capitalization and Valuation of Long-Lived and Intangible Assets

In accordance with Statement of Financial Accounting Standards No. 141, “Business Combinations” (“FAS 141”) and Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“FAS 142”), goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead are tested for impairment on an annual basis or more frequently if certain indicators arise. Goodwill represents the excess of purchase price of an acquired business over the fair value of the underlying net tangible and intangible assets. The Company operates in one segment and goodwill is evaluated at the company level as there is only one reporting unit. Goodwill is tested for impairment in the fourth quarter of each fiscal year.

Intangible assets with finite useful lives are amortized over their respective useful lives and reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“FAS 144”.) The method of amortization reflects the pattern in which the economic benefits of the intangible asset are consumed or otherwise used up. If that pattern cannot be reliably determined, a straight-line amortization method will be used. Intangible assets with finite useful lives include product rights, customer relationships, trade name, non-compete agreement and license agreement, and are being amortized over their estimated useful lives ranging from one to 15.5 years.

In accordance with FAS 144, intangible assets with finite useful lives are evaluated for impairment whenever events or changes in circumstances indicate that their carrying value may not be recoverable. If the review indicates that intangible assets or long-lived assets are not recoverable (i.e. the carrying amount is less than the future projected undiscounted cash flows), their carrying amount would be reduced to fair value. Factors we consider important that could trigger an impairment review include a significant underperformance relative to expected historical or projected future operating results; a significant change in the manner of our use of the acquired asset or the strategy for our overall business; and/or a significant negative industry or economic trend.

Prior to October 1, 2005, intangible assets with finite useful lives also included capitalized legal costs incurred in connection with approved patents and patent applications pending. We amortized the costs of patents and patent applications that are pending over their estimated useful lives. For patents pending, we amortized the costs over the shorter of a period of twenty years from the date of filing the application or, if licensed, the term of the license agreement. For patent and patent applications pending and trademarks that we abandon, we charge the remaining unamortized accumulated costs to expense.

Share-Based Compensation

We adopted the provisions of revised Statement of Financial Accounting Standards No. 123 (“FAS 123R”), “Share-Based Payment,” including the provisions of Staff Accounting Bulletin No. 107 (“SAB 107”) on October 1, 2005, the first day of our fiscal 2006, using the modified prospective transition method to account for our employee share-based awards. The valuation provisions of FAS 123R apply to new awards and to awards that are outstanding at the effective date and subsequently modified or cancelled. Estimated compensation expense for awards outstanding at the effective date are being recognized over the remaining service period using the compensation cost calculated for pro forma disclosure purposes under Statement of Financial Accounting Standards No. 123, “Accounting for Share-based Compensation” (“FAS 123”).

On November 10, 2005, the FASB issued FASB Staff Position No. FAS 123R-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards” (“FAS 123R-3”). We have elected to adopt the alternative transition method provided in FAS 123R-3. The alternative transition method includes a simplified method to establish the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employee share-based compensation, which is available to absorb tax deficiencies recognized subsequent to the adoption of FAS 123R.

Share-based compensation expense recognized during a period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Share-based compensation expense recognized in our condensed consolidated statements of operations for the three-month and nine-month periods ended June 30, 2007 and 2006 include compensation expense under research & development expenses and selling, general and administrative expenses for share-based payment awards granted prior to, but not yet vested as of September 30, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of FAS 123, adjusted for estimated forfeitures, and share-based payment awards granted subsequent to September 30, 2005 based on the grant date fair value estimated in accordance with FAS 123R. For share awards granted prior to October 1, 2005, expenses are amortized under the straight-line single option method prescribed by FAS 123.

Share-based compensation expense recognized in the condensed consolidated statements of operations is based on awards ultimately expected to vest, reduced for estimated forfeitures. FAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures rates differ from those estimates. The estimation of the number of stock awards that will ultimately be forfeited requires judgment, and to the extent actual results or updated estimates differ from the Company’s current estimates, such amounts will be recorded as a cumulative adjustment in the period in which estimates are revised. The Company considers many factors when estimating expected forfeitures, including types of awards, employee class and historical experience. During the second quarter of fiscal 2007, the Company updated its projected forfeiture rates as it applies to share-based compensation considering recent actual data following the implementation of various restructuring initiatives earlier that year. Forfeiture rates for the nine-month periods ended June 30, 2007 and 2006 were estimated to be approximately 30% and 8%, respectively, for both officers and directors, and 30% and 13%, respectively, for other employees based on our historical experience. Future estimates, may differ substantially from the Company’s current estimates.

Share-based compensation expense under FAS 123R was $538,000 and $757,000 in the three-month periods ended June 30, 2007 and 2006, respectively. Share-based compensation expense under FAS123R, excluding the second quarter 2007 cumulative adjustment for the change in estimated forfeitures, was $2.3 million and $2.0 million for the nine-month periods ended June 30, 2007 (as restated) and 2006, respectively. The change in estimated forfeiture rates in the second quarter 2007 had the effect of decreasing operating expenses by $245,000, and decreased the diluted loss per share by $0.01, for the nine-months ended June 30, 2007 (as restated).

Total compensation expense related to all of our share-based awards, recognized under FAS 123R, for the three-month periods ended June 30, 2007 and 2006 and the nine-month periods ended June 30, 2007 and 2006 was comprised of the following:


	For the three months ended						For the nine months ended
	June 30,						June 30,
	2007			2006			2007			2006
							(as restated)
Share-based compensation expense from:
Stock options	$	302,505		$	397,222		$	960,407		$	1,044,276
Restricted stock awards		35,430			302,403			425,190			845,877
Restricted stock units		199,708			57,775			670,028			86,980

Total	$	537,643		$	757,400		$	2,055,625		$	1,977,133

Loss per share	$	(0.01	)	$	(0.02	)	$	(0.06	)	$	(0.07	)

Since we have a net operating loss carry forward as of June 30, 2007, no excess tax benefits for the tax deductions related to share-based awards were recognized in the consolidated statements of operations. Additionally, no incremental tax benefits were recognized from stock options exercised in the three and nine month periods ended June 30, 2007 and 2006 that would have resulted in a reclassification to reduce net cash provided by operating activities with an offsetting increase in net cash provided by financing activities.

Change in Accounting for Patent-Related Costs

In the fourth quarter of fiscal 2006, we changed our method of accounting, effective October 1, 2005 for legal costs which included only external legal costs and were associated with the application for patents. Prior to the change, we expensed as incurred all internal costs associated with the application for patents and capitalized external legal costs associated with the application for patents. Costs of approved patents were amortized over their estimated useful lives or if licensed, the terms of the license agreement, whichever was shorter, while costs for patents pending were amortized over the shorter period of twenty years from the date of the filing application or if licensed, the term of the license agreement. Under the new method, external legal costs are expensed as incurred and classified as selling, general and administrative expenses in our consolidated statements of operations. We believe that this change is preferable because it will result in a consistent treatment for all costs by expensing both internal and external costs associated with the application for patents as these costs are incurred. In addition, the change will provide a better comparison with our industry peers. The cumulative effect of the change of $3.6 million is included as a charge to the net loss, retrospectively applied to the first quarter of fiscal year 2006. The effect of the change for fiscal 2006 was to increase the net loss by approximately the cumulative effect of the change on prior years, or $0.12 per basic and diluted share.

Recently Issued Accounting Pronouncements

In July 2006, the FASB issued FIN 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB 109” which prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on derecognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. The accounting provisions of FIN 48 will be effective for us beginning October 1, 2007. We are in the process of determining the effect, if any, the adoption of FIN 48 will have on our financial statements.

In September 2006, the FASB issued FAS 157, “Fair Value Measurements.” FAS 157 defines fair value, established a framework for measuring fair value in generally accepted accounting principles (GAAP) and expands disclosures about fair value measurements. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. We do not expect the adoption of FAS 157 to significantly affect our financial condition or results of operations.

In February 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities- Including an Amendment of FASB Statement No. 115” (“FAS 159”). FAS 159 would create a fair value option of accounting for qualifying financial assets and liabilities under which an irrevocable election could be made at inception to measure such assets and liabilities initially and subsequently at fair value, with all changes in fair value reported in earnings. FAS 159 is effective as of the beginning of the first fiscal year beginning after November 15, 2007. The Company is currently evaluating the impact that the adoption of FAS 159 will have on its consolidated financial position, results of operations and cash flows.

4. ALAMO PHARMACEUTICALS, INC.

On May 24, 2006, we acquired all of the outstanding equity interests in Alamo from the former members of Alamo (the “Selling Holders”) for approximately $30.0 million in initial consideration, consisting of approximately $4.0 million in cash, $25.1 million in promissory notes and the payment of $912,000 in acquisition-related transaction costs. The results of operations of Alamo have been included in our consolidated financial statements since the date of acquisition. The Company intended to leverage the FazaClo sales force to assist with the commercial launch of Zenvia, which was planned for early 2007; however, due to the receipt of the approvable letter and resulting delay in the planned launch of Zenvia, we entered into an agreement to sell FazaClo in July 2007. Details of the sale of FazaClo are described below.

In connection with the Alamo acquisition, we also agreed to pay the Selling Holders up to an additional $39,450,000 in revenue-based earn-out payments, based on future sales of FazaClo (clozapine USP), Alamo’s orally disintegrating drug for the treatment of refractory schizophrenia. In the quarter ended March 30, 2007, we issued an additional $2,000,000 promissory note based on FazaClo sales rates through that quarter and in the quarter ended June 30, 2007, we issued a second promissory note, also in the principal amount of $2,000,000. The remaining earn-out payments of $35,450,000 are based on the achievement of certain target levels of FazaClo sales in the U.S. from the closing date of the acquisition through December 31, 2018. In connection with the FazaClo sale, Azur assumed these remaining contingent payment obligations, however, we are still contingently liable in the event of default by Azur.

We also previously agreed to pay the Selling Holders one-half of all net licensing revenues that we may receive through December 31, 2018 from licenses of FazaClo outside of the U.S., if any (“Non-US Licensing Revenues”). There were no Non-US Licensing Revenues through August 3, 2007, the date of sale of FazaClo, and these future obligations have been assumed by Azur as described below. We also agreed to apply 20% of any future net offering proceeds to repay the promissory notes and through June 30, 2007, we have paid approximately $6.1 million of the principal amounts due under the notes. In August 2007, we paid an additional $11 million of outstanding principal and interest under these notes and amended our agreement with the Selling Holders to partially suspend the early payment obligations remaining under the promissory notes.

Purchase Price Allocation

In accordance with FAS 141, we allocated the total purchase price to the tangible and identifiable intangible assets acquired and liabilities assumed based on their preliminary estimated fair values as of the date of acquisition, using the purchase method of accounting

The components of the purchase price allocation are as follows as of June 30, 2007:


Purchase price:
Cash paid at closing	$	4,040,000
Estimated fair value of notes payable issued, net of imputed discount		28,343,000
Transaction costs		911,536

	$	33,294,536

Allocation:
Net tangible assets acquired	$	5,749,898
Identifiable intangible assets acquired		11,960,000
Goodwill		22,042,439

Total assets acquired		39,752,337
Liabilities assumed		(6,457,801	)

	$	33,294,536

Pursuant to EITF 01-3, “Accounting in a Business Combination for Deferred Revenue of an Acquiree,” we did not assume Alamo’s deferred revenue balance as of the acquisition date, and accordingly will not record revenue associated with product that was shipped prior to the acquisition date. However, in connection with the acquisition, we assumed an obligation for future product returns, pricing allowances and royalties associated with pre-acquisition shipments of FazaClo. As such, we recorded preliminary estimated liabilities for such returns and other discounts of $6.5 million based on our estimate of the fair values of these liabilities at the acquisition date, which is classified as assumed liabilities for returns and other discounts in the accompanying consolidated balance sheets. Since the acquisition in May 2006 the Company has been receiving and analyzing historical data regarding FazaClo product returns and product pricing allowances (See Note 3 Revenue Recognition- Product Sales). Based on this analysis, the Company recorded in the first

quarter and second quarters of fiscal year 2007, adjustments to reduce the preliminary estimate of these assumed liabilities by $3.1 million and $1.0 million, respectively, and recorded a corresponding reduction in goodwill. The remaining liabilities associated with Fazaclo will be eliminated in the quarter and year ending September 30, 2007 in connection with our sale of FazaClo.

We determined fair values of identifiable intangible assets acquired based on estimates and assumptions by management on projected sales and product returns, pricing allowances and discounts. Identifiable intangible assets acquired represent expected benefits of the FazaClo product rights, customer relationships, trade name and non-compete agreement. The fair values of the customer relationships, technology, trade name and covenants not to compete were determined using an income approach and discounted cash flow (“DCF”) techniques. The fair value of the software registry and assembled workforce were determined using a cost approach. The remaining goodwill value of the Company was determined using a residual approach, by comparing the total fair market value of the assumed liabilities and equity consideration paid less the fair value of the tangible and identified intangible assets.

The identifiable intangible assets are being amortized, with the annual amortization amount based on the rate of consumption of the expected benefits of the intangible, if identifiable, or the straight-line method over the remaining estimated economic life ranging from one to 12 years, if the rate of consumption of the expected benefits cannot be reasonably determined otherwise. Since the acquisition of Alamo, the Company has recorded amortization expense relating to the identifiable intangible assets of $1.9 million. A detailed schedule of estimated amortization percentages by year is included in the Company’s Annual Report on Form 10-K for the year ended September 30, 2006.

