INSPIRE PHARMACEUTICALS INC - 10-Q Quarterly Report

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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934.

For the quarterly period ended September 30, 2002

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934.

For the transition period from to

Commission File Number: 000-31135

INSPIRE PHARMACEUTICALS, INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware (State or Other Jurisdiction of Incorporation or Organization)		04-3209022 (I.R.S. Employer Identification No.)

4222 Emperor Boulevard, Suite 470 Durham, North Carolina (Address of Principal Executive Offices)		27703-8466 (Zip Code)

Registrant’s Telephone Number, Including Area Code: (919) 941-9777

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 x NO ¨

Indicate the number of shares outstanding of common stock, as of the latest practical date: 25,849,646 as of October 31, 2002.

INSPIRE PHARMACEUTICALS, INC.

(a development stage company)

INDEX

		Page
PART I. FINANCIAL INFORMATION

Item 1.	Financial Statements

	Condensed Balance Sheets—September 30, 2002 (unaudited) and December 31, 2001	3

	Condensed Statements of Operations—Three and Nine months ended September 30, 2002 and 2001 (unaudited)	4

	Condensed Statements of Cash Flows—Nine months ended September 30, 2002 and 2001 (unaudited)	5

	Notes to Unaudited Condensed Financial Statements	6

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

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	14

Item 4.	Controls and Procedures	15

PART II. OTHER INFORMATION

Item 2.	Changes in Securities and Use of Proceeds	15

Item 5.	Other Information	15

Item 6.	Exhibits and Reports on Form 8-K	25

Signatures		26

Certifications		27

Exhibit Index		29

INSPIRE PHARMACEUTICALS, INC.

(a development stage company)

PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

Condensed Balance Sheets

(in thousands except share amounts)

	(Unaudited)
	September 30, 2002			December 31, 2001
Assets
Current assets:
Cash and cash equivalents	$	31,597		$	29,959
Short-term investments		8,993			22,395
Other receivables		5			104
Interest receivable		58			102
Prepaid expenses		830			531

Total current assets		41,483			53,091

Property and equipment, net		1,129			1,471
Other assets		538			5,525

Total assets	$	43,150		$	60,087

Liabilities & stockholders’ equity
Current liabilities:
Accounts payable	$	1,102		$	1,141
Accrued expenses		869			1,367
Capital leases, current portion		320			376
Deferred revenue, current portion		3,300			4,083

Total current liabilities		5,591			6,967
Capital leases, excluding current portion		279			525

Total liabilities		5,870			7,492

Stockholders’ equity:
Common stock, $0.001 par value, 60,000,000 shares authorized; 25,849,646 and 25,751,468 shares issued and outstanding at September 30, 2002 and December 31, 2001, respectively		26			26
Additional paid-in capital		125,068			125,099
Other comprehensive income (loss)		5			1
Deferred compensation		(639	)		(1,525	)
Deficit accumulated during the development stage		(87,180	)		(71,006	)

Total stockholders’ equity		37,280			52,595

Total liabilities and stockholders’ equity	$	43,150		$	60,087

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

INSPIRE PHARMACEUTICALS, INC.

(a development stage company)

Condensed Statements of Operations

(in thousands except share and per share amounts)

(Unaudited)

	Three Months Ended						Nine Months Ended						Cumulative From Inception (October 28, 1993) to September 30, 2002
	September 30, 2002			September 30, 2001			September 30, 2002			September 30, 2001
Revenues:
Collaborative research agreements	$	1,350		$	2,238		$	3,783		$	5,047		$	17,900

Operating expenses:
Research and development (includes $105, $124, $345, $394 and $2,285, of stock-based compensation, respectively)		5,873			6,557			16,809			20,190			86,953
General and administrative (includes $150, $169, $487, $508 and $2,417, of stock-based compensation, respectively)		1,131			1,320			3,813			4,093			22,172

Total operating expenses		7,004			7,877			20,622			24,283			109,125

Operating loss		(5,654	)		(5,639	)		(16,839	)		(19,236	)		(91,225	)

Other income (expense), net:
Interest income		205			772			731			3,305			7,747
Interest expense		(17	)		(49	)		(60	)		(130	)		(1,851	)
Loss on disposal of property and equipment		—			—			(6	)		—			(375	)

Other income (expense), net		188			723			665			3,175			5,521

Loss before provision for income taxes		(5,466	)		(4,916	)		(16,174	)		(16,061	)		(85,704	)

Provision for income tax		—			—			—			—			820

Net loss		(5,466	)		(4,916	)		(16,174	)		(16,061	)		(86,524	)

Preferred stock dividends		—			—			—			—			(656	)

Net loss available to common stockholders	$	(5,466	)	$	(4,916	)	$	(16,174	)	$	(16,061	)	$	(87,180	)

Net loss per common share-basic and diluted	$	(0.21	)	$	(0.19	)	$	(0.63	)	$	(0.62	)

Weighted average common shares outstanding-basic and diluted		25,848			25,734			25,811			25,688

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

INSPIRE PHARMACEUTICALS, INC.

(a development stage company)

Condensed Statements of Cash Flows

(in thousands)

(Unaudited)

	Nine Months Ended						Cumulative From Inception (October 28, 1993) to September 30, 2002
	September 30, 2002			September 30, 2001
Cash flows from operating activities:
Net loss	$	(16,174	)	$	(16,061	)	$	(86,524	)
Adjustments to reconcile net loss to net cash used in operating activities:
Stock issued for exclusive licenses		—			—			144
Stock issued for consulting services		—			—			72
Depreciation and amortization		537			1,651			6,319
Amortization of deferred compensation		831			902			4,730
Loss on disposal of property and equipment		6			—			375
Changes in operating assets and liabilities:
Other receivables		99			(7	)		(5	)
Interest receivable		44			147			(58	)
Prepaid expenses		(299	)		(6	)		(830	)
Other assets		(15	)		(2	)		(38	)
Accounts payable		(39	)		279			1,102
Accrued expenses		(498	)		6			865
Deferred revenue		(783	)		(47	)		3,300

Net cash used in operating activities		(16,291	)		(13,138	)		(70,548	)

Cash flows from investing activities:
Purchase of investments		(11,294	)		(93,774	)		(212,251	)
Proceeds from sale of investments		29,700			122,291			202,685
Proceeds from sale of property and equipment		—			—			127
Purchases of property and equipment		(199	)		(591	)		(2,650	)

Net cash provided by (used in) investing activities		18,207			27,926			(12,089	)

Cash flows from financing activities:
Proceeds from bridge loans		—			—			780
Proceeds from issuance of notes payable		—			401			408
Payments on notes payable		—			—			(420	)
Issuance of common stock, net		24			61			70,440
Issuance of convertible preferred stock, net		—			—			45,061
Payments on capital lease obligations		(302	)		(218	)		(2,035	)

Net cash (used in) provided by financing activities		(278	)		244			114,234

Increase in cash and cash equivalents		1,638			15,032			31,597
Cash and cash equivalents, beginning of period		29,959			35,109			—

Cash and cash equivalents, end of period	$	31,597		$	50,141		$	31,597

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

INSPIRE PHARMACEUTICALS, INC.

(a development stage company)

NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS

Organization

Inspire Pharmaceuticals, Inc. (the “Company”) was founded on October 28, 1993. Since that time, we have been engaged in the discovery, development and commercialization of novel pharmaceutical products that treat diseases which are characterized by deficiencies in the body’s innate defense mechanisms of mucosal hydration and mucociliary clearance, as well as other non-mucosal disorders. The Company’s technologies are based in part on exclusive license agreements with The University of North Carolina at Chapel Hill (“UNC”) for rights to certain developments from the founder’s laboratories.

The Company is considered a development stage enterprise. Since inception, the Company has devoted substantially all of its efforts towards establishing its business and research and development programs.

Summary of Significant Accounting Policies

Unaudited Interim Financial Statements

The accompanying unaudited interim financial statements have been prepared in accordance with generally accepted accounting principles and applicable Securities and Exchange Commission regulations for interim financial information. These financial statements are unaudited and, in the opinion of management, include all adjustments necessary to present fairly the balance sheets, statements of operations, and statements of cash flows for the periods presented in accordance with generally accepted accounting principles and the applicable rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to Securities and Exchange Commission rules and regulations. Operating results for the three months and nine months ended September 30, 2002 are not necessarily indicative of the results that may be expected for the year ending December 31, 2002. These financial statements and notes should be read in conjunction with the financial statements and notes thereto for the year ended December 31, 2001 included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 26, 2002.

