ACUSPHERE INC - 10-Q Quarterly Report

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

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

As of August 3, 2004 there were 17,213,261 shares of the registrant’s common stock, $.01 par value per share, outstanding.

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

The accompanying unaudited consolidated financial statements of Acusphere, Inc. and Subsidiaries (the “Company”), have been prepared in accordance with generally accepted accounting principles in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles in the United States of America for complete financial statements. These statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s latest audited annual financial statements. Those audited statements are included in our Annual Report on Form 10-K for the year ended December 31, 2003, which has been filed with the SEC.

In the opinion of management, all adjustments, consisting only of normal, recurring adjustments considered necessary for a fair presentation of the results of these interim periods have been included. The results of operations for the three and six months ended June 30, 2004 may not be indicative of the results that may be expected for the full fiscal year.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of expenses during the reporting period. Actual results could differ from those estimates or assumptions. The more significant estimates reflected in these financial statements include judgmental accrued expenses and valuation of stock-based compensation.

The Company’s employee stock option plans are accounted for using the intrinsic-value-based method of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, no compensation expense is recorded for options issued to employees with fixed amounts and fixed exercise prices which for accounting purposes are at least equal to the fair value of the Company’s common stock at the date of grant. Conversely, when the exercise price for accounting purposes is below fair value of the Company’s common stock on the date of grant, a non-cash charge to compensation expense is recorded ratably over the term of the option vesting period in an amount equal to the difference between the value calculated using the exercise price and the fair value. The Company uses the fair-value method to account for non-employee stock-based compensation.

The stock options granted in the three months ended March 31, 2004 and in the three months ended June 30, 2004 were granted at fair market value on the date of grant.

Had compensation cost for grants issued during the current and prior periods been determined consistent with Statement of Financial Accounting Standard (“SFAS”) No. 123, “Accounting for Stock-based

Compensation,” using the fair value method, pro forma net loss and net loss per share would have been the following:

Basic and diluted net loss per common share is calculated by dividing the net loss applicable to common stockholders by the weighted-average number of unrestricted common shares outstanding during the period. Diluted net loss per common share is the same as basic net loss per common share, since the effects of potentially dilutive securities are antidilutive for all periods presented. Antidilutive securities, which consist of redeemable convertible preferred stock prior to 2004, stock options, warrants, and restricted common stock that are not included in the diluted net loss per share calculation, aggregated 8,011,739 and 2,401,058 as of June 30, 2003 and 2004, respectively.

The following table reconciles weighted-average common shares outstanding to the shares used in the computation of basic and diluted weighted-average common shares outstanding:

Long-term obligations, including current maturities, outstanding as of June 30, 2004 consisted of capital equipment leased under various capital lease arrangements and promissory notes under the equipment financing line, described below. Monthly payments under the capital lease obligations range from $3,708 to $46,222 with maturities through April 2005.

In April 2004, the Company entered into an $8.0 million equipment financing line with an equipment financing company. Borrowings under this equipment line can be made against qualified purchases through March 2005. Such borrowings are to be secured by the qualified purchases and repaid over 36 to 48 months, depending on the nature of the equipment financed. No warrants were granted in connection with this equipment line. The $8.0 million equipment line is structured as a loan agreement. However, the Company may elect to borrow up to $4.0 million of this amount in the form of a capital lease. The interest rate on this facility varies depending upon whether the borrowing is in the form of a loan or lease and whether the term is 36 months or 48 months. Such interest rates are fixed at the time of each borrowing under the equipment line with such rates adjusted between borrowings based on the U.S. Federal Reserve’s Three Year and Four Year Treasury Constant Maturity Rates. The equipment line includes provisions to increase the line to $11.3 million upon the occurrence of certain defined events. As of June 30, 2004, the Company has approximately $7.6 million available in additional borrowings under this equipment line. Monthly payments for the amounts outstanding under the equipment financing line range from $1,526 to $4,697 with maturities through July 2008.

On July 1, 2003, 3,731,999 shares of several series of preferred stock were converted into 732,600 shares of common stock. These conversions were based upon the conversion ratios then applicable for each series of

preferred stock. On October 14, 2003, upon the closing of the Company’s initial public offering, all remaining outstanding shares of preferred stock were converted into shares of common stock based upon the conversion ratios then applicable.

As of June 30, 2004, there were 1,203,707 shares of common stock reserved for outstanding stock options previously issued under the Company’s 1994 Stock Plan and 614,451 shares common stock reserved for outstanding stock options issued under the 2003 Stock Option and Incentive Plan. The 1994 Stock Plan expired as of March 7, 2004 and there are no more shares available for issuance under this plan.

On September 12, 2003, the Company effected a one for six reverse stock split, the effect of which has been retroactively applied to all common stock outstanding and to all common stock equivalents.

Comprehensive loss is defined as the change in stockholders’ deficit during a period from transactions and other events and circumstances from non-owner sources. During the three and six months ended June 30, 2003 and 2004, other than reported net loss, the only other component of comprehensive loss incurred by the Company were unrealized losses of zero and $288, respectively, in 2003 and zero and zero, respectively, in 2004, on short term investments.

In July 2004, the Company entered into a collaboration, license and supply agreement with Nycomed Danmark ApS (Nycomed) in which the Company granted Nycomed rights to develop and market AI-700 in Europe. As part of this agreement, in July 2004 Nycomed paid the Company a $4.0 million license fee and the first of eight consecutive quarterly installments of $1.0 million each. We anticipate that a portion of these fees and installments will be recognized as revenues in 2004. Beginning in October 2004, Nycomed is required to pay the Company the remaining seven consecutive quarterly installments of $1.0 million each. The agreement also provides for Nycomed to pay the Company up to $58.0 million in milestone payments upon achievement of certain regulatory milestones and sales goals. Under the agreement, the Company will also be paid to manufacture AI-700 for Nycomed and is entitled to royalties on Nycomed’s sales of AI-700. The Company will pay a customary fee to its financial advisor in this transaction. The fee will be comprised of cash and warrants and the total amount of such payments are dependent upon the timing and magnitude of the amounts paid by Nycomed to the Company.

In July 2004, the Company entered into a lease agreement for 58,000 square feet of commercial manufacturing space in Tewksbury, Massachusetts. This lease has a five year, nine month term with options to extend the lease for up to two additional five-year terms at predetermined rental rates. Initially, Acusphere will receive nine months of occupancy free of base rent, followed by base rent of approximately $400,000 for the next twelve months with scheduled annual rental rate increases thereafter. An initial security deposit of $1.0 million is required as part of the lease, subject to reduction upon the Company making certain tenant improvements and the installation of equipment in the facility.

consummated, resulting in aggregate gross proceeds to the Company of approximately $17.9 million and the issuance of 2,865,522 shares of common stock and warrants to purchase up to an additional 573,105 shares of common stock.

A second and final closing of this private financing will occur subject to receiving shareholder approval in accordance with Nasdaq marketplace rules and customary closing conditions. The second closing is expected to occur later in 2004 and would result in aggregate gross proceeds to the Company of approximately $3.6 million and the issuance of 574,478 shares of common stock at a price of $6.25 per share and warrants to purchase up to an additional 114,895 shares of common stock at an exercise price of $8.50 per share.

Net proceeds from the financing are expected to be used to further fund the development program for AI-700 and for working capital and general corporate purposes.

The shares of common stock and warrants sold in the private placement have not been registered under the Securities Act of 1933, as amended, or state securities laws and may not be offered or sold in the United States absent registration with the Securities and Exchange Commission or an applicable exemption from these registration requirements. The Company has agreed to file a registration statement with the Securities and Exchange Commission covering the resale of the shares of common stock issued in the private placement and the shares of common stock issued upon exercise of the warrants.

From time to time, information provided by us, statements made by our employees or information included in our filings with the Securities and Exchange Commission (including this quarterly report on Form 10-Q) may contain statements that are not historical facts, so-called “forward-looking statements,” that involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by these forward-looking statements. Such forward-looking statements are made pursuant to the safe harbor provisions of Section 21E of the Securities Exchange Act of 1934, as amended.

Forward-looking statements made in connection with this Form 10-Q include, but are not limited to our estimates of expenses, staffing and capital requirements and our need and abilities to raise additional financing; statements regarding our recent private financing, in particular regarding the second closing and shareholder approval; timing of our clinical trials and regulatory milestones for AI-700; collaborative relationships and related license, development, milestone, manufacturing, royalty and other payments; research and development of and commercial prospects for our various product candidates; and our manufacturing capabilities and timing of manufacturing production for our product candidates, including statements concerning our new commercial manufacturing space and related build-out.

In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expect,” “plans,” “anticipates,” “believes,” “estimates,” “projects,” “predicts,” “intends,” “potential” and similar expression intended to identify forward-looking statements. These statements reflect our current views with respect to future events, and are based on assumptions and subject to risks and uncertainties. Also, these forward-looking statements represent our estimates and assumptions only as of the date of this report. Given these uncertainties, you should not place undue reliance on these forward-looking statements. When considering forward-looking statements, you should keep in mind the “Factors That May Affect Future Results” and other cautionary statements included in this report.

You should read this report with the understanding that our actual future results may be materially different from what we expect. Our business, financial condition, results of operations and prospects may change. We may not update these forward-looking statements, even though our situation may change in the future, unless we have obligations under the Federal securities laws to update and disclose material developments related to previously disclosed information. We qualify all of the information presented in this report, and particularly our forward-looking statements, by these cautionary statements.

We are a specialty pharmaceutical company that develops new drugs and improved formulations of existing drugs using our proprietary porous microparticle technology. We are focused on developing proprietary drugs that can offer significant benefits over existing drugs such as improved safety and efficacy, increased patient compliance, greater ease of use, expanded indications or reduced cost. Our three initial product candidates are in clinical development and are designed to address large unmet clinical needs within cardiology, oncology and asthma. Our lead product candidate is a cardiovascular drug in Phase III clinical development for the detection of coronary heart disease, the leading cause of death in the United States.

We created our three initial product candidates using technology that enables us to control the size and porosity of particles in a versatile manner, so we can customize the particles to address the delivery needs of a variety of drugs. We are focused on creating porous microparticles that are smaller than red blood cells. Some of these microparticles are smaller than 1 micron, which we refer to as nanoparticles. Microparticles are important for delivering drugs intravenously so that they can pass through the body’s smallest blood vessels, for increasing the surface area of a drug so that the drug will dissolve more rapidly, and for delivering drugs to the lung via inhalation. Porosity is important for entrapping gases in microparticles, for controlling the release rate of the drug from a microparticle, and for targeting inhaled drugs to specific regions of the lung.

We are a development stage company and have devoted substantially all of our efforts towards the research and development of our product candidates and raising capital. Since our inception, we have had no revenue from product sales and have funded our operations almost exclusively through the private and public placement of equity securities, equipment leases and debt financings. We have not been profitable and have incurred a cumulative net loss of $130.0 million from inception through June 30, 2004. We expect to emerge from the development stage, for financial statement purposes, in the third quarter of 2004 as a result of entering into a collaboration, license and supply agreement with Nycomed Danmark ApS.

We expect to incur significant operating losses for the next several years. Research and development expenses relating to our product candidates will continue to increase. In particular, we expect to incur increased costs for Phase III clinical trials of AI-700. General and administrative costs will increase as we prepare for the commercialization of our product candidates and as we incur costs associated with operating as a newly public company. Manufacturing expenses, which are currently part of research and development expenses, will also increase as we prepare for the commercialization of AI-700.

