CYPRESS BIOSCIENCE INC - 10-Q Quarterly Report

ITEM 1 – CONDENSED FINANCIAL STATEMENTS (UNAUDITED)

CYPRESS BIOSCIENCE, INC.

	September 30, 2004			December 31, 2003
	(Unaudited)			(Note)
ASSETS
Current assets:
Cash and cash equivalents	$	13,469,994		$	859,820
Short-term investments	101,129,667			22,664,826
Receivable from Forest Laboratories	3,141,047			—
Prepaid expenses and other current assets	795,710			149,538
Total current assets	118,536,418			23,674,184

Property and equipment, net	75,279			101,035
Other assets	31,462			31,462
Total assets	$	118,643,159		$	23,806,681

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	1,403,780		$	415,166
Accrued compensation	279,992			891,714
Accrued liabilities	355,630			302,956
Current portion of long-term obligations	15,625			14,474
Current portion of deferred revenue	3,125,000			—
Total current liabilities	5,180,027			1,624,310

Deferred rent	20,500			16,379
Long-term obligations, net of current portion	25,008			36,870
Deferred revenue, net of current portion	19,531,250			—

Stockholders’ equity:
Common stock, $.001 par value; 60,000,000 shares of common stock authorized; 29,693,201 and 22,184,952 shares issued and outstanding at September 30, 2004 and December 31, 2003, respectively; 15,000,000 shares of preferred stock authorized; no shares issued and outstanding	29,693			22,185
Additional paid-in capital	228,712,161			148,509,080
Shareholder receivable	—			(189,973		)
Accumulated other comprehensive income	88,210			65,206
Accumulated deficit	(134,943,690		)	(126,277,376		)
Total stockholders’ equity	93,886,374			22,129,122
Total liabilities and stockholders’ equity	$	118,643,159		$	23,806,681

See accompanying notes to financial statements.

Note: The balance sheet at December 31, 2003 has been derived from the audited financial statements at that date but does not include all of the information and disclosures required by accounting principles generally accepted in the United States.

CYPRESS BIOSCIENCE, INC.

STATEMENTS OF OPERATIONS

(Unaudited)

	Three Months Ended September 30,									Nine Months Ended September 30,
	2004					2003				2004			2003
Revenue:
Revenues under collaborative agreement	$	4,259,010				$		—		$	11,117,451		$	—

Costs and expenses:
Research and development	3,846,506					2,763,081				11,209,049			9,687,352
General and administrative	1,119,855					861,251				4,452,976			2,424,261
Non-cash compensation charges (A)	131,235					25,078				6,199,064			91,275
Compensation expense (benefit) – variable stock options (B)	(782,454				)	1,616,342				(1,378,362		)	2,402,800
Total costs and expenses	4,315,142					5,265,752				20,482,727			14,605,688

Other income (expense):
Interest and other income, net	434,233					34,360				703,795			84,768
Interest expense	(1,676				)	(2,666			)	(4,833		)	(6,450			)
	432,557					31,694				698,962			78,318

Net income (loss)	$		376,425			$	(5,234,058		)	$	(8,666,314	)	$		(14,527,370	)

Net income (loss) per share – basic	$			0.01		$		(0.28	)	$	(0.32	)	$		(0.88	)

Shares used in computing net income (loss) per share – basic	29,624,813					18,946,581				27,001,323			16,566,699

Net income (loss) per share – diluted	$			0.01		$		(0.28	)	$	(0.32	)	$		(0.88	)

Shares used in computing net income (loss) per share – diluted	32,890,482					18,946,581				27,001,323			16,566,699

(A) Non-cash compensation charges include the following related expenses:
Research and development	$	86,794		$	17,970	$	296,697		$	45,793
General and administrative	44,441			7,108		5,902,367			45,482
	$	131,235		$	25,078	$	6,199,064		$	91,275

(B) Compensation expense (benefit) –variable stock options includes the following related expenses:
Research and development	$	(61,854	)	$	175,597	$	(179,928	)	$	261,037
General and administrative	(720,600		)	1,440,745		(1,198,434		)	2,141,763
	$	(782,454	)	$	1,616,342	$	(1,378,362	)	$	2,402,800

See accompanying notes to financial statements.

CYPRESS BIOSCIENCE, INC.

STATEMENTS OF CASH FLOWS

(Unaudited)

	Nine Months Ended September 30,
	2004			2003
Operating Activities
Net loss	$	(8,666,314	)	$	(14,527,370	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation and amortization	37,171			45,425
Gain on sale and disposal of property and equipment	—			(4,931		)
Stock, stock options and warrants issued for services	6,199,064			91,275
Stock and warrants issued in connection with restated license agreement	—			5,021,000
Stock compensation (benefit) on variable employee options	(1,378,362		)	2,402,800
Changes in operating assets and liabilities, net	19,302,718			210,980
Net cash provided by (used in) operating activities	15,494,277			(6,760,821		)

Investing Activities
Purchases of short-term investments	(411,194,837		)	(30,626,554		)
Proceeds from sale of short-term investments	332,753,000			17,000,000
Purchases of property and equipment	(11,415		)	(5,465		)
Proceeds from sale of property and equipment	—			5,500
Net cash used in investing activities	(78,453,252		)	(13,626,519		)

Financing Activities
Proceeds from exercise of stock options and warrants	1,170,990			4,255,524
Proceeds from secondary offering of common stock	74,218,897			—
Proceeds from private placement of common stock and warrants	—			9,508,302
Proceeds from payment of shareholder receivable	189,973			—
Proceeds from issuance of warrants	—			6,872
Payment of capital lease obligations	(10,711		)	(9,698		)
Net cash provided by financing activities	75,569,149			13,761,000

Increase (decrease) in cash and cash equivalents	12,610,174			(6,626,340		)
Cash and cash equivalents at beginning of period	859,820			7,235,403
Cash and cash equivalents at end of period	$	13,469,994		$	609,063

Supplemental disclosure of cash flow information
Interest paid	$	4,833		$	6,450

See accompanying notes to financial statements.

CYPRESS BIOSCIENCE, INC.

NOTES TO FINANCIAL STATEMENTS

(Unaudited)

1. Business

We are committed to being the innovator and leader in providing products for the treatment of patients with Functional Somatic Syndromes, such as Fibromyalgia Syndrome, or FMS, and other related chronic pain and central nervous system disorders. We in-licensed our first clinical candidate for clinical development, milnacipran, in August of 2001 from Pierre Fabre Médicament, or Pierre Fabre. We completed our Phase II trial to evaluate milnacipran in the potential treatment of FMS in the fall of 2002, and the final results were announced in the first quarter of 2003. After successful resolution of clinical trial design issues with the U.S. Food and Drug Administration, or FDA, we began initiating our Phase III clinical trial evaluating the use of milnacipran as a potential treatment for FMS in the fourth quarter of 2003. In January 2004, we entered into an agreement with Forest Laboratories for the development and marketing of milnacipran whereby we and Forest Laboratories will work together to complete the initial Phase III clinical trial (Note 10).

2. Basis of Presentation

The accompanying financial statements have been prepared by our management without audit, pursuant to the rules and regulations of the Securities and Exchange Commission, or the SEC. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to the rules and regulations of the SEC. In the opinion of our management, all adjustments necessary for a fair presentation of the accompanying unaudited financial statements are reflected herein. All such adjustments are normal and recurring in nature. Interim results are not necessarily indicative of results for the full year. For more complete financial information, these financial statements should be read in conjunction with the audited financial statements and the related disclosures included in our 2003 report on Form 10-K filed with the SEC on March 29, 2004.

3. Short-Term Investments

Our short-term investments consist of securities of the U.S. government or its agencies or instrumentalities and certificates of deposit with maturities ranging from one to eighteen months. We have classified our short-term investments as “available-for-sale” and carry them at fair value with unrealized gains and losses, if any, reported as a separate component of stockholders’ equity and included in comprehensive income (loss).

At September 30, 2004 and December 31, 2003, short-term investments consisted of the following:

	September 30, 2004
	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value

U.S. government and agency debt	$	91,341,017	$	99,180	$	—		$	91,440,197
Certificates of deposit	9,700,440		—		(10,970		)	9,689,470
	$	101,041,457	$	99,180	$	(10,970	)	$	101,129,667

	December 31, 2003
	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value

U.S. government and agency debt	$	19,899,324	$	68,525	$	—		$	19,967,849
Certificates of deposit	2,700,296		—		(3,319		)	2,696,977
	$	22,599,620	$	68,525	$	(3,319	)	$	22,664,826

4. Revenue Recognition

In accordance with Staff Accounting Bulletin (“SAB”) No. 101, Revenue Recognition in Financial Statements, revenues are recognized when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed and determinable and collectibility is reasonably assured. Amounts received for upfront license fees under multiple-element arrangements are deferred and recognized over the period of such services or performance if such arrangements require on-going services or performance. Amounts received for sponsored development activities, including funding received for certain of our employees, are recognized as research costs are incurred over the period specified in the related agreement or as the services are performed. Amounts received for milestones are recognized upon achievement of the milestone, which requires substantive effort and was not readily assured at the inception of the agreement. Any amounts received prior to satisfying revenue recognition criteria will be recorded as deferred revenue.

5. Research and Development Expenses

Research and development expenses are expensed as incurred and consist primarily of salaries and related personnel expenses for our research and development personnel, fees paid to external service providers, patient enrollment costs, fees and milestone payments under our license and development agreements and costs for facilities, supplies, materials and equipment. All such costs are charged to research and development expenses as incurred. Such costs also include research and development expenses incurred in connection with our first Phase III clinical trial which are reimbursed by Forest Laboratories pursuant to our collaboration agreement.

6. Net Income (Loss) Per Share

Net income (loss) per share is computed using the weighted average number of shares of common stock outstanding and is presented for basic and diluted income (loss) per share. Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period increased to include, if dilutive, the number of additional common shares that would have been outstanding if the potential common shares had been issued. The dilutive effect of outstanding stock options and warrants is reflected in diluted income (loss) per share by application of the treasury stock method. We have excluded all outstanding stock options and warrants from the calculation of diluted loss per share for the three months ended September 30, 2003 and the nine months ended September 30, 2004 and 2003 because such securities are antidilutive for these periods. The total number of potential common shares excluded from the calculation of diluted loss per common share was 3,843,907 for the three months ended September 30, 2003 and 3,596,045 and 1,790,105 for the nine months ended September 30, 2004 and 2003, respectively.