Use of Estimates

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

Cash and Cash Equivalents

The Company considers all highly liquid investments with a maturity of three months or less at the date of purchase to be cash equivalents.

Investments

Investments consist primarily of U.S. government agency obligations and other fixed or variable income investments. The Company invests in high-credit quality investments in accordance with its investment policy which minimizes the possibility of loss. Investments with original maturities at date of purchase beyond three months and which mature at or less than twelve months from the balance sheet date are classified as current. Investments with a maturity beyond twelve months from the balance sheet date are classified as long-term. Investments are considered to be available for sale and are carried at fair value with unrealized gains and losses recognized in other comprehensive income (loss). Realized gains and losses are determined using the specific identification method and transactions are recorded on a settlement date basis.

INSPIRE PHARMACEUTICALS, INC.

(a development stage company)

NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS—(Continued)

Property and Equipment

Property and equipment is primarily comprised of furniture, laboratory and computer equipment which are recorded at cost and depreciated using the straight-line method over their estimated useful lives which range from three to seven years. Property and equipment, which includes certain equipment under capital leases, and leasehold improvements are depreciated over the shorter of the lease period or their estimated useful lives.

Other Assets

At September 30, 2002, other assets are primarily comprised of long-term investments totaling $500,000 and $38,000 related to deposits. At December 31, 2001, other assets were comprised of $5.5 million in long-term investments and $25,000 related to deposits and deferred costs. Deferred costs are amortized using the effective interest rate method over the life of the related collaborative research agreement or lease.

Deferred Compensation

The Company accounts for deferred compensation (“stock based compensation”) based on the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” which states that no compensation expense is recorded for stock options or other stock-based awards to employees that are granted with an exercise price equal to or above the estimated fair value per share of the Company’s common stock on the grant date. In the event that stock options are granted with an exercise price below the estimated fair value of the Company’s common stock, the difference between the estimated fair value of the Company’s common stock and the exercise price of the stock option is recorded as deferred compensation. The Company did not recognize any deferred compensation associated with stock option grants for the three and nine months ended September 30, 2002 and 2001.

Deferred compensation is amortized over the vesting period of the related stock option, which is generally four years. The Company recognized $255,000 and $293,000 of stock based compensation expense related to amortization of deferred compensation during the three months ended September 30, 2002 and 2001, respectively. The Company recognized $832,000 and $902,000 during the nine months ended September 30, 2002 and 2001, respectively. The Company has adopted the disclosure requirements of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” which requires compensation expense be disclosed based on the fair value of the options granted at the date of the grant.

Income Taxes

The Company accounts for income taxes using the liability method which requires the recognition of deferred tax assets or liabilities for the temporary differences between financial reporting and tax bases of the Company’s assets and liabilities and for tax carryforwards at enacted statutory tax rates in effect for the years in which the differences are expected to reverse. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. In addition, valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

Revenue Recognition

Revenue is recognized under collaborative research agreements when services are performed or when contractual obligations are met. Non-refundable fees received at the initiation of collaboration agreements for which the Company has an ongoing research and development commitment are deferred and recognized ratably over the period of the related research and development commitment. Milestone payments under collaboration agreements and research agreements will be recognized as revenues, ratably over the remaining period of the research and development commitment beginning on the date the Company achieves the indicated milestone and such

INSPIRE PHARMACEUTICALS, INC.

(a development stage company)

NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS—(Continued)

achievement is acknowledged by the collaborative partner, which generally coincides with the receipt of the milestone payment.

Research and Development

Research and development costs include all direct costs, including salaries for research and development personnel, outside consultants, costs of clinical trials, sponsored research and clinical trials insurance related to the development of drug compounds. These costs have been charged to operating expense as incurred. Costs associated with obtaining and maintaining patents on the Company’s drug compounds and license initiation and continuation fees, including milestone payments by the Company to its licensors, are evaluated based on the stage of development of the related drug compound and whether the underlying drug compound has an alternative use. Costs of these types incurred for drug compounds not yet approved by the United States Food and Drug Administration (“FDA”) and for which no alternative use exists are recorded as research and development expense. In the event the drug compound has been approved by the FDA or an alternative use exists for the drug compound, patent costs and license costs are capitalized and amortized over the expected life of the related drug compound. License milestone payments to the Company’s licensors are recognized when the underlying requirement is met by the Company.

Significant Customers and Credit Risk

All revenues recognized and recorded in the three months ended September 30, 2002 were from two collaborative partners. All revenues recognized and recorded in the same period in 2001 were from four collaborative partners. During the nine month period ended September 30, 2002 and 2001, revenues were from two collaborative partners and four collaborative partners, respectively.

Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of short-term cash investments. The Company primarily invests in short-term interest-bearing investment-grade securities and certificates of deposits. Cash deposits are all in financial institutions in the United States.

Cash Flows

The Company made cash payments for interest of $16,000 and $41,000 for the three months ended September 30, 2002 and 2001, respectively. The Company made cash payments for interest of $59,000 and $111,000 for the nine months ended September 30, 2002 and 2001, respectively.

The Company acquired property and equipment amounting to $37,000 in the three months and $199,000 in the nine months ended September 30, 2002. During the same periods in 2001, the Company acquired property and equipment amounting to $104,000 and $591,000 respectively, of which $401,000 was financed through a capital lease obligation in the second quarter of 2001.

Net Income (Loss) Per Common Share

Basic net income (loss) per common share (“basic EPS”) is computed by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding. Diluted net income (loss) per common share (“diluted EPS”) is computed by dividing net income (loss) available to common stockholders by the weighted average number of common shares and dilutive potential common share equivalents then outstanding. Potential common share equivalents consist of shares issuable upon the exercise of stock options and warrants. The calculation of diluted EPS for the three months ended September 30, 2002 and 2001 does not include 1,373,433 and 1,481,787, respectively, of potential shares of common stock equivalents, as their impact would be antidilutive.

Segment Reporting

The Company has determined that it did not have any separately reportable operating segments as of September 30, 2002 or 2001.

INSPIRE PHARMACEUTICALS, INC.

(a development stage company)

NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS—(Continued)

Other Comprehensive Income (Loss)

At September 30, 2002, the Company had $5,000 of unrealized gain on investments that is classified as other comprehensive income and is disclosed as a component of stockholders’ equity. The Company had $1,000 of unrealized gain on investments at December 31, 2001.

Recent Accounting Pronouncements

In April 2002, the FASB issued FASB Statement No. 145 (“SFAS 145”), “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” SFAS 145 rescinds FASB Statement No. 4, “Reporting Gains and Losses from Extinguishment of Debt”, FASB Statement No. 64, “Extinguishment of Debt Made to Satisfy Sinking-Fund Requirements” and FASB Statement No. 44, “Accounting for Intangible Assets of Motor Carriers.” This Statement amends FASB Statement No. 13, “Accounting for Leases”, to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The provisions of SFAS 145 are required to be applied to fiscal years beginning after May 15, 2002. The adoption of SFAS 145 is not expected to have any impact on the Company’s financial position or results of operations.

In June 2002, the FASB issued FASB Statement No. 146 (“SFAS 146”), “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issue Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The provisions of SFAS 146 are required to be applied for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS 146 is not expected to have any impact on the Company’s financial position or results of operations.

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

CAUTIONARY STATEMENT

The discussion below contains forward-looking statements regarding the financial condition of Inspire Pharmaceuticals, Inc. (the “Company,” “we” or “our”) and the results of operations that are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted within the United States. The preparation of these financial statements requires our management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We evaluate our estimates on an ongoing basis. These estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.

We operate in a highly competitive environment that involves a number of risks, some of which are beyond our control. Statements contained in Management’s Discussion and Analysis of Financial Conditions and Results of Operations which are not historical facts are, or may constitute, forward looking statements. Forward looking statements involve known and unknown risks that could cause our actual results to differ materially from expected results. These risks are discussed in the section entitled “Other Information—Risk Factors” as well as in our Annual Report on Form 10-K for the year ended December 31, 2001. Although we believe the expectations reflected in the forward looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements.

INSPIRE PHARMACEUTICALS, INC.

(a development stage company)

OVERVIEW

We were incorporated in October 1993 and commenced operations in March 1995 following our first substantial financing. Since that time, we have been engaged in the discovery and development of novel pharmaceutical products that treat diseases which are characterized by deficiencies in the body’s innate defense mechanisms of mucosal hydration and mucociliary clearance as well as other diseases. Our technologies are based in part on exclusive license agreements with The University of North Carolina at Chapel Hill for rights to certain developments.