In-Process Research and Development

We evaluated research and development projects including new manufacturing technology for FazaClo under development by CIMA Labs. As the basis for identifying whether or not the development projects represented in-process research and development (“IPR&D”), we conducted an evaluation in the context of FASB Interpretation 4 (“FIN 4: Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method”). A detailed discussion of the Company’s examination of in-process research and development is included in the Company’s Annual Report on Form 10-K for the year ended September 30, 2006.

Pro Forma Results of Operations for Acquisition

The following unaudited financial information presents the pro forma results of operations and gives effect to the Alamo acquisition as if the acquisition was consummated at the beginning of fiscal 2006. The Company also presented pro forma results of operations accounting for the FazaClo disposition in the Company’s Current Report of Form 8-K filed on August 8, 2007.


	For the			For the
	three months ended			nine months ended
	June 30,2006			June 30, 2006

Pro forma net revenues(1)	$	2,551,218		$	15,294,299
Pro forma net loss(2)	$	(12,651,297	)	$	(45,681,343	)
Pro forma loss per basic and diluted share	$	(0.40	)	$	(1.51	)
Shares used for basic and diluted computation		31,419,394			30,352,690


(1)		In accordance with the provisions of EITF 01-3, we will not recognize deferred revenues recorded as of the acquisition date, resulting in lower net revenues in the periods following the merger than Alamo would likely have achieved as a separate company.

(2)		Pro forma net loss for the periods presented includes the amortization of identifiable intangible assets, interest expense associated with the notes payable issued as part of the purchase price, elimination of interest expense associated with Alamo’s historical debt that was not assumed by us in the acquisition, reduction of interest income by an amount determined by applying the average rate of return for the respective periods to the decrease in our cash balance of $4.0 million used to fund the acquisition, and amortization of discount associated with the notes payable. The charge of $1.3 million for purchased IPR&D is not included in the pro forma results of operations because it reflects a one-time charge directly related to the acquisition and does not have a continuing impact on our future operations.

Sale of FazaClo/Subsequent Event

In July 2007, the Company entered into a definitive agreement to sell FazaClo to Azur Pharma. The transaction closed on August 3, 2007, at which time the Company received approximately $43.9 million in upfront consideration. The Company has the right to receive up to an additional $10 million in contingent payments in 2009, subject to the satisfaction of certain regulatory conditions. In addition, the Company could receive up to $2 million in royalties, based on 3% of annualized net product revenues in excess of $17 million. The Company’s earn-out obligations that would have been payable to the prior owner of Alamo Pharmaceuticals upon the achievement of certain milestones were assumed by Azur Pharma, however the Company is contingently liable in the event of default. The Company transferred all FazaClo related business operations to Azur Pharma in August 2007.

The estimated gain resulting from the sale of FazaClo is approximately $11.6 million which will be recorded in the fourth fiscal quarter of 2007. The carrying amounts of the assets and liabilities included as part of the disposal group as of the close of the transaction, August 3, 2007, are as follows:


	As of
	August 3, 2007
ASSETS
CURRENT ASSETS:
Receivables, net	$	2,606,463
Inventory		1,267,460
Prepaids		45,251

TOTAL CURRENT ASSETS		3,919,174


Property and equipment		611,727
Intangible assets		8,916,091
Goodwill		20,042,439

TOTAL ASSETS	$	33,489,431


LIABILITIES

CURRENT LIABILITIES:
Accounts payable	$	47,307
Accrued expenses		326,739
Accrued chargebacks and rebates		1,660,902
Deferred revenue		2,000,000

TOTAL CURRENT LIABILITIES	$	4,034,948


NET ASSETS INCLUDED IN DISPOSAL GROUP	$	29,454,483

5. RELOCATION OF COMMERCIAL AND GENERAL AND ADMINISTRATIVE OPERATIONS

In fiscal 2006, we relocated all operations other than research and development from San Diego, California to Aliso Viejo, California. Further, in the quarter ended June 30, 2007, the Board of Directors approved a plan of disposition to exit the Company’s facilities in San Diego. Pursuant to this plan, the Company subleased a total of approximately 48,000 square feet of laboratory and office space in San Diego and relocated remaining personnel and clinical trial support functions to the Company’s offices in Orange County, California. The disposition of these facilities follows the Company’s receipt of non-renewal and termination notices from Novartis and AstraZeneca, respectively. In the third quarter of fiscal 2007, the Company recorded restructuring expenses of approximately $3.3 million, including approximately $2.6 million of non-cash charges. These restructuring expenses include severance of approximately $700,000, the acceleration of amortization of leasehold improvements of approximately $900,000 and the recognition of the loss under the expected terms of the sublease of approximately $1.7 million.

The following table presents the restructuring activities for the nine-months ended June 30, 2007:


	September 30,							June 30,
	2006		Additions		Payments			2007
Accrued Restructuring:
Employee severance and relocation benefits	$	237,050	$	771,852	$	(1,008,902	)	$	—
Lease restructuring liability fiscal year 2006		273,998		—		(32,661	)		241,337
Lease restructuring liability fiscal year 2007		—		1,742,696		—			1,742,696

Total	$	511,048	$	2,514,548	$	(1,041,563	)	$	1,984,033

The lease restructuring liability is included in “Other Current Liabilities” and “Other Non-Current Liabilities” in the accompanying consolidated balance sheet.

6. INVENTORIES

Components of inventories are as follows:


	June 30,		September 30,
	2007		2006
Raw materials	$	1,599,254	$	923,822
Work in progress		225,463		80,580
Finished goods		535,384		1,642,208
Finished goods — FazaClo inventories subject to return		201,454		536,017

Total inventories	$	2,561,555	$	3,182,627

Inventories include costs associated with marketed products and certain products prior to regulatory approval based upon estimated probable future use. We could be required to expense these costs related to pre-approval or pre-launch inventory upon a change in such judgment, due to a denial or delay of approval by regulators, a delay in commercialization, or other potential factors. At June 30, 2007, we had $1.1 million of raw material inventory costs related to the pre-approved drug Zenvia. As of September 30, 2006 we had $347,424 of Abreva classified as long-term in other assets. Inventories subject to return are the costs associated with FazaClo shipments not yet recognized as revenues.

7. ACCRUED EXPENSES

Accrued expenses and other liabilities at June 30, 2007 and September 30, 2006 are as follows:


	June 30, 2007		September 30, 2006

Accrued compensation and payroll taxes	$	2,570,821	$	3,125,862
Accrued returns, rebates and other discounts		2,692,486		2,371,703
Accrued research and development expenses		3,960,371		3,947,191
Accrued sales and marketing expenses		1,171,836		2,354,344
Deferred rent		664,399		680,730
Other		1,318,498		503,671

Total	$	12,378,411	$	12,983,501

8. DEFERRED REVENUES

The following table sets forth as of June 30, 2007 the deferred revenue balances for our sale of future Abreva^® royalty rights to Drug Royalty USA, FazaClo product shipments and other agreements.


	Drug Royalty			FazaClo
	USA			Net			Other
	Agreement			Shipments			Agreements			Total

Deferred revenues as of October 1, 2006	$	17,111,913		$	3,955,150		$	2,242,262		$	23,309,325
Changes during the period:
Shipments, net		—			13,111,375			244,587			13,355,962
Recognized as revenues during period		(1,741,485	)		(15,038,523	)		(1,806,987	)		(18,586,995	)

Deferred revenues as of June 30, 2007	$	15,370,428		$	2,028,002		$	679,862		$	18,078,292


Classified and reported as:
Current portion of deferred revenues	$	2,065,890		$	2,028,002		$	263,763		$	4,357,655
Deferred revenues, net of current portion		13,304,538			—			416,099			13,720,637

Total deferred revenues	$	15,370,428		$	2,028,002		$	679,862		$	18,078,292

See Note 4 for a discussion regarding the August 2007 sale of FazaClo to Azur Pharma.

9. NET PRODUCT REVENUES

We recognized net revenues on FazaClo product sales of $4.9 million in the third quarter ended June 30, 2007 and $3.8 million in the second quarter ended March 31, 2007. Revenues recognized for the first quarter include wholesale shipments deferred as of September 30, 2006. FazaClo net product revenues for the three and nine months ended June 30, 2007 are as follows:


	For the three			For the nine months
	months ended			ended
	June 30, 2007			June 30, 2007

Gross product revenues	$	6,545,786		$	20,802,601
Less product sales allowances :
Prompt payment discount		(56,635	)		(341,771	)
Medicaid and managed care rebates		(811,678	)		(2,775,494	)
Chargebacks and other fees		(738,765	)		(2,646,813	)


Net product revenues	$	4,938,708		$	15,038,523

See Note 4 for a discussion regarding the August 2007 sale of FazaClo to Azur Pharma.

10. COMPUTATION OF NET LOSS PER COMMON SHARE

Basic net loss per common share is computed by dividing net loss by the weighted-average number of common shares outstanding during the period, excluding restricted stock that has been issued but is not yet vested. Diluted net loss per common share is computed by dividing net loss by the weighted-average number of common shares outstanding during the period plus additional weighted average common equivalent shares outstanding during the period. Common equivalent shares result from the assumed exercise of outstanding stock options and warrants (the proceeds of which are then presumed to have been used to repurchase outstanding stock using the treasury stock method) and the vesting of restricted shares of common stock. In the loss periods, certain of the common equivalent shares have been excluded from the computation of diluted net loss per share, because their effect would have been anti-dilutive. For the nine-month period ended June 30, 2007, a total of 1,011,544 stock options and 1,018,943 stock warrants, were excluded from the computation of diluted net loss per share. For the nine-month period ended June 30, 2006 a total 1,610,559 of stock options and 269,305 of stock warrants were excluded from the computation of diluted net loss per share.

11. COMPREHENSIVE LOSS

Comprehensive loss consists of the following:


	For the three months						For the nine months
	ended June 30,						Ended June 30,
	2007			2006			2007			2006
							(as restated)
Net loss	$	(9,150,379	)	$	(17,619,218	)	$	(33,018,268	)	$	(40,375,674	)
Other comprehensive loss, net of tax:
Unrealized (loss) gain on available-for-sale securities		3,042			59,829			82,341			(131,502	)

Total comprehensive loss	$	(9,147,337	)	$	(17,559,389	)	$	(32,935,927	)	$	(40,507,176	)

12. SHAREHOLDERS’ EQUITY

In November 2006, we sold and issued 5,263,158 shares of our Class A common stock for aggregate gross offering proceeds of $15.0 million ($14.4 million after expenses). In connection with this offering, we issued warrants to purchase a total of 1,053,000 shares of our Class A common stock at an exercise price of $3.30 per share. The warrants became exercisable beginning in May 2007 and all unexercised warrants expire in November 2007. The warrants may be exercised on a net basis in certain circumstances, but in no event is the Company obligated to settle the warrants in cash. During the nine month period ended June 30, 2007 we sold 6,125,632 shares of our Class A common stock under our financing facility with Brinson Patrick Securities Corporation, raising net offering proceeds of $16.2 million. These offerings were made pursuant to our shelf registration statement on Form S-3 filed on July 22, 2005. Approximately $6.1 million of the net proceeds from these offerings were used to partially repay the outstanding principal balance of a note payable issued in the Alamo acquisition, with such repayment being made in accordance with the terms of the note.

In the nine months ended June 30, 2007, we issued to employees 15,000 shares of restricted stock awards at a weighted average grant date fair value of $7.34 and with a purchase price of $0.01 per share. During the nine months ended June 30, 2007, we also awarded 2,320,143 of restricted stock units with a grant date fair value of $1.74 and no purchase price per share.

As of June 30, 2007, warrants to purchase 1,322,305 shares of common stock at a weighted-average exercise price per share of $4.44 remained outstanding, of which all are exercisable.

13. EMPLOYEE EQUITY INCENTIVE PLANS

We currently have five equity incentive plans (the “Plans”): the 2005 Equity Incentive Plan (the “2005 Plan”), the 2003 Equity Incentive Plan (the “2003 Plan”), the 2000 Stock Option Plan (the “2000 Plan”), the 1998 Stock Option Plan (the “1998 Plan”) and the 1994 Stock Option Plan (the “1994 Plan”), which are described below. All of the Plans were approved by the shareholders, except for the 2003 Equity Incentive Plan, which was approved solely by the Board of Directors. Share-based awards are subject to terms and conditions established by the Compensation Committee of our Board of Directors. Our policy is to issue new common shares upon the exercise of stock options, conversion of share units or purchase of restricted stock.

During the three-month and nine-month periods ended June 30, 2007 and 2006, we granted share-based awards under both the 2003 Plan and the 2005 Plan. Under the 2003 Plan and 2005 Plan, options to purchase shares, restricted stock units, restricted stock and

other share-based awards may be granted to our employees and consultants. Under the Plans, as of June 30, 2007, we had an aggregate of 1,803,045 shares of our common stock reserved for future issuance. Of those shares, 891,544 were subject to outstanding options and other awards and 911,501 shares were available for future grants of share-based awards. As of June 30, 2007, no options were outstanding to consultants. We may also, from time to time, issue share-based awards outside of the Plans to the extent permitted by NASDAQ rules. As of June 30, 2007, options to purchase 120,000 shares of our common stock that were issued outside of the Plans (inducement option grants) were outstanding. None of the share-based awards is classified as a liability as of June 30, 2007.