The following table presents the computation of basic and diluted shares outstanding:

	Three Months Ended September 30,		Nine Months Ended September 30,
	2004	2003	2004	2003

Weighted average common shares outstanding – shares used in calculating per share amounts - basic	29,624,813	18,946,581	27,001,323	16,566,699
Effect of dilutive common share equivalents – stock options and warrants outstanding	3,265,669	—	—	—
Shares used in calculating per share amounts - diluted	32,890,482	18,946,581	27,001,323	16,566,699

7. Comprehensive Income (Loss)

The components of comprehensive income (loss) are as follows:

	Three Months Ended September 30,					Nine Months Ended September 30,
	2004		2003			2004			2003
Net income (loss)	$	376,425	$	(5,234,058	)	$	(8,666,314	)	$	(14,527,370	)
Unrealized gain (loss) on short-term Investments	76,580		2,976			23,004			38,299
Comprehensive income (loss)	$	453,005	$	(5,231,082	)	$	(8,643,310	)	$	(14,489,071	)

8. Stock-Based Compensation

We record compensation expense for employee stock options based upon their intrinsic value on the date of grant pursuant to Accounting Principles Board Opinion No. 25 (“APB 25”), Accounting for Stock Issued to Employees. Accordingly, no compensation expense is recognized if the exercise price of stock options equals the fair market value of the underlying stock at the date of grant. Options which were granted to employees pursuant to our option cancel and re-grant program are accounted for as variable in accordance with FASB Interpretation No. 44 (“FIN 44”), Accounting for Certain Transactions Involving Stock Compensation — An Interpretation of APB Opinion No. 25, whereby the intrinsic value of the options to purchase common stock are re-measured at the end of each period for the term of the option and amortized over the vesting period.

Compensation expense for options granted to non-employees has been determined at the grant date in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, and Emerging Issues Task Force (“EITF”) No. 96-18, Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring or in Conjunction with Selling Goods or Services, and has been recorded at the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measured. Such compensation is recognized over the related vesting period of the underlying option.

As required under SFAS No. 123, Accounting for Stock-Based Compensation Transition and Disclosure, the pro forma effects of stock-based compensation on net income (loss) and net income (loss)

per share have been estimated at the date of grant using the Black-Scholes option-pricing model. Had compensation cost for our stock-based compensation plans been determined based on the fair value at the grant dates for awards under those plans, our net income (loss) and net income (loss) per share would have been adjusted to the pro forma amounts presented below:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003

Net income (loss), as reported	$	376,425		$	(5,234,058	)	$	(8,666,314	)	$	(14,527,370	)
Add: Stock-based employee compensation expense (benefit) included in reported net loss	(782,454		)	1,616,342			(1,378,362		)	2,402,800
Deduct: Total stock-based employee compensation expense determined under fair value based methods	(744,987		)	(271,217		)	(1,868,453		)	(1,053,764		)
Pro forma net loss	$	(1,151,016	)	$	(3,888,933	)	$	(11,913,129	)	$	(13,178,334	)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003
Net income (loss) per share:
Basic – as reported	$	0.01		$	(0.28	)	$	(0.32	)	$	(0.88	)
Basic – pro forma	$	(0.04	)	$	(0.21	)	$	(0.44	)	$	(0.80	)
Diluted – as reported	$	0.01		$	(0.28	)	$	(0.32	)	$	(0.88	)
Diluted – pro forma	$	(0.04	)	$	(0.21	)	$	(0.44	)	$	(0.80	)

9. Stockholders’ Equity

Public Offering of Shares of Our Common Stock

On April 7, 2004, we completed a public offering of 6,900,000 shares of our common stock, including the underwriters’ purchase of an additional 900,000 shares to cover over-allotments, at $11.50 per share resulting in proceeds of approximately $74.2 million, net of placement costs.

Stock Option Cancel and Re-Grant Program

In June 2001, we implemented an option cancel and re-grant program. Pursuant to the program, the exercise price of certain options held by certain of our executive officers and directors were exchanged for options with an exercise price of $2.50 per share, the fair market value of our common stock on June 27, 2001, the date the option cancel and re-grant program was effected. As a condition to participating in the option cancel and re-grant program, option holders who elected to surrender their old options for the replacement options had to exercise at least twenty percent of the replacement options on June 27, 2001. In addition, the replacement options expire no later than the earlier of the expiration date of the original option grant or June 27, 2006. Our chief executive officer exercised his options to purchase 101,319 shares of common stock pursuant to a promissory note that was issued by us and was secured by his stock. The outstanding principal amount of the promissory note in the amount of $189,973 was originally due on June 27, 2006, with interest payable annually at a rate of two points above the federal funds rate (adjusted monthly). In January 2004, the principal amount of the loan and related interest was paid in full.

As a result of the program, we granted options to purchase 618,738 shares of our common stock. In accordance with FIN 44, the shares underlying the options are accounted for as variable, and the intrinsic value of the options to purchase common stock are re-measured at the end of each period for the term of the option and amortized over the vesting period. During the three and nine months ended September 30, 2004, as the intrinsic value of the common stock underlying the options decreased due to a decrease in our stock price during these periods, we recognized a compensation benefit of $782,454 and $1,378,362, respectively. In contrast, due to an increase in our stock price during the three and nine months ended September 30, 2003, we recognized compensation expense of $1,616,342 and $2,402,800, respectively, during these periods.

Warrants

On May 21, 2004, we issued an outside consultant warrants to purchase 50,000 shares of our common stock as compensation for services provided. These warrants, which have an exercise price of $13.23 per share and expire in May 2007, were valued at $385,000 using the Black-Scholes valuation model and recorded as a non-cash compensation charge during the second quarter of 2004.

10. Collaboration Agreement

In January 2004, we entered into a collaboration agreement with Forest Laboratories for the development and marketing of milnacipran. Under our agreement with Forest Laboratories, we sublicensed our exclusive rights to develop and commercialize milnacipran to Forest Laboratories for the United States, with an option to extend the territory to include Canada. In addition, Forest Laboratories has an option to acquire an exclusive license from us in the United States, and potentially Canada, to any compounds developed under our agreement with Collegium Pharmaceutical, Inc. Forest Laboratories assumed responsibility for funding all continuing development of milnacipran, including the funding of clinical trials and regulatory approvals, as well as a certain number of our employees. In light of the increased expense and risk associated with running two parallel trials, we and Forest Laboratories are discussing an arrangement whereby, for the second Phase III trial only, we would initially share in some of the costs of the trial, with Forest Laboratories reimbursing us a premium under certain circumstances. Forest Laboratories will also be responsible for sales and marketing activities related to any product developed under the agreement, and we will have the option to co-promote up to 25% of the total physician details.

Under the agreement with Forest Laboratories, we received an upfront, non-refundable payment of $25.0 million, of which $1.25 million, classified as research and development expenses, was paid to Pierre Fabre as a sublicense fee. The total upfront and milestone payments to us under the agreement could total approximately $205.0 million related to the development of milnacipran for the treatment of FMS, a large portion of which will depend upon achieving certain sales of milnacipran and an additional $45.0 million in the event that we and Forest Laboratories develop other indications for milnacipran. In addition, we have the potential to receive royalty payments based on sales of licensed product under this agreement. Forest Laboratories also assumed the future royalty payments due to Pierre Fabre and the transfer price for the active ingredient used in milnacipran. The agreement with Forest Laboratories extends until the later of (i) the expiration of the last to expire of the applicable patents, (ii) 10 years after the first commercial sale of a product under the agreement or (iii) the last commercial sale of a generic product, unless terminated earlier. Each party has the right to terminate the agreement upon prior written notice of the bankruptcy or dissolution of the other party, or a breach of any material provision of the agreement if such breach has not been cured within the required time period following such written notice. Forest Laboratories may also terminate the agreement upon an agreed notice period in the event Forest Laboratories reasonably determines that the development program indicates issues of safety or efficacy that are likely to prevent or significantly delay the filing or approval of a new drug application or to result in labeling or indications that would have a significant adverse affect on the marketing of any product developed under the agreement.

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

Except for the historical information contained herein, the following discussion contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 that involve risks and uncertainties. Our actual results could differ materially from those discussed below and elsewhere in this 10-Q. Factors that could cause or contribute to such differences include, without limitation, those discussed in this section, as well as other sections of this 10-Q, including “Risk Factors” and those discussed in our report on Form 10-K for the year ended December 31, 2003 and our quarterly reports on Form 10-Q, which we urge investors to consider. We undertake no obligation to publicly release revisions in such forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrences of unanticipated events or circumstances, except as required by securities and other applicable laws.

Company Overview

We are committed to being the innovator and leader in providing products for the treatment of patients with Functional Somatic Syndromes and other related chronic pain and central nervous system disorders. Functional Somatic Syndromes refer to several related syndromes characterized more by symptoms, suffering and disability than by disease-specific abnormalities that are found upon physical examination and include many overlapping pain and psychiatric conditions such as Fibromyalgia Syndrome, or FMS, irritable bowel syndrome, non-cardiac chest pain and interstitial cystitis, or chronic pelvic pain. Our goal is to be the first to commercialize a product approved in the United States for the treatment of FMS, the focus of our initial efforts in the area of Functional Somatic Syndromes. In January 2004, we entered into a collaboration agreement with Forest Laboratories, Inc., a leading marketer of central nervous system drugs with a strong franchise in the primary care and psychiatric markets, for the development and marketing of milnacipran. We are currently running the first Phase III trial for milnacipran, which was commenced in October 2003. Enrollment in this trial is expected to be completed by the end of the year, with results available in the third quarter of 2005. Forest Laboratories has initiated the second Phase III trial evaluating milnacipran for the treatment of FMS during the fourth quarter of this year, and the Investigator’s meeting was held on October 7, 2004. As originally agreed, Forest Laboratories will run the second Phase III clinical trial for milnacipran, with our assistance. In light of the increased expense and risk associated with running two parallel trials, we and Forest Laboratories are discussing an arrangement whereby, for this trial only, we would initially share in some of the costs of the trial, with Forest Laboratories reimbursing us with a premium under certain circumstances. These two Phase III trials and any additional studies needed for regulatory approval could possibly be completed in 2006 and, if successful, a New Drug Application, or NDA, for FMS could possibly be submitted as early as later in that year.