To date, we have not derived any commercial revenues from product sales and we do not expect to receive sales revenues for at least one year. We have devoted substantially all of our efforts to discovery and clinical development of our product candidates as well as establishing strategic partnerships for the development and potential marketing of our products when approved. Currently, we have five product candidates in clinical development.

We have completed our Phase II program and two Phase III trials in INS365 Ophthalmic for the treatment of dry eye. We have an ongoing Phase IIIb trial. We expect to have a pre-NDA meeting with the FDA within the next few months. We completed one Phase II trial for INS37217 Intranasal for the treatment of perennial allergic rhinitis in August of 2002 and a Phase II trial for the treatment of the common cold in November 2002. We intend to launch a Phase III trial for INS37217 Intranasal in chronic rhinitis patients during the fourth quarter of this year. INS316 Diagnostic is in a Phase III clinical trial. Our Phase I/II trial for INS37217 Ophthalmic for the treatment of retinal disease was completed in October 2002; we expect to launch a Phase II trial in the first half of 2003. Our Phase I/II trial for INS37217 Respiratory for the treatment of cystic fibrosis was completed in October 2002; we expect to launch a Phase II trial in the fourth quarter of 2002.

We have decided to discontinue the global development of INS365 Respiratory for chronic bronchitis, which has been on hold since January 2002, as a result of the high cost and difficulty of conducting clinical trials in the chronic bronchitis patient population and the availability of other near-term product opportunities. As a result of our discontinuance of the program, Kissei Pharmaceuticals, Inc. has determined that it will cease the development of INS365 Respiratory in Japan and we have agreed to terminate our Joint Development, License and Supply Agreement with Kissei effective November 17, 2002. Upon termination of the agreement, Kissei will return to Inspire all rights to INS365 Respiratory. During the term of the agreement we received an aggregate of $7.2 million in equity, upfront, milestone and employee reimbursement payments from Kissei. The milestone and upfront payments are non-refundable.

We have incurred significant operating losses since our inception and, as of September 30, 2002, we had an accumulated deficit of $87.2 million. We have primarily financed our operations through proceeds received from the sale of equity securities including private sales of preferred stock and the sale of common stock in our initial public offering, as well as revenues received under corporate collaborations. We operate in a single business segment and do not have any foreign operations.

In June 2001, we entered into a joint license, development and marketing agreement with Allergan, Inc. (“Allergan”) to develop and commercialize INS365 Ophthalmic and Allergan’s Restasis(R). Under the agreement, we may receive up to $39 million in up-front and milestone payments. We will also receive royalty payments on sales, if any, of INS365 Ophthalmic in the United States and on Allergan’s Restasis(R) worldwide, excluding most Asian markets. The agreement also provides for potential co-promotion by Inspire of INS365 Ophthalmic and Restasis(R) and one or more of Allergan’s other marketed products in the United States.

In September 2000, we entered into a License Agreement with Kirin Brewing Co., Ltd. Pharmaceutical Division (“Kirin”) for the development and commercialization of INS316 Diagnostic. Under the agreement we granted Kirin an exclusive license to commercialize INS316 Diagnostic in most of Asia. Under the terms of the agreement, we received an upfront payment in cash and may receive milestone payments based on clinical success and regulatory approval. We may also receive royalties on net sales of this product.

INSPIRE PHARMACEUTICALS, INC.

(a development stage company)

In December 1999, we entered into a collaboration with Genentech, Inc. (“Genentech”) to develop treatments for respiratory disorders, pursuant to which we received in excess of $16 million in equity and cash payments prior to the termination of the agreement in November 2001. Upon termination, Genentech returned to us all rights for the use of INS365 Respiratory, INS37217 Respiratory, INS37217 Intranasal and other related P2Y2 agonists at no charge.

In December 1998, we entered into a Development, License and Supply Agreement with Santen Pharmaceutical Co., Ltd. (“Santen”) for the development of INS365 Ophthalmic for the therapeutic treatment of ocular surface diseases. We are obligated to supply Santen with its requirements of INS365 Ophthalmic in bulk drug substance form for all preclinical studies, clinical trials and commercial requirements at agreed-upon prices. Under the agreement, we received an up-front equity investment of $1.5 million for shares of our stock and a milestone payment of $500,000. In addition, if all milestones are met, we could receive additional payments of up to $4.25 million, as well as royalties on net sales of licensed products.

SIGNIFICANT ACCOUNTING POLICIES

Revenue Recognition

We recognize revenue under our collaborative research and development agreements when we have performed services under such agreements or when we or our collaborative partner has met a contractual milestone triggering a payment to us. Non-refundable fees received at the initiation of collaborative agreements for which we have an ongoing research and development commitment are deferred and recognized ratably over the period of ongoing research and clinical development commitment. We are also entitled to receive milestone payments under our collaborative research and development agreements based upon achievement of development milestones by us or our collaborative partners. We recognize milestone payments as revenues ratably over the remaining period of our research and clinical development commitment. The recognition period begins at the date the milestone is achieved and acknowledged by the collaborative partner, which is generally at the date payment is received from the collaborative partner, and ends on the date that we have fulfilled our research and clinical development commitment. This period is based on estimates by management and the progress towards milestones in our collaborative agreements. The estimate is subject to revision as our development efforts progress and we gain knowledge regarding required additional development. Revisions in the commitment period are made in the period that the facts related to the change first become known. This may cause our revenue to fluctuate from period to period.

Taxes

Significant management judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against net deferred tax assets. We record valuation allowances because of uncertainties related to our ability to utilize deferred tax assets, primarily consisting of certain net operating losses carried forward, before they expire. The valuation allowance is based on estimates of taxable income in each of the jurisdictions in which we operate and the period over which our deferred tax assets will be recoverable. In the event the actual results differ from these estimates or we adjust these estimates in future periods we may need to establish an additional valuation allowance which could materially impact our financial position and results of operations.

RESULTS OF OPERATIONS

Three and Nine Months Ended September 30, 2002 and 2001

Revenues

Our revenues are derived from collaborative research and development agreements with strategic partners. Revenues were $1.4 million for the three month period ended September 30, 2002 and $2.2 million for the same period in 2001, a decrease of 36%. During the three month period ended September 30, 2002, revenues related to an

INSPIRE PHARMACEUTICALS, INC.

(a development stage company)

upfront payment received from Allergan in the third quarter of 2001, a milestone payment received from Allergan in the second quarter of 2002 and an upfront payment received from Kirin in the fourth quarter of 2000. Revenues in the same period in 2001 related to upfront and milestone payments received from Kirin, Kissei, Genentech and Allergan.

Revenues were $3.8 million for the nine month period ended September 30, 2002, compared to $5.0 million for the same period in 2001, a decrease of 24%. During the nine month period ended September 30, 2002, revenues related to an upfront payment received from Allergan in the third quarter of 2001, a milestone payment received from Allergan in the second quarter of 2002 and an upfront payment received from Kirin in the fourth quarter of 2000. Revenues for the same period in 2001 related to upfront and milestone payments received from Kirin, Kissei, Genentech and Allergan.

Upfront and milestone payments from our collaborative partners are recognized over the period of ongoing research and development commitment period under the applicable collaborative research and development agreements with the respective company.

Research and Development Expenses

Research and development expenses include all direct costs, including salaries for our research and development personnel, consulting fees, clinical trial costs, sponsored research, clinical trial insurance, and other fees and costs related to the development of product candidates. Costs associated with obtaining and maintaining patents and licenses on our drug compounds, are evaluated based on the stage of development of the related drug compound and whether the underlying compound has an alternative use. Costs of these types incurred for drug compounds not yet approved by the FDA and for which no alternative use exists are recorded as research and development expense. In the event the drug compound has been approved by the FDA or an alternative use exists for the drug compound, patent costs and license costs are capitalized and amortized over the expected life of the related drug compound. Milestone payments are recognized when the underlying requirement is met by us.

Research and development expenses were $5.9 million for the three month period ended September 30, 2002, compared to $6.6 million for the same period in 2001, a decrease of 11%. Research and development expenses were $16.8 million for the nine month period ended September 30, 2002, compared to $20.2 million for the same period in 2001, a decrease of 17%.