Stock Options. Stock options are granted with an exercise price equal to the current market price of our common stock at the grant date and have 10-year contractual terms. For option grants to employees, 25% of the option shares vest and become exercisable on the first anniversary of the grant date and the remaining 75% of the option shares vest and become exercisable quarterly in equal installments thereafter over three years; for option grants to non-employee directors, one-third of the option shares vest and become exercisable on the first anniversary of the grant date and the remaining two-thirds of the option shares vest and become exercisable daily or quarterly in equal installments thereafter over two years; and for certain option grants to non-employee directors, options fully vest and become exercisable at the date of grant. Certain option awards provide for accelerated vesting if there is a change in control (as defined in the Plans).

Summaries of stock options outstanding and changes during the nine-month period ended June 30, 2007 are presented below.


						Weighted
				Weighted		average
				average		remaining
				exercise		contractual		Aggregate
				price per		term		intrinsic
	Number of shares			share		(in years)		value
Outstanding, October 1, 2006		1,587,070		$	10.07		7.2	$	817,000
Granted		369,380		$	5.14
Exercised		(67,758	)	$	4.33
Forfeited		(869,023	)	$	10.16
Expired		(8,125	)	$	7.89

Outstanding, June 30, 2007		1,011,544		$	8.59		8.3	$	169,656


Vested and expected to vest in the future, June 30, 2007		763,365		$	9.34		0.6	$	68,169

Exercisable, June 30, 2007		341,118		$	10.40		6.6	$	—

The weighted average grant-date fair values of options granted during the nine-month periods ended June 30, 2007 and 2006 were $2.14 and $7.42 per share, respectively. The total intrinsic value of options exercised during the nine-month periods ended June 30, 2007 and 2006 was $271,141 and $4.6 million, respectively, based on the differences in market prices on the dates of exercise and the option exercise prices. As of June 30, 2007 (as restated), the total unrecognized compensation cost related to unvested options was $2,671,291 which is expected to be recognized over the weighted-average period of 2.9 years, based on the vesting schedules.

The fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton option pricing model (“Black-Scholes model”), which uses the assumptions noted in the following table. Expected volatilities are based on historical volatility of our common stock and other factors. The expected term of options granted is based on analyses of historical employee termination rates and option exercises. The risk-free interest rates are based on the U.S. Treasury yield for a period consistent with the expected term of the option in effect at the time of the grant.

Assumptions used in the Black-Scholes model for options granted during the nine-month periods ended June 30, 2007 and 2006 were as follows:


	2007			2006
Expected volatility		75%-103	%		77.5% - 80.4	%
Weighted-average volatility		88	%		78.6	%
Average expected term in years		6.0			4.5
Risk-fee interest rate (zero coupon U.S. Treasury Note)		4.7	%		4.5	%
Expected dividend yield		0	%		0	%

The following table summarizes information concerning outstanding and exercisable Class A stock options as of June 30, 2007:


	Options Outstanding						Options Exercisable
			Weighted
			Average		Weighted				Weighted
			Remaining		Average				Average
Range of	Number		Contractual		Exercise		Number		Exercise
Exercise Prices	Outstanding		Life in Years		Price		Exercisable		Price
$1.20 -$4.64		228,931		8.9	$	2.09		38,471	$	4.19
$5.12 -$6.92		168,054		7.8	$	6.34		42,679	$	6.07
$7.12 -$9.92		120,440		8.4	$	8.69		42,855	$	8.92
$10.10 - $10.70		146,250		8.8	$	10.68		42,189	$	10.65
$11.08 - $11.76		184,572		8.0	$	11.71		94,050	$	11.70
$12.12 - $13.84		90,022		7.5	$	13.18		50,567	$	13.17
$14.28 - $19.38		73,275		7.7	$	16.24		30,307	$	17.45

		1,011,544		8.3	$	8.59		341,118	$	10.40

Restricted stock units. RSUs generally vest based on three years of continuous service and may not be sold or transferred until the awardee’s termination of service. The following table summarizes the RSU activities for the nine months ended June 30, 2007:


				Weighted
	Number of			average grant
	shares			date fair value
Unvested, October 1, 2006		51,480		$	15.54
Granted		2,320,143		$	1.74
Vested		—		$	—
Forfeited		(263,920	)	$	2.79

Unvested, June 30, 2007		2,107,703		$	1.94

The grant-date fair value of RSUs granted during the nine-month periods ended June 30, 2007 and 2006 was $4,031,886 and $800,000, respectively. During the nine-month period ended June 30, 2006, 51,480 RSUs were granted. As of June 30, 2007 (as restated), the total unrecognized compensation cost related to unvested shares was $3,532,928 which is expected to be recognized over a weighted-average period of 2.5 years, based on the vesting schedules.

Restricted stock awards. Restricted stock awards are grants that entitle the holder to acquire shares of restricted common stock at a fixed price, which is typically nominal. The shares of restricted stock cannot be sold, pledged or otherwise disposed of until the award vests, and any unvested shares may be reacquired by us for the original purchase price following the awardee’s termination of service. The restricted stock awards typically vest on the second or third anniversary of the grant date or on a graded vesting schedule over three years of employment. A summary of our unvested restricted stock awards as of June 30, 2007 and changes during the nine month period ended June 30, 2007 are presented below.


				Weighted
	Number of			average grant
	shares			date fair value
Unvested, October 1, 2006		223,915		$	13.48
Granted		15,000		$	7.34
Vested		(44,999	)	$	13.96
Forfeited		(150,999	)	$	13.54

Unvested, June 30, 2007		42,917		$	10.62

The grant-date fair value of restricted stock awards granted in the nine month periods ended June 30, 2007 and 2006 was $110,025 and $640,000, respectively. As of June 30, 2007 (as restated), the total unrecognized compensation cost related to unvested shares was $339,234 which is expected to be recognized over a weighted-average period of 1.0 year.

During the nine month periods ended June 30, 2007 and 2006, we received a total of $293,510 and $3.3 million, respectively, in cash from exercised options and restricted stock awards under all share-based payment arrangements. No tax benefit was realized for the tax deductions from option exercise of the share-base payment arrangements in the nine month periods ended June 30, 2007 and 2006.

14. COMMITMENTS AND CONTINGENCIES

Center for Neurologic Study (“CNS”) — We hold the exclusive worldwide marketing rights to Zenvia for certain indications pursuant to an exclusive license agreement with the CNS. We will be obligated to pay CNS up to $400,000 in the aggregate in milestones to continue to develop Zenvia for both IEED/PBA and diabetic peripheral neuropathic pain (“DPN pain”), assuming they are both approved for marketing by the FDA. We are not currently developing, nor do we have an obligation to develop, any other indications under the CNS license agreement. In fiscal 2005, we paid $75,000 to CNS under the CNS license agreement, and will need to pay a $75,000 milestone if the FDA approves Zenvia for the treatment of IEED/PBA. In addition, we are obligated to pay CNS a royalty on commercial sales of Zenvia with respect to each indication, if and when the drug is approved by the FDA for commercialization. Under certain circumstances, we may have the obligation to pay CNS a portion of net revenues received if we sublicense Zenvia to a third party. Under our agreement with CNS, we are required to make payments on achievements of up to a maximum of ten milestones, based upon five specific medical indications. Maximum payments for these milestone payments could total approximately $2.1 million if we pursued the development of Zenvia for all of the licensed indications. Of the clinical indications that we currently plan to pursue, expected milestone payments could total $800,000. In general, individual milestones range from $150,000 to $250,000 for each accepted new drug application (“NDA”) and a similar amount for each approved NDA. In addition we are obligated to pay CNS a royalty ranging from approximately 5% to 7% of net revenues.

Eurand Agreement for Zenvia - — In August 2006, we entered into a development and license agreement with Eurand, Inc. (“Eurand”), under which Eurand will provide R&D services using Eurand’s proprietary technology to develop a once-a-day controlled release capsule, a new formulation, of Zenvia for the treatment of IEED/PBA. Under this agreement, we will be required to make payments of up to $7.6 million, contingent upon achievement of certain development milestones, and up to $14.0 million, contingent upon achievement of certain sales targets. Development milestone events include program initiation, delivery of prototypes, delivery of clinical trial material for phase 1, achieving target PK Profile in the pilot clinical study, delivery of clinical trial material for phase 3, filing of the first NDA for the Product with the FDA, completion of manufacturing validation and approval of the NDA with the FDA. Payment target milestones are $2.0 million upon achieving $100 million of U.S. net revenues, $4.0 million upon achieving $200 million of U.S. net revenues and $8.0 million upon achieving $400 million of U.S. net revenues. The agreement remains in effect on a country by country basis for the longer of 10 years after first commercial sale or the life of any Eurand patent, unless earlier terminated in accordance with the agreement. In November 2006, we notified Eurand to suspend activity on this project until further notice. The Company may terminate the agreement upon 30 days notice in the event the company receives a response from the FDA that is something other than an unconditional approval. Upon expiration of the agreement the Company shall own a fully-paid irrevocable license to the licensed Eurand technology.

CIMA Agreement for FazaClo — In connection with the Alamo acquisition, we acquired a development, license and supply agreement with CIMA Labs Inc. (“CIMA”), which holds intellectual property rights related to certain aspects of the development and production of FazaClo. The CIMA agreement extends through the life of the longest FazaClo patent. Currently the patent that relates to the OraSolv formulation expires in 2010 and the patent that relates to PakSolv expires in 2018. In the third fiscal quarter of 2007 we achieved approval of the DuraSolv formulation, thereby extending the patent life to 2019. The agreement terminates for insolvency by either party, with 60-day notice if certain terms of the agreement are not met, with 60-days notice if we fail to pay royalties, and CIMA can terminate region-by-region if Alamo/Avanir does not commercialize in other regions. See Note 4 for a discussion regarding the August 2007 sale of FazaClo to Azur Pharma.

In the ordinary course of business, we may face various claims brought by third parties and we may, from time to time, make claims or take legal actions to assert or protect our rights. Any of these claims could subject us to costly litigation and, while we generally believe that we have adequate insurance to cover many different types of liabilities, our insurance carriers may deny coverage or our policy limits may be inadequate to fully satisfy any damage awards or settlements. If this were to happen, the payment of any such awards could have a material adverse effect on our operations, cash flows and financial position. Additionally, any such claims, whether or not successful, could damage our reputation and business. Management believes the outcome of currently pending claims and lawsuits will not likely have a material effect on our operations or financial position.

In addition, we could terminate contracts with certain vendors, including Clinical Research Organizations, where such terminations could result in substantial termination fees.

15. SEGMENT INFORMATION

We operate our business on the basis of a single reportable segment, which is the business of discovery, development and commercialization of novel therapeutics for chronic diseases. Our chief operating decision-maker is the Chief Executive Officer, who evaluates our Company as a single operating segment.

We categorize revenues by geographic area based on selling location. All our operations are currently located in the U.S.; therefore, total revenues for the three and nine month periods ended June 30, 2007, fiscal 2006, 2005 and 2004 are attributed to the U.S. All long-lived assets at June 30, 2007 and September 30, 2006, are located in the U.S. For purposes of the evaluation for impairment of goodwill, the Company’s operating segment represents its single reporting unit.

For the nine-month period ended June 30, 2007, 6% of our total net revenues were derived from our license agreement with AstraZeneca. No revenue was derived from AstraZeneca in the three-month period ended June 30, 2007. For the three-month and nine-month periods ended June 30, 2007, the sale of rights to royalties under the GlaxoSmithKline license agreement were 6% and 9%, respectively, of our total net revenues. For the three-month and nine-month periods ended June 30, 2006, 53% and 75%, respectively, of our total net revenues were derived from our license agreement with AstraZeneca. For the three-month and nine-month periods ended June 30, 2006, the sale of rights to royalties under the GlaxoSmithKline license agreement were 20% and 11%, respectively of our total net revenues. Net receivables from AstraZeneca and Novartis accounted for approximately 3% and 3%, respectively, of our net receivables at June 30, 2007 and 26% and 3%, respectively, of our net receivables at September 30, 2006.

For the three-month period ended June 30, 2007 the gross wholesale value of FazaClo shipments, net of returns, to McKesson Corporation, AmeriSourceBergen Corporation and Cardinal Health were 42%, 21% and 21%, respectively, of our total gross wholesale shipments. For the nine-month period ended June 30, 2007 the gross wholesale value of FazaClo shipments, net of returns, to McKesson Corporation, AmeriSourceBergen Corporation and Cardinal Health were 41%, 20% and 23% respectively, of our total gross wholesale shipments. Net receivables from McKesson Corporation, AmeriSourceBergen Corporation and Cardinal Health accounted for 32%, 14% and 17%, respectively, of our total net receivables at June 30, 2007 and 27%, 11% and 14%, respectively, of our total net receivables at September 30, 2006.