We completed a Phase II trial evaluating milnacipran for the treatment of FMS in the Fall of 2002. The Phase II trial was a three-month, randomized, placebo-controlled study involving 14 sites and 125 FMS patients who were randomized to either milnacipran treatment or placebo. In this clinical trial, milnacipran was shown to provide statistically significant improvement in pain, the primary symptom of FMS. No unexpected safety concerns arose from this trial and there were no serious adverse events.

We obtained an exclusive license for milnacipran from Pierre Fabre Medicament in 2001. Milnacipran has been marketed outside of the United States since 1997 as an antidepressant and has been used by over 3,000,000 patients worldwide. We have paid Pierre Fabre a total of $2.5 million, including upfront payments of $1.5 million in connection with the execution of the original license agreement in 2001 and a $1.0 million milestone payment in September 2003. Additional payments to Pierre Fabre of up to a total of $4.5 million will be due to Pierre Fabre based on meeting certain clinical and regulatory milestones.

Additionally, we are obligated to pay Pierre Fabre 5% of any upfront and milestone payments received from Forest Laboratories as a sublicense fee, including $1.25 million of our $25.0 million upfront payment. We paid Pierre Fabre this $1.25 million payment in May 2004. After a total of $7.5 million has been paid, any additional sublicense fees are credited against any subsequent milestone and royalty payments owed by us to Pierre Fabre. If not used, these credits are carried forward to subsequent years.

Under our agreement with Forest Laboratories, we sublicensed our rights to milnacipran to Forest Laboratories for the United States, with an option to extend the territory to include Canada. Additionally, Forest Laboratories assumed responsibility for funding all continuing development of milnacipran, including the funding of clinical trials and regulatory approval, as well as a specified number of our employees, subject to our ongoing discussions regarding the second Phase III clinical trial, as discussed above. We expect the amount of funding that we have received from Forest Laboratories for certain of our employees will decrease, or be eliminated, as we complete enrollment in the first Phase III trial. Forest Laboratories will also be responsible for sales and marketing activities related to any product developed under the agreement, while we have the option to co-promote up to 25% of the total physician details.

In August 2002, we entered into a reformulation and new product agreement with Collegium Pharmaceutical, Inc. pursuant to which Collegium is attempting to develop new formulations of milnacipran and new products that are analogs of milnacipran. In January 2004, we exercised our option to acquire an exclusive license to technology developed under this agreement. In the event we commercialize any of the reformulations or new products developed under our agreement with Collegium, we will be obligated to pay Collegium milestone payments of up to $5.1 million in the aggregate upon achievement of defined clinical and regulatory objectives, as well as potential royalty payments based on the net sales of reformulated or new products. We also entered into a common stock issuance agreement with Collegium, pursuant to which Collegium may elect to be issued shares of our common stock, subject to certain conditions, in lieu of cash, for milestone payments. Forest Laboratories has an option to license any technology developed under our agreement with Collegium.

We are actively continuing to evaluate other various potential strategic transactions, including the potential acquisitions of products and companies, and other alternatives that we believe may enhance stockholder value.

Results of Operations

The following discussion should be read in conjunction with the financial statements and the related notes contained elsewhere in this quarterly report.

Comparison of Three Months Ended September 30, 2004 and 2003

Revenue

We had revenues under our collaborative agreement of $4.3 million for the three months ended September 30, 2004 compared to no revenue for the three months ended September 30, 2003. The revenues recorded during 2004 consist solely of amounts earned pursuant to our collaboration agreement with Forest Laboratories for the development and marketing of milnacipran, entered into in January 2004. Such revenues include the amortization of the upfront payment of $25.0 million from Forest Laboratories over a period of 8 years, funding received from Forest Laboratories for certain of our employees devoted to the development of milnacipran and sponsored development reimbursements.

$25.0 million, sponsored development reimbursements and possible future milestone payments under our agreement with Forest Laboratories, which are contingent upon the achievement of agreed upon objectives. We expect the amount of funding that we have received from Forest Laboratories for certain of our employees will decrease, or be eliminated, as we complete enrollment in the first Phase III trial. Additionally, the amount of sponsored development reimbursements from Forest Laboratories may change periodically based on the level of development activity. Our collaboration agreement is subject to early termination by Forest Laboratories upon specified events, including breach of the agreement.

Research and Development

Research and development expenses for the three months ended September 30, 2004 were $3.8 million compared to $2.8 million for the three months ended September 30, 2003. The increase in research and development expenses is primarily attributable to increased costs and activity during the third quarter of 2004 in connection with our first Phase III clinical trial for milnacipran and costs incurred during 2004 in connection with the extension trial and the preparation for our second Phase III trial for milnacipran. The increase in research and development expenses would have been higher; however, we also incurred a $1.0 million milestone payment due and paid to Pierre Fabre in September 2003 and increased costs and activity in connection with the Collegium agreement during the third quarter of 2003. The costs for the first Phase III clinical trial incurred during 2004 are being reimbursed by Forest Laboratories as noted below.

Effective January 9, 2004, pursuant to our collaboration agreement with Forest Laboratories, Forest Laboratories assumed responsibility for funding all continuing development of milnacipran, including the funding of clinical trials and regulatory approvals, as well as a certain number of our employees. This funding received from Forest Laboratories for certain of our employees devoted to the development of milnacipran and sponsored development reimbursements are included as a component of our revenue under collaborative agreement on the statement of operations. In light of the increased expense and risk associated with running two parallel trials, we and Forest Laboratories are discussing an arrangement whereby, for this trial only, we would initially share in some of the costs of the trial, with Forest Laboratories reimbursing us with a premium under certain circumstances.

In addition, as discussed below in “Non-Cash Compensation Charges,” we recognized non-cash compensation expense of $87,000 and $18,000 related to research and development expenses for the three months ended September 30, 2004 and 2003, respectively, and as discussed below in “Compensation Expense (Benefit) — Variable Stock Options,” we recognized a compensation (benefit) for variable stock options of $(62,000) and compensation expense of $176,000 related to research and development expenses for the three months ended September 30, 2004 and 2003, respectively.

General and Administrative

General and administrative expenses for the three months ended September 30, 2004 were $1.1 million compared to $0.9 million for the three months ended September 30, 2003. The increase in general and administrative expenses is primarily due to increased wages expense associated with an increase in headcount, increased consulting costs in connection with business development activities surrounding potential strategic transactions and increased business insurance costs.

In addition, as discussed below in “Non-Cash Compensation Charges,” we recognized non-cash compensation expense of $44,000 and $7,000 related to general and administrative expenses for the three months ended September 30, 2004 and 2003, respectively, and as discussed below in “Compensation Expense (Benefit) — Variable Stock Options,” we recognized a compensation (benefit) for variable stock

options of $(720,000) and compensation expense of $1.4 million related to general and administrative expenses for the three months ended September 30, 2004 and 2003, respectively.

Non-Cash Compensation Charges

Non-cash compensation charges for the three months ended September 30, 2004 were $131,000, consisting of approximately $87,000 related to research and development expenses and $44,000 related to general and administrative expenses, compared to $25,000, consisting of approximately $18,000 related to research and development expenses and $7,000 related to general and administrative expenses, for the three months ended September 30, 2003. The increase in non-cash compensation charges is primarily due to an increase in the Black-Scholes value for stock options previously granted to consultants due to the increase experienced in our stock price. These options are being expensed over their related vesting period.

Compensation Expense (Benefit) – Variable Stock Options

In June 2001, we implemented an option cancel and re-grant program, which resulted in variable accounting for the newly issued options under Financial Accounting Standards Board Interpretation No. 44 (“FIN 44”), Accounting for Certain Transaction Involving Stock Compensation - An Interpretation of APB 25. During the three months ended September 30, 2004, as the intrinsic value of the common stock underlying the options declined due to a decrease in our stock price during the period, we recognized a compensation (benefit) of $(782,000), consisting of $(62,000) related to research and development expenses and $(720,000) related to general and administrative expenses. In contrast, due to an increase in our stock price during the three months ended September 30, 2003, we recognized compensation expense of $1.6 million, consisting of $176,000 related to research and development expenses and $1.4 million related to general and administrative expenses. In the event our stock price is above $11.67 (closing price on September 30, 2004) on December 31, 2004, we will record additional compensation charges (however, we cannot predict what our stock price will be in the future and it may be substantially lower than $11.67).

Interest and Other Income

Interest and other income, net, for the three months ended September 30, 2004 was $434,000 compared to $34,000 for the three months ended September 30, 2003. The increase in interest and other income for the three months ended September 30, 2004 compared to the corresponding period in 2003 is primarily due to higher cash and investment balances during 2004 achieved primarily through our call for the redemption of outstanding warrants during October 2003, the upfront payment received from Forest in January 2004 and the proceeds from our secondary offering completed in April 2004.

Comparison of Nine Months Ended September 30, 2004 and 2003

Revenue

We had revenues under our collaborative agreement of $11.1 million for the nine months ended September 30, 2004 compared to no revenue for the nine months ended September 30, 2003. The revenues recorded during 2004 consist solely of amounts earned pursuant to our collaboration agreement with Forest Laboratories for the development and marketing of milnacipran, entered into in January 2004. Such revenues include the amortization of the upfront payment of $25.0 million from Forest Laboratories over a period of 8 years, funding received from Forest Laboratories for certain of our employees devoted to the development of milnacipran and sponsored development reimbursements.

We currently are not generating any revenues from product sales and we do not expect to generate revenues from product sales for at least the next several years, if at all. Until we generate revenues from product sales, we expect our revenues to consist of the continued amortization of the upfront payment of $25.0 million, sponsored development reimbursements and possible future milestone payments under our agreement with Forest Laboratories, which are contingent upon the achievement of agreed upon objectives. We expect the amount of funding that we have received from Forest Laboratories for certain of our employees will decrease, or be eliminated, as we complete enrollment in the first Phase III trial. Additionally, the amount of sponsored development reimbursements from Forest Laboratories may change periodically based on the level of development activity. Our collaboration agreement is subject to early termination by Forest Laboratories upon specified events, including breach of the agreement.