Our Phase III program for AI-700 commenced in 2003 under a U.S. Investigational New Drug application (“IND”) and in compliance with applicable European regulatory requirements. The Phase III clinical plan provides for a two-part program consisting of a pilot phase, which is designed to qualify and train new investigators, and two multi-center pivotal trials each for approximately 300 patients with suspected coronary heart disease. The Phase III pilot and pivotal phase studies are taking place at clinical sites in North America and Europe with data from the trials intended for submission to U.S., Canadian and European regulatory authorities. The endpoints for the trials are sensitivity and specificity in comparison to nuclear stress testing, angiography or clinical outcome.

Our primary current emphasis in the Phase III program is to enroll patients. We plan to cumulatively enroll 300 patients in the Phase III program by the end of 2004, to complete cumulative enrollment of approximately 600 patients in the Phase III pivotal trials by the end of 2005 and to file a New Drug Application (“NDA”) for AI-700 in the first half of 2006. Although these projected enrollment rates, milestones and target completion dates reflect our current plans, we cannot assure you that we will complete these activities on this schedule, if at all.

Our Phase I human safety study of AI-850 was completed during the three months ended June 30, 2004. AI-850 is a Cremophor-free reformulation of paclitaxel, the active ingredient in Taxol®, a product used to treat a variety of solid tumors. The primary goal of the study was to provide human proof-of-concept that our Hydrophobic Drug Delivery System (HDDS^TM) is capable of intravenously delivering hydrophobic drugs without the need for co-solvents that are inconvenient to administer and are associated with undesirable side effects. The primary objective of this trial was to determine the maximum tolerated dose (“MTD”) of AI-850. In the dose escalation study, 22 patients with solid tumors (taxane naïve patients and patients who previously had received taxane therapy) were treated with AI-850 doses of 36-250 mg/m² every three weeks in cohorts of 3-6 patients. AI-850 was administered without standard taxane pre-medications. Infusions of AI-850 were delivered in less than 30 minutes at all doses, which is significantly shorter that the three-hour infusion typically required by Taxol. The MTD of AI-850 for patients with extensive prior taxane therapy was 205 mg/m², which is higher than the Taxol dose of 175 mg/m² typically used to treat taxane naïve patients with metastatic breast cancer. It is our current plan to seek strategic collaborators for HDDS and AI-850 before commencing additional clinical testing of this technology and product candidate.

During the six months ended June 30, 2004, we were issued two additional U.S. patents as follows:

As of June 30, 2004, we owned fifteen issued U.S. patents, one allowed U.S. patent application and twelve U.S. patent applications. We also own a number of pending international and foreign patent applications corresponding to these U.S. patents and applications.

Revenues. We have not generated any operating revenues since our inception. In connection with our collaboration with Nycomed, we expect to receive $12 million in license fees and development payments from July 2004 through June 2006. We anticipate that a portion of these fees and payments will be recognized as revenues in 2004. Further in the future, we will seek to generate revenues from a combination of product sales, up-front or milestone payments in connection with collaborative or strategic relationships, and royalties resulting from the license of our products and intellectual property and manufacturing revenues.

Research and Development Expense. Research and development expense consists of expenses incurred in developing and testing product candidates. These expenses consist primarily of salaries and related expenses for personnel, fees paid to professional service providers in conjunction with independently monitoring our clinical trials and acquiring and evaluating data in conjunction with our clinical trials, costs of contract manufacturing services, costs of materials used in clinical trials and research and development, depreciation of capital resources used to develop our products, costs of facilities and the legal costs of pursuing patent protection on select elements of our intellectual property. We expense research and development costs, including patent related costs, as incurred. We believe that significant investment in product development is a competitive necessity and plan to continue these investments in order to realize the potential of our product candidates and proprietary technologies. Development programs for later stage product candidates, such as AI-700, tend to cost more than earlier stage programs due to the length and the number of patients enrolled in clinical trials for later stage programs. From inception through June 30, 2004, we cumulatively spent $84.2 million on research and development. Additionally, from June 2000 through September 2002, we performed research and development through a joint venture, as discussed below.

General and Administrative Expense. General and administrative expense consists primarily of salaries and other related costs for personnel in executive, finance, accounting, information technology and human resource functions. Other costs include facility costs not otherwise included in research and development expense and professional fees for legal and accounting services. From inception through June 30, 2004, we have cumulatively incurred $22.8 million in general and administrative expense.

Stock-Based Compensation Expense. Stock-based compensation expense, which is a non-cash charge, results principally from stock option grants to our employees at exercise prices deemed for accounting purposes to be below the fair market value of our stock on the date the stock options were granted (“fixed awards”). Prior to our initial public offering, which closed on October 14, 2003, we granted certain stock options for which the exercise prices were deemed for accounting purposes to be below the fair value of the underlying common stock resulting in our recording stock-based compensation expense associated with such grants. Stock-based compensation expense is also recorded for stock option grants to non-employees and for restricted stock grants provided to directors and advisors in lieu of cash compensation. Deferred compensation on fixed awards is amortized as a charge to operations over the vesting periods of the options and grants, subject to adjustment for forfeiture during the vesting period. As of June 30, 2004, we deferred $1.4 million in

Equity in Loss of Joint Venture. In June 2000, we established in collaboration with Elan Corporation, plc and its affiliates a joint venture, Acusphere Newco, Ltd., a Bermuda corporation, to develop and commercialize pulmonary drug delivery product candidates. In September 2002, we reached an agreement with Elan terminating the joint venture in a cash-free transaction. Equity in loss of joint venture consists of our portion of the losses from Acusphere Newco, Ltd. from June 2000, when the joint venture was established, until September 2002, when the joint venture was terminated. During that period, we owned an 80.1% interest in the joint venture and Elan owned a 19.9% interest in the joint venture on a fully diluted basis. Elan had retained significant minority investor rights that prevented us from exercising full control over the joint venture. Accordingly, during the period from June 2000 to September 2002, we recorded net losses of the joint venture in accordance with our percentage ownership (80.1%) of such entity and reported such loss using the equity method of accounting. In connection with the termination of the joint venture we recorded a loss of $381,413 for an amount previously recorded as due from Elan. Including this amount, from inception through the date on which we terminated our joint venture with Elan, we cumulatively incurred $15.2 million in equity in loss of joint venture.

Interest and Other Income (Expense). Interest income consists of interest earned on our cash, and cash equivalents. Interest expense consists of interest incurred on equipment leases and on debt financings.

Accretion of Dividends and Offering Costs on Convertible Preferred Stock. Accretion of dividends and offering costs on convertible preferred stock primarily consists of dividends on convertible preferred stock. Prior to conversion of convertible preferred stock to common stock, which occurred on October 14, 2003 upon the completion of the our initial public offering, our convertible preferred stock was entitled to accretion of dividends, the amount of which decreased the amount of stockholders’ equity available to common stockholders and effectively increases the loss per share of common stock. After October 14, 2003, no existing convertible preferred stock is outstanding, and accordingly there will be no further accretion of dividends and offering costs on these shares. All preferred stock dividends which were accreted before October 14, 2003 were forfeited by the preferred stockholders on that date in connection with the conversion of these preferred shares to common stock.

Research and Development Expense. Research and development expense increased $3.0 million, or 94%, to $6.1 million in the three months ended June 30, 2004 from $3.1 million in the three months ended June 30, 2003. Research and development expense increased primarily due to increased activities in the AI-700 Phase III clinical program, including clinical site costs, data management costs, independent clinical monitoring costs and costs of manufacturing of clinical materials. The increase in research and development costs also includes costs associated with increasing our full and part-time personnel.

The following table summarizes the primary components of our research and development expense for the three months ended June 30, 2003 and 2004. Because of our ability to utilize resources across several projects, many of our research and development costs are not tied to any individual project and are allocated

Research and development costs generally increase as programs progress from early stage clinical trials to late stage clinical trials. Our primary research and development programs are as follows:


	•	Late Stage Clinical Development Program (AI-700). Our lead product candidate, AI-700, is a cardiovascular drug for the detection of coronary heart disease. We incurred direct research and development expense for AI-700 in the three months ended June 30, 2004 of $4.4 million compared to $1.8 million in the three months ended June 30, 2003. Of these amounts, $688,000 for the three months ended June 30, 2004 and $344,000 for the three months ended June 30, 2003 were incurred in connection with the production of clinical trial material by a third-party contract manufacturer. In 2003, we commenced clinical studies in our Phase III clinical program for AI-700, and we identified and began training additional clinical sites to be part of this Phase III clinical program. We commenced the pivotal phase studies of our Phase III clinical program at select clinical sites in December 2003. As increasing numbers of patients are enrolled in the Phase III clinical program, we anticipate incurring increased costs from professional service firms helping to support the clinical trial by providing services such as independent clinical monitoring, data acquisition and data evaluation. We also anticipate incurring increased costs related to hiring of additional research and development and clinical personnel. In addition, we anticipate incurring increased costs associated with preparation for commercial production, including the build-out of our new commercial manufacturing space.

	•	Early Stage Clinical Development Programs (AI-850 and AI-128). Our initial clinical applications of our HDDS technology, AI-850, and our PDDS technology, AI-128, are in early stages of clinical development. We incurred direct research and development expense for AI-850 and AI-128 in the three months ended June 30, 2004 of $46,000 compared to $167,000 in the three months ended June 30, 2003. There were no contract manufacturing costs incurred in connection with these product development programs during the three months ended June 30, 2004 or for the three months ended June 30, 2003. During the three months ended June 30, 2004, we completed our Phase I clinical trials for AI-850. We anticipate that our costs associated with these clinical programs will not increase significantly until we are prepared to commence further pre-clinical and clinical testing using our own resources or through strategic collaborations.

	•	Other. Other direct research and development costs primarily consist of management and preclinical evaluation of other product candidates.

marketing challenges before they can be successfully commercialized. As a result of these risks and uncertainties, we are unable to predict with any certainty the period in which material net cash inflows from such projects could be expected to commence or the completion date of these programs. Failure to commercialize these product candidates on a timely basis could have a material adverse affect on our business, financial condition and results of operations. We may seek to establish additional collaborative relationships to help us commercialize these product candidates, but there can be no assurance that we will be successful in doing so.

General and Administrative Expense. General and administrative expense increased $417,000, or 42%, to $1.4 million in the three months ended June 30, 2004 from $991,000 in the three months ended June 30, 2003. The higher general and administrative expense incurred in the three months ended June 30, 2004 was principally due to the various costs of being a public company, including costs associated with investor relations, legal counsel, auditing and additional personnel. Also contributing to the higher expenses are increased activities in business development and marketing, including market research expenses.

Stock-Based Compensation Expense. Stock-based compensation expense decreased $166,000, or 42%, to $226,000 in the three months ended June 30, 2004 from $392,000 in the three months ended June 30, 2003. Stock-based compensation expense incurred in both periods resulted principally from the vesting of stock options granted in prior periods on which deferred compensation had previously been recorded and decreased as a result of certain prior year awards becoming fully vested in the current period.

Equity in Loss of Joint Venture. Our joint venture with Elan was terminated in September 2002. Research and development costs for pulmonary drug delivery product candidates in the three months ended June 30, 2004 and for the three months ended June 30, 2003 are included in research and development expense, as discussed above.

Interest and Other Income (Expense). Interest and other income (expense) increased $1.0 million, or 113%, to a net income of $118,000 in the three months ended June 30, 2004 from a net expense of $890,000 in the three months ended June 30, 2003. During these periods, interest and other income (expense) consisted of the following:

The increase in interest income in the three months ended June 30, 2004 compared to the three months ended June 30, 2003 was primarily due to higher average fund balances available for investment resulting from funds received from the initial public offering in October 2003. The decrease in interest expense in the three months ended June 30, 2004 compared to the three months ended June 30, 2003 was primarily due to interest costs associated with the bridge loans of $610,000, interest paid on the subordinated loans payable of $86,000 and amortization of the discount of $77,000 in the three months ended June 30, 2003 compared to zero in the three months ended June 30, 2004. The subordinated loans were paid off in June of 2003 and the bridge loans converted into common stock upon completion of the Company’s Initial Public Offering on October 14, 2003. In addition to this, the interest expense on the lower capital lease balances has decreased $22,000 from the three months ended June 30, 2003 compared to the three months ended June 30, 2004.