16. SUBSEQUENT EVENTS

As previously filed on the Company’s Current Report on Form 8-K, on July 2, 2007, the Company entered into sublease agreements (the “Subleases”) with Halozyme, Inc. (“Halozyme”) for the Company’s excess leased facilities in San Diego, California. Halozyme will sublease approximately 48,758 square feet of office and laboratory space (the “Subleased Premises”). The Company is presently the tenant at such premises under Standard Industrial Net Leases, dated February 1, 2001 and May 20, 2002 (collectively, the “Master Leases”). The Subleases will not become effective unless and until the master landlords consent thereto. Upon their effectiveness, the Subleases continue through the term of the Master Leases. Halozyme will pay base rent for the Subleased Premises, net of costs and property taxes associated with the operation and maintenance of the Subleased Premises, starting January 1, 2008 in the amounts set forth below. Halozyme will also pay a 69.75% pro rata share of operating costs, insurance costs, costs of utilities and real property taxes for the Subleased Premises incurred by the Company under the Master Leases.

As previously filed on the Company’s Current Report on Form 8-K, on July 19, 2007, the Company and RREEF America REIT II Corp. FFF (the “Lessor”) entered into a Third Amendment to Lease (the “Lease Amendment”), amending the terms of their lease agreement with respect to the Company’s headquarters and commercial and administrative offices located in Aliso Viejo, California. Effective as of August 1, 2007 (the “Reduction Effective Date”), the Lease Amendment modifies the space that the Company leases from 17,609 rentable square feet to 11,319 rentable square feet, which comprises the space that the Company currently occupies, and reflects the Company’s decision not to expand into the additional space of 6,290 rentable square feet during the second quarter of 2007 as originally planned.

Also in July 2007, the Company received notice from Healthcare Brands International Limited (“HBI”) that they have achieved a regulatory milestone related to Docosanol in the European market. As a result of this milestone, Avanir will receive a payment from HBI of approximately $1.5 million pursuant to the Data Transfer and Patent License Agreement between Avanir and HBI.

See Note 4 for a discussion regarding the August 2007 sale of FazaClo to Azur Pharma.

Item 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Quarterly Report on Form 10-Q contains forward-looking statements concerning future events and performance of the Company. When used in this report, the words “intend,” “estimate,” “anticipate,” “believe,” “plan” or “expect” and similar expressions are included to identify forward-looking statements. These forward-looking statements are based on our current expectations and assumptions and many factors could cause our actual results to differ materially from those indicated in these forward-looking statements. You should review carefully the factors identified in this report under the caption, “Risk Factors” and in our most recent Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”). We disclaim any intent to update or announce revisions to any forward-looking statements to reflect actual events or developments. Except as otherwise indicated herein, all dates referred to in this report represent periods or dates fixed with reference to the calendar year, rather than our fiscal year ending September 30. The three-month and nine-month periods ended June 30, 2007, may also be referred to as the third quarter of fiscal 2007 and first nine months of fiscal 2007, respectively.

EXECUTIVE OVERVIEW

Avanir Pharmaceuticals is a pharmaceutical company focused on developing, acquiring and commercializing novel therapeutic products for the treatment of chronic diseases. Our product candidates address therapeutic markets primarily that include the central nervous system, inflammatory and infectious diseases. Our lead product candidate, Zenvia, is currently in Phase III development for the treatment of pseudobulbar affect (“PBA”) and diabetic peripheral neuropathic pain (“DPN pain”). Our first commercialized product, docosanol 10% cream, (sold as Abreva^® by our marketing partner GlaxoSmithKline Consumer Healthcare in North America) is the only over-the-counter treatment for cold sores that has been approved by the FDA. We also have three other collaborations for docosanol around the world that may generate future revenue for the company depending on clinical and regulatory success outside the United States.

Zenvia Status

Zenvia is currently in Phase III clinical development for the treatment of two conditions, (1) pseudobulbar affect (“PBA”) also known as involuntary emotional expression disorder (“IEED”) and (2) diabetic peripheral neuropathic pain (“DPN pain”).

In October 2006, we received an “approvable” letter from the FDA for Zenvia for PBA/IEED. The approvable letter raised certain safety and efficacy concerns that will require additional clinical development to resolve. Based on discussions with the FDA, we expect that we may be able to obtain approval for Zenvia for the PBA/IEED indication following the completion of one additional Phase III clinical trial, which is expected to take approximately two years to complete. We expect to commence this trial in the fourth calendar quarter of 2007 and any delays in starting the clinical trial would delay the anticipated approval date.

In April 2007, we announced preliminary top-line data from our first Phase III clinical trial of Zenvia for DPN pain. After receipt of the positive results we requested a meeting with the FDA to discuss the next steps for the program. The FDA informed Avanir it would not be necessary to meet and that Avanir should submit the protocol for the next study as well as any questions related to the development program for Zenvia.

Restructuring Activities

In May 2006, we acquired FazaClo, a product that is marketed for the management of treatment-resistant schizophrenia and the reduction in the risk of recurrent suicidal behavior in schizophrenia or schizoaffective disorders. We had intended to leverage the FazaClo sales force to assist with the commercial launch of Zenvia for PBA/IEED, which was planned for early 2007; however, due to the receipt of the approvable letter and the resulting delay in the planned launch of Zenvia, we entered into an agreement in July 2007 to sell FazaClo to Azur Pharma, Inc. The sale, which closed August 3, 2007, provided approximately $43.9 million in an upfront payment and up to an additional $12 million in contingent payments paid in 2009, subject to certain regulatory conditions and annualized sales levels. Azur acquired the FazaClo sales force and support operations, representing approximately 80 employees in total. As a result, we became a substantially smaller organization following the sale of FazaClo and will be principally focused over the next two to three years on seeking regulatory approval of Zenvia for PBA/IEED and DPN pain.

We have also undertaken other cost-cutting measures following receipt of the Zenvia approvable letter. We have ceased all pre-launch commercial activities for Zenvia and have significantly reduced our administrative organization. We also cut back our research

operations following (1) the non-renewal and termination in March 2007 of our research collaboration agreement with AstraZeneca U.K. and (2) the non-renewal in March 2007 of our research collaboration with Novartis International Pharmaceutical Ltd. Our license agreement with Novartis remains in effect and Novartis is continuing development of the licenses compounds. Details of these agreements and the circumstances around the non-renewal/termination are set forth in our Quarterly Report on Form 10-Q for the period ended March 31, 2007. In late 2006 and early 2007, we moved critical clinical support functions to our headquarters in Orange County, California and, in July 2007, we subleased approximately 49,000 square feet of laboratory and office space, which represented all of our remaining excess facilities in San Diego, CA. We also subleased a portion of our excess space in Orange County in July 2007, representing approximately 6,290 square feet of office space.

Based on our current capital resources and focus on obtaining approval of Zenvia, we have also structured the ongoing development of our XENEREX technology so that direct development costs do not exceed funding levels from research grants or development partners. In May 2007, we received a one-year extension of our grant from the National Institutes of Health to fund further pre-clinical development of XENEREX for anthrax and we expect to continue development to the extent funded under this grant. Our other development programs, which include our selective cytokine inhibitor, have been placed on hold.

As a result of these initiatives, we have undergone significant change in fiscal 2007. Our principal focus is currently on gaining regulatory approval for Zenvia for PBA/IEED and then for DPN pain. We expect that the proceeds from our sale of FazaClo will be sufficient to fund our operations, including our planned confirmatory Phase III trial for Zenvia for PBA/IEED, through the end of the next fiscal year, excluding the costs associated with the DPN pain program. We are currently considering additional means of raising capital, including borrowing funds, selling common stock or other securities, and the monetization of additional assets. If we are unable to raise capital as needed to fund our operations, then we may need to slow the rate of development of some of our programs or sell additional rights to one or more of our drug candidates. For additional information about the risks and uncertainties that may affect our business and prospects, please see “Risk Factors.”

Our principal executive offices are located at 101 Enterprise, Suite 300, Aliso Viejo, California 92656. Our telephone number is (949) 389-6700 and our e-mail address is info@avanir.com. Our Internet website address is www.avanir.com. We make our periodic and current reports available on our Internet website, free of charge, as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”). No portion of our website is incorporated by reference into this Report on Form 10-Q.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

To understand our financial statements, it is important to understand our critical accounting policies and estimates. The preparation of our financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates and assumptions are required in the determination of revenue recognition and sales deductions for estimated chargebacks, rebates, sales incentives and allowances, certain royalties and returns and losses. Significant estimates and assumptions are also required in the appropriateness of capitalization and amortization periods for identifiable intangible assets, inventories, the potential impairment of goodwill and other intangible assets, income taxes, contingencies, and share-based compensation. Some of these judgments can be subjective and complex, and, consequently, actual results may differ from these estimates. For any given individual estimate or assumption made by us, there may also be other estimates or assumptions that are reasonable. Although we believe that our estimates and assumptions are reasonable, they are based upon information available at the time the estimates and assumptions are made. Actual results may differ significantly from our estimates.

A summary of significant accounting policies and a description of accounting policies that are considered critical may be found in Part II, Item 7 of our Annual Report on Form 10-K for the year ended September 30, 2006 in the “Critical Accounting Policies and Estimates” section and in Note 2 of the Notes to our condensed consolidated financial statements included herein.

Share-Based Compensation

Effective at the beginning of fiscal year 2006, we adopted Statement of Financial Accounting Standards No. 123(R) (“SFAS 123(R)”), “Share-Based Payment,” and elected to adopt the modified prospective application method. SFAS No. 123(R) requires us to use a fair-valued based method to account for share-based compensation. Accordingly, share-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as expense over the employees’ requisite service period. The estimation of the number of stock awards that will ultimately be forfeited requires judgment, and to the extent actual results or updated estimates

differ from the Company’s current estimates, such amounts will be recorded as a cumulative adjustment in the period in which estimates are revised. The Company considers many factors when estimating expected forfeitures, including types of awards, employee class and historical experience.

In October 2007, the Company performed an extensive analysis of share-based compensation and determined that share-based compensation expense was understated by $2.4 million from October 1, 2005 through June 30, 2007. As a result of the review, the Company determined it was necessary to restate the Company’s previously issued consolidated financial statements for the fiscal quarter ended March 31, 2007 in order to correct the amount of share-based compensation recorded by the Company for that period. The effect of these restatement adjustments have been reflected in Management’s Discussion and Analysis.

RESULTS OF OPERATIONS

COMPARISON OF THREE MONTHS ENDED JUNE 30, 2007 AND 2006


	Three Months ended
	June 30
	2007		2006			$ Change			% Change
PRODUCT SALES
Net revenues	$	4,938,708	$	—		$	4,938,708			100	%
Cost of revenues		1,535,535		260,164			1,275,371			490	%

Gross margin	$	3,403,173	$	(260,164	)	$	3,663,337			-1,408	%


LICENSES, RESEARCH SERVICES AND GRANTS
Revenues:
License agreements	$	1,443,543	$	104,174		$	1,339,369			1,286	%
Research services		181,692		1,746,581			(1,564,889	)		-90	%
Government research grant		122,398		47,345			75,053			159	%
Royalty and sale of royalty rights		453,091		465,147			(12,056	)		-3	%

		2,200,724		2,363,247			(162,523	)		-7	%
Costs:
Research services		1,202,476		1,488,363			(285,887	)		-19	%
Government research grant		201,178		46,402			154,776			334	%

		1,403,654		1,534,765			(131,111	)		-9	%

Gross margin	$	4,200,243	$	568,318		$	3,631,925			639	%

Revenues

Net product revenues for the three months ended June 30, 2007 include sales of FazaClo of $4.9 million. Product revenues are recorded net of product pricing allowances including: State Medicaid base and supplemental rebates, Medicare Part D discounts, managed care contract discounts and prompt payment discounts aggregating approximately 25.8% of gross revenues. Net wholesale shipments for the three months ended June 30, 2007 was $5.0 million.

Revenues from licenses, royalties, research services and grants declined to $2.2 million for the third quarter of 2007 compared to $2.4 million for the third quarter of fiscal 2006. This decline is primarily due to a decrease in revenues of $1.6 million from research services earned from our collaborative agreements with AstraZeneca and Novartis. This decline is partially due to direct reimbursable costs having declined from period to period and AstraZeneca having elected to rely less upon our resources when the research agreement was still active. The March 2007 non-renewal and termination of the research agreement with AstraZeneca also led to the decrease in period to period revenues. The decrease was partially offset by an increase of $1.3 million in license fees most of which resulted from a $1.4 million milestone payment received in the third quarter of 2007 from Healthcare Brands International Limited (“HBI”) pursuant to the Data Transfer and Patent License Agreement between Avanir and HBI.

As discussed above in the Executive Overview, the Company received notice from Novartis International Pharmaceutical Ltd. of the non-renewal of the research collaboration portion of our agreement with them. However, the Company remains eligible to receive over $200 million in milestone payments, contingent upon Novartis’ performance and achievement of certain development and regulatory milestones, including achievement of certain sales targets, if a licensed compound is approved by the FDA. In addition, the Company received notice from AstraZeneca of the termination of the research support services agreement and license agreements with them. In light of the loss of these revenues, we have terminated those employees who were principally supporting these programs and we subleased excess laboratory space in our San Diego facilities and moved critical clinical support functions to our headquarters in

Orange County, California. As a result of these two research collaboration programs ending, the Company will no longer receive revenues from the research portion of these arrangements after the quarter ended June 30, 2007.