Research and Development

Research and development expenses for the nine months ended September 30, 2004 were $11.2 million compared to $9.7 million for the nine months ended September 30, 2003. The increase in research and development expenses is primarily attributable to increased costs in connection with our first Phase III clinical trial for milnacipran due to a full nine months of activity during 2004, costs incurred during 2004 in connection with the extension trial and the preparation for our second Phase III trial for milnacipran, the recognition of a $1.25 million sublicense fee to Pierre Fabre during the first quarter of 2004, payable as a result of our collaboration agreement with Forest Laboratories, the exercise of our option in January 2004 to acquire an exclusive license to technology developed under our reformulation and new product agreement with Collegium and the hiring of additional personnel related to the expansion of our research and development activities into Phase III clinical trials. This increase in research and development expenses was partially offset by the non-cash charge in the amount of $5.0 million recognized during the second quarter of 2003 in connection with the issuance of 1,000,000 shares of our common stock and warrants to purchase 300,000 shares of our common stock to Pierre Fabre under the Restated Pierre Fabre Agreement, a $1.0 million milestone payment due and paid to Pierre Fabre in September 2003 and costs incurred during the first quarter of 2003 related to the Phase II clinical trial for milnacipran, which was in its final completion stage during the first quarter of 2003. The costs for the first Phase III clinical trial incurred during 2004 are being reimbursed by Forest Laboratories as noted below.

In addition, as discussed below in “Non-Cash Compensation Charges,” we recognized non-cash compensation expense of $297,000 and $46,000 related to research and development expenses for the nine months ended September 30, 2004 and 2003, respectively, and as discussed below in “Compensation Expense (Benefit)—Variable Stock Options,” we recognized a compensation (benefit) for variable stock options of $(180,000) and compensation expense for variable stock options of $261,000 related to research and development expenses for the nine months ended September 30, 2004 and 2003, respectively.

General and Administrative

General and administrative expenses for the nine months ended September 30, 2004 were $4.5 million compared to $2.4 million for the nine months ended September 30, 2003. The increase in general and administrative expenses is primarily due to a success-based fee paid to our investment bankers in connection with the closing of our collaboration agreement with Forest Laboratories, a one-time fee associated with our being listed during the first quarter of 2004 on the Nasdaq National Market, increased wages expense associated with an increase in headcount, increased consulting costs and travel expenses in connection with business development activities surrounding potential strategic transactions and increased business insurance costs.

In addition, as discussed below in “Non-Cash Compensation Charges,” we recognized non-cash compensation expense of $5.9 million and $45,000 related to general and administrative expenses for the nine months ended September 30, 2004 and 2003, respectively, and as discussed below in “Compensation Expense (Benefit)—Variable Stock Options,” we recognized a compensation (benefit) for variable stock options of $(1.2) million and compensation expense for variable stock options of $2.1 million related to general and administrative expenses for the nine months ended September 30, 2004 and 2003, respectively.

Non-Cash Compensation Charges

Non-cash compensation charges for the nine months ended September 30, 2004 were $6.2 million, consisting of approximately $297,000 related to research and development expenses and $5.9 million related to general and administrative expenses, compared to $91,000, consisting of approximately $46,000 related to research and development expenses and $45,000 related to general and administrative expenses, for the nine months ended September 30, 2003. The increase in non-cash compensation charges is primarily due to non-recurring, non-cash compensation charges recognized during the first quarter of 2004, consisting of $2.4 million related to stock options previously granted to consultants and two former board members for services that vested upon the execution of the collaboration agreement with Forest Laboratories and $2.8 million related to the accounting treatment for stock options in connection with the resignation of certain board members to roles as consultants during the first quarter of 2004, a non-recurring, non-cash compensation charge in the amount of $385,000 recognized during the second quarter of 2004 related to the issuance of warrants to purchase 50,000 shares of our common stock to an outside consultant as compensation for services provided and an increase in the Black-Scholes value for stock options previously granted to consultants due to the increase experienced in our stock price. These options are being expensed over their related vesting period.

Compensation Expense (Benefit) – Variable Stock Options

In connection with the option cancel and re-grant program implemented in June 2001, which resulted in variable accounting for the newly issued options under FIN 44, we recognized a compensation (benefit) for the nine months ended September 30, 2004 in the amount of $(1.4) million compared to compensation expense of $2.4 million for the nine months ended September 30, 2003. During the nine months ended September 30, 2004, as the intrinsic value of the common stock underlying the options declined due to a decrease in our stock price during the period, we recognized a compensation (benefit) of $(1.4) million, consisting of $(180,000) related to research and development expenses and $(1.2) million related to general and administrative expenses. In contrast, as our stock price increased during the nine months ended September 30, 2003, we recognized compensation expense of $2.4 million, consisting of

$261,000 related to research and development expenses and $2.1 million related to general and administrative expenses. In the event our stock price is above $11.67 (closing price on September 30, 2004) on December 31, 2004, we will record additional compensation charges (however, we cannot predict what our stock price will be in the future and it may be substantially lower than $11.67).

Interest and Other Income

Interest and other income, net, for the nine months ended September 30, 2004 was $704,000 compared to $85,000 for the nine months ended September 30, 2003. The increase in interest and other income for the nine months ended September 30, 2004 compared to the corresponding period in 2003 is due to higher cash and investment balances during 2004 achieved primarily through our call for the redemption of outstanding warrants during October 2003, the upfront payment received from Forest in January 2004 and the proceeds from our secondary offering completed in April 2004.

Liquidity and Capital Resources

At September 30, 2004, we had cash, cash equivalents and short-term investments of $114.6 million compared to cash, cash equivalents and short-term investments of $23.5 million at December 31, 2003. Working capital at September 30, 2004 totaled $113.4 million compared to $22.0 million at December 31, 2003. We have invested a substantial portion of our available cash in high quality marketable debt instruments of governmental agencies and certificates of deposit, which are within federally insured limits. We have established guidelines relating to our investments to preserve principal and maintain liquidity.

Net cash provided by operating activities totaled $15.5 million for the nine months ended September 30, 2004, compared to net cash used in operating activities of $6.8 million for the nine months ended September 30, 2003. The primary source of cash from operations during the nine months ended September 30, 2004 was the upfront payment of $25.0 million received from Forest Laboratories, offset by cash used in operations of approximately $9.5 million. The primary use of cash during the nine months ended September 30, 2003 was to fund our operating activities during the period.

Net cash used in investing activities was $78.5 million for the nine months ended September 30, 2004, compared to $13.6 million for the nine months ended September 30, 2003. The increase in net cash used in investing activities during the nine months ended September 30, 2004 compared to the corresponding prior year period was primarily a result of the increase in the level of activity related to the purchase of short-term securities, net of the proceeds from the sale of short-term securities.

Net cash provided by financing activities was $75.6 million for the nine months ended September 30, 2004, compared to $13.8 million for the nine months ended September 30, 2003. The increase in net cash provided by financing activities during the nine months ended September 30, 2004 compared to the corresponding prior year period was primarily the result of proceeds of approximately $74.2 million from the completion of our public offering of common stock during April 2004, proceeds of approximately $1.2 million from the exercise of stock options and warrants during 2004 and the receipt of the payment of the shareholder receivable in the amount of $0.2 million during 2004, compared to net proceeds of approximately $9.5 million from the private placement of our common stock and warrants to purchase our common stock completed in April 2003 and proceeds of approximately $4.3 million from the exercise of stock options and warrants during the first nine months of 2003.

The following table summaries our long-term contractual obligations as of September 30, 2004:

	Total		Less than 1 year (2004)		1 - 3 years (2005– 2007)		After 4 years (2008 and beyond)
Capital leases, including interest payments	$	45,965	$	4,755	$	41,210	$	—
Operating leases	516,476		43,698		472,778		—
Purchase obligations (1)	344,000		119,000		225,000		—
Total	$	906,441	$	167,453	$	738,988	$	—

(1) Purchase obligations include agreements to purchase goods or services, including consulting services, that are enforceable and legally binding on us and that specify all significant terms. This includes contracts that are cancelable with notice and the payment of an early termination penalty. Purchase obligations exclude agreements that are cancelable without penalty and also exclude liabilities to the extent presented on the balance sheet as of September 30, 2004.

Other commercial commitments include certain potential milestone, sublicense and royalty payments to Pierre Fabre and Collegium discussed in the “Overview” section. Contractual obligations for which we will be reimbursed by Forest Laboratories are not included in the table above. In light of the increased expense and risk associated with running two parallel trials, we and Forest Laboratories are discussing an arrangement whereby, for this trial only, we would initially share in some of the costs of the trial, with Forest Laboratories reimbursing us with a premium under certain circumstances.

Until we can consistently generate significant cash from our operations, we expect to continue to fund our operations with existing cash resources that were primarily generated from the proceeds of offerings of our equity securities and from revenue from our collaboration agreement. Our current expected primary cash needs on both a short term and long-term basis are for the identification, acquisition or license, and development of potential future products, working capital and other general corporate purposes. In addition to the amounts required to pay any amounts payable under our agreements with Pierre Fabre and Collegium, and costs of in-licensing or acquiring additional compounds or companies, we estimate that based on our current business plan, we will require approximately $3.0 million to fund our operations for the remainder of 2004. In the event we acquire, license or develop any new products, the amount to fund our operations for 2004 would increase. We expect the current trend of net losses to continue for at least the next several years as we seek to acquire, license or develop additional products for the treatment of Functional Somatic Syndromes and other related chronic pain and central nervous system disorders. Such losses may fluctuate, and the fluctuations may be substantial.

Based on our current business plan, we believe our cash and cash equivalents and short-term investments balances at September 30, 2004 are sufficient to fund operations for the next several years. We are actively continuing to evaluate various potential strategic transactions, including the potential acquisitions of products and companies, and other alternatives that we believe may enhance stockholder value. In order to acquire or develop additional products, we will require additional capital. The amount of capital we require is dependent upon many forward-looking factors that could significantly increase our capital requirements, including the following:

• the extent to which we acquire or invest in other products and businesses, although we currently have no commitments or agreements relating to any of these types of transactions;

• the costs of in-licensing drug candidates;

• the ability of Forest Laboratories and us to reach milestones, and other events or developments under our collaboration agreement;

• the costs and timing of development and regulatory approvals for milnacipran; and

• the costs of commercialization of any future products.