Accretion of Dividends and Offering Costs on Convertible Preferred Stock. Accretion of dividends and offering costs on convertible preferred stock decreased $1.6 million, or 100%, to zero in the three months ended June 30, 2004 from $1.6 million in the three months ended June 30, 2003. The decrease was primarily due to the conversion of all outstanding preferred stock into common stock upon completion of the our initial public offering on October 14, 2003. All preferred stock dividends which were accreted before October 14,

2003 were forfeited by the preferred stockholders on that date in connection with the conversion of these preferred shares to common stock. After October 14, 2003, no existing convertible preferred stock is outstanding, and accordingly there will be no further accretion of dividends and offering costs on these shares.

Research and Development Expense. Research and development expense increased $5.4 million, or 86%, to $11.6 million in the six months ended June 30, 2004 from $6.2 million in the six months ended June 30, 2003. Research and development expense increased primarily due to increased activities in the AI-700 Phase III clinical program, including clinical site costs, data management costs, independent clinical monitoring costs and costs of manufacturing of clinical materials. The increase in research and development costs also includes costs associated with increasing full and part-time personnel.

The following table summarizes the primary components of our research and development expense for the six months ended June 30, 2003 and 2004. Because of our ability to utilize resources across several projects, many of our research and development costs are not tied to any individual project and are allocated among multiple projects. We record direct costs on a project-by-project basis. We record indirect costs in aggregate in support of all research and development.

Research and development costs generally increase as programs progress from early stage clinical trials to late stage clinical trials. Our primary research and development programs are as follows:


	•	Late Stage Clinical Development Program (AI-700). Our lead product candidate, AI-700, is a cardiovascular drug for the detection of coronary heart disease. We incurred direct research and development expense for AI-700 in the six months ended June 30, 2004 of $8.1 million compared to $3.3 million in the six months ended June 30, 2003. Of these amounts, $1.6 million for the six months ended June 30, 2004 and $494,000 for the six months ended June 30, 2003 were incurred in connection with the production of clinical trial material by a third-party contract manufacturer. In 2003, we commenced clinical studies in our Phase III clinical program for AI-700, and we identified and began training additional clinical sites to be part of this Phase III clinical program. We commenced the pivotal phase studies of our Phase III clinical program at select clinical sites in December 2003. As increasing numbers of patients are enrolled in the Phase III clinical program, we anticipate incurring increased costs from professional service firms helping to support the clinical trial by providing services such as independent clinical monitoring, data acquisition and data evaluation. We also anticipate incurring increased costs related to hiring of additional research and development and clinical personnel. In addition, we anticipate incurring increased costs associated with preparation for commercial production, including the build-out of our new commercial manufacturing space.

	•	Early Stage Clinical Development Programs (AI-850 and AI-128). Our initial clinical applications of our HDDS technology, AI-850, and our PDDS technology, AI-128, are in early stages of clinical development. We incurred direct research and development expense for AI-850 and AI-128 in the six months ended June 30, 2004 of $126,000 compared to $459,000 in the six months ended June 30, 2003.


		There were no contract manufacturing costs incurred in connection with these product development programs during the six months ended June 30, 2004 or for the six months ended June 30, 2003. During the three months ended June 30, 2004, we completed our Phase I clinical trials for AI-850. We anticipate that our costs associated with these clinical programs will not increase significantly until we are prepared to commence further pre-clinical and clinical testing using our own resources or through strategic collaborations.

	•	Other. Other direct research and development costs primarily consist of management and preclinical evaluation of other product candidates.

Each of our research and development programs are subject to risks and uncertainties, including the requirement to seek regulatory approvals, which are outside of our control. For example, our clinical trials may be subject to delays or rejections based on our inability to enroll patients at the rate that we expect or our inability to produce clinical trial material in sufficient quantities and of sufficient quality to meet the schedule for our planned clinical trials. Moreover, the product candidates identified in these research and development programs, particularly our early stage programs, must overcome significant technological, manufacturing and marketing challenges before they can be successfully commercialized. As a result of these risks and uncertainties, we are unable to predict with any certainty the period in which material net cash inflows from such projects could be expected to commence or the completion date of these programs. Failure to commercialize these product candidates on a timely basis could have a material adverse affect on our business, financial condition and results of operations. We may seek to establish additional collaborative relationships to help us commercialize these product candidates, but there can be no assurance that we will be successful in doing so.

General and Administrative Expense. General and administrative expense increased $815,000, or 44%, to $2.7 million in the six months ended June 30, 2004 from $1.9 million in the six months ended June 30, 2003. The higher general and administrative expense incurred in the six months ended June 30, 2004 was principally due to the various costs of being a public company, including costs associated with investor relations, legal counsel, auditing and additional personnel. Also contributing to the higher expenses are increased activities in business development and marketing, including market research expenses.

Stock-Based Compensation Expense. Stock-based compensation expense decreased $253,000, or 36%, to $459,000 in the six months ended June 30, 2004 from $712,000 in the six months ended June 30, 2003. Stock-based compensation expense incurred in both periods resulted principally from the vesting of stock options granted in prior periods on which deferred compensation had previously been recorded and decreased as a result of certain prior year awards becoming fully vested in the current period.

Equity in Loss of Joint Venture. Our joint venture with Elan was terminated in September 2002. Research and development costs for pulmonary drug delivery product candidates in the six months ended June 30, 2004 and for the six months ended June 30, 2003 are included in research and development expense, as discussed above.

Interest and Other Income (Expense). Interest and other income (expense) increased $1.3 million, or 118%, to a net income of $200,000 in the six months ended June 30, 2004 from a net expense of $1.1 million in the six months ended June 30, 2003. During these periods, interest and other income (expense) consisted of the following:

The increase in interest income in the six months ended June 30, 2004 compared to the six months ended June 30, 2003 was primarily due to higher average fund balances available for investment resulting from funds received from the initial public offering in October 2003. The decrease in interest expense in the six months ended June 30, 2004 compared to the six months ended June 30, 2003 was primarily due to interest costs associated with the bridge loans of $610,000, interest paid on the subordinated loans payable of $195,000 and amortization of the discount of $108,000 in the six months ended June 30, 2003 compared to zero in the six months ended June 30, 2004. The subordinated loans were paid off in June of 2003 and the bridge loans converted into common stock upon completion of the Company’s Initial Public Offering on October 14, 2003. In addition to this, the interest expense on the lower capital lease balances has decreased $45,000 from the six months ended June 30, 2003 compared to the six months ended June 30, 2004.

Accretion of Dividends and Offering Costs on Convertible Preferred Stock. Accretion of dividends and offering costs on convertible preferred stock decreased $3.2 million, or 100%, to zero in the six months ended June 30, 2004 from $3.2 million in the six months ended June 30, 2003. The decrease was primarily due to the conversion of all outstanding preferred stock into common stock upon completion of the our initial public offering on October 14, 2003. All preferred stock dividends which were accreted before October 14, 2003 were forfeited by the preferred stockholders on that date in connection with the conversion of these preferred shares to common stock. After October 14, 2003, no existing convertible preferred stock is outstanding, and accordingly there will be no further accretion of dividends and offering costs on these shares.

Historically, we have financed our business through the issuance of equity securities, debt financings and equipment leases. Our liquidity requirements have arisen primarily from research and development expenditures, equipment expenditures and payments on outstanding indebtedness. As of June 30, 2004, we had cash and cash equivalents of $38.8 million. Since our inception in July 1993 through June 30, 2004, we have raised $161.6 million through the issuance of equity securities, including $47.6 million from our initial public offering in October 2003 and the $19.4 million in convertible promissory notes which converted to common stock upon the completion of our initial public offering. As of June 30, 2004 we owed $644,000 from capital leases, $415,000 from notes payable and had commitments totaling $21.0 million for rent under our facility leases, including the lease agreement signed in July 2004 for commercial manufacturing space in Tewksbury, Massachusetts.

During the six months ended June 30, 2004, operating activities used $12.4 million of cash. Net cash used by operating activities during this period resulted primarily from a net loss of $14.5 million. This use of cash was partially offset by an increase in accrued expenses of $684,000, an increase in accounts payable of $312,000, non-cash charges for depreciation and amortization of $635,000 and non-cash charges for stock-based compensation expense of $459,000.

During the six months ended June 30, 2004, investing activities used $3.4 million in cash. This use of cash was solely for purchases of equipment.

During the six months ended June 30, 2004, financing activities provided $8,000 in cash. Net cash provided by financing activities during this period resulted primarily from entering in promissory notes under the equipment financing line, described below, of $424,000, proceeds from stock option exercises of $36,000 and proceeds from the sale of common stock through the Employee Stock Purchase Plan of $12,000. These proceeds were partially offset by payments on the capital leases and promissory notes of $465,000.

In April 2004, we entered into an $8.0 million equipment financing line with an equipment financing company. Borrowings under this equipment line can be made against qualified purchases through March 2005. Such borrowings are to be secured by the qualified purchases and repaid over 36 to 48 months, depending on the nature of the equipment financed. No warrants were granted in connection with this equipment line. The $8.0 million equipment line is structured as a loan agreement. However, we may elect to borrow up to $4.0 million of this amount in the form of a capital lease. The interest rate on this facility varies depending upon whether the borrowing is in the form of a loan or lease and whether the term is 36 months or 48 months. Such interest rates are fixed at the time of each borrowing under the equipment line with such rates adjusted

between borrowings based on the U.S. Federal Reserve’s Three Year and Four Year Treasury Constant Maturity Rates. The equipment line includes provisions to increase the line to $11.3 million upon the occurrence of certain defined events. As of June 30, 2004, the Company had approximately $7.6 million available for additional borrowings under this equipment line.

In July 2004, the Company entered into a collaboration, license and supply agreement with Nycomed Danmark ApS (Nycomed) in which the Company granted Nycomed rights to develop and market AI-700 in Europe. As part of this agreement, in July 2004 Nycomed paid the Company a $4.0 million license fee and the first of eight consecutive quarterly installments of $1.0 million each. Beginning in October 2004, Nycomed is required to pay the Company the remaining seven consecutive quarterly installments of $1.0 million each. The agreement also provides for Nycomed to pay the Company up to $58.0 million in milestone payments upon achievement of certain regulatory milestones and sales goals. Under the agreement, the Company will also be paid to manufacture AI-700 for Nycomed and is entitled to royalties on Nycomed’s sales of AI-700. The Company will pay a customary fee to its financial advisor in this transaction. The fee will be comprised of cash and warrants and the total amount of such payments are dependent upon the timing and magnitude of the amounts paid by Nycomed to the Company.

In July 2004, the Company entered into definitive purchase agreements with institutional and accredited investors for a $21.5 million private placement of up to 3,440,000 newly issued shares of common stock at a price of $6.25 per share and warrants to purchase up to an additional 688,000 shares of common stock at an exercise price of $8.50 per share. In August 2004, a partial closing of this private placement was consummated, resulting in aggregate gross proceeds to the Company of approximately $17.9 million and the issuance of 2,865,522 shares of common stock and warrants to purchase up to an additional 573,105 shares of common stock.

Net proceeds from the financing are expected to be used to further fund the development program for AI-700 and for working capital and general corporate purposes.