The decrease in research and development expense was due to our efforts to focus resources on our higher priority clinical programs in the ophthalmology and respiratory areas. The programs of primary focus were indications for dry eye, lung cancer diagnostics, upper respiratory disorders and cystic fibrosis. We expect to incur increases in expenses in future periods as later phases of development typically involve an increase in the scope of studies and the number of patients treated.

Our research and development expenses from inception through September 30, 2002 were $87.0 million. Of this amount, we have spent the following amounts on external pre-clinical and clinical development for the indicated product candidates: $3.7 million on INS316 Diagnostic; $16.7 million on INS365 Ophthalmic; $4.5 million on INS37217 Respiratory; $2.7 million on INS37217 Intranasal and $1.9 million on INS37217 Ophthalmic. The balance of our historic research and development expenses, $57.5 million, includes internal personnel costs of our discovery and development programs, internal and external general research related to the discovery and development of our technology, and internal and external expenses of other drug discovery and development programs. We cannot reasonably predict future research and development expenses for these programs; however, historical trends indicate that expenses tend to increase in later phases of development.

General and Administrative Expenses

General and administrative expenses consist primarily of personnel costs, facilities costs, business development costs, professional expenses, and general corporate expenses, such as legal, accounting, finance, human resources and information systems.

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General and administrative expenses were $1.1 million for the three month period ended September 30, 2002, compared to $1.3 million for the same period in 2001, a decrease of 15%. General and administrative expenses were $3.8 million for the nine month period ended September 30, 2002, compared to $4.1 million for the same period in 2001, a decrease of 7%.

The decrease in general and administrative expenses from year to year resulted primarily from our efforts to focus our resources on our higher priority clinical programs in the ophthalmic and respiratory areas. By focusing our clinical efforts, we were able to reduce the corporate and administrative efforts needed to support the company. The decreases occurred primarily in personnel costs and decreases in additional professional services, including legal and public relation expenses.

Other Income (Expense), Net

Other income (expense), net consists of interest income earned on cash deposits and investments, reduced by interest expense on notes payable, capital lease obligations and losses on sales of property and equipment.

Other income (expense), net was $188,000 for the three month period ended September 30, 2002, compared to $723,000 for the same period in 2001, a decrease of 74%. Other income (expense), net was $665,000 for the nine month period ended September 30, 2002, compared to $3.2 million for the same period in 2001, a decrease of 79%.

The decrease was primarily due to lower interest income which resulted from lower interest rates on lower average cash and investment balances.

Net Loss

Net loss consists of revenues less operating expenses plus other income (expense), net. Net loss was $5.5 million for the three month period ended September 30, 2002, compared to $4.9 million for the same period in 2001, an increase of 12%. Net loss was $16.2 million for the nine month period ended September 30, 2002 compared to $16.1 million for the same period in 2001, an increase of 1%.

The increase in net loss was primarily due to a decrease in revenues recognized on collaborative research agreements and a decrease in other income (expense), net which was partially offset by a decrease in research and development expenses. We have incurred net losses since our inception and will continue to incur losses in the future.

LIQUIDITY AND CAPITAL RESOURCES

Historically, we have financed our operations through the sale of equity securities, including private sales of preferred stock and the sale of common stock in our initial public offering.

As of September 30, 2002, cash and cash equivalents totaled $31.6 million, an increase of $1.6 million as compared to December 31, 2001. The increase in cash and cash equivalents resulted from the net proceeds of investment grade securities of $18.4 million, the issuance of common stock of $24,000, partially offset by $16.3 million in cash used in operations, purchase of property, plant and equipment of $199,000 and the payment of capital lease obligations of $302,000.

Cash used in operations during the nine month period ended September 30, 2002, totaling $16.3 million, consists of a net loss of $16.2 million, non-cash expenses of $1.4 million, a decrease in other receivables of $99,000, and a decrease in interest receivable of $44,000, offset by an increase in prepaid expenses of $299,000, an increase in other assets of $15,000, a decrease in accounts payable of $39,000, a decrease in accrued expenses of $498,000 and a decrease in deferred revenue of $783,000.

Cash provided by investing activities during the nine month period ended September 30, 2002, totaling $18.2 million, consisted of the proceeds of investment grade securities, net of purchases totaling $18.4 million and the

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purchase of property and equipment totaling $199,000.

Cash used in financing activities during the nine month period ended September 30, 2002, totaling $278,000, was comprised of the issuance of common stock of $24,000 offset by the payment of lease obligations of $302,000.

We will not generate revenues, other than license and milestone payments, from the sale of our products unless or until we or our licensees receive marketing clearance from the FDA and appropriate governmental agencies in other countries. We cannot predict the timing of any potential marketing clearance nor can assurances be given that the FDA or such agencies will approve any of our products.

IMPACT OF INFLATION

Although it is difficult to predict the impact of inflation on our costs and revenues in connection with our products, we do not anticipate that inflation will materially impact our cost of operation or the profitability of our products when marketed.

IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Our exposure to market risk for changes in interest rates relates to the increase or decrease in the amount of interest income we can earn on our investment portfolio and on the increase or decrease in the amount of interest expense we must pay with respect to various outstanding debt instruments. Our risk associated with fluctuating interest expense is limited, however, to capital lease obligations. The interest rates are closely tied to market rates and our investments in interest rate sensitive financial instruments. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. We ensure the safety and preservation of invested principal funds by limiting default risk, market risk and reinvestment risk. We reduce default risk by investing in investment grade securities. A hypothetical 100 basis point drop in interest rates along the entire interest rate yield curve would not significantly affect the fair value of our interest sensitive financial instruments at September 30, 2002 or September 30, 2001. Declines in interest rates over time will, however, reduce our interest income while increases in interest rates over time will increase interest expense.

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(a development stage company)

Item 4. Controls and Procedures

EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

Our Chief Executive Officer and President have reviewed and evaluated the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 240.13a-14(c) and 15d-14(c)) as of a date within 90 days before the filing date of this quarterly report. Based on that evaluation, the Chief Executive Officer and President have concluded that our current disclosure controls and procedures are effective in timely providing them with material information relating to us which is required to be disclosed in the reports we file or submit under the Exchange Act.

CHANGES IN INTERNAL CONTROLS

There have been no significant changes in our internal controls or in other factors that could significantly affect internal controls subsequent to the date we carried out this evaluation.

PART II: OTHER INFORMATION

Item 2. Changes in Securities and Use of Proceeds

(d) On August 2, 2000, the Securities and Exchange Commission declared a Registration Statement on Form S-1, as amended (Registration No. 333-31174) effective, registering 6,325,000 shares of our common stock. The aggregate net proceeds after deduction of expenses were approximately $69.3 million. Through September 30, 2002, we have used approximately $43 million of the net proceeds of the offering as follows:


Discovery and research programs	$	34,255,000
General and administrative expenses		7,023,000
Purchase of equipment		884,000
Payment of debt		831,000

Total	$	42,993,000

Except with respect to the compensation of our officers and the reimbursement of director expenses included in discovery and research programs and general and administrative expenses, all of the net proceeds of the offering which have been used to date were payable to parties other than our directors, officers or their associates of such persons, persons owning ten percent or more of any class of our equity securities, or our affiliates. Through September 30, 2002, all of the remaining net proceeds of the offering were being invested in interest bearing investment grade securities and certificates of deposit which are classified as available for sale.

Item 5. Other Information

Risk Factors

An investment in the shares of our common stock involves a substantial risk of loss. You should carefully read this entire report and should give particular attention to the following risk factors. You should recognize that other significant risks may arise in the future, which we cannot foresee at this time. Also, the risks that we now foresee might affect us to a greater or different degree than expected. There are a number of important factors that could cause our actual results to differ materially from those indicated by any forward-looking statements in this document. These factors include, without limitation, the risk factors listed below and other factors presented throughout this

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document and any other documents filed by us with the Securities and Exchange Commission.

IF OUR PRODUCTS ARE NOT SAFE OR WE ARE NOT ABLE TO DEMONSTRATE EFFICACY, WE WILL BE UNABLE TO OBTAIN FDA APPROVAL AND WILL NOT BE ABLE TO SELL THOSE PRODUCTS.

To achieve profitable operations, we must, alone or with others, successfully identify, develop, introduce and market proprietary products. Even if we identify potential products, we will have to conduct significant additional development activities and preclinical and clinical tests, and obtain regulatory approval before our products can be commercialized. Product candidates that may appear to be promising at early stages of development may not successfully reach the market for a number of reasons. We have not submitted any products for marketing approval by the U.S. Food and Drug Administration (“FDA”) or any other regulatory body.