Because we are unable to predict the outcome of the foregoing factors, some of which are beyond our control, we are unable to estimate with certainty our mid to long-term capital needs. Until we can generate a sufficient amount of product revenue, if ever, we expect to finance future capital needs through public or private equity offerings or collaboration and licensing arrangements, as well as interest income earned on cash balances. We do not currently have any commitments for future external funding. We may not be able to raise additional capital through such sources and the funds we raise, if any, may not allow us to maintain our current and planned operations. If we are unable to obtain additional capital, we may be required to delay, scale back or eliminate some or all of our development of future additional product candidates.

To date, we have not had any relationships with unconsolidated entities or financial partnerships, such as entities referred to as structured finance or special purpose entities, which are established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, research and development expenses, stock-based compensation and income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following are some of the more critical accounting policies that affect the significant judgments and estimates used in the preparation of our financial statements (also see the notes to our financial statements included on our report on Form 10-K for the year ended December 31, 2003).

Revenue Recognition

In accordance with Staff Accounting Bulletin (“SAB”) No. 101, Revenue Recognition in Financial Statements, revenues are recognized when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed and determinable and collectibility is reasonably assured. Amounts received for upfront license fees under multiple-element arrangements are deferred and recognized over the period of such services or performance if such arrangements require on-going services or performance. Accordingly, the upfront payment of $25.0 million from Forest Laboratories is being amortized over a period of 8 years, which represents the estimated period of significant on-going services and performance, including the development period, under our agreement

with Forest Laboratories. Amounts received for sponsored development activities, including funding received for certain of our employees, are recognized as research costs are incurred over the period specified in the related agreement or as the services are performed. Amounts received for milestones are recognized upon achievement of the milestone, which requires substantive effort and was not readily assured at the inception of the agreement. Any amounts received prior to satisfying revenue recognition criteria will be recorded as deferred revenue.

Research and Development Expenses

We expense research and development costs as they are incurred pursuant to SFAS No. 2, Accounting for Research and Development Costs, as the ultimate commercialization of the related products is uncertain and the technology has no alternative uses. In connection with our agreement with Pierre Fabre, we have paid certain upfront and milestone payments and are also obligated to make additional payments based on meeting certain clinical and regulatory milestones. Such upfront and milestone payments are expensed as incurred pursuant to SFAS No. 2. We also issued Pierre Fabre 1,000,000 shares of our common stock and warrants to purchase 300,000 shares of our common stock in the second quarter of 2003 in connection with the second restated license agreement. Pursuant to SFAS No. 2, the additional license consideration in the form of these equity instruments has been expensed as the ultimate commercialization of the related product is uncertain and the technology has no alternative uses. Additionally, in connection with our agreement with Collegium, the upfront and project management fees paid to Collegium have been expensed pursuant to SFAS No. 2, as well as the other direct costs incurred in connection with the agreement.

Stock-Based Compensation

We grant stock options for a fixed number of shares to employees in accordance with Accounting Principles Board Opinion No. 25 (“APB 25”), Accounting for Stock Issued to Employees, as amended by SFAS No. 123 (“FAS 123”), Accounting for Stock Based Compensation. Accordingly, we ordinarily recognize no compensation expense for stock option grants to employees provided that the option exercise price is not less than the fair market value of the underlying stock on the date of grant. The value of options or stock awards issued to non-employees has been determined in accordance with FAS 123 and Emerging Issues Task Force No. 96-18, Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring or in Conjunction with Selling Goods and Services, and is periodically re-measured as the options vest. For the three months ended September 30, 2004 and 2003, we recorded compensation expense of $131,235 and $25,078, respectively, related to options issued to consultants. For the nine months ended September 30, 2004 and 2003, we recorded compensation expense of $2.9 million (including $2.4 million related to stock options that vested upon the execution of the collaboration agreement with Forest Laboratories) and $91,275, respectively, related to options issued to consultants. Additionally, during the nine months ended September 30, 2004, we recorded compensation expense of $2.8 million in connection with the accounting treatment for stock options related to the resignation of certain board members during the first quarter of 2004 and compensation expense of $385,000 in connection with the issuance of warrants to purchase 50,000 shares of our common stock to an outside consultant as compensation for services provided.

September 30, 2004, as the intrinsic value of the common stock underlying the options decreased due to a decrease in our stock price during these periods, we recognized a compensation benefit of $782,454 and $1,378,362, respectively. However, during the three and nine months ended September 30, 2004, as the intrinsic value of the common stock underlying the options increased due to an increase in our stock price during these periods, we recognized compensation expense of $1,616,342 and $2,402,800, respectively. In the event our stock price is above $11.67 (closing price on September 30, 2004) on December 31, 2004, we will record additional compensation charges (however, we cannot predict what our stock price will be in the future and it may be substantially lower than $11.67). Pursuant to the option cancel and re-grant program, options with certain exercise prices held by certain of our employees, including executive officers, and directors were exchanged for options with an exercise price of $2.50, the fair market value of our common stock on June 27, 2001, the date the program was effected.

Valuation Allowance for Deferred Tax Assets

A valuation allowance is provided for deferred tax assets if it is more likely than not these items will either expire before we are able to realize their benefit, or that future deductibility is uncertain. In general, companies that have a history of operating losses are faced with a difficult burden of proof on their ability to generate sufficient future taxable income in the near future in order to realize the benefit of the deferred tax assets. We have recorded a full valuation allowance against our deferred tax assets based on our history of losses. The deferred tax assets are still available for us to use in the future to offset taxable income, which would result in the recognition of a tax benefit and a reduction to our effective tax rate.

ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

We invest our excess cash in United States government securities, certificates of deposit and money market funds with strong credit ratings. As a result, our interest income is most sensitive to changes in the general level of United States interest rates. We do not use derivative financial instruments, derivative commodity instruments or other market risk sensitive instruments, positions or transactions in any material fashion. Accordingly, we believe that, while the investment-grade securities we hold are subject to changes in the financial standing of the issuer of such securities, we are not subject to any material risks arising from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices or other market changes that affect market risk sensitive instruments. A hypothetical 1% adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of our financial instruments that are exposed to changes in interest rates.

ITEM 4 – CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, or the Exchange Act. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective and sufficient to ensure that the information required to be disclosed in the reports that we file under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms.

Changes in Internal Control

There have been no significant changes in the Company’s internal control over financial reporting during the quarter ended September 30, 2004 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Risk Factors

We are dependent on our collaboration with Forest Laboratories to develop and commercialize milnacipran, our only product candidate, and to obtain regulatory approval. Events or circumstances may occur that delay or prevent the development and commercialization of milnacipran.

Pursuant to the terms of our collaboration agreement with Forest Laboratories, we granted Forest Laboratories an exclusive sublicense for the development and marketing of milnacipran, our only product candidate, for all indications in the United States, with an option to extend the territory to include Canada. In addition, Forest Laboratories has the option to acquire an exclusive license from us in the United States, and potentially Canada, to any compounds developed under our agreement with Collegium Pharmaceutical. Forest Laboratories is responsible for funding the development of milnacipran, including clinical trials and regulatory approval. If the FDA approves this product candidate, Forest Laboratories will also have primary responsibility for the marketing and sale of the approved product and will share responsibility for compliance with regulatory requirements. We have limited control over the amount and timing of resources that Forest Laboratories will dedicate to the development, approval and marketing of milnacipran. Our ability to generate milestone and royalty payments from Forest Laboratories depends on Forest Laboratories’ ability to establish the safety and efficacy of milnacipran, obtain regulatory approvals and achieve market acceptance of milnacipran for the treatment of FMS.

We are subject to a number of additional risks associated with our dependence on our collaboration with Forest Laboratories, including:

• Forest Laboratories could delay the commencement of any additional clinical trials for milnacipran for the treatment of FMS, extend the timeframe of any clinical trials, including the second Phase III clinical trial for milnacipran, underfund such clinical trials, stop either phase III trials or any other clinical trials for milnacipran or abandon development of milnacipran, repeat or conduct additional clinical trials or require a new formulation of milnacipran for clinical testing;

• We and Forest Laboratories could disagree as to development plans, including the number and timing of clinical trials or regulatory approval strategy, or as to which additional indications for milnacipran should be pursued, if any;

• Forest Laboratories could independently develop, develop with third parties or acquire products that could compete with milnacipran, including drugs approved for other indications used by physicians off-label for the treatment of FMS;

• Forest Laboratories could fail to devote sufficient resources to the development, approval, commercialization, or marketing and distribution of any products developed under our collaboration agreement, including by failing to develop specialty sales forces if such sales forces are necessary for the most effective distribution of any approved product; and

• Disputes regarding the collaboration agreement that delay or terminate the development, commercialization or receipt of regulatory approvals of milnacipran, delay or prevent the achievement of clinical or regulatory objectives that would result in the payment of milestone payments or result in significant litigation or arbitration.

Furthermore, Forest Laboratories may terminate our collaboration agreement upon our material breach or our bankruptcy and may also terminate our agreement upon 120 days’ notice in the event Forest Laboratories reasonably determines that the development program indicates issues of safety or efficacy that are likely to prevent or significantly delay the filing or approval of a new drug application or to result in labeling or indications that would significantly adversely affect the marketing of any product developed

under the agreement. If any of these events occur, we may not be able to find another collaborator for development or commercialization, and if we elected to pursue further development and commercialization of milnacipran, we would experience substantially increased capital requirements that we might not be able to fund.

We rely upon an exclusive license from Pierre Fabre in order to develop and sell our milnacipran product candidate, and our ability to pursue the development and commercialization of milnacipran for the treatment of FMS depends upon the continuation of our license from Pierre Fabre.