We believe, based on our operating plans, that our existing resources, including scheduled proceeds from Nycomed and from our $21.5 million private financing, will be sufficient to fund our planned operations, including increases in spending for our AI-700 Phase III clinical program, through 2005. However, over the next several months and years we may require significant additional funds to develop, conduct clinical trials, achieve regulatory approvals, build-out commercial manufacturing space and, subject to regulatory approval, commercially launch AI-700, our other product candidates under development and future product candidates. Our future capital requirements will depend on many factors, including the scope and progress made in our research and development activities and our clinical trials and the size and timing of creating expanded manufacturing capabilities. We may also need additional funds for possible future strategic acquisitions of

businesses, products or technologies complementary to our business. We do not expect to generate significant revenues, other than possible license or milestone payments, from commercial sale of our products unless or until we or current or potential partners complete clinical trials for our products and receive marketing approval from the applicable regulatory authorities. If additional funds are required, we may raise such funds from time to time through public or private sales of equity or from borrowings. Financing may not be available on acceptable terms, or at all, and our failure to raise capital when needed could materially adversely impact our growth plans and our financial condition and results of operations. Additional equity financing may be dilutive to the holders of our common stock and debt financing, if available, may involve significant cash payment obligations and covenants that restrict our ability to operate our business.

The following table summarizes our contractual obligations as of June 30, 2004 and the effect such obligations are expected to have on our liquidity and cash flow in future periods:

The operating lease obligations in the table above include the lease agreement for commercial manufacturing space in Tewksbury, Massachusetts that was entered into in July 2004.

As of June 30, 2004, we have entered into purchase orders for capital equipment which total approximately $8.0 million. Against these purchase orders we have paid approximately $2.9 million in deposits. The table above reflects the remaining amounts due on these purchase orders.

Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses. On an on-going basis, we evaluate our estimates and judgments, including those related to accrued expenses, fair valuation of stock related to stock-based compensation and income taxes. We based our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Accrued Expenses. As part of the process of preparing consolidated financial statements we are required to estimate accrued expenses. This process involves identifying services which have been performed on our behalf and estimating the level of service performed and the associated cost incurred for such service as of

each balance sheet date in our consolidated financial statements. Examples of estimated expenses for which we accrue include professional service fees, such as lawyers and accountants, and contract service fees such as amounts paid to clinical monitors, data management organizations and investigators in conjunction with clinical trials, and fees paid to contract manufacturers in conjunction with the production of clinical materials. In connection with such service fees, our estimates are most affected by our understanding of the status and timing of services provided relative to the actual levels of services incurred by such service providers. The majority of our service providers invoice us monthly in arrears for services performed. In the event that we do not identify certain costs which have begun to be incurred or we under- or over-estimate the level of services performed or the costs of such services, our reported expenses for such period would be too low or too high. The date on which certain services commence, the level of services performed on or before a given date and the cost of such services are often judgmental. We make these judgments based upon the facts and circumstances known to us in accordance with generally accepted accounting principles.

Stock-Based Compensation and Other Equity Instruments. We have elected to follow APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, in accounting for our stock-based compensation plans, rather than the alternative fair value accounting method provided for under SFAS No. 123, Accounting for Stock-Based Compensation. Accordingly, we have not recorded stock-based compensation expense for stock options issued to employees in fixed amounts with exercise prices at least equal to the fair value of the underlying common stock on the date of grant. In the notes to our consolidated financial statements we provide pro forma disclosures in accordance with SFAS No. 123 and related pronouncements. We account for transactions in which services are received in exchange for equity instruments based on the fair value of such services received from non-employees or of the equity instruments issued, whichever is more reliably measured, in accordance with SFAS No. 123 and EITF Issue No. 96-18, Accounting for Equity Instruments that Are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. We account for transactions in which we grant warrants in connection with the issuance of debt in accordance with APB 14, Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants. The two factors which most affect charges or credits to operations related to stock-based compensation are the fair value of the common stock underlying stock options for which stock-based compensation is recorded and the volatility of such fair value.

Accounting for equity instruments granted or sold by us under APB No. 14, APB No. 25, SFAS No. 123 and EITF No. 96-18 requires fair value estimates of the equity instrument granted or sold. If our estimates of the fair value of these equity instruments are too high or too low, it would have the effect of overstating or understating expenses. When equity instruments are granted or sold in exchange for the receipt of goods or services and the value of those goods or services can be readily estimated, we use the value of such goods or services to determine the fair value of the equity instruments. When equity instruments are granted or sold in exchange for the receipt of goods or services and the value of those goods or services can not be readily estimated, as is true in connection with most stock options and warrants granted to employees or non-employees, we estimated the fair value of the equity instruments based upon consideration of factors which we deemed to be relevant at the time using cost, market and/or income approaches to such valuations. Because shares of our common stock were not publicly traded prior to our initial public offering in October 2003, market factors historically considered in valuing stock and stock option grants included comparative values of public companies discounted for the risk and limited liquidity provided for in the shares we are issuing, pricing of private sales of our convertible preferred stock, prior valuations of stock grants and the effect of events that have occurred between the time of such grants, economic trends, perspective provided by investment banks and the comparative rights and preferences of the security being granted compared to the rights and preferences of our other outstanding equity.

Income Taxes. As part of the process of preparing our consolidated financial statements we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatments of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. In addition, as of December 31, 2003, we had federal tax net operating loss carryforwards of $68.5 million, which expire through 2023. We also have research and development credit carryforwards of

$2.6 million. We have recorded a valuation allowance to fully offset against these otherwise recognizable net deferred tax assets due to the uncertainty surrounding the timing of the realization of the tax benefit. In the event that we determine in the future that we will be able to realize all or a portion of its net deferred tax benefit, an adjustment to deferred tax valuation allowance would increase net income in the period in which such a determination is made. The Tax Reform Act of 1986 contains provisions that may limit the utilization of net operating loss carryforwards and credits available to be used in any given year in the event of significant changes in ownership interest, as defined.

Our operating results and financial condition have varied in the past and may in the future vary significantly depending on a number of factors. Except for the historical information in this report, the matters contained in this report include forward-looking statements that involve risks and uncertainties. The following factors, among others, could cause actual results to differ materially from those contained in forward-looking statements made in this report and presented elsewhere by management from time to time. Such factors, among others, may have a material adverse effect upon our business, results of operations and financial condition.

We are focused on product development and we have not generated any revenues to date. We have incurred losses each year of our operations and we expect to continue to incur operating losses for the next several years. The process of developing our products requires significant clinical, development and laboratory testing and clinical trials as well as regulatory approvals. In addition, commercialization of our product candidates will require us to establish sales, marketing and manufacturing capabilities, either through internal hiring or through contractual relationships with others. We expect our research and development and general and administrative expenses will increase over the next several years. As of June 30, 2004, our cumulative net loss was $130.0 million.

We must receive regulatory approval of each of our product candidates before we can commercialize or sell that product candidate. The pre-clinical laboratory testing, formulation development, manufacturing and clinical trials of any product candidates we develop independently or in collaboration with third parties, as well as the distribution and marketing of these product candidates, are regulated by numerous federal, state and local governmental authorities in the United States, principally the FDA, and by similar agencies in other countries. The development and regulatory approval process takes many years, requires the expenditure of substantial resources, is uncertain and subject to delays, and will thus delay our receipt of revenues, if any, from any of our product candidates. We cannot assure you that our clinical trials will demonstrate the safety and efficacy of any of our product candidates or will result in marketable products.

No product can receive FDA approval unless human clinical trials show both safety and efficacy for each target indication in accordance with FDA standards. A number of companies in the pharmaceutical and biotechnology industries have suffered significant setbacks in late stage clinical trials even after achieving promising results in early stage development. We therefore cannot assure you that the results from our Phase II clinical trials for AI-700 will be predictive of results obtained in our Phase III clinical trials. Many of the patients in our AI-700 clinical trial have coronary heart disease. As part of our AI-700 Phase III clinical trials, patients will be exposed to potential safety risks associated with a stress test, including risks associated with a pharmacological stressor, and AI-700. Given the nature of the AI-700 Phase III clinical trial, including administering AI-700 to larger numbers of at-risk patients and new clinical sites, adverse events are expected to be encountered during the clinical trial. Adverse events are also likely to be encountered in clinical trials for

our other products, which clinical trials also include at-risk patients. For example, our AI-850 trial consists of patients being treated for late-stage cancer. If significant adverse events are detected and these events are attributable to our products, such events could delay, limit or prevent regulatory agency approval. Further, data obtained from pre-clinical and clinical activities are subject to varying interpretations that could delay, limit or prevent regulatory agency approval. We cannot assure you that our Phase III plan for AI-700 will successfully address the concerns of the FDA or that the results of the Phase III program will establish the safety and efficacy of AI-700 sufficiently for us to obtain regulatory approval.

We may also encounter delays or rejections based on our inability to enroll enough patients to complete our clinical trials. We may also encounter delays, resulting in the need to enroll more patients than expected in our clinical trials, based on our inability to enroll a mix of patients that is consistent with our estimated clinical trial enrollment. Patient enrollment depends on many factors, including the size of the patient population, the nature of the protocol, the proximity of patients to clinical sites, and the eligibility criteria for the study and the freedom to operate with respect to intellectual property. Delays in planned patient enrollment, or the need to enroll more patients, may result in increased costs and delays, which could have a harmful effect on our ability to develop products. We may encounter delays or rejections based on changes in regulatory agency policies during the period in which we develop a drug or the period required for review of any application for regulatory agency approval of a particular compound. On May 1, 2004, changes went into effect in the regulation of clinical trials in Europe. Implementation of these changes could lead to delays to our clinical trials. We also may encounter delays in the event we are unable to produce clinical trial material in sufficient quantities and of sufficient quality to meet the schedule for our planned clinical trials. In addition, we rely on a number of third parties, such as clinical research organizations, to help support the clinical trials by performing independent clinical monitoring, data acquisition and data evaluations. Any failure on the part of these third parties could delay the regulatory approval process.

Failure to obtain regulatory approval or any delay or setback in obtaining regulatory agency approvals could:


	•	adversely affect our ability to market any drugs we develop independently or with collaborative partners;

	•	impose additional costs and diminish any competitive advantages that we may attain; or

	•	adversely affect our ability to generate royalties.

In particular, failure to obtain approval or substantial delays in obtaining approval for our lead product candidate, AI-700, would delay our receipt of product revenues and materially adversely affect our business, financial condition and results of operations.

We cannot be certain that we will obtain any regulatory approvals in other countries and the failure to obtain these approvals may materially adversely affect our business, financial condition and results of operations. In order to market our products outside of the United States, we and our current, and potential future, collaborative partners must establish and comply with numerous and varying regulatory requirements of other countries regarding safety and efficacy. The approval procedures vary among countries and can involve additional product testing and additional administrative review periods. The time required to obtain approval in other countries might differ from that required to obtain FDA approval. The regulatory approval process in other countries may include all of the risks associated with obtaining FDA approval detailed above. Approval by the FDA does not ensure approval by the regulatory authorities of other countries. In addition, many countries outside the United States require a separate review process prior to marketing to determine whether their national health insurance scheme will pay for newly approved products, as well as the price which may be charged for a product.

There can be no assurance that any products we successfully develop, if approved for marketing, will achieve market acceptance or generate significant revenues. Each of our product candidates is intended to replace or alter existing therapies or procedures, and hospitals, physicians or patients may conclude that these

products are less safe or effective or otherwise less attractive than these existing therapies or procedures. For example, our lead product candidate, AI-700, is a contrast agent for use in ultrasound imaging procedures which will compete with existing nuclear imaging and stress echocardiography. Hospitals, physicians or patients may prefer these existing procedures to AI-700 enhanced ultrasound imaging. If our products do not receive market acceptance for any reason, it would adversely affect our business, financial condition and results of operations.