Potential revenue-generating contracts that remained active as of June 30, 2007 include several docosanol 10% cream license agreements and our license agreement with Novartis for the Company’s MIF technology. Partnering, licensing and research collaborations have been, and may continue to be, an important part of our business development strategy. We may continue to seek partnerships with pharmaceutical companies that can help fund our operations in exchange for sharing in the success of any licensed compounds or technologies.

Cost of Revenues

Cost of product revenues was $1.5 million or 31% of net product revenues for the three months ended June 30, 2007. Costs consist primarily of product manufacturing costs of $573,505 or 12% of net product revenues, royalties to CIMA of $714,180 or 14% of net product revenues and amortization of acquired FazaClo product rights of $257,140 or 5% of net product revenue. The CIMA royalties totaling $714,180 include a $450,000 settlement, or 9% of net product revenues, resulting from a royalty audit conducted by CIMA.

Cost of licenses, research services and grants declined to $1.4 million or 64% of revenues compared with $1.5 million or 65% of revenues for the three-month period ended June 30, 2006. The cost of licenses, research services and grants includes primarily direct and indirect payroll costs and the costs of outside vendors.


	Three Months ended
	June 30
	2007		2006		$ Change			% Change
OPERATING EXPENSES
Research and development	$	3,906,024	$	8,426,870	$	(4,520,846	)		-54	%
Selling, general and administrative		10,647,281		10,105,474		541,807			5	%

Total Operating Expenses	$	14,553,305	$	18,532,344	$	(3,979,039	)		-21	%

Research and Development Expenses

Research and development expenses decreased by $4.5 million from $8.4 million in the third quarter of 2006 to $3.9 million for the third quarter of 2007. The decrease is primarily due to decreased costs incurred for the AVP-13358 Allergy study and decreased costs incurred for Zenvia product research and development.

All future development work on MIF will be undertaken by Novartis and will be fully paid by Novartis. We expect that spending on our monoclonal antibodies will depend in part on the progress that we make in these programs and on our strategy for partnering these programs or in obtaining additional government grants, so that we are able to defray at least part of these ongoing development costs.

Selling, General and Administrative Expenses

Selling, general and administrative expenses remained essentially unchanged for the three-month period ended June 30, 2007 compared to the three-month period ended June 30, 2006. Expenses increased $542,000, or 5% for the three-month period ended June 30, 2007 compared to the three-month period ended June 30, 2006.

We expect that selling, general and administrative expenses will decrease starting in the quarter ending September 30, 2007 as a result of our sale of FazaClo and the related reduction in headcount.

Share-Based Compensation

During the second quarter of fiscal 2007, the Company updated its projected forfeiture rates as it applies to share-based compensation considering recent actual data. Forfeiture rates for the nine-month periods ended June 30, 2007 and 2006 were estimated to be approximately 30% and 8%, respectively, for both officers and directors and 30% and 13%, respectively, for other employees based on our historical experience. Future estimates may differ substantially from the Company’s current estimates.

Total compensation expense for our share-based payments in the three month period ended June 30, 2007 and the same period in 2006 was $538,000 and $757,000, respectively. Selling, general and administrative expense in the three-month period ended June 30, 2007 and 2006 include share-based compensation expense of $419,000 and $597,000, respectively. Research and development expense in the three-month period ended June 30, 2007 and 2006 include share-based compensation expense of $119,000 and $160,000, respectively. As of June 30, 2007 (as restated), $6.5 million of total unrecognized compensation costs related to nonvested awards is expected to be recognized over a weighted average period of 2.6 years. See Note 3, “Nature of Business and Significant Accounting Policies” in the Notes to Condensed Consolidated Financial Statements (Unaudited) for further discussion.

Interest Expense and Interest Income

For the three-month period ended June 30, 2007, interest expense increased to $416,000, compared to $191,000 for the same period in the prior year. The increase is primarily due to the Seller Notes with an original balance of $25.1 million issued in May 2006 in connection with the purchase of Alamo.

For the three-month period ended June 30, 2007, interest income decreased to $89,000, compared to $552,000 for the same period in the prior year. The decrease is due to approximately a 71% decrease in the average balance of cash, cash equivalents and investments in securities for the quarter ended June 30, 2007, compared to the same period in the prior year.

Net Loss

Net loss was $9.1 million, or $0.23 per share, in the three-month period ended June 30, 2007, compared to a net loss of $17.6 million, or $0.56 per share for the three-month period ended June 30, 2006.

COMPARISON OF NINE MONTHS ENDED JUNE 30, 2007 AND 2006


	Nine Months ended
	June 30
	2007		2006			$ Change			% Change
PRODUCT SALES
Net revenues	$	15,038,523	$	—		$	15,038,523			100	%
Cost of revenues		4,190,975		260,164			3,930,811			1,511	%

Gross margin	$	10,847,548	$	(260,164	)	$	11,107,712			-4,270	%

LICENSES, RESEARCH SERVICES AND GRANTS
Revenues:
License agreements	$	1,556,827	$	5,113,516		$	(3,556,689	)		-70	%
Research services		2,372,384		6,181,164			(3,808,780	)		-62	%
Government research grant		475,474		208,032			267,442			129	%
Royalty and sale of royalty rights		1,955,804		1,474,451			481,353			33	%

		6,360,489		12,977,163			(6,616,674	)		-51	%
Costs:
Research services		2,973,715		5,302,796			(2,329,081	)		-44	%
Government research grant		666,166		214,491			451,675			211	%

		3,639,881		5,517,287			(1,877,406	)		-34	%

Gross margin	$	13,568,156	$	7,199,712		$	6,368,444			88	%

Revenues

Net product revenues for the nine-month period ended June 30, 2007 include sales of FazaClo of $15.0 million, including revenue that was deferred as of September 30, 2006. Product revenues are recorded net of product pricing allowances including: State Medicaid base and supplemental rebates, Medicare Part D discounts, managed care contract discounts and prompt payment discounts aggregating approximately 25.8% of gross revenues. Net wholesale shipments for the nine-month period ended June 30, 2007 were $12.3 million.

Revenues from licenses, research services and grants declined to $6.4 million for the nine month period ended June 30, 2007 compared to $13.0 million for the nine month period ended June 30, 2006. This decline was principally due to a $5.0 million milestone earned under the AstraZeneca license agreement in the first quarter of fiscal year 2006 which was not repeated in the first quarter of fiscal year 2007 and a decrease in revenues of $3.8 million from research services earned from our collaborative agreements with AstraZeneca and Novartis as AstraZeneca has elected to rely less upon our scientists and to run more of the projects themselves.

Cost of Revenues

Cost of product revenues was $4.2 million or 28% of net product revenues for the nine month period ended June 30, 2007. Costs include the direct and indirect costs to manufacture of $2.0 million or 13% of net product revenues, royalties to CIMA of $1.2 million or 8% of net product revenues, amortization of acquired FazaClo product rights of $771,000 or 5% of net product revenue and the write-off of obsolete inventory of $260,000 or 2% of net product revenue. The CIMA royalties totaling $1.2 million include a $450,000 settlement, or 3% of net product revenues, resulting from a royalty audit conducted by CIMA.

Cost of licenses, research services and grants declined to $3.6 million or 57% of revenues compared with $5.5 million or 43% of revenues for the nine-month period ended June 30, 2006. The cost of licenses, research services and grants includes primarily direct and indirect payroll costs and the costs of outside vendors.


	Nine Months ended
	June 30
	2007		2006		$ Change			% Change
	(as restated)
OPERATING EXPENSES
Research and development	$	16,468,878	$	21,788,150	$	(5,319,272	)		-24	%
Selling, general and administrative		31,154,904		23,366,332		7,788,572			33	%

Total Operating Expenses	$	47,623,782	$	45,154,482	$	2,469,300			5	%

Research and Development Expenses

R&D expenses decreased $5.3 million or 24% for the nine-month period ended June 30, 2007 (as restated) compared to the nine-month period ended June 30, 2006. The decrease is primarily due to decreased costs incurred for the AVP-13358 Allergy study and decreased costs incurred for Zenvia product research and development offset by increased costs for the FazaClo patient registry. In addition. an adjustment to the forfeiture rate used in the calculation of share- based compensation expense resulted in a decrease in non-cash expense of $94,000.

In October 2006, we received an “approvable” letter from the FDA for Zenvia for PBA/IEED. The approvable letter raised certain safety and efficacy concerns that will require additional clinical development to resolve. Based on discussions with the FDA in early 2007, we expect that we may be able to obtain approval for Zenvia for the PBA/IEED indication following the completion of one additional Phase III clinical trial, which is expected to take approximately two years to complete. We expect to commence this trial in the fourth quarter of 2007 and any delays in starting the clinical trial would delay the anticipated approval date.

We expect that our research and development costs will increase substantially through the end of calendar 2007 and will remain at relatively high levels as we commence the planned confirmatory Phase III trial for Zenvia for IEEB/PBA.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $7.8 million, or 33% for the nine-month period ended June 30, 2007 (as restated), compared to the nine-month period ended June 30, 2006. The increase is primarily attributed to expenditures resulting from the Alamo acquisition such as headcount increases, the Company’s re-launch of FazaClo and amortization of the Alamo acquisition. In addition, expenses were incurred in the current year relating to headcount increases and external marketing costs associated with the anticipated Zenvia product launch of which commercialization has since been delayed. The increase was offset by an adjustment in non-cash expenses of $151,000 resulting from an adjustment in the forfeiture rate used in the calculation of share-based compensation expense.

We expect that selling, general and administrative expenses will decrease starting in the quarter ending September 30, 2007 as a result of our sale of FazaClo and the related reduction in headcount.

Share-Based Compensation

Total compensation expense for our share-based payments in the nine-month period ended June 30, 2007 (as restated) and the same period in 2006 was $2.1 million and $2.0 million, respectively. Selling, general and administrative expense in the nine-month period ended June 30, 2007 (as restated) and 2006 include share-based compensation expense of $1.7 million and $1.6 million, respectively. Research and development expense in the nine-month period ended June 30, 2007 (as restated) and 2006 include share-based compensation expense of $337,000 and $423,000, respectively. As of June 30, 2007 (as restated), $6.5 million of total unrecognized compensation costs related to nonvested awards is expected to be recognized over a weighted average period of 2.6 years. See Note 3, “Nature of Business and Significant Accounting Policies” in the Notes to Condensed Consolidated Financial Statements (Unaudited) for further discussion.

Interest Expense and Interest Income

For the nine-month period ended June 30, 2007, interest expense increased to $1.3 million, compared to $236,000 for the same period in the prior year. The increase is primarily due to the Seller Notes with an original balance of $25.1 million issued in May 2006 in connection with the purchase of Alamo.

For the nine-month period ended June 30, 2007, interest income decreased to $425,000, compared to $1.4 million for the same period in the prior year. The decrease is due to approximately a 71% decrease in the average balance of cash, cash equivalents and investments in securities for the nine-month period ended June 30, 2007, compared to the same period in the prior year.

Net Loss

Net loss was $33.0 million, or $0.93 per share, for the nine-month period ended June 30, 2007 (as restated), compared to a net loss of $40.4 million, or $1.33 per share for the nine-month period ended June 30, 2006. A slightly lower net loss and significantly higher weighted average number of shares outstanding accounted for the lower loss per share. The cumulative adjustment of our estimated forfeiture rates decreased the net loss for the nine-month period ended June 30, 2007 (as restated) by $245,000 and reduced the diluted net loss per share by $0.01.

LIQUIDITY AND CAPITAL RESOURCES

We assess our liquidity by our ability to generate cash to fund future operations. Key factors in the management of our liquidity are: cash required to fund operating activities including expected operating losses and the levels of accounts receivable, inventories, accounts payable and capital expenditures; the timing and extent of cash received from milestone payments under license agreements; funds required for acquisitions; funds required to repay notes payable and capital lease obligations as they become due; adequate credit facilities; and financial flexibility to attract long-term equity capital on favorable terms. Historically, cash required to fund on-going business operations has been provided by financing activities and used to fund operations and working capital requirements and investing activities.

Cash, cash equivalents and investments, as well as, net cash provided by or used for operating, investing and financing activities are summarized in the table below.


				Increase
	June 30,			(Decrease)			September 30,
	2007			During Period			2006
Cash, cash equivalents and investment in securities	$	10,924,174		$	(13,825,899	)	$	24,750,073
Cash and cash equivalents	$	7,538,570		$	2,640,356		$	4,898,214
Net working capital	$	(2,766,411	)	$	4,203,366		$	(6,969,777	)


	Nine Months						Nine Months
	Ended			Change			Ended
	June 30,			Between			June 30,
	2007			Periods			2006
Net cash used for operating activities	$	(38,194,688	)	$	(10,517,861	)	$	(27,676,827	)
Net cash provided by (used for) investing activities		16,875,256			40,166,616			(23,291,360	)
Net cash provided by financing activities		23,959,788			(20,547,128	)		44,506,916

Net increase (decrease) in cash and cash equivalents	$	2,640,356		$	9,101,627		$	(6,461,271	)

Operating activities. Net cash used for operating activities amounted to $38.2 million in the first nine months of fiscal 2007 compared to $27.7 million in the first nine months of fiscal 2006. The increase in cash used is primarily related to the funding the operating loss for the period, reductions in accounts payable and deferred revenues. Accounts payable decreased by $9.6 million and is primarily due to payments of invoices in clinical, marketing and general and administrative activities. A decrease in deferred revenues of $5.2 million resulted from the recognition of deferred revenue for the first nine months of fiscal 2007.