Our license agreement with Pierre Fabre provides us with an exclusive license to develop and sell any products with the compound milnacipran as an active ingredient for any indication in the United States and Canada, with a right to sublicense certain rights to Forest Laboratories under our collaboration with Forest Laboratories. Either we or Pierre Fabre may terminate the license agreement for cause upon 90 days’ prior written notice to the other party upon the bankruptcy or dissolution of the other party, or upon a breach of any material provision of the agreement if the breach is not cured within 90 days following the written notice. Furthermore, Pierre Fabre has the right to terminate the agreement upon 90 days’ prior notice to us if we and our sub-licensees terminate our development and marketing activities with respect to milnacipran, if we challenge certain patent rights of Pierre Fabre and under specified other circumstances. If our license agreement with Pierre Fabre were terminated, we would lose our rights to develop and commercialize products using the compound milnacipran as an active ingredient, as the compound is manufactured under Pierre Fabre patents and using Pierre Fabre know-how and trade secrets, and it would be unlikely that we could obtain the active ingredient in milnacipran from any other source.

We rely upon Pierre Fabre as our exclusive supplier of the compound used as the active ingredient in our milnacipran product candidate and if Pierre Fabre fails to supply us sufficient quantities of the active ingredient it may delay or prevent us from developing and commercializing our only product candidate.

Pursuant to our purchase and supply agreement with Pierre Fabre, Pierre Fabre is the exclusive supplier to us and Forest Laboratories of the compound used as the active pharmaceutical ingredient in our milnacipran product candidate. Neither we nor Forest Laboratories have facilities for the manufacture of the product candidate. Currently, Pierre Fabre manufactures the active ingredient of milnacipran in its facility in Gaillac, France and Pierre Fabre is the only worldwide supplier of the active ingredient of milnacipran that is currently approved for sale as an antidepressant and sold in 32 countries, but is not approved for sale in the United States. If any product is commercialized under the agreement, Pierre Fabre will have the exclusive right to manufacture the active ingredient used in our commercial product. If milnacipran is commercialized in the United States, Pierre Fabre’s facility will need to be inspected by the FDA for compliance with current good manufacturing practices, or cGMP, requirements. Due to the projected commercial quantities of milnacipran that we may require and to provide a second manufacturing site, Pierre Fabre has agreed that within a certain time period after commercial launch of milnacipran, it will qualify an additional manufacturing facility. We do not have control over Pierre Fabre’s compliance with cGMP requirements or Pierre Fabre’s compliance with its obligation to qualify a second manufacturing facility. If Pierre Fabre fails or is unable to provide, in a timely and economic manner, required quantities of the active ingredient that Forest Laboratories or we request for clinical purposes, our development program could be delayed. In addition, if Pierre Fabre fails to timely and economically supply us sufficient quantities for commercial sale, our product sales and market acceptance of the product could be adversely affected.

Furthermore, our purchase and supply agreement may be terminated for cause either by us or by Pierre Fabre upon 90 days’ prior written notice to the other party upon a material breach of the agreement if the breach is not cured within 90 days following the written notice. We have the right to manufacture milnacipran if Pierre Fabre does not have a required buffer stock or in the event that we terminate our license agreement with Pierre Fabre under certain circumstances. If our purchase and supply agreement with Pierre Fabre is terminated, we are unlikely to be able to qualify another supplier of the active ingredient

within a reasonable time period, and our ability to develop and commercialize milnacipran will be significantly impaired.

Our agreements with Pierre Fabre and Forest Laboratories restrict our ability to develop specified compounds, which limits how we can expand our product candidates.

Under our agreements with Pierre Fabre and Forest Laboratories, Forest Laboratories has agreed to pay Pierre Fabre and us a royalty, in the event that Forest Laboratories sells a product other than milnacipran for FMS for a specified period of time, which shall not be less than three years. We are, in turn, obligated to pay a portion of the royalty we receive from Forest Laboratories to Pierre Fabre. In addition, each of us is subject to limitations related to each party’s development of any serotonin norephinephrine reuptake inhibitors, or SNRI, products other than milnacipran. These limitations include: (i) a prohibition on developing an SNRI product for specified indications for which milnacipran is being developed; and (ii) a prohibition on developing an SNRI product for any indication for a specified time period, and after such specified time period, a requirement that if one of the parties launches and sells an SNRI product that is prescribed off-label for any indication for which milnacipran is being developed, the selling party must reimburse the other parties for losses due to the off-label use.

Provisions in our collaboration agreement with Forest Laboratories and our license agreement with Pierre Fabre may prevent or delay a change in control.

Our collaboration agreement with Forest Laboratories provides that Forest Laboratories may elect to terminate our co-promotion rights for milnacipran or any other product developed under the collaboration agreement and we may lose our decision making authority with respect to the development and marketing of milnacipran if we engage in a merger, consolidation or sale of all or substantially all of our assets, or if another person or entity acquires at least 50% of our voting capital stock. Our license agreement with Pierre Fabre provides that Pierre Fabre may elect to terminate the agreement upon a change in control transaction in which a third party acquiror of us controls an SNRI product, and the acquiror does not take certain actions (e.g., divestiture of such SNRI product) within a specified time period to cure the breach of certain restrictions in the agreement that results from such SNRI product.

If Forest Laboratories and/or Pierre Fabre elected to exercise these termination rights, we or our successor could lose the ability to develop, commercialize and market milnacipran. These provisions may have the effect of delaying or preventing a change in control or a sale of all or substantially all of our assets, or may reduce the number of companies interested in acquiring us.

We are at an early stage of development and we do not have and may never develop any commercial drugs or other products that generate revenues.

We are at an early stage of development as a biotechnology company and do not have any commercial products. We have only one product candidate, milnacipran, which we sublicensed to Forest Laboratories in January 2004. Milnacipran, or any future product candidates we may acquire or develop, will require significant additional development, clinical trials, regulatory approvals and additional investment before they can be commercialized. Our product development and product acquisition efforts may not lead to commercial drugs, either because the product candidates are not shown to be safe and effective in clinical trials, because we have inadequate financial or other resources to pursue clinical development of the product candidate, or because the FDA does not grant regulatory approval. We do not expect milnacipran to be marketed for a number of years, if at all. If we and Forest Laboratories are unable to develop milnacipran as a commercial drug in the United States and Canada, or if such development is delayed, we will be unable to generate revenues, may be unsuccessful in raising additional capital, and may cease our operations.

There are limited data regarding milnacipran as a treatment of FMS.

There are limited data supporting the use of milnacipran, our only product candidate, for the treatment of FMS. Although milnacipran is currently being sold by Pierre Fabre outside North America as an antidepressant, it has only been tested as a treatment for FMS in our Phase II trial, during which milnacipran was administered to only 97 individuals with FMS. We must conduct and obtain favorable results in at least two pivotal Phase III trials to support an application for FDA approval of the product candidate. We cannot predict whether the results of our Phase II trial will be repeated in future clinical trials with larger patient populations and for longer time periods. The FDA has never approved a drug for the treatment of FMS. In addition, our future clinical trials may reveal that milnacipran is not safe or that it is not effective for the treatment of FMS. If milnacipran is not demonstrated to be a safe and effective treatment for FMS to the satisfaction of the FDA or other regulatory agencies, we will not receive regulatory approval and our business would be materially harmed.

The FDA approval of milnacipran or any future product candidate is uncertain and will involve the commitment of substantial time and resources.

Even if our Phase III trials or any future clinical trials are successful, we may not receive required regulatory approval from the FDA or any other regulatory body required for the commercial sale of milnacipran in the United States, or the approval process may take longer than we anticipate. The regulatory approval of a new drug typically takes many years and the outcome is uncertain. Despite the time and resources expended, regulatory approval is never guaranteed. If we fail to obtain regulatory approval for milnacipran or any future product candidates, we will be unable to market and sell any products and therefore may never generate any revenues from product sales or become profitable. In addition, our collaborators, or our third party manufacturers’ failure to comply with the FDA and other applicable United States or foreign regulations may subject us to administrative or judicially imposed sanctions, including warning letters, civil and criminal penalties, injunctions, product seizure or detention, product recalls, total or partial suspension of production and refusal to approve new drug approval applications.

As part of the regulatory approval process, we must conduct, at our own expense, preclinical research and clinical trials for each product candidate sufficient to demonstrate its safety and efficacy to the satisfaction of the FDA and other regulatory agencies in the United States and other countries where the product candidate will be marketed if approved. The number of preclinical studies and clinical trials that will be required varies depending on the product, the disease or condition that the product is in development for and the regulations applicable to any particular product. The regulatory process typically also includes a review of the manufacturing process to ensure compliance with applicable regulations and standards, including the cGMP requirements. The FDA can delay, limit or decline to grant approval for many reasons, including:

• a product candidate may not be safe or effective;

• we may not achieve statistical significance for the primary endpoint;

• FDA officials may interpret data from preclinical testing and clinical trials in different ways than we interpret such data;

• the FDA might not approve our manufacturing processes or facilities, or the processes or facilities of any future collaborators or contract manufacturers, including Pierre Fabre’s facility for the manufacture of the active ingredient in milnacipran; and

• the FDA may change its approval policies or adopt new regulations.

If we receive regulatory approval for milnacipran or any other future product candidate, we will be subject to ongoing FDA obligations and continuing regulatory review.

Any regulatory approvals that we or our collaborators receive for milnacipran or any future product candidates will be limited to the indications, dosages and restrictions on the product label. We currently intend to seek approval for milnacipran in the treatment of FMS. The FDA may not approve milnacipran for this indication at all, or may impose additional limitations on the indicated uses or contain requirements for post-marketing surveillance or the performance of potentially costly post-marketing studies. Even if we receive FDA and other regulatory approvals, milnacipran or any of our other future product candidates may later exhibit adverse effects that limit or prevent their widespread use or that force us to withdraw those product candidates from the market. In our Phase II trial evaluating milnacipran for the treatment of FMS, the most common dose-related side effects reported by patients were nausea, particularly early in the study, as well as a slight increase in heart rate. Any marketed product and its manufacturer continue to be subject to strict FDA regulation after approval, including regulation of product labeling and packaging, adverse event reporting, manufacture, storage, advertising, promotion and recordkeeping. Any unforeseen problems with an approved product or any violation of regulations could result in restrictions on the product, including its withdrawal from the market.

We rely on third parties to conduct all of our clinical trials. If these third parties do not successfully carry out their contractual duties or meet expected deadlines, we may not be able to obtain regulatory approval for or commercialize milnacipran or any of our other future product candidates.