Generally, all of our product candidates are in research or preclinical development, with only five, INS365 Ophthalmic, INS316 Diagnostic, INS37217 Respiratory, INS37217 Intranasal, and INS37217 Ophthalmic currently in clinical trials. The results of preclinical and initial clinical testing of our products under development may not necessarily indicate the results that will be obtained from later or more extensive testing. Companies in the pharmaceutical and biotechnology industries have suffered significant setbacks in advanced clinical trials, even after obtaining promising results in earlier trials. Our ongoing clinical studies might be delayed or halted for various reasons, including:

•

the drug is not effective, or physicians think that the drug is not effective;

•

the drug effect is not statistically significant compared to placebo;

•

patients experience severe side effects during treatment;

•

patients die during the clinical study because their disease is too advanced or because they experience medical problems that may or may not relate to the drug being studied;

•

patients do not enroll in the studies at the rate we expect;

•

drug supplies are not sufficient to treat the patients in the studies; or

•

we decide to modify the drug during testing.

In October 2002, we announced our intent to file a New Drug Application for INS365 Ophthalmic for dry eye based upon the safety and efficacy data from our completed Phase II and III clinical trials. We have now scheduled a pre-NDA meeting with the FDA. Even if the pre-NDA meeting with the FDA is successfully completed and the NDA is filed, there is no guarantee that the FDA will approve our application and allow us to begin selling INS365 Ophthalmic in the United States. Even if we do receive FDA approval of the application, we and Allergan may not be able to successfully commercialize INS365 Ophthalmic in the United States.

BECAUSE OUR PRODUCT CANDIDATES UTILIZE A NEW MECHANISM OF ACTION AND IN SOME CASES THERE ARE NO REGULATORY PRECEDENTS, OBTAINING REGULATORY APPROVAL MAY BE DIFFICULT, EXPENSIVE AND PROLONGED, WHICH WOULD DELAY ANY MARKETING OF OUR PRODUCTS.

Other than INS365 Ophthalmic, we cannot apply for regulatory approval to market a product candidate until we successfully complete Phase III clinical trials for the product. To complete successful clinical trials, the products must meet the criteria for clinical approval, or endpoints, which we establish for the product in the clinical study.

Generally, we will establish these endpoints in consultation with the regulatory authorities, following design guidelines on the efficacy, safety and tolerability measures required for approval of products.

Because all of our existing product candidates utilize a new approach to the treatment of respiratory and eye diseases, and because some of the indications for which such products may be used have no regulatory precedents, we may have trouble establishing endpoints that the regulatory authorities agree sufficiently evaluate the effectiveness of each product candidate. For this and other reasons, we could encounter delays and increased expenses in our clinical trials if the regulatory authorities determine that the endpoints established for a clinical trial do not predict a clinical benefit, and the authorities will not approve the product for marketing without further

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clinical trials. The regulatory authorities could change their view on clinical trial design and establishment of appropriate standards for efficacy, safety and tolerability and require a change in study design, additional data or even further clinical trials before approval of a product candidate.

After initial regulatory approval, regulatory authorities continue to review a marketed product and its manufacturer. They may require us to conduct long-term safety studies after approval. Discovery of previously unknown problems through adverse event reporting may result in restrictions on the product, including withdrawal from the market. Additionally, we and our officers and directors could be subject to civil and criminal penalties.

IF PHYSICIANS AND PATIENTS DO NOT ACCEPT OUR PRODUCT CANDIDATES, THEY MAY NOT BE COMMERCIALLY SUCCESSFUL.

Even if regulatory authorities approve our product candidates, those products may not be commercially successful. Acceptance of and demand for our products will depend largely on the following:

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acceptance by physicians and patients of our products as safe and effective therapies;

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reimbursement of drug and treatment costs by third-party payors;

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safety, effectiveness and pricing of alternative products; and

•

prevalence and severity of side effects associated with our products.

In addition, to achieve broad market acceptance of our product candidates, in many cases we will need to develop, alone or with others, convenient methods for administering product candidates. INS37217 Intranasal is administered through a nasal mist pump. Patients may find the pump difficult to operate. Our current product candidate for the treatment of dry eye disease, INS365 Ophthalmic, is applied from a vial containing a single day’s dosage of non-preserved medication. Patients may prefer to purchase the medication in a bottle containing a sufficient quantity of preserved medication for multiple doses. We have not yet executed a plan to develop a multi-dose formulation. Although our Asian partner, Santen, is developing a multi-dose formulation for use in their licensed territories, a multi-dose formulation has not been developed with respect to the application of the medication throughout the remainder of the world. Allergan, our corporate partner in the rest of the world, is responsible for developing a multi-dose formulation of INS365 Ophthalmic for all other territories. INS37217 Ophthalmic is administered through an intraocular injection. It may be beneficial to patients to a have a sustained delivery device. We have not yet established a plan for a sustained delivery device for certain indications such as for chronic use. Similar challenges exist in identifying and perfecting convenient methods of administration for many of our other product candidates.

WE INTEND TO RELY ON THIRD PARTIES TO DEVELOP, MARKET, DISTRIBUTE AND SELL OUR PRODUCT CANDIDATES AND THOSE THIRD PARTIES MAY NOT PERFORM.

We do not yet have the ability to independently market, distribute or sell our products and intend to rely on experienced third parties to perform, or assist us in the performance of, all of those functions. We may not identify acceptable partners or enter into favorable agreements with them. If third parties do not successfully carry out their contractual duties or meet expected deadlines, we will be unable to obtain required governmental marketing approvals and will be unable to sell our products.

OUR DEPENDENCE ON COLLABORATIVE RELATIONSHIPS MAY LEAD TO DELAYS IN PRODUCT DEVELOPMENT AND DISPUTES OVER RIGHTS TO TECHNOLOGY.

Our business strategy depends to some extent upon the formation of research collaborations, licensing and/or marketing arrangements. We currently have development collaborations with Allergan, Santen and Kirin. The termination of any collaboration may lead to delays in product development and disputes over technology rights and may reduce our ability to enter into collaborations with other potential partners. Allergan has the right, by giving us

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180 days prior notice, to terminate our collaboration. Similarly, Kirin has the right to terminate our license agreement by giving us 180 days prior notice. If we do not maintain the Allergan, Santen or Kirin collaborations or establish additional research and development collaborations or licensing arrangements it will be difficult to develop and commercialize therapeutic or diagnostic products using our technology. Any future collaborations or licensing arrangements may not be on terms favorable to us. Our current or any future collaborations or licensing arrangements ultimately may not be successful. Under our current strategy, and for the foreseeable future, we do not expect to develop or market therapeutic or diagnostic products on our own. As a result, we will continue to depend on collaborators and contractors for the preclinical study and clinical development of therapeutic products and for regulatory approval, manufacturing and marketing of therapeutic and diagnostic products which result from our technology. The agreements with collaborators typically will allow them some discretion in electing whether to pursue such activities. If any collaborator were to breach or terminate its agreement with us or otherwise fail to conduct collaborative activities in a timely and successful manner, the preclinical or clinical development or commercialization of product candidates or research programs would be delayed or terminated. Any delay or termination in clinical development or commercialization would delay or eliminate potential product revenues relating to our research programs.

We intend to rely on Allergan, Santen, Kirin and any future collaborators for significant funding in support of our development efforts. If Allergan, Santen or Kirin reduces or terminates its funding, we will need to devote additional internal resources to product development, scale back or terminate certain research and development programs or seek alternative collaborators.

Disputes may arise in the future over the ownership of rights to any technology developed with collaborators. These and other possible disagreements between us and our collaborators could lead to delays in the collaborative development or commercialization of therapeutic or diagnostic products. Such disagreement could also result in litigation or require arbitration to resolve.

IF WE ARE UNABLE TO CONTRACT WITH THIRD PARTIES FOR SYNTHESIS AND MANUFACTURING OF PRODUCT CANDIDATES FOR PRECLINICAL TESTING AND CLINICAL TRIALS AND FOR LARGE SCALE MANUFACTURING OF ANY OF OUR DRUG CANDIDATES, WE MAY BE UNABLE TO DEVELOP OR COMMERCIALIZE PRODUCTS.