Investing activities. Net cash provided by investing activities was $16.9 million in the first nine months of fiscal 2007, compared to $23.3 million used in the first nine months of fiscal 2006. Our proceeds from the sale of securities provided $16.9 million in the first nine months of fiscal 2007 compared with $42.0 million in the first nine months of fiscal 2006, offset by investments in securities of $59.2 million in 2006. We invested $131,000 in property and equipment in the first nine months of fiscal 2007, compared to $1.4 million in the first nine months of fiscal 2006.

Financing activities. Net cash provided by financing activities was $24.0 million in the first nine months of fiscal 2007, consisting of $30.8 million in net proceeds from sales of our common stock offset by $6.9 million to reduce long-term debt. Net cash provided by financing activities amounted to $44.5 million in the first nine months of fiscal 2006, consisting of $44.8 million received from the sale of our common stock through private placements and from exercises of warrants and stock options.

In June 2005, we filed a shelf registration statement on Form S-3 with the SEC to sell an aggregate of up to $100 million in Class A common stock and preferred stock, depositary shares, debt securities and warrants. This shelf registration statement was declared effective on August 3, 2005 and through June 30, 2007, we had sold a total of 14,406,755 shares of Class A common stock under this registration statement, raising gross offering proceeds of approximately $71.5 million and net offering proceeds of approximately $69.5 million. We have also issued under this registration statement common stock warrants to purchase a total of 1,053,000 shares of our Class A common stock at an exercise price of $3.30 per share. The warrants become exercisable beginning in May 2007 and all unexercised warrants expire in November 2007. The warrants may be exercised on a net basis in certain circumstances but in no event would the company be required to settle the warrants in cash.

In December 2006 we entered into a financing facility with Brinson Patrick Securities Corporation. Under this facility, we have offered and sold an aggregate of 6,126,000 shares of Class A common stock, which resulted in net proceeds of $16.2 million. As of August 8, 2007, 5.6 million shares remained available for sale under this facility.

As of June 30, 2007, we have contractual obligations for long-term debt, capital (finance) lease obligations and operating lease obligations, as summarized in the table that follows.


	Payments Due by Period
			Less than						More than
	Total		1 Year		1-3 Years		3-5 Years		5 Years
Long-term debt (principal and interest)	$	26,298,538	$	1,872,741	$	24,425,797	$	—	$	—
Operating lease obligations		9,869,528		2,331,891		3,633,158		3,247,180		657,299
Purchase obligations (1)		6,135,857		5,522,271		613,586		—		—

Total	$	42,303,923	$	9,726,903	$	28,672,541	$	3,247,180	$	657,299


(1)		Purchase obligations consist of the total of trade accounts payable and trade related accrued expenses at June 30, 2007 which approximates our contractual commitments for goods and services in the normal course of our business.

As part of the purchase consideration of the Alamo acquisition, we initially issued three promissory notes in the principal amounts of $14,400,000, $6,675,000 and $4,000,000 (the “First Note,” “Second Note” and “Third Note” respectively) (collectively, the “Notes”). The Notes bear interest at an average rate equal to the London Inter-Bank Offered Rate, or “LIBOR,” plus 1.33%. Interest accruing on the Notes is payable monthly and the principal amount of the Notes matures on May 24, 2009, provided that (i) the Selling Holders may demand early repayment of the First Note if the closing price of our common stock, as reported on the NASDAQ Global Market, equals or exceeds $15.00 per share for a total of 20 trading days in any 30 consecutive trading-day period (the “Stock Contingency”), and (ii) we must apply 20% of any future net offering proceeds from equity offerings and other financing transactions to repay the Notes (starting with the First Note), and must repay the Notes in full if we have raised in an offering more than $100,000,000 in future aggregate net proceeds. In connection with the equity offering we completed in the first nine months of fiscal year 2007, and in accordance with the terms of the Notes, we used approximately $6.1 million or 20% of the net proceeds received to pay down the First Note. In connection with our sale of FazaClo in August 2007, we agreed to prepay $11 million of outstanding principal due under the Notes, and the Note holder agreed to suspend the Company’s obligation to use a portion of future equity offering proceeds to repay the Notes, up to $55 million in net offering proceeds. Twenty percent of any offering proceeds above this amount will need to be paid to the Note holders, as per the original agreement.

If the Selling Holders demand repayment of the First Note following satisfaction of the Stock Contingency, we must repay the First Note within 180 days from the demand in our choice of cash or shares of common stock. If we elect to repay the First Note in shares of common stock, the shares will be valued at 95% of the average closing price of the common stock, as reported on the NASDAQ Global Market, for the five trading days prior to repayment, subject to a price floor.

We have the right to prepay, in cash or in common stock, the amounts due under the Notes at any time, provided that we may only pay the Notes in common stock if the Stock Contingency has occurred prior to the maturity date and if we have registered the shares on an effective registration statement filed with the SEC. If we elect to prepay the Notes with common stock, the shares will be valued at 95% of the average closing price of the common stock, as reported on the NASDAQ Global Market, for the five trading days prior to repayment, subject to a price floor.

Alamo Earn-Out Payments. In connection with the Alamo acquisition, we agreed to pay up to an additional $39,450,000 in revenue-based earn-out payments, based on future sales of FazaClo. These earn-out payments are based on FazaClo sales in the U.S. from the closing date of the acquisition through December 31, 2018 (the “Contingent Payment Period”). Based on the results of the quarter ended June 30, 2007, we issued the second of these revenue-based payments through the issuance of an additional promissory note in the principal amount of $2,000,000.

As previously discussed in Note 4 to the condensed consolidated financial statements, on August 3, 2007, the Company sold the FazaClo product line to Azur Pharma. The Company’s earn-out obligations that would have been payable to the prior owner of Alamo Pharmaceuticals upon the achievement of certain milestones were assumed by Azur Pharma.

CIMA Royalty payments. In connection with the Alamo acquisition, we acquired a development, license and supply agreement with CIMA Labs Inc. (“CIMA”), which holds intellectual property rights related to certain aspects of the development and production of FazaClo (the “FazaClo Supply Agreement”). The FazaClo Supply Agreement grants, through our Alamo subsidiary, an exclusive license to us to market, distribute and sell FazaClo. The FazaClo Supply Agreement provides royalty rates of 5% to 6%, based on annual net sales and minimum annual royalty targets set forth in the agreement. The FazaClo Supply Agreement extends through the life of the longest patent which is currently the DuraSolv patent expiring in 2019. Minimum future annual royalty payments under the CIMA agreement, which was assigned to Azur Pharma in connection with the August 2007 sale of FazaClo, are as follows:


Twelve-month period ended June 30:
2007	$	250,000
2008	$	300,000
2009 and each year thereafter	$	400,000

The CIMA agreement extends through the life of the longest patent. Currently the patent that relates to the OraSolv formulation expires in 2010. In the third fiscal quarter of 2007 we achieved approval of the DuraSolv formulation thereby extending the patent life to 2019. The agreement terminates for insolvency by either party, with 60-day notice if certain terms of the agreement are not met, with 60-days notice if we fail to pay royalties, and CIMA can terminate region-by-region if Avanir does not commercialize in other regions.

Eurand Milestone and Royalty Payments. In August 2006, we entered into a development and license agreement (“Eurand Agreement”) with Eurand, Inc. (“Eurand”), under which Eurand will provide R&D services using Eurand’s certain proprietary technology to develop a once-a-day controlled release capsule, a new formulation, of Zenvia for the treatment of IEED/PBA (“Controlled-Release Zenvia”). Under the terms of the Eurand Agreement, we will pay Eurand for development services on time and material basis. We will be required to make payments up to $7.6 million contingent upon achievement of certain development milestones and up to $14.0 million contingent upon achievement of certain sales targets. In addition, we will be required to make royalty payments based on sales of Controlled-Release Zenvia, if it is approved for commercialization. Development milestone events include program initiation, delivery of prototypes, delivery of clinical trial material for phase 1, achieving target PK Profile in the pilot clinical study, delivery of clinical trial material for phase 3, filing of the first NDA for the Product with the FDA, completion of manufacturing validation and approval of the NDA with the FDA. Sales target milestones are $2.0 million upon achieving $100 million of U.S. net revenues, $4.0 million upon achieving $200 million of U.S. net revenues and $8.0 million upon achieving $400 million of U.S. net revenues. The agreement remains in effect on a country by country basis for the longer of 10 years after first commercial sale or the life of any Eurand patent, unless earlier terminated in accordance with the agreement. In November 2006, we notified Eurand to suspend activity on this project until further notice. The Company may terminate the agreement upon 30 days notice in the event the company receives a response from the FDA that is something other than an unconditional approval of the original formulation of Zenvia. Upon expiration of the agreement the Company shall own a fully-paid irrevocable license. Effective December 2006, we suspended further work under this agreement until resolution of further development plans for Zenvia resulting from our meeting with the FDA in late February 2007. All material remaining obligations would only be due in the event we initiate the agreement in future.

Zenvia License Milestone Payments. We hold the exclusive worldwide marketing rights to Zenvia for certain indications pursuant to an exclusive license agreement with the Center for Neurologic Study (“CNS”). We will be obligated to pay CNS up to $400,000 in the aggregate in milestones to continue to develop both indications, assuming they are both approved for marketing by the FDA. We are not currently developing, nor do we have an obligation to develop, any other indications under the CNS license agreement. In fiscal 2005, we paid $75,000 to CNS under the CNS license agreement, and will need to pay a $75,000 milestone if the FDA approves our NDA for Zenvia for the treatment of IEED/PBA. In addition, we are obligated to pay CNS a royalty on commercial sales of Zenvia with respect to each indication, if and when the drug is approved by the FDA for commercialization. Under certain circumstances, we may have the obligation to pay CNS a portion of net revenues received if we sublicense Zenvia to a third party.

Under our agreement with CNS we are required to make payments on achievements of up to a maximum of ten milestones, based upon five specific medical indications. Maximum payments for these milestone payments could total approximately $2.1 million if we pursued the development of Zenvia for all of the licensed indications. Of the clinical indications that we currently plan to pursue, expected milestone payments could total $800,000. In general, individual milestones range from $150,000 to $250,000 for each accepted NDA and a similar amount for each approved NDA. In addition we are obligated to pay CNS a royalty ranging from approximately 5% to 7% of net revenues.

Management Outlook

The minimum balance of securities available for sale under our existing shelf registration was approximately $28.5 million as of June 30, 2007. We believe that cash equivalents and unrestricted investments in securities of approximately $9.8 million at June 30, 2007, and the net proceeds from the sale of FazaClo, will be sufficient to sustain our planned level of operations through the end of the fiscal year, excluding the costs related to the development of Zenvia for DPN pain. However, the Company cannot provide assurances that our plans will not change, or that changed circumstances will not result in the depletion of capital resources more rapidly than

anticipated. If we are unable to generate sufficient cash flows from licensed technologies or are unable to raise sufficient capital, management believes that expenditures could be curtailed in order to continue operations for the next 12 months.

For information regarding the risks associated with our need to raise capital to fund our ongoing and planned operations, please see “Risk Factors.”

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

As described below, we are exposed to market risks related to changes in interest rates. Because substantially all of our revenue, expenses, and capital purchasing activities are transacted in U.S. dollars, our exposure to foreign currency exchange rates is immaterial. However, in the future we could face increasing exposure to foreign currency exchange rates as we expand international distribution of docosanol 10% cream and purchase additional services from outside the U.S. Until such time as we are faced with material amounts of foreign currency exchange rate risks, we do not plan to use derivative financial instruments, which can be used to hedge such risks. We will evaluate the use of derivative financial instruments to hedge our exposure as the needs and risks should arise.

Interest rate sensitivity

Our investment portfolio consists primarily of fixed income instruments with an average duration of approximately 9-12 months. The primary objective of our investments in debt securities is to preserve principal while achieving attractive yields, without significantly increasing risk. We classify our investments in securities as of June 30, 2007 as available-for-sale and our restricted investments in securities as held-to-maturity. These available-for-sale securities are subject to interest rate risk. In general, we would expect that the volatility of this portfolio would decrease as its duration decreases. Based on the average duration of our investments as of June 30, 2007 and 2006, an increase of one percentage point in the interest rates would have resulted in increases in interest expense of approximately $29,000 and $318,000, respectively.

Item 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

In connection with the preparation of our Quarterly Report on Form 10-Q, for the period ended June 30, 2007, originally filed on August 9, 2007, an evaluation was performed under the supervision of our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (“Exchange Act”)). Based on that evaluation, our CEO and CFO concluded at that time that our disclosure controls and procedures were effective as of the end of the period covered by that Quarterly Report. Subsequently, the Company determined that it was necessary to restate the Company’s condensed consolidated financial statements for the nine months ended June 30, 2007 and that the condensed consolidated financial statements for those periods should no longer be relied upon.