Further, our competitors may develop new technologies or products that are more effective or less costly, or that seem more cost-effective, than our products. We can give no assurance that hospitals, physicians, patients or the medical community in general will accept and use any products that we may develop.

We will require substantial future capital in order to continue to conduct the research and development, clinical and regulatory activities necessary to bring our product candidates to market and to establish commercial manufacturing, marketing and sales capabilities. Our future capital requirements will depend on many factors, including:


	•	the progress of pre-clinical development and laboratory testing and clinical trials;

	•	the timing and size to which we expand our manufacturing capabilities;

	•	the time and costs involved in obtaining regulatory approvals;

	•	the number of product candidates we pursue;

	•	the costs involved in filing and prosecuting patent applications and enforcing or defending patent claims; and

	•	the establishment of selected strategic alliances and activities required for product commercialization.

We intend to seek additional funding through strategic collaborations and may seek funding through private or public sales of our securities or by licensing all or a portion of our technology. This funding may significantly dilute existing stockholders or may limit our rights to our technology.

In July 2004, we entered into definitive purchase agreements with institutional and accredited investors for a $21.5 million private placement of up to 3,440,000 newly issued shares of common stock at a price of $6.25 per share and warrants to purchase up to an additional 688,000 shares of common stock at an exercise price of $8.50 per share. In August 2004, a partial closing of this private placement was consummated, resulting in aggregate gross proceeds to the Company of approximately $17.9 million and the issuance of 2,865,522 shares of common stock and warrants to purchase up to an additional 573,105 shares of common stock. A second and final closing of this private financing would result in aggregate gross proceeds to the Company of approximately $3.6 million and the issuance of 574,478 shares of common stock at a price of $6.25 per share and warrants to purchase up to an additional 114,895 shares of common stock at an exercise price of $8.50 per share. This second and final closing will occur only upon receiving shareholder approval in accordance with Nasdaq marketplace rules and satisfaction of customary closing conditions, including the absence of any material adverse event affecting Acusphere. We can not assure you that we will receive shareholder approval for this second closing, or that all of the other closing conditions, such as the absence of a material adverse event affecting Acusphere, will be satisfied. Failure to satisfy all of these closing conditions would prevent us from consummating this second closing, which would have a material adverse impact on our financial condition.

We cannot assure you that we can obtain additional funding on reasonable terms, or at all. If we cannot obtain adequate funds, we may:


	•	terminate or delay clinical trials for one or more of our product candidates;

	•	delay our establishment of sales, marketing and/or manufacturing capabilities;


	•	curtail significant product development programs that are designed to identify new product candidates; and/or

	•	relinquish rights to our technologies or product candidates.

Competitors and other third parties may initiate patent litigation against us in the United States or in foreign countries based on existing patents or patents that may be granted in the future. Many of our competitors have obtained patents covering products and processes generally related to our products and processes, and they may assert these patents against us. Moreover, there can be no assurance that these competitors have not sought or will not seek additional patents that may cover aspects of our technology. As a result, there is a greater likelihood of a patent dispute than would be expected if our competitors were pursuing unrelated technologies.

While we conduct patent searches to determine whether the technologies used in our products infringe patents held by third parties, numerous patent applications are currently pending and may be filed in the future for technologies generally related to our technologies, including many patent applications that remain confidential after filing. Due to these factors and the inherent uncertainty in conducting patent searches, there can be no guarantee that we will not violate third-party patent rights that we have not yet identified.

We know of U.S. and foreign patents issued to third parties that relate to aspects of our product candidates. There may also be patent applications filed by these or other parties in the United States and various foreign jurisdictions that relate to some aspects of our product candidates, which, if issued, could subject us to infringement actions. In particular, we are aware of U.S. and foreign patents owned by third parties, including potential competitors, that arguably cover aspects of our AI-700 contrast agent. We and several of these parties have recently been actively engaged in opposing the grant of European patents with claims that arguably cover aspects of our AI-700 product. Parties may contest patents in Europe prior to contesting the counterpart patents in the United States because of procedural differences between European and U.S. patent laws as well as economic considerations. There is a significant possibility that one or more of these third parties will use litigation to assert their patents in the United States or Europe.

The owners or licensees of these and other patents may file one or more infringement actions against us. In addition, a competitor may claim misappropriation of a trade secret by an employee hired from that competitor. Any such infringement or misappropriation action could cause us to incur substantial costs defending the lawsuit and could distract our management from our business, even if the allegations of infringement or misappropriation are unwarranted. The defense of multiple claims could have a disproportionately greater impact. Furthermore, a party making this type of claim could secure a judgment that requires us to pay substantial damages. A judgment could also include an injunction or other court order that could prevent us from making, using, selling, offering for sale or importing our products or prevent our customers from using our products. If a court determined or if we independently discovered that any of our products or manufacturing processes violated third-party proprietary rights, our clinical trials could be delayed and there can be no assurance that we would be able to reengineer the product or processes to avoid those rights, or to obtain a license under those rights on commercially reasonable terms, if at all.


	•	receiving patent protection for our product candidates;

	•	maintaining our trade secrets;


	•	not infringing on the proprietary rights of others; and

	•	preventing others from infringing our proprietary rights.

We will be able to protect our proprietary rights from unauthorized use by third parties only to the extent that our proprietary rights are covered by valid and enforceable patents or are effectively maintained as trade secrets.

We try to protect our proprietary position by filing U.S. and foreign patent applications related to our proprietary technology, inventions and improvements that are important to the development of our business. Because the patent position of pharmaceutical companies involves complex legal and factual questions, the issuance, scope and enforceability of patents cannot be predicted with certainty. Patents, if issued, may be challenged, invalidated or circumvented. Thus, any patents that we own or license from others may not provide any protection against competitors. Our pending patent applications, those we may file in the future, or those we may license from third parties, may not result in patents being issued. If issued, they may not provide us with proprietary protection or competitive advantages against competitors with similar technology. Furthermore, others may independently develop similar technologies or duplicate any technology that we have developed. The laws of many foreign countries do not protect our intellectual property rights to the same extent as do the laws of the United States.

We also rely on trade secrets, know-how and technology, which are not protected by patents, to maintain our competitive position. We try to protect this information by entering into confidentiality agreements with parties that have access to it, such as our corporate partners, collaborators, employees and consultants. Any of these parties may breach the agreements and disclose our confidential information or our competitors might learn of the information in some other way. If any trade secret, know-how or other technology not protected by a patent were to be disclosed to or independently developed by a competitor, our business and financial condition could be materially adversely affected.

In order to protect or enforce our patent rights, we may initiate patent litigation against third parties in the United States or in foreign countries. In addition, we may become subject to interference or opposition proceedings conducted in patent and trademark offices to determine the priority of inventions. The defense of intellectual property rights, including patent rights through lawsuits, interference or opposition proceedings, and other legal and administrative proceedings would be costly and divert our technical and management personnel from their normal responsibilities. An adverse determination of any litigation or defense proceedings could put one or more of our patents at risk of being invalidated or interpreted narrowly and could put our patent applications at risk of not issuing.

Furthermore, because of the substantial amount of discovery required in connection with intellectual property litigation, there is a risk that some of our confidential information could be compromised by disclosure during this type of litigation. For example, during the course of this kind of litigation, confidential information may be inadvertently disclosed in the form of documents or testimony in connection with discovery requests, depositions or trial testimony. This disclosure could materially adversely affect our business and financial results.

We have no experience in manufacturing our products for commercial use and limited experience in designing equipment for the manufacture of our products. We intend to create and qualify a commercial manufacturing facility in Tewksbury, Massachusetts and to demonstrate that we can produce AI-700 at a commercial manufacturing scale prior to our filing of a NDA for AI-700 and, subject to required regulatory approvals, we intend to manufacture AI-700 in this facility for commercial use. We can not assure you that we

will be able to successfully manufacture our products in sufficient quantities for commercial sale, or obtain the necessary regulatory approvals for such commercial manufacture, at all or in a timely or economical manner. Our intention to manufacture AI-700 or other products exposes us to the following risks, any of which could delay or prevent the approval of our products by the FDA or corresponding state and foreign agencies, or the commercialization of our products, or result in higher costs or inability to meet demand for AI-700 leading to potential revenue loss, and any of which would have a material adverse impact on our business, financial condition and results of operations.


	•	Manufacturers often encounter difficulties in achieving volume production, quality control and quality assurance. Accordingly, we might not be able to manufacture sufficient quantities of drugs to meet our clinical schedules or to commercialize our products.

	•	Manufacturers are obliged to manufacture in highly controlled environments and to operate in accordance with FDA and international mandated current good manufacturing practices, or cGMPs. For our clinical trials we have relied on contract manufacturers for such facilities and cGMP compliance. In July 2004, we entered into a lease for a facility in Tewksbury, Massachusetts that we intend to convert into a commercial manufacturing facility for AI-700. Creation and qualification of a commercial manufacturing environment requires significant expertise and capital resources, including the development of advanced manufacturing techniques and process controls and is subject to local and state planning approvals. Manufacturers of pharmaceutical products often encounter difficulties in constructing and qualifying new manufacturing facilities and in production, especially in scaling-up initial production. A failure within this new facility to establish and follow cGMPs and to document adherence to such practices may lead to significant delays in the availability of material for our NDA filing or commercial production for AI-700 and may delay or prevent filing or approval of marketing applications for our products or the ability to continue to manufacture the products. Any such delays would further require us to continue to operate this facility and incur related costs.

	•	For each of our current product candidates we will initially rely on a single commercial manufacturing site, directly or through a contract manufacturer, without the backup of a second site that is qualified for commercial manufacture of the product. Qualification of another manufacturing site can be expensive and time consuming. Prior to using product from a new manufacturing site, we must demonstrate that the specifications for the product are consistent with the specifications for the product as it was manufactured at a prior qualified site or we must clinically or otherwise demonstrate that the safety and efficacy of the product produced in the new manufacturing site is consistent with the product as it was manufactured at the prior site. Demonstrating such consistency may be difficult, expensive or time consuming. In addition, before we would be able to produce product for clinical use at a new facility, it will have to undergo a pre-approval inspection by the FDA and corresponding state and foreign agencies. Once approved, drug manufacturers are subject to ongoing periodic unannounced inspection by the FDA and corresponding state and foreign agencies to ensure strict compliance with cGMPs, other government regulations and corresponding foreign standards. Failure to maintain compliance with cGMP or with safety or environmental regulations could result in penalties, product recalls or restrictions on the use of the manufacturing site.

Under the terms of our collaboration agreement with Nycomed, we are responsible for the commercial manufacture of AI-700 for marketing and sale by Nycomed in Europe. Failure to manufacture AI-700 in a timely manner or on an economic basis, or in sufficient quantities, could jeopardize our relationship with Nycomed. We do not currently have a European sales force, nor do we have experience with regard to the commercialization, marketing, sale or distribution of pharmaceutical products in Europe, and we rely entirely on Nycomed for this expertise. Any termination of our relationship with Nycomed would have a material adverse impact on our business, financial condition and results of operations.

We may rely substantially on third-party contract manufacturers to supply, store and distribute our potential products for our clinical trials and other development needs. Our reliance on these third-party manufacturers will expose us to the following risks, any of which could delay or prevent the completion of our clinical trials, the approval of our products by the FDA, or the commercialization of our products, result in higher costs, or deprive us of additional product candidates, and any of which would have a material adverse impact on our business, financial condition and results of operations.