We have no experience or capabilities in large scale commercial manufacturing of any of our product candidates or any experience or capabilities in the manufacturing of pharmaceutical products generally. We do not currently expect to engage directly in the manufacturing of products, but instead intend to contract with others for these services. We have relied upon supply agreements with third parties for the manufacture and supply or our product candidates for purposes of preclinical testing and clinical trials. Although we have previously received preclinical and clinical supplies of our product candidates from several suppliers, we presently depend upon Yamasa Corporation as the sole manufacturer of our supply of product candidates. If we are unable to retain third party manufacturing on commercially acceptable terms, we may not be able to commercialize products as planned. Our manufacturing strategy presents the following risks:

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the manufacturing processes for most of our product candidates have not been tested in quantities needed for commercial sales;

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delays in scale-up to commercial quantities and any change to a manufacturer other than Yamasa Corporation could delay clinical studies, regulatory submissions and commercialization of our products;

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manufacturers of our products are subject to the FDA’s good manufacturing practices regulations and similar foreign standards, and we do not have control over compliance with these regulations by third-party manufacturers;

•

if we need to change to manufacturers other than Yamasa Corporation, FDA and comparable foreign regulators would require new testing and compliance inspections and the new manufacturers would have to be educated in the processes necessary for the production of our product candidates;

•

without satisfactory long-term agreements with manufacturers, we will not be able to develop or commercialize our product candidates as planned or at all; and

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•

we may not have intellectual property rights, or may have to share intellectual property rights, to any improvements in the manufacturing processes or new manufacturing processes for our product candidates.

IF WE ARE UNABLE TO SUPPLY SANTEN WITH SUFFICIENT QUANTITIES OF MATERIALS WE MAY BREACH OUR AGREEMENT WITH SUCH PARTY.

We are currently a party to a development, license and supply agreement with Santen, under which we granted a license to develop and market INS365 Ophthalmic. Generally, the agreement with Santen will require us to supply Santen with sufficient quantities of finished products for the purpose of commercial distribution. We will need to establish, alone or with third parties, a manufacturing process in relation to the product. Our dependence upon third parties for the manufacture of product may adversely affect our ability to develop and deliver the product on a timely and competitive basis.

Our inability to successfully manufacture commercial products could result in our breach of the terms of our agreement with Santen. Any of these factors could delay our preclinical studies, clinical trials or commercialization of our product candidates, entail higher costs and result in our inability to effectively sell our product candidates.

IF OUR PATENT PROTECTION IS INADEQUATE, THE DEVELOPMENT AND ANY POSSIBLE SALES OF OUR PRODUCT CANDIDATES COULD SUFFER OR COMPETITORS COULD FORCE OUR PRODUCTS COMPLETELY OUT OF THE MARKET.

Our business and competitive position depends on our ability to continue to develop and protect our products and processes, proprietary methods and technology. Except for one patent covering new chemical compounds, most of our patents are use patents containing claims covering methods of treating disorders and diseases by administering therapeutic chemical compounds. Use patents, while providing adequate protection for commercial efforts in the United States, may afford a lesser degree of protection in European and possibly other countries due to their particular patent laws. Besides our use patents, we have patents covering pharmaceutical formulations of these chemical compounds. We also have patent applications covering processes for large-scale manufacturing of these chemical compounds. Many of the chemical compounds included in the claims of our use patents, formulation patents and process applications were known in the scientific community prior to our formation. None of our patents cover these previously known chemical compounds themselves, which are in the public domain. As a result, competitors may be able to commercialize products that use the same chemical compounds used by us for the treatment of disorders and diseases not covered by our use patents. In such a case, physicians, pharmacies and wholesalers could possibly substitute these products for our products. Such substitution would reduce any revenues received from the sale of our products.

We believe that there may be significant litigation in the pharmaceutical and biotechnology industry regarding patent and other intellectual property rights. A patent does not provide the patent holder with freedom to operate in a way that infringes the patent rights of others. While we are not aware of any patent that we are infringing, nor have we been accused of infringement by any other party, other companies currently have or may acquire patent rights which we might be accused of infringing. If we must defend a patent suit, or if we choose to initiate a suit to have a third party patent declared invalid, we may need to make considerable expenditures of money and management time in litigation. A judgment against us in a patent infringement action could cause us to pay monetary damages, require us to obtain licenses, or prevent us from manufacturing or marketing the affected products. In addition, we may need to initiate litigation to enforce our proprietary rights against others, or we may have to participate in interference proceedings in the United States Patent and Trademark Office (“USTPO”) to determine the priority of invention of any of our technologies.

In general, the development of patent rights in pharmaceutical, biopharmaceutical and biotechnology products to a degree sufficient to support commercial efforts in these areas is typically uncertain and involves complex legal and factual questions. For instance, while the USPTO has recently issued guidelines addressing the requirements for demonstrating utility for biotechnology inventions, USPTO examiners may not follow these guidelines in examining patent applications. Such applications may have to be appealed to the USPTO’s Appeals Board for a final determination of patentability.

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IF WE FAIL TO REACH MILESTONE OR OTHER OBLIGATIONS, THE UNIVERSITY OF NORTH CAROLINA AT CHAPEL HILL AND OTHER LICENSORS MAY TERMINATE OUR AGREEMENTS WITH THEM.

Our INS316 Diagnostic clinical development program depends on two exclusive licenses and one non-exclusive license from The University of North Carolina at Chapel Hill. Generally, if we fail to meet milestones under the respective UNC licenses, UNC may terminate the applicable license. In addition, it may be necessary in the future for us to obtain additional licenses from UNC or other third parties to develop future commercial opportunities or to avoid infringement of third party patents. We do not know the terms on which such licenses may be available, if at all.

Failure to license or otherwise acquire necessary technologies may reduce or eliminate our ability to develop product candidates. Even if we acquire all necessary licenses, if we breach any license provision, either intentionally or unintentionally, we may lose our right to continued use of the licensed technology.

BECAUSE WE RELY UPON TRADE SECRETS AND AGREEMENTS TO PROTECT SOME OF OUR INTELLECTUAL PROPERTY, THERE IS A RISK THAT UNAUTHORIZED PARTIES MAY OBTAIN AND USE INFORMATION THAT WE REGARD AS PROPRIETARY.

We rely upon the laws of trade secrets and non-disclosure agreements and other contractual arrangements to protect our proprietary compounds, methods, processes, formulations and other information for which we are not seeking patent protection. We have taken security measures to protect our proprietary technologies, processes, information systems and data, and we continue to explore ways to further enhance security. However, despite these efforts to protect our proprietary rights, unauthorized parties may obtain and use information that we regard as proprietary. Employees, academic collaborators and consultants with whom we have entered confidentiality and/or non-disclosure agreements, may improperly disclose our proprietary information. In addition, competitors may, through a variety of proper means, independently develop substantially the equivalent of our proprietary information and technologies, gain access to our trade secrets, or properly design around any of our patented technologies.

BECAUSE ALL OF OUR PRODUCT CANDIDATES USE RELATED MECHANISMS OF ACTION, WE MAY NOT BE ABLE TO COMMERCIALIZE OUR PRODUCTS IF THE MECHANISM OF ACTION IS NOT EFFECTIVE.

Any products resulting from our product development efforts are not expected to be available for sale for at least one year, if at all. Five of our product candidates, INS365 Ophthalmic, INS37217 Respiratory, INS316 Diagnostic, INS37217 Intranasal and INS37217 Ophthalmic are P2Y2 receptor agonists. If the clinical results of one of the compounds is not favorable, the results of the other compound may not be favorable. Moreover, we have designed all of our product candidates to use related mechanisms of action. If these mechanisms of action are not effective, we may not be able to commercialize any of our product candidates. Even if all of our product candidates prove effective, we may choose not to commercialize all of them.

IF WE CONTINUE TO INCUR OPERATING LOSSES FOR A PERIOD LONGER THAN ANTICIPATED, OR IN AN AMOUNT GREATER THAN ANTICIPATED, WE MAY BE UNABLE TO CONTINUE OUR OPERATIONS.

We have experienced significant losses since inception. We incurred net losses of $16.2 million for the nine months ended September 30, 2002, $23.1 million for the year ended December 31, 2001 and $14.6 million for the year ended December 31, 2000. As of September 30, 2002 our accumulated deficit was approximately $87.2 million. We expect to incur additional significant operating losses over the next several years and expect cumulative losses to increase in the near-term due to expanded research and development efforts, preclinical studies and clinical trials. We expect that losses will fluctuate from quarter to quarter and that such fluctuations may be substantial. Such fluctuations will be affected by the following:

•

timing of regulatory approvals and commercial sales of our product candidates;

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•

the level of patient demand for our products;

•

timing of payments to and from licensors and corporate partners; and

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timing of investments in new technologies.