These restatements have no impact on the Company’s previously reported revenues, cash flows from operations or total cash and cash equivalents shown in the Company’s condensed consolidated financial statements for the three and nine months ended June 30, 2007.

In connection with the restatement, for the period covered by this report, we carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s CEO and CFO of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15 (e) under the Exchange Act). Based upon that evaluation, our CEO and CFO concluded that our disclosure controls and procedures were not effective as of June 30, 2007 because of a material weakness in internal controls over financial reporting.

The Company did not have effective internal controls over financial reporting for the calculation of share-based compensation expense. Previous versions of a widely utilized software program used to calculate share-based compensation expense incorrectly applied a weighted average forfeiture rate in the calculation of share-based compensation. Previous versions consistently applied the forfeiture rate throughout the vesting period and allowed for a true-up of share-based compensation expense once the

award had vested in full. The true-up was necessary because the old versions did not properly attribute the expense over the vesting period. Because of the use of this method, the old version failed to properly account for the full expense of vested awards during the interim periods prior to the award reaching its final vest date.

Under the new version of the software, forfeiture rates are applied in the calculation of share-based compensation expense up to the point each individual tranche is fully vested. As each tranche vests, the new version properly recognizes 100% of share-based compensation expense over the attribution period related to these vested tranches.

In addition, the Company’s evaluation of share-based compensation expense uncovered a data input error when the forfeiture rate was adjusted to 30%. This data input error, combined with the software version issue discussed above, resulted in a material understatement of share-based compensation expense for the nine months ended as of June 30, 2007.

The error had no impact on the Company’s previously reported revenues, cash flows from operations or total cash and cash equivalents shown in the Company’s condensed consolidated financial statements as of June 30, 2007 and for the nine months ended June 30, 2007.

The Company’s corporate monitoring controls failed to operate at a sufficient level of precision to detect the understatement of share-based compensation expense and the material misstatement of operating expenses and net loss.

The Company intends to review share-based compensation expense on a quarterly basis, supplemented by external consultants and independent computational reviews, to ensure that total share-based compensation expense is recognized for vested shares. The Company is in the process of evaluating remediation efforts to address the issues affecting the calculation of share-based compensation expense. The Company will perform these measures during the preparation of the 2008 first quarter financial reports. Additional measures may be forthcoming as the Company evaluates the effectiveness of these efforts.

Changes in Internal Controls over Financial Reporting

Except for the material weakness in internal controls over financial reporting for the calculation of share-based compensation expense, there has been no change in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) during the Company’s fiscal quarter ended June 30, 2007, that has materially affected, or is reasonably likely to materially affect the Company’s internal control over financial reporting. However, we have initiated or intend to initiate remediation measures to address the material weakness in internal controls over financial reporting. The remediation measures include or are expected to include the following:

	•		The Company intends to review share-based compensation expense on a quarterly basis, supplemented by external consultants and independent computational reviews, to ensure that total share-based compensation expense is recognized for vested shares.

	•		The Company has hired a FAS 123R consultant who is also an expert user of the software system utilized by the Company. This consultant will assist in the FAS 123R calculation and the Company’s quarterly analysis of total share-based compensation.

	•		The Company has hired a consulting firm that offers FAS 123R calculation services for clients. This consulting firm will perform shadow calculations on certain awards to ensure that the software system is calculating share-based compensation expense accurately.

We may adopt additional remediation measures related to the identified control deficiencies as necessary as well as to continue to evaluate our internal controls on an ongoing basis and to upgrade and enhance them as needed.

Our Audit Committee has taken an active role in reviewing and discussing the identified material weakness with our auditors and financial management. Our management and the Audit Committee will actively monitor the implementation and effectiveness of the remediation measures taken by the Company’s financial management.

PART II OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS

In the ordinary course of business, we may face various claims brought by third parties. Any of these claims could subject us to costly litigation. Management believes the outcome of currently identified claims and lawsuits will not have a material adverse effect on our financial condition or results of operations.

Item 1A. RISK FACTORS

Below are the risk factors that have been revised since the filing of our annual report on Form 10-K for the year ended September 30, 2006 (the “2006 Form 10-K”). We face significant additional risks, which are set forth in the other risk factors contained in our 2006 Form 10-K under the caption “Risk Factors.” You are urged to read these risk factors in the 2006 Form 10-K, in addition to the following revised risk factors set forth below, before making an investment decision with regard to our securities.

We must conduct additional clinical trials for Zenvia and there can be no assurance that the FDA will approve Zenvia or that an approval, if granted, will be on terms we may seek.

In October 2006, we received an “approvable letter” from the FDA for our new drug application (“NDA”) submission for Zenvia for IEED/PBA. The approvable letter outlined concerns that the FDA had regarding certain efficacy and safety data contained in our NDA submission. To address these concerns, we have agreed to conduct a single confirmatory Phase III clinical trial and to conduct certain preclinical and pharmacokinetic studies, which we expect will provide sufficient data to allow us to seek regulatory approval. Because the Phase III trial will be testing a lower dose of Zenvia to address the FDA’s safety concerns, we expect that the drug’s efficacy will be at least somewhat lower than in previous trials. It is possible that the efficacy will be so reduced that we will not be able to satisfy the FDA’s efficacy requirements and there can be no assurance that the FDA will approve Zenvia for commercialization.

Even if the confirmatory trial is successful, it will be costly and time consuming. Because our patents covering Zenvia expire at various times from 2011 through 2019 (without accounting for potential extensions that might be available), any substantial delays in regulatory approval would negatively affect the commercial potential for Zenvia for this indication. Additionally, it is possible that Zenvia may not be approved with the labeling claims or for the patient population that we consider most desirable for the promotion of the product. Less desirable labeling claims could adversely affect the commercial potential for the product and could also affect our long-term prospects.

Additionally, although we have a Special Protocol Assessment, or “SPA”, from the FDA for our recently completed Phase III trial for DPND and are seeking an SPA for our planned confirmatory trial for Zenvia for IEED/PBA, there can be no assurance that the terms of the SPA will ultimately be binding on the FDA. An SPA is intended to serve as a binding agreement from the FDA on the adequacy of the design of a planned clinical trial. However, even if an SPA is granted, additional data may subsequently become available that causes the FDA to reconsider the previously agreed upon scope of review and the FDA may have subsequent safety or efficacy concerns that override the SPA. As a result, even if an SPA is granted, we cannot be certain that the trial design will be found to be adequate, assuming that we receive positive results.

We have limited capital resources and will need to raise additional funds to support our operations.

We have experienced significant operating losses in funding the research, development and clinical testing of our drug candidates, accumulating operating losses totaling $251 million as of June 30, 2007 (as restated), and we expect to continue to incur substantial operating losses for the foreseeable future. As of June 30, 2007, we had approximately $10.9 million in cash, cash equivalents, investments in securities and restricted cash and we will not generate any further revenues or positive cash flows from FazaClo following its sale in August 2007.

In light of our current existing capital resources, lack of near-term revenue opportunities and substantial near-term capital needs, we will need to raise significant amounts of additional capital in the future to finance our long-term operations. Based on our current loss rate and existing capital resources as of the date of this filing, we estimate that we have sufficient funds to sustain our operations at their current levels through the end of the next fiscal year. Although we expect to be able to raise additional capital and/or curtail

current levels of operations to be able to continue to fund our operations beyond that time, there can be no absolute assurance that we will be able to do so. If we are unable to raise additional capital to fund future operations, then we may be unable to fully execute our development plans for Zenvia. This may result in significant delays in our planned clinical trial of Zenvia for PBA/IEED and may force us to further curtail our operations.

Any transactions that we may engage in to raise capital could dilute our shareholders and diminish certain commercial prospects.

We will seek to raise additional capital and may do so at any time through various financing alternatives, including licensing or sales of our technologies, drugs and/or drug candidates, selling shares of common or preferred stock, or through the issuance of one or more forms of senior or subordinated debt. Each of these financing alternatives carries certain risks. Raising capital through the issuance of common stock may depress the market price of our stock and any such financing will dilute our existing shareholders. If we instead seek to raise capital through licensing transactions or sales of one or more of our technologies, drugs or drug candidates, as we have stated we are actively considering with certain investigational compounds, then we will likely need to share a significant portion of future revenues from these drug candidates with our licensees. Additionally, the development of any drug candidates licensed or sold to third parties will no longer be in our control and thus we may not realize the full value of any such relationships. Additionally, because we just sold FazaClo, we will no longer receive the revenues and cash flows associated with product sales and our operations and product pipeline will be less diverse, effectively concentrating investor risk in the success of Zenvia.

The FDA’s safety concerns regarding Zenvia for the treatment of IEED/PBA may extend to other clinical indications that we are pursuing, including DPN pain. Due to these concerns, we may not be able to develop Zenvia for these other indications.

The FDA raised certain safety concerns and questions regarding Zenvia for the treatment of IEED/PBA. We are currently developing Zenvia for the treatment of other clinical indications, including DPN pain, for which we have recently completed a Phase III trial. Although the FDA has not expressly stated that the safety concerns and questions raised in IEED/PBA indication would apply to other indications such as DPN pain, we believe that it is possible that the FDA will raise similar concerns for this indication. Accordingly, we are considering the use of lower doses in the next Phase III trial for Zenvia for this indication. Although we achieved positive results in our initial Phase III trial, a lower dose may not yield the same levels of efficacy as seen in the earlier trials and the drop in efficacy may be so great that the drug does not demonstrate a statistically significant improvement over placebo. Additionally, any new lower dose that we develop may not be low enough to satisfy the FDA’s safety concerns. If this were to happen, we may not be able to pursue the development of Zenvia for other indications or may need to undertake significant additional clinical trials, which would be costly and cause potentially substantial delays.

We have recently experienced significant turnover in senior management.

Over the past 12 months, we have experienced significant turnover in our senior management team, including the departures of our President and Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer (formerly our Chief Financial Officer), Vice President of Human Resources, Vice President of Drug Discovery, Vice President of Business Development, Vice President of Clinical Affairs and Executive Director of Investor Relations. As a result of these changes, we essentially have a new management team. It is not yet possible to assess how effective this management team will be and whether they will be able to work together to accomplish the Company’s business objectives. Additionally, changes in management are disruptive to the organization and further changes may slow the Company’s progress toward its goals. Further, it is possible that the Board of Directors will seek to reduce the size of the Board to streamline its operations and to reflect the fact that the Company is significantly smaller than it was previously. Changes in Board composition may also be disruptive and the loss of the experience and capabilities of any of our Board members may reduce the effectiveness of the Board.

We face challenges retaining members of management and other key personnel.

The industry in which we compete has a high level of employee mobility and aggressive recruiting of skilled employees. This type of environment creates intense competition for qualified personnel, particularly in clinical and regulatory affairs, sales and marketing and accounting and finance. Because we have a relatively small organization, the loss of any executive officers or other key employees could adversely affect our operations. For example, if we were to lose one or more of the senior members of our clinical and regulatory affairs team, the pace of clinical development for Zenvia could be slowed significantly. We have experienced extensive employee turnover recently, as discussed above, and the loss of any additional key employees could adversely affect our business and cause significant disruption in our operations

If we fail to comply with regulatory requirements, regulatory agencies may take action against us, which could significantly harm our business.

Our marketed products, along with the manufacturing processes, post-approval clinical data, labeling, advertising and promotional activities for these products, are subject to continual requirements and review by the FDA and other regulatory bodies. With respect to our product candidates being developed, even if regulatory approval of a product is granted, the approval may be subject to limitations on the indicated uses for which the product may be marketed or to the conditions of approval or contain requirements for costly post-marketing testing and surveillance to monitor the safety or efficacy of the product.

In addition, regulatory authorities subject a marketed product, its manufacturer and the manufacturing facilities to continual review and periodic inspections. We will be subject to ongoing FDA requirements, including required submissions of safety and other post-market information and reports, registration requirements, cGMP regulations, requirements regarding the distribution of samples to physicians and recordkeeping requirements. For example, we are required to maintain a patient registry for FazaClo and provide the FDA with reports of adverse events suffered by patients taking FazaClo. Because FazaClo carries significant safety risks, the label carries a “black box” warning and patients taking the drug may suffer significant harm and even death. These safety concerns result in substantial regulatory oversight and compliance procedures that we must comply with.

The cGMP regulations also include requirements relating to quality control and quality assurance, as well as the corresponding maintenance of records and documentation. We rely on the compliance by our contract manufacturers with cGMP regulations and other regulatory requirements relating to the manufacture of products. We are also subject to state laws and registration requirements covering the distribution of our products. Regulatory agencies may change existing requirements or adopt new requirements or policies. We may be slow to adapt or may not be able to adapt to these changes or new requirements.

Because Zenvia contains ingredients that also are marketed in over-the-counter drug products, there is a risk that the FDA or an outside third party at some point would propose that this product, if approved for commercialization, be distributed over-the-counter rather than by prescription, thereby potentially affecting third-party and government reimbursement.

Later discovery of previously unknown problems with our products, manufacturing processes or failure to comply with regulatory requirements, may result in any of the following:

	•		restrictions on our products or manufacturing processes;

	•		warning letters;

	•		withdrawal of the products from the market;

	•		voluntary or mandatory recall;

	•		fines;

	•		suspension or withdrawal of regulatory approvals;

	•		suspension or termination of any of our ongoing clinical trials;

	•		refusal to permit the import or export of our products;

	•		refusal to approve pending applications or supplements to approved applications that we submit;

	•		product seizure; and

	•		injunctions or the imposition of civil or criminal penalties.