	•	Contract manufacturers often encounter difficulties in achieving volume production, quality control and quality assurance, as well as shortages of qualified personnel. Accordingly, a manufacturer might not be able to manufacture sufficient quantities of drugs to meet our clinical schedules.

	•	Contract manufacturers are obliged to operate in accordance with FDA-mandated current good manufacturing practices, or cGMPs. A failure of these contract manufacturers to establish and follow cGMPs and to document their adherence to such practices may lead to significant delays in the availability of material for clinical study and may delay or prevent filing or approval of marketing applications for our products.

	•	For each of our current product candidates we will initially rely on a single manufacturer. Changing these or future manufacturers may be difficult and the number of potential manufacturers is limited. Changing manufacturers may require re-validation of the manufacturing processes and procedures in accordance with FDA-mandated cGMPs. Such re-validation may be costly and time-consuming. It may be difficult or impossible for us to find replacement manufacturers on acceptable terms quickly, or at all.

	•	Our contract manufacturers may not perform as agreed or may not remain in the contract manufacturing business for the time required to produce, store and distribute our products successfully. Our manufacturing levels, while important to us, can represent relatively small fractions of the overall business of most qualified contract manufactures. As a result, the contract manufactures may not provide us with the attention that we need or may be unwilling to adapt to necessary changes in our manufacturing requirements.

Drug manufacturers are subject to ongoing periodic unannounced inspection by the FDA and corresponding state and foreign agencies to ensure strict compliance with cGMPs, other government regulations and corresponding foreign standards. While we are obligated to audit the performance of third party contractors, we do not have control over our third-party manufacturers’ compliance with these regulations and standards. Failure by our third-party manufacturers or us to comply with applicable regulations could result in sanctions being imposed on us, including fines, injunctions, civil penalties, failure of the government to grant market approval of drugs, delays, suspension or withdrawal of approvals, seizures or recalls of product, operating restrictions and criminal prosecutions, any of which could significantly and adversely affect our business.

To date our product candidates have been manufactured in small quantities for pre-clinical and clinical trials. If any of these product candidates are approved by the FDA or foreign regulatory authorities for commercial sale, we will need to manufacture them in larger quantities. We cannot assure you that we will be able to successfully increase the manufacturing capacity, whether on our own or in collaboration with third party manufacturers, for any of our product candidates in a timely or economic manner, or at all. Significant scale-up of manufacturing may require certain additional validation studies, which the FDA must review and approve. If we are unable to successfully increase the manufacturing capacity for a product candidate, the regulatory approval or commercial launch of that product candidate may be delayed or there may be a shortage in supply of that product candidate. Our product candidates require precise, high quality manufacturing. Our failure to achieve and maintain these high manufacturing standards, including the incidence of

Only a few facilities manufacture some of the raw materials necessary to manufacture our products. For example, the manufacture of AI-850 will require bulk quantities of paclitaxel, a natural substance that is difficult to produce and is in limited supply. We currently have no supply agreements in place with any supply facility. If we need to purchase a raw material that is in limited supply for our clinical trials, or for commercial distribution if we obtain marketing approval of a product candidate, we cannot assure you that one or more suppliers would be able to sell us that raw material at the time we need it and on commercially reasonable terms. If we change suppliers for any of these materials or any of our suppliers experiences a shutdown or disruption in the facilities used to produce these materials, due to technical, regulatory or other problems, it could harm our ability to manufacture our products. Our inability to obtain required raw materials for any reason could substantially impair our development activities or the production, marketing and distribution of our products.

If we receive regulatory approval to commence commercial sales of any of our products, we will face competition with respect to commercial sales, marketing and distribution. These are areas in which we have no experience. To market any of our products directly, we must develop a direct marketing and sales force with technical expertise and supporting distribution capability. Alternatively, we may engage a pharmaceutical or other healthcare company with an existing distribution system and direct sales force to assist us. There can be no assurance that we will successfully establish sales and distribution capabilities either on our own or in collaboration with third parties or gain market acceptance for our products. To the extent we have or will enter co-promotion or other licensing arrangements, any revenues we receive will depend on the efforts of third parties and there can be no assurance that our efforts will succeed.

We will rely on a number of significant collaborative relationships with pharmaceutical or other healthcare companies for our manufacturing, research funding, clinical development and/or sales and marketing performance. Reliance on collaborative relationships poses a number of risks, including the following:


	•	we cannot effectively control whether our corporate partners will devote sufficient resources to our programs or product candidates;

	•	disputes may arise in the future with respect to the ownership of rights to technology developed with collaborators;

	•	disagreements with collaborators could delay or terminate the research and development, regulatory approval or commercialization of product candidates, or result in litigation or arbitration;

	•	corporate partners may have considerable discretion in electing whether to pursue the development of any additional product candidates and may pursue technologies or products either on their own or in collaboration with our competitors; and

	•	collaborators with marketing rights may choose to devote fewer resources to the marketing of our product candidates than they do to product candidates of their own development.

For example, we established a joint venture with Elan Corporation, plc and affiliates in 2000. At the time, we anticipated that we would share the cost of pre-clinical and clinical trials for product candidates being developed by the joint venture with Elan. In 2002, for reasons beyond our control, Elan ceased funding the joint venture and the joint venture was terminated. In connection with the termination, we agreed to pay Elan

a royalty if we commercialize the asthma product candidate that was being developed by the joint venture. Future development of product candidates will require that we provide all the funding for the cost of development and clinical trials or identify collaborators to share in the costs.

In July 2004, we entered into a collaboration, license and supply agreement with Nycomed in which we granted Nycomed rights to develop and market AI-700 in Europe. There can be no assurance that the regulatory goals, sales targets and other objectives of this agreement will be achieved. Failure to achieve these goals, targets and objectives would result in our inability to receive license, milestone, royalty and other payments under this agreement, which would have a material adverse impact on our business, financial condition and results of operations.

Given these risks, our current and future collaborative efforts may not be successful. Failure of these efforts could delay our product development or impair commercialization of our products, and have a material adverse effect on our business, financial condition and results of operations.

We engage in a business characterized by extensive research efforts, rapid developments and intense competition. We cannot assure you that our products will compete successfully or that research and development by others will not render our products obsolete or uneconomical. Our failure to compete effectively would materially adversely affect our business, financial condition and results of operations. We expect that successful competition will depend, among other things, on product efficacy, safety, reliability, availability, timing and scope of regulatory approval and price. Specifically, we expect important factors will include the relative speed with which we can develop products, complete the clinical, development and laboratory testing and regulatory approval processes and supply commercial quantities of the product to the market.

We expect competition to increase as technological advances are made and commercial applications broaden. In commercializing our initial product candidates and any additional products we develop using our HDDS and PDDS technologies, we will face substantial competition from large pharmaceutical, biotechnology and other companies, universities and research institutions.


	•	AI-700, our ultrasound contrast agent and lead product candidate, if approved for marketing and sale, will compete with nuclear stress tests, the current standard of care in myocardial perfusion imaging. Nuclear contrast agents that are approved for use in myocardial perfusion imaging include products marketed by Amersham, Bristol-Myers Squibb and Tyco International. In addition, Amersham, Bristol-Myers Squibb and Imcor have developed ultrasound contrast agents that have been approved by the FDA for resting wall motion studies, and in the future they may seek to broaden their products to include stress echo and myocardial perfusion assessment. Moreover, we are aware that other companies, such as Bracco, are developing ultrasound contrast agents for wall imaging and for radiology applications, and that Point Biomedical is developing an ultrasound contrast agent specifically for myocardial perfusion imaging. In March 2004, Point announced that it had recently completed two pivotal Phase III trials for this contrast agent and plans to file an NDA with the FDA later this year. Finally, some cardiologists may find it satisfactory to use stress echo without contrast for the detection of coronary heart disease.

	•	AI-850, our reformulation of paclitaxel, if approved for marketing and sale, will also face intense competition from companies such as American Pharmaceutical Partners, NeoPharm and Sonus Pharmaceuticals, which are applying significant resources and expertise to developing reformulations of paclitaxel for intravenous delivery. Other companies, such as Cell Therapeutics, are developing new chemical entities that involve paclitaxel conjugated, or chemically bound, to another chemical.

	•	AI-128, our sustained release formulation of an asthma drug, if approved for marketing and sale, will also face intense competition. Companies such as Alkermes possess technology that may be suitable for sustained release pulmonary drug delivery and may have competitive programs that have not been


		publicly announced or may decide to begin such programs in the future. In addition, large pharmaceutical companies that market FDA-approved asthma drugs may be developing sustained release versions of their asthma drugs that would compete with our product candidates.

Relative to us, most of our competitors have substantially greater capital resources, research and development staffs, facilities and experience in conducting clinical trials and obtaining regulatory approvals, as well as in manufacturing and marketing pharmaceutical products. Many of our competitors may achieve product commercialization or patent protection earlier than we will. Furthermore, we believe that some of our competitors have used, and may continue to use, litigation to gain a competitive advantage. Finally, our competitors may use different technologies or approaches to the development of products similar to the products we are seeking to develop.

We depend on the principal members of our scientific and management staff. The loss of any of these principal members’ services might significantly delay or prevent the achievement of research, development or business objectives and could materially adversely affect our business, financial condition and results of operations. We do not maintain key person life insurance on any of these principal members. We do not have employment contracts with any of these principal members.

Our success depends, in large part, on our ability to attract and retain qualified scientific and management personnel such as these individuals. We face intense competition for such personnel and consultants. We cannot assure you that we will attract and retain qualified management and scientific personnel in the future.

Further, we expect that our potential expansion into areas and activities requiring additional expertise, such as further clinical trials, governmental approvals, commercial manufacturing and marketing, will place additional requirements on our management, operational and financial resources. We expect these demands will require an increase in management and scientific personnel and the development of additional expertise by existing management personnel. The failure to attract and retain such personnel or to develop such expertise could materially adversely affect prospects for our success.

In the future, we expect to develop operations outside the United States in order to market and distribute our products. Regardless of the extent to which we seek to develop these operations ourselves or in collaboration with others, we cannot be sure that our international efforts will be successful. Any expansion into international markets will require additional resources and management attention and will subject us to new business risks. These risks could lower the prices at which we can sell our products or otherwise have an adverse effect on our operating results. Among the risks we believe are most likely to affect any international operations are:


	•	different regulatory requirements for approval of our product candidates;

	•	dependence on local distributors;

	•	longer payment cycles and problems in collecting accounts receivable;

	•	adverse changes in trade and tax regulations;

	•	the absence or significant lack of legal protection for intellectual property rights;

	•	political and economic instability; and

	•	currency risks.

If regulatory approval of a product is granted, such approval may be subject to limitations on the indicated uses for which the product may be marketed or contain requirements for costly, post-marketing follow-up studies. As to products for which marketing approval is obtained, the manufacturer of the product and the manufacturing facilities will be subject to continual review and periodic inspections by the FDA and other regulatory authorities. In addition, the labeling, packaging, adverse event reporting, storage, advertising, promotion and record keeping related to the product will remain subject to extensive regulatory requirements. The subsequent discovery of previously unknown problems with the product, manufacturer or facility may result in restrictions on the product or the manufacturer, including withdrawal of the product from the market. We may be slow to adapt, or we may never adapt, to changes in existing requirements or adoption of new requirements or policies.

If we fail to comply with applicable regulatory requirements, we may be subject to fines, suspension or withdrawal of regulatory approvals, product recalls, seizure of products, operating restrictions and criminal prosecution.