We currently have only 14 full-time employees. We have in the past and expect to continue to rely on third parties to conduct all of our clinical trials. We and Forest Laboratories are using the services of Scirex, a contract research organization, to conduct the first Phase III trial with respect to milnacipran. Because we do not conduct our own clinical trials, we must rely on the efforts of others and cannot always control or predict accurately the timing of such trials, the costs associated with such trials or the procedures that are followed for such trials. We do not anticipate significantly increasing our personnel in the foreseeable future and therefore, expect to continue to rely on third parties to conduct all of our future clinical trials. If these third parties do not successfully carry out their contractual duties or obligations or meet expected deadlines, or if the quality or accuracy of the clinical data they obtain is compromised due to their failure to adhere to our clinical protocols or for other reasons, or if they fail to maintain compliance with applicable government regulations and standards, our clinical trials may be extended, delayed or terminated, and we may not be able to obtain regulatory approval for or successfully commercialize milnacipran or any of our other future product candidates.

Even if our product candidates are approved, the market may not accept these products.

Even if our product development efforts are successful and even if the requisite regulatory approvals are obtained, milnacipran or any future product candidates that we may develop may not gain market acceptance among physicians, patients, healthcare payors and the medical community. The FDA has never approved a drug for the treatment of FMS and we cannot predict whether milnacipran, if approved for this indication, will gain market acceptance. A number of additional factors may limit the market acceptance of products including the following:

• timing of market entry relative to competitive products;

• extent of marketing efforts by us and third-party distributors or agents retained by us; and

• rate of adoption by healthcare practitioners;

• rate of a product’s acceptance by the target community;

• availability of alternative therapies;

• price of our product relative to alternative therapies;

• availability of third-party reimbursement; and

• the prevalence or severity of side effects or unfavorable publicity concerning our products or similar products.

If milnacipran or any future product candidates that we may develop do not achieve market acceptance, we may lose our investment in that product candidate, which may cause our stock price to decline.

Our competitors may develop and market products that are less expensive, more effective or safer, which may diminish or eliminate the commercial success of any products we may commercialize.

The biotechnology market is highly competitive. Large pharmaceutical and biotechnology companies have developed or are attempting to develop products that will compete with any products we may develop to target Functional Somatic Syndromes, such as FMS. In particular, Pfizer, Inc. has publicly disclosed that it has conducted a Phase II clinical trial evaluating the efficacy and safety of its compound, pregabalin, as a treatment for FMS, and we believe that they intend to commence a Phase III clinical trial in the near future. In addition, Eli Lilly and Company has publicly disclosed that it has conducted a Phase II clinical trial evaluating the efficacy and safety of its compound, duloxetine, as a treatment for FMS. Duloxetine is a serotonin norepinephrine reuptake inhibitor, and as a dual reuptake inhibitor is therefore similar in pharmacology to milnacipran, which is a norepinephrine serotonin reuptake inhibitor. Based on the similar pharmacology, it is anticipated that duloxetine, which is currently approved but not yet available for the treatment of depression, will receive some off-label use for the treatment of FMS. TCAs, which are inexpensive generic formulations, are currently viewed as the drugs of choice in treating FMS.

It is possible that our competitors will develop and market products for FMS prior to us and furthermore, that are less expensive and more effective than milnacipran or any of our future products or that will render milnacipran or any other of our products obsolete. We also expect that, in the treatment of Functional Somatic Syndromes and other related chronic pain and central nervous system disorders, competition from other biopharmaceutical companies, pharmaceutical companies, universities and public and private research institutions will increase. Many of these competitors have substantially greater financial resources, technical expertise, research capabilities and other resources than we do. We may not have the financial resources, technical expertise or marketing, distribution or support capabilities to compete successfully.

We have the right to co-promote milnacipran, but we do not have the marketing, sales or distribution experience or capabilities.

Our ability to co-promote any product developed under our agreement with Forest Laboratories is subject to our building our own marketing and sales capabilities, and we currently do not have the ability to directly sell, market or distribute any product. In addition, in the event our agreement with Forest Laboratories is terminated or with respect to any other product we may develop that is not covered by our collaboration with Forest Laboratories, we would have to obtain the assistance of a pharmaceutical company or other entity with a large distribution system and a large direct sales force or build a substantial marketing and sales force with appropriate technical expertise and supporting distribution capabilities. We may not be able to enter into such arrangements with third parties in a timely manner or on acceptable terms or establish sales, marketing and distribution capabilities of our own. To the extent that we enter into co-promotion or other licensing arrangements, our product revenues are likely to be lower than if we directly marketed and

sold our products, and any revenues we receive will depend upon the efforts of third parties, which efforts may not be successful.

We are subject to uncertainty relating to health care reform measures and reimbursement policies which, if not favorable to our product candidates, could hinder or prevent our product candidate’s commercialization success.

The continuing efforts of the government, insurance and management care organizations and other health care payors to contain or reduce prescription drug costs may adversely affect:

• our ability to set a price we believe is fair for our products;

• our ability to generate revenues and achieve or maintain profitability;

• the future revenues and profitability of our potential customers, suppliers and collaborators; and

• the availability of capital.

Successful commercialization of milnacipran in the United States will depend in part on the extent to which government, insurance and management care organizations and other health care payors establish appropriate coverage and reimbursement levels for the cost of our products and related treatments. Third-party payors are increasingly challenging the prices charged for prescription drugs. Third-party payors are also encouraging the use of generic drugs. These trends could influence health care purchases, as well as legislative proposals to reform health care or reduce government insurance programs and result in the exclusion of our product candidates from coverage and reimbursement programs or lower the prices of our product candidates. Our revenues from the sale of any approved products could be significantly reduced as a result of these cost containment measures and reforms.

We rely on our employees and consultants for their scientific and technical expertise in connection with our business operations.

We rely significantly on the scientific and technical expertise of our employees and consultants to conduct our business. If any of our relationships with our employees or consultants are terminated, we may lose access to scientific knowledge and expertise necessary for the research, development and commercialization of milnacipran. We do not anticipate significantly increasing our personnel in the foreseeable future and therefore, we expect to continue to rely on consultants and our current employees for scientific and technical knowledge and expertise essential to our business.

Our employment agreement with our chief executive officer provides for “at will” employment, which means that he may terminate his services to us at any time. In addition, our scientific advisors may terminate their services to us at any time.

We have limited experience in identifying, completing and integrating acquisition targets and we may incur unexpected costs and disruptions to our businesses if we make mistakes in our selection of future acquisitions or fail to integrate any future acquisitions.

As part of our strategy, we are continuing to evaluate potential strategic transactions, including potential acquisitions of products and companies, in order to expand our product pipeline. As we did with our in-licensing of milnacipran, we may seek to in-license compounds or acquire products or businesses. We have no agreements or understandings with respect to any acquisitions. Future acquisitions, however, may expose us to operational and financial risks, including:

• higher development costs than we anticipate;

• higher than expected acquisition and integration costs;

• exposure to unknown liabilities of acquired intellectual property, compounds or products;

• disruption of our business and diversion of our management’s time and attention to developing acquired compounds or products;

• incurrence of dilutive issuances of securities or substantial debt to pay for acquisitions; and

• impairment of relationships with key collaborators, suppliers or customers of any acquired businesses due to changes in management or ownership.

We also may devote resources to potential strategic transactions that we never complete or may fail to realize the anticipated benefit of any strategic transaction we do complete. Finally, we may incur unexpected costs in connection with the disposition of products or businesses, including our disposition of our PROSORBA column for which we indemnified Fresenius HemoCare for any losses related to patent or trademark infringement claims.

We may be subject to product liability claims that could cause us to incur liabilities beyond our insurance coverage.

We plan to continue conducting clinical trials on humans using milnacipran, and the use of milnacipran may result in adverse effects. We cannot predict all possible harm or side effects that may result from the treatment of patients with milnacipran or any of our future products, and the amount of insurance coverage we currently hold may not be adequate to protect us from any liabilities. We currently maintain $10,000,000 in insurance for product liability claims. We may not have sufficient resources to pay any liability resulting from such a claim beyond our insurance coverage.

We have a history of operating losses and we may never be profitable.

We have incurred substantial losses during our history. For the nine months ended September 30, 2004 and the years ended December 31, 2003, 2002 and 2001, we incurred net losses of $8.7 million, $21.7 million, $1.0 million and $7.2 million, respectively. As of September 30, 2004, we had an accumulated deficit of approximately $134.9 million. Our ability to become profitable will depend upon our and Forest Laboratories’ ability to develop, market and commercialize milnacipran with sufficient sales volumes, and our ability to develop, market and commercialize any other products. We do not expect to generate revenue from the sale of products for the next several years or become profitable in the foreseeable future and may never achieve profitability.

We will need substantial additional funding and may be unable to raise capital when needed, which could force us to scale back or discontinue the completion of any proposed acquisitions or adversely affect our ability to realize the expected benefits of any completed acquisitions.

Although Forest Laboratories has assumed responsibility for the development of milnacipran, subject to our discussions regarding the financial responsibilities of the second Phase III clinical trial, we will incur certain non-reimbursable expenses in connection with such development. In addition, we will incur expenses in connection with the evaluation of potential acquisitions or other strategic transactions and additional expenses in the event we close any such transactions. We do not have any committed external sources of funding and we may need to raise additional capital through the sale of equity. The amount of capital we will require will depend upon many factors, including but not limited to, the development strategy for milnacipran and the evaluation and potential closing of any strategic transactions. If we are

unable to raise capital when we need it, we may have to scale back or discontinue the evaluation or completion of any proposed acquisitions or strategic transaction(s).

Raising additional funds by issuing securities or through collaboration and licensing arrangements may cause dilution to existing stockholders, restrict our operations or require us to relinquish propriety rights.

We may raise additional funds through public or private equity offerings or corporate collaborations and licensing arrangements. As was the case when we issued 6,900,000 shares of common stock in our secondary offering completed in April 2004, to the extent that we raise additional capital by issuing equity securities, our existing stockholders’ ownership percentage will be diluted. In addition, if we raise additional funds through collaborations and licensing arrangements, it may be necessary to relinquish potential valuable rights to our potential products on terms that are not favorable to us.