We generally do not control the development of compounds licensed to third parties and, as a result, we may not realize a significant portion of the potential value of any such license arrangements.

Under our license arrangement for our MIF compound, we have no direct control over the development of this drug candidate and have only limited, if any, input on the direction of development efforts. These development efforts are ongoing by our licensing partner and if the results of their development efforts are negative or inconclusive, it is possible that our licensing partner(s) could elect to defer or abandon further development of these programs, as was the case in early 2007 when AstraZeneca terminated our license and collaboration agreement for our revere cholesterol transport (RCT) mechanism technology. Because much of the potential value of these license arrangements is contingent upon the successful development and commercialization of the licensed technology,

the ultimate value of these licenses will depend on the efforts of licensing partners. If our licensing partners do not succeed in developing the licensed technology for whatever reason, or elect to discontinue the development of these programs, we may be unable to realize the potential value of these arrangements.

If we fail to obtain regulatory approval in foreign jurisdictions, we would not be able to market our products abroad and our revenue prospects would be limited.

We may seek to have our products or product candidates marketed outside the United States. In order to market our products in the European Union and many other foreign jurisdictions, we must obtain separate regulatory approvals and comply with numerous and varying regulatory requirements. The approval procedure varies among countries and jurisdictions and can involve additional testing. The time required to obtain approval may differ from that required to obtain FDA approval. The foreign regulatory approval process may include all of the risks associated with obtaining FDA approval. We may not obtain foreign regulatory approvals on a timely basis, if at all. Approval by the FDA does not ensure approval by regulatory authorities in other countries or jurisdictions, and approval by one foreign regulatory authority does not ensure approval by regulatory authorities in other foreign countries or jurisdictions or by the FDA. We may not be able to file for regulatory approvals and may not receive necessary approvals to commercialize our products in any market. The failure to obtain these approvals could materially adversely affect our business, financial condition and results of operations.

Because we depend on clinical research centers and other contractors for clinical testing and for certain research and development activities, the results of our clinical trials and such research activities are, to a certain extent, beyond our control.

The nature of clinical trials and our business strategy of outsourcing a substantial portion of our research require that we rely on clinical research centers and other contractors to assist us with research and development, clinical testing activities, patient enrollment and regulatory submissions to the FDA. As a result, our success depends partially on the success of these third parties in performing their responsibilities. Although we pre-qualify our contractors and we believe that they are fully capable of performing their contractual obligations, we cannot directly control the adequacy and timeliness of the resources and expertise that they apply to these activities. If our contractors do not perform their obligations in an adequate and timely manner, the pace of clinical development, regulatory approval and commercialization of our drug candidates could be significantly delayed and our prospects could be adversely affected.

Risks Relating to Our Industry

There are a number of difficulties and risks associated with clinical trials and our trials may not yield the expected results.

There are a number of difficulties and risks associated with conducting clinical trials. For instance, we may discover that a product candidate does not exhibit the expected therapeutic results, may cause harmful side effects or have other unexpected characteristics that may delay or preclude regulatory approval or limit commercial use if approved. It typically takes several years to complete a late-stage clinical trial, such as the planned Phase III confirmatory trial for Zenvia for IEED/PBA, and a clinical trial can fail at any stage of testing. If clinical trial difficulties or failures arise, our product candidates may never be approved for sale or become commercially viable.

In addition, the possibility exists that:

	•		the results from earlier clinical trials may not be statistically significant or predictive of results that will be obtained from subsequent clinical trials, particularly larger trials;

	•		institutional review boards or regulators, including the FDA, may hold, suspend or terminate our clinical research or the clinical trials of our product candidates for various reasons, including noncompliance with regulatory requirements or if, in their opinion, the participating subjects are being exposed to unacceptable health risks;

	•		subjects may drop out of our clinical trials;

	•		our preclinical studies or clinical trials may produce negative, inconsistent or inconclusive results, and we may decide, or regulators may require us, to conduct additional preclinical studies or clinical trials; and

	•		the cost of our clinical trials may be greater than we currently anticipate.

It is possible that earlier clinical and pre-clinical trial results may not be predictive of the results of subsequent clinical trials. If earlier clinical and/or pre-clinical trial results cannot be replicated or are inconsistent with subsequent results, our development programs may be cancelled or deferred. In addition, the results of these prior clinical trials may not be acceptable to the FDA or similar foreign regulatory authorities because the data may be incomplete, outdated or not otherwise acceptable for inclusion in our submissions for regulatory approval.

Additionally, the FDA has substantial discretion in the approval process and may reject our data or disagree with our interpretations of regulations or our clinical trial data or ask for additional information at any time during their review. For example, there are various statistical methods that can be used to analyze clinical trial data. In the FDA’s approvable letter for Zenvia, the FDA expressed disagreement with one of the statistical methods we used to analyze certain efficacy data contained in our NDA submission. In addition, although we concluded that the safety data from our definitive QT safety study of quinidine sulfate in Zenvia suggested that cardiac risks were within an acceptable range, the FDA has expressed concern about these potential risks in the IEED/PBA patient population and has asked us to address these concerns. Similarly, the use of different statistical methods to analyze the efficacy data from our recent Phase III trial of Zenvia in DPN pain results in significantly different conclusions about the efficacy of the drug. Although we believe we have legitimate reasons to use the methods that we have adopted as outlined in our SPA with the FDA, the FDA may not agree with these reasons and may disagree with our conclusions regarding the results of these trials.

Although we expect to be able to fully address these concerns, we may not be able to resolve these matters favorably, if at all. Disputes that are not resolved favorably could result in one or more of the following:

	•		delays in our ability to submit an NDA;

	•		the refusal by the FDA to file any NDA we may submit;

	•		requests for additional studies or data;

	•		delays of an approval; or

	•		the rejection of an application.

If we do not receive regulatory approval to sell our product candidates or cannot successfully commercialize our product candidates, we would not be able to grow revenues in future periods, which would result in significant harm to our financial position and adversely impact our stock price.

Clinical trials can be delayed for a variety of reasons. If we experience any such delays, we would be unable to commercialize our product candidates on a timely basis, which would materially harm our business.

Clinical trials may not begin on time or may need to be restructured after they have begun. Clinical trials can be delayed for a variety of reasons, including delays related to:

	•		obtaining an effective investigational new drug application, or IND, or regulatory approval to commence a clinical trial;

	•		identifying and engaging a sufficient number of clinical trial sites;

	•		negotiating acceptable clinical trial agreement terms with prospective trial sites;

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

	•		recruiting qualified subjects to participate in clinical trials;

	•		competition in recruiting clinical investigators;

	•		shortage or lack of availability of supplies of drugs for clinical trials;

	•		the need to repeat clinical trials as a result of inconclusive results or poorly executed testing;

	•		the placement of a clinical hold on a study;

	•		the failure of third parties conducting and overseeing the operations of our clinical trials to perform their contractual or regulatory obligations in a timely fashion; and

	•		exposure of clinical trial subjects to unexpected and unacceptable health risks or noncompliance with regulatory requirements, which may result in suspension of the trial.

If we experience significant delays in or termination of clinical trials, our financial results and the commercial prospects for our product candidates or any other products that we may develop will be adversely impacted. In addition, our product development costs would increase and our ability to generate revenue could be impaired.

Developing and marketing pharmaceutical products for human use involves product liability risks, for which we currently have limited insurance coverage.

The testing, marketing and sale of pharmaceutical products involves the risk of product liability claims by consumers and other third parties. Although we maintain product liability insurance coverage, product liability claims can be high in the pharmaceutical industry and our insurance may not sufficiently cover our actual liabilities. Additionally, FazaClo is required by the FDA to carry the most severe type of warning (a “black box” warning) regarding adverse side effects, including the possibility of death, and other drugs of the same class are currently the subject of large class-action lawsuits relating to adverse effects. If product liability claims were made against us, it is possible that our insurance carriers may deny, or attempt to deny, coverage in certain instances. If a lawsuit against us is successful, then the lack or insufficiency of insurance coverage could affect materially and adversely our business and financial condition. Furthermore, various distributors of pharmaceutical products require minimum product liability insurance coverage before their purchase or acceptance of products for distribution. Failure to satisfy these insurance requirements could impede our ability to achieve broad distribution of our proposed products and the imposition of higher insurance requirements could impose additional costs on us.

Risks Relating to Our Stock

Our stock price has historically been volatile and we expect that this volatility will continue for the foreseeable future.

The market price of our Class A common stock has been, and is likely to continue to be, highly volatile. This volatility can be attributed to variability in our operating results, as well as many factors independent of our operating results, including the following:

	•		Comments made by securities analysts, including changes in their recommendations;

	•		Short selling activity by certain investors, including any failures to timely settle short sale transactions;

	•		Announcements by us of financing transactions and/or future sales of equity or debt securities;

	•		Sales of our Class A common stock by our directors, officers, or significant shareholders;

	•		Announcements by our competitors of clinical trial results or product approvals; and

	•		Market and economic conditions.

Additionally, our stock price has been volatile as a result of announcements of regulatory actions and decisions relating to our product candidates, including Zenvia, and periodic variations in our operating results. We expect that our operating results will continue to vary from quarter-to-quarter, particularly in light of the loss of FazaClo revenue starting in the fourth quarter of fiscal 2007 and the expected increase in research and development expenditures relating to the planned Zenvia Phase III clinical trials.

Finally, our results of operations and stock price may vary due to acquisitions or divestitures that we may make. We may acquire other companies or technologies, and if we do so, we will incur potentially significant charges in connection with such acquisitions and may have ongoing charges after the closing of any such transaction. Any such acquisitions could also be disruptive to our operations and

may adversely affect our results of operations. We are also considering divesting certain investigational compounds. The announcement of any such transaction would be expected to impact our stock price, as was the case following our announcement of the FazaClo divestiture, and also impact our results of operations in future periods.

As a result of these factors, our stock price may continue to be volatile and investors may be unable to sell their shares at a price equal to, or above, the price paid. Additionally, any significant drops in our stock price, such as the one we experienced following the announcement of the Zenvia approvable letter, could give rise to shareholder lawsuits, which are costly and time consuming to defend against and which may adversely affect our ability to raise capital while the suits are pending, even if the suits are ultimately resolved in favor of the Company.

The preparation of our financial statements requires the use of certain assumptions and estimates. If the facts underlying these assumptions or estimates change, or if our analysis and conclusions change, our financial position and operating results could vary significantly from period to period.

We must make certain assumptions and estimates in preparing our financial statements. These assumptions and estimates relate to a wide range of matters, including but not limited to, allowances for uncollectible accounts receivable, allowances for obsolete inventories, impairment of asset values, product return rates, product pricing allowances, in-channel inventories, probability and size of potential liabilities and many factors related to share-based compensation expense including employee turnover, forfeiture rates, expected stock volatility, and expected term of stock options. If any of the facts underlying these assumptions and estimates change, or if our analysis changes, then the resulting change in conclusions could materially affect our operating results. These changes could increase the volatility in our stock price and could cause our stock price to decline.

Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Not applicable.

Item 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Not applicable.

Item 5. OTHER INFORMATION

On August 2, 2007, the Board of Directors approved an increase in the number of shares of common stock reserved for issuance under the Company’s 2003 Equity Incentive Plan. The plan initially reserved 625,000 shares of common stock for issuance and contains an “evergreen” feature whereby the Board may, on an annual basis, increase the number of shares reserved for issuance under the plan, up to 5% of the total shares outstanding as of December 31 of the prior year. To date, the Board had not increased the number of shares as allowed for calendar year 2007. Based on a total of 37,158,572 shares issued and outstanding as of December 31, 2006, the Board approved an increase of 1,857,928 shares. The increase became effective as of August 3, 2007.

Item 6. EXHIBITS

Exhibits

31.1		Certification of Principal Executive Officer Required Under Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.

31.2		Certification of Principal Financial Officer Required Under Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.

32		Certification of Principal Executive Officer and Principal Financial Officer Required Under Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C. 1350.


Signature	Title	Date

/s/ Keith A. Katkin Keith A. Katkin	President and Chief Executive Officer (Principal Executive Officer)	December 20, 2007

/s/ Martin J. Sturgeon Martin J. Sturgeon	Vice President, Interim Chief Financial Officer (Principal Financial and Accounting Officer)	December 20, 2007


		Page

PART I. FINANCIAL INFORMATION			4

Item 1.	Financial Statements		4

	Condensed Consolidated Balance Sheets		4

	Condensed Consolidated Statements of Operations		5

	Condensed Consolidated Statements of Cash Flows		6

	Notes to Condensed Consolidated Financial Statements		7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		27

Item 3.	Quantitative and Qualitative Disclosures about Market Risk		37

Item 4.	Controls and Procedures		37

PART II. OTHER INFORMATION			39

Item 1.	Legal Proceedings		39

Item 1A.	Risk Factors		39

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		45

Item 3.	Defaults Upon Senior Securities		45

Item 4.	Submission of Matters to a Vote of Security Holders		45

Item 5.	Other Information		45

Item 6.	Exhibits		45

Signatures			46
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32