Government health administration authorities, private health insurers and other organizations generally provide reimbursement for products like our product candidates, and our commercial success will depend in part on these third-party payors agreeing to reimburse patients for the costs of our products. Even if we succeed in bringing any of our proposed products to market, we cannot assure you that third-party payors will consider our products cost-effective or provide reimbursement in whole or in part for their use.

Significant uncertainty exists as to the reimbursement status of newly approved health care products. Each of our product candidates is intended to replace or alter existing therapies or procedures. These third-party payors may conclude that our products are less safe, effective or cost-effective than these existing therapies or procedures. Therefore, third-party payors may not approve our products for reimbursement.

If third-party payors do not approve our products for reimbursement or fail to reimburse them adequately, sales will suffer as some physicians or their patients will opt for a competing product that is approved for reimbursement or is adequately reimbursed. Even if third-party payors make reimbursement available, these payors’ reimbursement policies may adversely affect the ability of us and our potential collaborators to sell our products on a profitable basis.

Moreover, the trend toward managed healthcare in the United States, the growth of organizations such as health maintenance organizations, and legislative proposals to reform healthcare and government insurance programs could significantly influence the purchase of healthcare services and products, resulting in lower prices and reduced demand for our products which could adversely affect our business, financial condition and results of operations.

In addition, legislation and regulations affecting the pricing of pharmaceuticals may change in ways adverse to us before or after the FDA or other regulatory agencies approve any of our proposed products for marketing. While we cannot predict the likelihood of any of these legislative or regulatory proposals, if any government or regulatory agencies adopt these proposals they could materially adversely affect our business, financial condition and results of operations.

We face an inherent business risk of exposure to product liability claims in the event that the use of our products is alleged to have resulted in harm to others. This risk exists in clinical trials as well as in commercial distribution. In addition, the pharmaceutical and biotechnology industries in general have been subject to

significant medical malpractice litigation. We may incur significant liability if product liability or malpractice lawsuits against us are successful. Furthermore, product liability claims, regardless of their merits, could be costly and divert our management’s attention from other business concerns, or adversely affect our reputation and the demand for our products. Although we maintain product liability insurance, we cannot be certain that this coverage will be adequate or that it will continue to be available to us on acceptable terms.

Pharmaceutical technologies have undergone rapid and significant change. We expect that pharmaceutical technologies will continue to develop rapidly. Our future will depend in large part on our ability to maintain a competitive position with respect to these technologies. Any compounds, products or processes that we develop may become obsolete before we recover any expenses incurred in connection with their development. Rapid technological change could make our products obsolete, which could materially adversely affect our business, financial condition and results of operations.

Our research and development activities involve the use of hazardous materials, including chemicals and biological materials. We believe that our procedures for handling hazardous materials comply with federal and state regulations. However, there can be no assurance that accidental injury or contamination from these materials will not occur. In the event of an accident, we could be held liable for any damages, which could exceed our available financial resources. This liability could materially adversely affect our business, financial condition and results of operations.

We are subject to federal, state and local laws and regulations governing the use, manufacture, storage, handling and disposal of hazardous materials and waste products, and we spent approximately $14,000 in the six months ended June 30, 2004 to dispose of these hazardous materials and waste products. We may be required to incur significant costs to comply with environmental laws and regulations in the future that could materially adversely affect our business, financial condition and results of operations.

We only recently completed our initial public offering. Prior to this offering, you could not buy or sell our common stock publicly. After this offering, the average daily trading volume for our common stock has been relatively low. An active public market for our common stock may not continue to develop or be sustained. The stock market, particularly in recent years, has experienced significant volatility particularly with respect to pharmaceutical and biotechnology stocks. The volatility of pharmaceutical and biotechnology stocks often does not relate to the operating performance of the companies represented by the stock. Factors that could cause this volatility in the market price of our common stock include:


	•	announcements of the introduction of new products by us or our competitors;

	•	market conditions in the pharmaceutical and biotechnology sectors;

	•	rumors relating to us or our competitors;

	•	litigation or public concern about the safety of our potential products;

	•	our quarterly operating results;

	•	deviations in our operating results from the estimates of securities analysts; and

	•	FDA or international regulatory actions.

In the past, when the market price of a stock has been volatile, holders of that stock have often instituted securities class action litigation against the company that issued the stock. If any of our stockholders brought a lawsuit against us, we could incur substantial costs defending the lawsuit. The lawsuit could also divert the time and attention of our management.

The market price of our common stock could decline as a result of sales by our existing stockholders of shares of common stock in the market, or the perception that these sales could occur. These sales might also make it more difficult for us to sell equity securities at a time and price that we deem appropriate. Upon the completion of our initial public offering on October 14, 2004, approximately 74% of our outstanding common stock was held by private investors, officers, employees and directors who acquired their shares prior to the initial public offering. Many of these shareholders, in connection with the initial public offering, were subject to lock-up agreements. Prohibitions on selling shares under these lock-up agreements expired on April 4, 2004.

Our directors and executive officers and their affiliates collectively control approximately 27.3% of our outstanding common stock, excluding unexercised options and warrants. As a result, these stockholders, if they act together, will be able to influence our management and affairs and all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may have the effect of delaying or preventing a change in control of our company and might affect the market price of our common stock.

Provisions of Delaware law or our charter or by-laws could hamper a third party’s acquisition of us, or discourage a third party from attempting to acquire control of us. Stockholders who wish to participate in these transactions may not have the opportunity to do so. These provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock. Further, these provisions make it more difficult for stockholders to change the composition of our board of directors in any one year.


	•	a provision allowing us to issue preferred stock with rights senior to those of the common stock without any further vote or action by the holders of the common stock;

	•	the existence of a staggered board of directors in which there are three classes of directors serving staggered three-year terms, thus expanding the time required to change the composition of a majority of directors and potentially discouraging someone from making an acquisition proposal for us;

	•	the by-laws’ requirement that stockholders provide advance notice when nominating our directors;

	•	the inability of stockholders to convene a stockholders’ meeting without the chairperson of the board, the chief executive officer, the president or a majority of the board of directors first calling the meeting; and

	•	the application of Delaware law prohibiting us from entering into a business combination with the beneficial owner of 15% or more of our outstanding voting stock for a period of three years after the 15% or greater owner first reached that level of stock ownership, unless we meet specified criteria.

We have paid no cash dividends on any of our classes of capital stock to date and we currently intend to retain our future earnings, if any, to fund the development and growth of our businesses. In addition, the terms of any future debt or credit facility may preclude us from paying these dividends. As a result, capital appreciation, if any, of our common stock will be your sole source of gain for the foreseeable future.

We have not used derivative financial instruments for speculation or trading purposes. However, we are exposed to market risk related to changes in interest rates. Our current policy is to maintain an investment portfolio consisting mainly of U.S. money market and government-grade securities, directly or through managed funds, with maturities of one year or less. Our cash is deposited in and invested through highly rated financial institutions in North America. Our short-term investments are subject to interest rate risk and will fall in value if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10% from levels at June 30, 2004, we estimate that the fair value of our investment portfolio would decline by an immaterial amount. We currently have the ability to hold our fixed income investments until maturity, and therefore we do not expect our operating results or cash flows to be affected to any significant degree by the effect of a change in market interest rates on our investments.

Our assets are primarily monetary, consisting of cash, and cash equivalents. Because of their liquidity, these assets are not directly affected by inflation. We also believe that we have intangible assets in the value of our technology. In accordance with generally accepted accounting principles, we have not capitalized the value of this intellectual property on our consolidated balance sheet. Due to the nature of this intellectual property, we believe that these intangible assets are not affected by inflation. Because we intend to retain and continue to use our equipment, furniture and fixtures and leasehold improvements, we believe that the incremental inflation related to replacement costs of such items will not materially affect our operations. However, the rate of inflation affects our expenses, such as those for employee compensation and contract services, which could increase our level of expenses and the rate at which we use our resources.

As of June 30, 2004 (the “Evaluation Date”), the Company’s management, with the participation of the Company’s Chief Executive Officer and the Company’s Senior Vice President and Chief Financial Officer, evaluated the effectiveness of the Company’s disclosure controls and procedures pursuant to Rule 13a-15(b) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based upon that evaluation, the Company’s Chief Executive Officer and the Company’s Senior Vice President and Chief Financial Officer concluded that, as of the Evaluation Date, the Company’s disclosure controls and procedures were effective in ensuring that material information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, including ensuring that such material information is accumulated and communicated to the Company’s management, including the Company’s Chief Executive Officer and the Company’s Senior Vice President and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

During the period covered by this report, there have been no changes in the Company’s internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

(a) In July 2004, the Company entered into definitive purchase agreements with institutional and accredited investors for a $21.5 million private placement of up to 3,440,000 newly issued shares of common stock at a price of $6.25 per share and warrants to purchase up to an additional 688,000 shares of common stock at an exercise price of $8.50 per share. In August 2004, a partial closing of this private placement was consummated, resulting in aggregate gross proceeds to the Company of approximately $17.9 million and the issuance of 2,865,522 shares of common stock and warrants to purchase up to an additional 573,105 shares of common stock.

Net proceeds from the financing are expected to be used to further fund the development program for AI-700 and for working capital and general corporate purposes.

(b) On October 14, 2003, we closed the sale of an aggregate of 3,750,000 shares of our common stock, $0.01 par value, in our initial public offering at a price to the public of $14.00 per share. The managing underwriters in the offering were SG Cowen Securities Corporation, Thomas Weisel Partners LLC, U.S. Bancorp Piper Jaffray and Friedman Billings Ramsey. All of the shares of common stock sold in the offering were registered under the 1933 Act on a Registration Statement on Form S-1 (Reg. No. 333-106725) that was declared effective by the SEC on October 7, 2003 and a Registration Statement filed pursuant to Rule 424(b) under the Securities Act that was filed on October 8, 2003 (Reg. No. 333-106725). The offering commenced on October 7, 2003 and did not terminate until after the sale of all of the securities registered in the Registration Statement. As part of the initial public offering, we granted the several underwriters an overallotment option to purchase up to an additional 562,500 shares of our common stock from us. The underwriters did not exercise the overallotment option. There were no selling stockholders in the offering.

The aggregate price of the offering amount registered on our behalf was $52.5 million. In connection with the offering, we paid $3.7 million in underwriting discounts and commissions to the underwriters and incurred an estimated $1.2 million in other offering expenses. None of the underwriting discounts and commissions or offering expenses were incurred or paid to directors or officers of ours or their associates or to persons owning 10 percent or more of our common stock or to any affiliates of ours. After deducting the underwriting discounts and commissions and offering expenses, we received net proceeds from the offering of approximately $47.6 million. The proceeds to us have conformed with our intended use outlined in the prospectus related to the offering.

At the Company’s Annual Meeting of Stockholders held on June 10, 2004, the stockholders approved the following:

On May 6, 2004, we furnished with the Securities and Exchange Commission a Current Report on Form 8-K reporting the public dissemination of a press release announcing our financial results for the first quarter of 2004.

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized on this 5th day of August 2004.


	By:	/s/ SHERRI C. OBERG



	Sherri C. Oberg
	President and Chief Executive Officer


	By:	/s/ JOHN F. THERO



	John F. Thero
	Senior Vice President and Chief Financial Officer
	(Principal Financial and Accounting Officer and
	Duly Authorized Officer)


(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, 2004

or

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		For the transition period from to .