No regulatory authorities have approved any of our product candidates for marketing, and therefore, we are not generating any revenues from product sales. To achieve and sustain profitable operations, we must, alone or with others, develop successfully, obtain regulatory approval for, manufacture, introduce, market and sell our products. The time frame necessary to achieve market success is long and uncertain. We do not expect to generate product revenues for at least the next few years. We may not generate sufficient product revenues to become profitable or to sustain profitability. If the time required to achieve profitability is longer than we anticipate, we may not be able to continue our business.

IF WE ARE NOT ABLE TO OBTAIN SUFFICIENT ADDITIONAL FUNDING TO MEET OUR EXPANDING CAPITAL REQUIREMENTS, WE MAY BE FORCED TO REDUCE OR ELIMINATE RESEARCH PROGRAMS AND PRODUCT DEVELOPMENT.

We have used substantial amounts of cash to fund our research and development activities. In the nine months ended September 30, 2002 our operating expenses exceeded $20 million. In the fiscal year ended December 31, 2001 our operating expenses exceeded $30 million. We expect our capital and operating expenditures to exceed our revenue over the next several years as we conduct our research and development activities, address possible difficulties with clinical studies and prepare for commercial sales. Many factors will influence our future capital needs. These factors include:

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the progress of our research programs;

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the number and breadth of these programs;

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our ability to attract collaborators for our products;

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achievement of milestones under our existing collaborations with Allergan, Santen and Kirin;

•

our ability to establish and maintain additional collaborations;

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progress by our collaborators: Allergan, Santen and Kirin;

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the level of activities relating to commercialization rights we retain in our collaborations;

•

competing technological and market developments;

•

the costs involved in enforcing patent claims and other intellectual property rights; and

•

the costs and timing of regulatory approvals.

We anticipate that our operating expenses will exceed $25 million in 2002. We also expect to purchase capital equipment at a cost of approximately $500,000 in 2002. We intend to rely on Allergan, Santen, Kirin, future collaborators and the proceeds of our initial public offering for significant funding in support of our development efforts. In addition, we may seek additional funding through public or private equity offerings and debt financings. Additional financing may not be available when needed. If available, such financing may not be on terms favorable to us or our stockholders. Stockholders’ ownership will be diluted if we raise additional capital by issuing equity securities. If we raise funds through collaborations and licensing arrangements, we may have to give up rights to our technologies or product candidates which are involved in these future collaborations and arrangements or grant licenses on unfavorable terms. If adequate funds are not available, we would have to scale back or terminate research programs and product development.

WE MAY NOT BE ABLE TO SUCCESSFULLY COMPETE WITH BIOTECHNOLOGY COMPANIES AND ESTABLISHED PHARMACEUTICAL COMPANIES.

The biotechnology and pharmaceutical industries are intensely competitive and subject to rapid and significant

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technological change. Our competitors in the United States and elsewhere are numerous and include, among others, major multinational pharmaceutical and chemical companies, specialized biotechnology firms and universities and other research institutions. These competitors include Abbott, Alcon, AstraZeneca, Boehringer Ingelheim, Chiron, Genentech, GlaxoSmithKline, Novartis, and Pfizer. Most of these competitors employ greater financial and other resources, including larger research and development staffs and more effective marketing and manufacturing organizations, than we or our collaborative partners. Acquisitions of competing companies and potential competitors by large pharmaceutical companies or others could enhance financial, marketing and other resources available to such competitors. As a result of academic and government institutions becoming increasingly aware of the commercial value of their research findings, such institutions are more likely to enter into exclusive licensing agreements with commercial enterprises, including our competitors, to market commercial products. Our competitors may develop technologies and drugs that are safer, more effective or less costly than any we are developing or which would render our technology and future drugs obsolete and non-competitive. The products of our competitors marketed to treat cystic fibrosis include Pulmozyme(R) and TOBI(R). The main current treatments for dry eye disease involve artificial tear replacement drops. The main current treatments for colds, allergic rhinitis and rhinosinusitis include antihistamines, antibiotics, decongestants and anti-inflammatory steroids. Our competitors market anti-inflammatory steroidal agents, such as Flonase(R) and Nasonex(R). In addition, alternative approaches to treating diseases which we have targeted, such as gene therapy, may make our product candidates obsolete. Our competitors may also be more successful in production and marketing.

In addition, some of our competitors have greater experience than we do in conducting preclinical and clinical trials and obtaining FDA and other regulatory approvals. Accordingly, our competitors may succeed in obtaining FDA or other regulatory approvals for drug candidates more rapidly than we do. Companies that complete clinical trials, obtain required regulatory approvals and commence commercial sale of their drugs before we do may achieve a significant competitive advantage, including patent and FDA marketing exclusivity rights that would delay our ability to market products. Drugs resulting from our research and development efforts, or from our joint efforts with our collaborative partners may not compete successfully with competitors’ existing products or products under development.

FAILURE TO HIRE AND RETAIN KEY PERSONNEL MAY HINDER OUR PRODUCT DEVELOPMENT PROGRAMS AND OUR BUSINESS EFFORTS.

We depend on the principal members of management and scientific staff, including Christy L. Shaffer, Ph.D., our Chief Executive Officer and director; and Gregory J. Mossinghoff, our President and director. If either of these people leaves us, we may have difficulty conducting our operations. We have not entered into agreements with either of the above principal members of our management and scientific staff that bind any of them to a specific period of employment. Our future success also will depend in part on our ability to attract, hire and retain additional personnel skilled or experienced in the pharmaceutical industry. There is intense competition for such qualified personnel. We may not be able to continue to attract and retain such personnel.

OUR OPERATIONS INVOLVE A RISK OF INJURY FROM HAZARDOUS MATERIALS, WHICH COULD BE VERY EXPENSIVE TO US.

Our research and development activities involve the controlled use of hazardous materials and chemicals. We cannot completely eliminate the risk of accidental contamination or injury from these materials. If such an accident were to occur, we could be held liable for any damages that result and any such liability could exceed our resources. In addition, we are subject to laws and regulations governing the use, storage, handling and disposal of these materials and waste products. The costs of compliance with these laws and regulations is substantial.

USE OF OUR PRODUCTS MAY RESULT IN PRODUCT LIABILITY CLAIMS FOR WHICH WE MAY NOT HAVE ADEQUATE INSURANCE COVERAGE.

Clinical trials or manufacturing, marketing and sale of our potential products by our collaborative partners may expose us to liability claims from the use of those products. Although we carry clinical trial liability insurance, we currently do not carry product liability insurance. We or our collaborators may not be able to obtain or maintain sufficient or even any insurance. If we can, it may not be at a reasonable cost. If we cannot or are unable otherwise to

INSPIRE PHARMACEUTICALS, INC.

(a development stage company)

protect against potential product liability claims, we may find it difficult or impossible to commercialize pharmaceutical products we or our collaborators develop. If claims or losses exceed our liability insurance coverage, we may go out of business.

IF THIRD PARTY PAYORS WILL NOT PROVIDE COVERAGE OR REIMBURSE PATIENTS FOR ANY PRODUCTS WE DEVELOP, OUR ABILITY TO DERIVE REVENUES WILL SUFFER.

Our success will depend in part on the extent to which government and health administration authorities, private health insurers and other third party payors will pay for our products. Reimbursement for newly approved health care products is uncertain. In the United States and elsewhere, third party payors, such as Medicare, are increasingly challenging the prices charged for medical products and services. Government and other third party payors are increasingly attempting to contain health care costs by limiting both coverage and the level of reimbursement for new therapeutic products. In the United States, a number of legislative and regulatory proposals aimed at changing the health care system have been proposed in recent years. In addition, an increasing emphasis on managed care in the United States has and will continue to increase pressure on pharmaceutical pricing. While we cannot predict whether legislative or regulatory proposals will be adopted or what effect those proposals or managed care efforts, including those relating to Medicare payments, may have on our business, the announcement and/or adoption of such proposals or efforts to do so could increase our costs and reduce or eliminate profit margins. Third party insurance coverage may not be available to patients for any products we discover or develop. If government and other third party payors do not provide adequate coverage and reimbursement levels for our products, the market acceptance of these products may be reduced. In various foreign markets, pricing or profitability of medical products is subject to government control.

OUR EXISTING DIRECTORS, EXECUTIVE OFFICERS AND PRINCIPAL STOCKHOLDERS HOLD A SUBSTANTIAL AMOUNT OF OUR COMMON STOCK AND MAY BE ABLE TO PREVENT OTHER STOCKHOLDERS FROM INFLUENCING SIGNIFICANT CORPORATE DECISIONS.

Our directors, executive officers and current 5% stockholders and their affiliates beneficially own over 41% of the common stock as of October 31, 2002. These stockholders, if they act together, may be able to direct the outcome of matters requiring approval of the stockholders, including the election of our directors and other corporate actions such as our merger with or into another company, a sale of substantially all of our assets and amendments to our amended and restated certificate of incorporation. The decisions of these stockholders may conflict with our interests or those of our other stockholders.

ANTI–TAKEOVER PROVISIONS IN OUR AMENDED AND RESTATED CERTIFICATE OF INCORPORATION AND BYLAWS, AND OUR RIGHT TO ISSUE PREFERRED STOCK, MAY DISCOURAGE A THIRD PARTY FROM MAKING A TAKE-OVER OFFER THAT COULD BE BENEFICIAL TO US AND OUR STOCKHOLDERS.

Our amended and restated certificate of incorporation and bylaws contain provisions which could delay or prevent a third party from acquiring shares of our common stock or replacing members of our board of directors. Our amended and restated certificate of incorporation allows our board of directors to issue shares of preferred stock. The board can determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. As a result, our board of directors could make it difficult for a third party to acquire a majority of our outstanding voting stock.

In October 2002, we entered into a Rights Agreement with Computershare Trust Company. The Rights Agreement could discourage, delay or prevent a person or group from acquiring 15% or more of our common stock. The Rights Agreement provides for a dividend of one preferred stock purchase right for each outstanding share of our common stock. Each right entitles a stockholder, after the rights become exercisable, to buy 1/1,000th of a share of our Series H Preferred Stock at an exercise price of $50. Each right will become exercisable following the tenth day after an acquiring person or group acquires, or announces its intention to acquire, 15% or more of our common stock. We will be entitled to redeem the rights at $0.001 per right at any time on or before the close of business on

INSPIRE PHARMACEUTICALS, INC.

(a development stage company)

the tenth day following acquisition by a person or group of 15% or more of our common stock. As a result of the Rights Agreement, if a person acquires 15% or more of our common stock without the approval of our Board of Directors, all other stockholders will have the right to purchase securities from us at a price that is less than its fair market value, which would substantially reduce the value of our common stock owned by the acquiring person. As a result, our Board of Directors has significant discretion to approve or disapprove a person’s efforts to acquire 15% or more of our common stock.

Our amended and restated certificate of incorporation provides that the members of the board will be divided into three classes. Each year the terms of approximately one-third of the directors will expire. Our bylaws will not permit our stockholders to call a special meeting of stockholders. Under the bylaws, only our President, Chairman of the Board or a majority of the board of directors are able to call special meetings. The bylaws also require that stockholders give advance notice to our Secretary of any nominations for director or other business to be brought by stockholders at any stockholders’ meeting. These provisions may delay or prevent changes of control or management.

Further, we are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law. Under this law, if anyone becomes an “interested stockholder,” we may not enter a “business combination” with that person for three years without special approval.

These provisions could discourage a third party from making a take-over offer and could delay or prevent a change of control.

OUR COMMON STOCK PRICE HAS BEEN HIGHLY VOLATILE AND YOUR INVESTMENT IN OUR STOCK MAY DECLINE IN VALUE.

The market price of our common stock has been highly volatile. Factors that have caused volatility and could cause additional volatility in the market price of our common stock include among others:

•

announcements made by us concerning results of our clinical trials with INS365 Ophthalmic, INS37217 Ophthalmic, INS316 Diagnostic, INS37217 Respiratory, INS37217 Intranasal and any other product candidates;

•

changes in government regulations;

•

regulatory actions;

•

changes in concerns of our collaborators, in particular our collaborations with Allergan, Santen and Kirin;

•

developments concerning proprietary rights including patents by us or our competitors;

•

variations in our operating results; and

•

litigation.

Extreme price and volume fluctuations occur in the stock market from time to time and that can particularly affect the prices of biotechnology companies. These extreme fluctuations are sometimes unrelated to the actual performance of the affected companies. These broad market fluctuations could result in significant declines in the market price of our common stock.

FUTURE SALES BY OUR CURRENT STOCKHOLDERS MAY CAUSE OUR STOCK PRICE TO DECLINE.

Sales of our common stock by our current stockholders in the public market could cause the market price of our stock to fall. Sales may also make it more difficult for us to sell equity securities or equity-related securities in the future at a time and price that our management deems acceptable, or at all. As of October 31, 2002, there were 25,849,646 shares of common stock outstanding. Of these outstanding shares of common stock, all of the 6,325,000 shares sold in our initial public offering are freely tradable, without restriction under the Securities Act of 1933, as amended, unless purchased by our “affiliates.” The remaining common stock may be resold in the public market only if registered or if there is an exemption from registration, such as Rule 144 under the Securities Act. Similarly, all of

INSPIRE PHARMACEUTICALS, INC.

(a development stage company)

the 3,004,220 shares of our common stock that were registered pursuant to our registration statement on Form S-8 are, or will be, freely tradable in accordance with such registration statement.

We may issue additional shares:

•

to employees, directors and consultants;

•

in connection with corporate alliances;

•

in connection with acquisitions; and

•

to raise capital.

As a result of these factors, a substantial number of shares of our common stock could be sold in the public market at any time.

Item 6. Exhibits and Reports on Form 8-K

Exhibit No.		Description of Exhibit

3.1		Amended and Restated Certificate of Incorporation (Incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-1 (Registration No. 333-31174) which became effective on August 2, 2000).

3.2		Certificate of Amendment of Amended and Restated Certificate of Incorporation (Incorporated by reference to Exhibit 3.2 to the Company’s Annual Report on Form 10-K filed on March 26, 2002).

3.3		Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.3 to the Company’s Quarterly Report on Form 10-Q filed on August 13, 2002).

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

99.2		Certification of the President, Secretary and Treasurer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

b) Reports on Form 8-K

On August 13, 2002, Inspire filed a Current Report on Form 8-K, dated August 13, 2002, announcing the results of the first Phase II trial of INS37217 Intranasal for the treatment of perennial allergic rhinitis.

SIGNATURES

Pursuant to 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.

	Inspire Pharmaceuticals, Inc.

Date: November 14, 2002	By:	/s/ Christy L. Shaffer
		Christy L. Shaffer Chief Executive Officer (principal executive officer) and Director


Date: November 14, 2002	By:	/s/ Gregory J. Mossinghoff
		Gregory J. Mossinghoff President, Secretary, Treasurer (principal financial officer and principal accounting officer) and Director

INSPIRE PHARMACEUTICALS, INC.

SARBANES-OXLEY SECTION 302(a) CERTIFICATION

I, Christy L. Shaffer, certify that:

I have reviewed this quarterly report on Form 10-Q of Inspire Pharmaceuticals, Inc.;

Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent function):

all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.


Date: November 14, 2002								/s/ Christy L. Shaffer
								Christy L. Shaffer Chief Executive Officer (principal executive officer)

INSPIRE PHARMACEUTICALS, INC.

SARBANES-OXLEY SECTION 302(a) CERTIFICATION

I, Gregory J. Mossinghoff, certify that:

I have reviewed this quarterly report on Form 10-Q of Inspire Pharmaceuticals, Inc.;

evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and


Date: November 14, 2002		/s/ Gregory J. Mossinghoff
		Gregory J. Mossinghoff President, Secretary and Treasurer (principal financial officer)

INSPIRE PHARMACEUTICALS, INC.

(a development stage company)

EXHIBIT INDEX

Exhibit No.		Description of Exhibit

3.3		Amended and Restated Certificate of Incorporation (Incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-1 (Registration No. 333-31174) which became effective on August 2, 2000).

3.4		Certificate of Amendment of Amended and Restated Certificate of Incorporation (Incorporated by reference to Exhibit 3.2 to the Company’s Annual Report on Form 10-K filed on March 26, 2002).

3.3		Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.3 to the Company’s Quarterly Report on Form 10-Q filed on August 13, 2002).

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

99.2		Certification of the President, Secretary and Treasurer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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