Delaware		04-3208947
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)

500 Arsenal Street Watertown, Massachusetts		02472 (Zip Code)
(Address of principal executive offices)


			Page
			Number

PART I: FINANCIAL INFORMATION				2
Item 1. Consolidated Financial Statements				2
	Consolidated Balance Sheets (Unaudited):
		December 31, 2003 and June 30, 2004.		2
	Consolidated Statements of Operations (Unaudited):
		Three and Six Months ended June 30, 2003 and 2004 and the period from inception (July 12, 1993) to June 30, 2004		3
	Consolidated Statements of Cash Flows (Unaudited):
		Six Months ended June 30, 2003 and 2004 and the period from inception (July 12, 1993) to June 30, 2004.		4
	Notes to Consolidated Financial Statements (Unaudited)			5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations				10
Item 3. Quantitative and Qualitative Disclosure about Market Risk				35
Item 4. Controls and Procedures				35
PART II: OTHER INFORMATION				36
Item 1. Legal Proceedings				36
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds				36
Item 3. Defaults Upon Senior Securities				37
Item 4. Submission of Matters to a Vote of Security Holders				37
Item 5. Other Information				37
Item 6. Exhibits and Reports on Form 8-K				37
Signature				38
Ex-31.1 Section 302 Certification of CEO
Ex-31.2 Section 302 Certification of CFO
Ex-32.1 Section 906 Certification of CEO & CFO


			December 31,			June 30,
			2003			2004

						(Unaudited)
ASSETS
CURRENT ASSETS:
	Cash and cash equivalents		$	54,562,378		$	38,817,222
	Other current assets			712,673			750,102

		Total current assets		55,275,051			39,567,324
PROPERTY AND EQUIPMENT, At cost:
	Property and equipment (Note 4)			9,959,855			13,373,308
	Less accumulated depreciation and amortization			7,935,450			8,570,169

		Property and equipment, net		2,024,405			4,803,139
OTHER ASSETS				1,624,797			1,481,778

TOTAL			$	58,924,253		$	45,852,241

LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK, AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
	Current portion of long-term obligations (Note 5)		$	884,799		$	743,205
	Accounts payable			1,519,981			1,831,739
	Accrued expenses			1,939,012			2,623,082

		Total current liabilities		4,343,792			5,198,026

LONG-TERM OBLIGATIONS, net of current portion				205,418			315,769

COMMITMENTS
REDEEMABLE CONVERTIBLE PREFERRED STOCK, authorized, 5,000,000 shares as of December 31, 2003 and June 30, 2004; no shares issued and outstanding as of December 31, 2003 and March 31, 2004				—			—

STOCKHOLDERS’ EQUITY:
	Common stock, $0.01 par value; authorized, 98,500,000 shares as of December 31, 2003 and June 30, 2004; issued and outstanding 14,294,533 shares as of December 31, 2003 and 14,332,310 shares as of June 30, 2004			142,945			143,323
	Additional paid-in capital			201,422,784			201,593,270
	Deferred stock-based compensation			(1,723,229	)		(1,386,918	)
	Deficit accumulated during development stage			(145,467,457	)		(160,011,229	)

		Total stockholders’ equity		54,375,043			40,338,446

TOTAL			$	58,924,253		$	45,852,241


															Period from
			Three Months Ended						Six Months Ended						Inception (July 12,
															1993) to June 30,
			June 30, 2003			June 30, 2004			June 30, 2003			June 30, 2004			2004

OPERATING EXPENSES:
	Research and development(1)		$	3,146,030		$	6,103,035		$	6,248,316		$	11,615,889		$	84,168,987
	General and administrative(1)			990,838			1,408,142			1,854,406			2,669,522			22,794,444
	Stock-based compensation			391,815			226,371			711,813			459,052			5,126,637

		Total operating expenses		4,528,683			7,737,548			8,814,535			14,744,463			112,090,068
Equity in loss of joint venture				—			—			—			—			15,164,257
Interest income				47,004			93,761			69,110			201,534			4,175,472
Other income (expense)				(121,208	)		74,268			(121,208	)		74,268			106,083
Interest expense				(815,566	)		(49,691	)		(1,040,008	)		(75,111	)		(6,781,009	)

NET LOSS				(5,418,453	)		(7,619,210	)		(9,906,641	)		(14,543,772	)		(129,753,779	)
Accretion of dividends and offering costs on preferred stock				1,625,778			—			3,234,945			—			30,257,450

NET LOSS AVAILABLE TO COMMON STOCKHOLDERS			$	(7,044,231	)	$	(7,619,210	)	$	(13,141,586	)	$	(14,543,772	)	$	(160,011,229	)

NET LOSS AVAILABLE TO COMMON STOCKHOLDERS PER SHARE — Basic and diluted			$	(5.81	)	$	(0.53	)	$	(10.87	)	$	(1.02	)

WEIGHTED-AVERAGE SHARES OUTSTANDING — Basic and diluted				1,212,066			14,310,311			1,209,318			14,298,202


(1) Excludes stock-based compensation as follows:
Research and development			$	197,028		$	89,580		$	325,028		$	179,529		$	2,173,672
	General and administrative			194,787			136,791			386,785			279,523			2,952,965

			$	391,815		$	226,371		$	711,813		$	459,052		$	5,126,637

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Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

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Table of Contents

Table of Contents

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											Period from
					Six Months Ended						Inception
											(July 12, 1993)
					June 30,			June 30,			to June 30,
					2003			2004			2004

CASH FLOWS FROM OPERATING ACTIVITIES:
	Net loss				$	(9,906,641	)	$	(14,543,772	)	$	(129,753,779	)
	Adjustments to reconcile net loss to cash used in operating activities:
		Stock-based compensation expense				711,813			459,052			5,126,637
		Depreciation and amortization				1,074,613			634,719			9,384,483
		Noncash interest expense				406,145			34,132			2,003,400
		Noncash rent expense				26,820			26,820			134,100
		Equity in loss from joint venture				—			—			15,164,257
		Changes in operating assets and liabilities:
			Due from joint venture			—			—			(3,149,257	)
			Other current assets			(67,428	)		20,575			(809,359	)
			Accounts payable			96,700			311,757			1,831,740
			Accrued expenses			301,800			684,069			3,607,008

				Net cash used in operating activities		(7,356,178	)		(12,372,648	)		(96,460,770	)

CASH FLOWS FROM INVESTING ACTIVITIES:
	Purchases of property and equipment					(252,551	)		(3,353,258	)		(5,130,856	)
	Increase in other assets					(243,350	)		(26,999	)		(1,765,245	)
	Investment in joint venture					—			—			(12,015,000	)
	Maturities of short-term investments					(3,546,219	)		—			17,499

				Net cash used in investing activities		(4,042,120	)		(3,380,257	)		(18,893,602	)

CASH FLOWS FROM FINANCING ACTIVITIES:
	Payments on long-term obligations					(3,957,712	)		(464,528	)		(18,245,746	)
	Proceeds from long-term obligations					19,440,342			424,153			29,864,495
	Proceeds from financing of equipment					—			—			347,960
	Net proceeds from sale of redeemable convertible preferred stock					—			—			94,337,203
	Net proceeds from sale of common stock in initial public offering					—			—			47,618,443
	Net proceeds from exercise of stock options					1,889			35,960			238,435
	Proceeds from issuance of common stock from employee stock purchase plan					—			12,164			12,164
	Purchase and retirement of treasury stock					—			—			(1,360	)

				Net cash provided by financing activities		15,484,519			7,749			154,171,594

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS						4,086,221			(15,745,156	)		38,817,222
CASH AND CASH EQUIVALENTS — Beginning of period						7,796,238			54,562,378			—

CASH AND CASH EQUIVALENTS — End of period					$	11,882,459		$	38,817,222		$	38,817,222


						Weighted
						Average
		Number		Exercise		Exercise
		of		Price Per		Price Per
		Shares		Share		Share

For the three months ended:
	March 31, 2004		541,139	$	8.50-9.60	$	9.08
	June 30, 2004		153,600	$	6.12-7.85	$	6.49



		As of:

		December 31,		June 30,
		2003		2004

Equipment		$	9,655,685	$	10,143,476
Furniture and fixtures			181,665		195,004
Leasehold improvements			122,505		129,465
Deposits on equipment purchases			—		2,905,363

	Total property and equipment	$	9,959,855	$	13,373,308


ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


U.S. Patent No.		Date Issued	Expiration Date	Subject

	6,689,390	February 10, 2004	February 22, 2019	Matrices Formed of Polymer and Hydrophobic Compounds for Use in Drug Delivery
	6,730,322	May 4, 2004	February 22, 2019	Matrices Formed of Polymer and Hydrophobic Compounds for Use in Drug Delivery



		Six Months Ended June 30,

		2003			2004

Interest income		$	69,000		$	201,000
Other income (expense)			(121,000	)		74,000
Interest expense			(1,040,000	)		(75,000	)

	Total, net	$	(1,092,000	)	$	200,000


	Total				2005		2007		2009
	Obligations		Remainder		through		through		through		After
	All Years		of 2004		2006		2008		2010		2010


	(In thousands)
Capital lease obligations	$	644	$	439	$	205	$	—	$	—	$	—
Operating lease obligations		20,974		1,073		5,239		5,911		6,022		2,729
Notes payable		415		42		106		117		103		47
Purchase orders for capital equipment		5,063		3,578		1,485		—		—		—

Total contractual cash obligations	$	27,096	$	5,132	$	7,035	$	6,028	$	6,125	$	2,776


	*We have not generated revenues to date, and we may not achieve profitability for some time, if at all.*


	If we fail to obtain regulatory approvals for our product candidates under development, and in particular our lead product candidate AI-700, we will not be able to generate revenues from the commercialization or sale of our product candidates.


	*Our products, if approved, may fail to achieve market acceptance.*


1.	Basis of Presentation


2.	Accounting for Stock-based Compensation


3.	Net Loss Per Common Share


4.	Property and Equipment


	*If we cannot raise additional capital on acceptable terms, we may be unable to complete planned clinical trials, obtain regulatory approvals or commercialize our product candidates.*


	*Claims by other companies that we infringe their proprietary technology may result in liability for damages or stop our development and commercialization efforts.*


	If we are unable to protect our intellectual propriety rights, our competitors may develop and market products with similar features that may reduce demand for our products, and we may be prevented from establishing collaborative relationships on favorable terms.


	*We may become involved in lawsuits to protect or enforce our patents that would be expensive and time consuming.*


	We have never manufactured any of our product candidates in commercial quantities, and if we fail to develop an effective manufacturing capability for our products, including our lead product candidate AI-700, we may be unable to commercialize these products.


	If third-party manufacturers of our products fail to devote sufficient time and resources to our concerns, or if their performance is substandard, our clinical trials may be delayed and our costs may rise.


	*We may not be able to manufacture our products in commercial quantities, which would prevent us from marketing our products.*


	*Materials necessary to manufacture our products may not be available, which may delay our development and commercialization activities.*


	*We have no experience selling, marketing or distributing our products and no internal capability to do so.*


	*We will establish collaborative relationships, and those relationships may expose us to a number of risks.*


	*Competition in the pharmaceutical industry is intense, and if we fail to compete effectively our financial results will suffer.*


	*If we are unable to retain key personnel and hire additional qualified scientific, sales and marketing, and other personnel, we may not be able to successfully achieve our goals.*


	*We expect to develop international operations that will expose us to additional business risks.*


	*Even if we obtain marketing approval, our products will be subject to ongoing regulatory review.*


	*Market acceptance of our products will be limited if users of our products are unable to obtain adequate reimbursement from third-party payors.*


	*We may be required to defend lawsuits or pay damages in connection with the alleged or actual harm caused by our products or product candidates.*


	*Rapid technological change could make our products obsolete.*


	Our products involve the use of hazardous materials, and as a result we are exposed to potential liability claims and to costs associated with complying with laws regulating hazardous waste.


	*We expect that our stock price will fluctuate significantly.*


	*We may be the subject of securities class action litigation due to future stock price volatility.*