We may lose our net operating loss carryforwards, which could prevent us from offsetting future taxable income.

Sales of our common stock in September 1991, October 1997, March 2002, April 2003 and April 2004 may have caused the limitation of Section 382 of the Internal Revenue Code of 1986, as amended, to be applicable. This limitation will allow us to use only a portion of the net operating loss carryforwards to offset future taxable income, if any, for federal income tax purposes. Based upon the limitations of Section 382, we may be allowed to use no more than a prescribed amount of such losses each year to reduce taxable income, if any. To the extent not used by us, unused losses will carry forward subject to the limitations to offset future taxable income, if any, until such unused losses expire. All unused federal net operating losses will expire 15 or 20 years after any year in which they were generated. The carryforward period is 15 years for losses incurred prior to 1998 and 20 years for losses incurred subsequent to 1997. Approximately $3.9 million in federal net operating losses expired in 2003. Our California tax loss carryforwards will begin to expire in 2006. As a result of the sale of common stock, ownership changes occurred in 1991, 1997, 2002, 2003 and 2004, which may result in a limitation to the use of our net operating loss carryforwards.

Our stock price will likely be volatile.

The market prices of the stock of technology companies, particularly biotechnology companies, have been highly volatile. For the period from January 1, 2001 through December 31, 2003, the high and low closing sales prices for our common stock ranged from $0.77 to $15.19. For the nine months ended September 30, 2004, our high and low closing sales prices were $16.05 and $8.94. Our stock price has been and will likely continue to be affected by this type of market volatility, as well as by our own performance. The following factors, among other risk factors, may have a significant effect on the market price of our common stock:

• the results and timing of clinical trials for milnacipran;

• developments in our relationship with Forest Laboratories;

• developments in our relationship with Pierre Fabre;

• our entering into, or failing to enter into, an agreement for the acquisition of any products or companies, or an agreement with any corporate collaborator;

• our available cash;

• announcements of technological innovations or new products by us or our competitors;

• developments in patent or other proprietary rights;

• fluctuations in our operating results;

• litigation initiated by or against us;

• developments in domestic and international governmental policy or regulation; and

• economic and other external factors or other disaster or crisis.

The concentration of ownership among our existing officers, directors and principal stockholders may result in the entrenchment of management, prevent other stockholders from influencing significant corporate decisions and depress our stock price.

As of November 1, 2004, our executive officers, directors and stockholders who hold at least 5% of our stock beneficially owned and controlled approximately 40% of our outstanding common stock. If these officers, directors and principal stockholders act together, they will be able to effect an entrenchment of management and to influence significantly and possibly control matters requiring approval by our stockholders, including a financing in which we sell more than 20% of our voting stock at a discount to the market price, the removal of any directors up for election, the election of the members of our board of directors, mergers, a sale of all or substantially all of our assets, going private transactions and other fundamental transactions. This concentration of ownership could also depress our stock price.

We may incur increased costs as a result of recently enacted and proposed changes in laws and regulations relating to corporate governance matters.

Recently enacted and proposed changes in the laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002 and rules adopted or proposed by the Securities and Exchange Commission and by the Nasdaq National Market, will result in increased costs to us as we evaluate the implications of these laws and regulations and respond to their requirements. These laws and regulations could make it more difficult or costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. The impact of these events could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, our board committees or as executive officers. We are presently evaluating and monitoring developments with respect to these laws and regulations and cannot predict or estimate the amount or timing of additional costs we may incur to respond to their requirements.

Risks Related to Our Intellectual Property

We rely primarily on a method patent to protect our proprietary technology for the development of milnacipran, and our ability to compete may decrease or be eliminated if we are not able to protect our proprietary technology.

Our ability to compete may decrease or be eliminated if we are not able to protect our proprietary technology. The composition of matter patent for milnacipran (U.S. Patent 4,478,836) expired in June 2002. Accordingly, we rely on the patent for the method of synthesis of milnacipran (U.S. Patent 5,034,541), which expires on December 27, 2009 and was assigned to Pierre Fabre and licensed to us and on patents on the method of use of milnacipran to treat symptoms of FMS (U.S. Patent 6,602,911) and the method of use of milnacipran to treat symptoms of chronic fatigue syndrome (U.S. Patent 6,635,675) issued to us, to protect our proprietary technology with respect to the development of milnacipran. We have also filed additional patent applications related to milnacipran and to the use of milnacipran for FMS (and other related pain syndromes and disorders), although no patents have issued on these patent applications.

Because there is limited patent protection for the composition of matter of milnacipran, other companies may be able to sell milnacipran in competition with us and Forest Laboratories unless we and Forest Laboratories are able to obtain additional protection through milnacipran-related patents or additional use patents that may issue from our pending patent applications or other regulatory exclusivity. It may be more difficult to establish infringement of methods of synthesis, formulation or use patents as compared to a patent on a compound. If we or Forest Laboratories are not able to obtain and enforce these patents, a competitor could use milnacipran for a treatment or use not covered by any of our patents.

We also expect to rely on the United States Drug Price Competition and Patent Term Restoration Act, commonly known as the Hatch-Waxman Amendments, for protection of milnacipran or our other future products. The Hatch-Waxman Amendments provide data exclusivity for new molecular entities, such as that in milnacipran. Once a drug containing a new molecule is approved by the FDA, the FDA cannot accept an abbreviated NDA for a generic drug containing that molecule for five years, although the FDA may accept and approve a drug containing the molecule pursuant to an NDA supported by independent clinical data. Recent amendments have been proposed that would narrow the scope of Hatch-Waxman exclusivity and permit generic drugs to compete with our drug. After the Hatch-Waxman exclusivity period expires, assuming our patents are valid, we still expect to rely on our method of use patents to protect our proprietary technology with respect to the development of milnacipran. The patent positions of pharmaceutical companies are uncertain and may involve complex legal and factual questions. We may incur significant expense in protecting our intellectual property and defending or assessing claims with respect to intellectual property owned by others. Any patent or other infringement litigation by or against us could result in significant expense to us, including diversion of the resources of management.

Others may file patent applications or obtain patents on similar technology or compounds that compete with milnacipran for the treatment of FMS. We cannot predict the breadth of claims that will be allowed and issued in patent applications. Once patents have issued, we cannot predict how the claims will be construed or enforced. We may infringe on intellectual property rights of others without being aware of the infringement. If another party claims we are infringing their technology, we could have to defend an expensive and time consuming lawsuit, pay a large sum if we are found to be infringing, or be prohibited from selling or licensing our products unless we obtain a license or redesign our product, which may not be possible.

We also rely on trade secrets and proprietary know-how to develop and maintain our competitive position. Some of our current or former employees, consultants or scientific advisors, or current or prospective corporate collaborators, may unintentionally or willfully disclose our confidential information to competitors or use our proprietary technology for their own benefit. Furthermore, enforcing a claim alleging the infringement of our trade secrets would be expensive and difficult to prove, making the outcome uncertain. Our competitors may also independently develop similar knowledge, methods and know-how or gain access to our proprietary information through some other means.

Our ability to compete may decline if we do not adequately protect our proprietary rights.

Our commercial success depends on obtaining and maintaining proprietary rights to our product candidates and technologies and their uses as well as successfully defending these rights against third party challenges. We will only be able to protect our product candidates, proprietary technologies and their uses from unauthorized use by third parties to the extent that valid and enforceable patents or effectively-protected trade secrets cover them.

Our ability to obtain patent protection for our products and technologies is uncertain due to a number of factors, including:

• we may not have been the first to make the inventions covered by our pending patent applications or issued patents;

A dispute concerning the infringement or misappropriation of our proprietary rights or the proprietary rights of others could be time consuming and costly and an unfavorable outcome could harm our business.

There is significant litigation in the industry regarding patent and other intellectual property rights. We may be exposed to future litigation by third parties based on claims that our product candidates, technologies or activities infringe the intellectual property rights of others. If our drug development activities are found to infringe any such patents, we may have to pay significant damages. There are many patents relating to chemical compounds and the uses thereof. If our compounds are found to infringe any such patents, we may have to pay significant damages. A patentee could prevent us from making, using or selling the patented compounds. We may need to resort to litigation to enforce a patent issued to us, protect our trade secrets or determine the scope and validity of third party proprietary rights. From time to time, we may hire scientific personnel formerly employed by other companies involved in one or more areas similar to the activities conducted by us. Either we or these individuals may be subject to allegations of trade secret misappropriation or other similar claims as a result of their prior affiliations. If we become involved in litigation, it could consume a substantial portion of our managerial and financial resources, whether we win or lose. We may not be able to afford the costs of litigation. Any legal action against our company or our collaborators could lead to:

• payment of damages, potentially treble damages, if we are found to have willfully infringed such parties’ patent rights;

• injunctive or other equitable relief that may effectively block our ability to further develop, commercialize and sell products; or

• we or our collaborators having to enter into license arrangements that may not be available on commercially acceptable terms, if at all.

As a result, we could be prevented from commercializing current or future products.

The patent applications of pharmaceutical and biotechnology companies involve highly complex legal and factual questions, which could negatively impact our patent position.

The patent positions of pharmaceutical and biotechnology companies can be highly uncertain and involve complex legal and factual questions. The United States Patent and Trademark Office’s standards are uncertain and could change in the future. Consequently, the issuance and scope of patents cannot be predicted with certainty. Patents, if issued, may be challenged, invalidated or circumvented. United States patents and patent applications may also be subject to interference proceedings and United States patents may be subject to reexamination proceedings in the United States Patent and Trademark Office (and foreign patents may be subject to opposition or comparable proceedings in the corresponding foreign patent office), which proceedings could result in either loss of the patent or denial of the patent application or loss or reduction in the scope of one or more of the claims of the patent or patent application. In addition, such interference, reexamination and opposition proceedings may be costly. Accordingly, rights under any issued patents may not provide us with sufficient protection against competitive products or processes.

In addition, changes in or different interpretations of patent laws in the United States and foreign countries may permit others to use our discoveries or to develop and commercialize our technology and products without providing any compensation to us. The laws of some countries do not protect intellectual property rights to the same extent as United States laws and those countries may lack adequate rules and procedures for defending our intellectual property rights. For example, some countries, including many in Europe, do not grant patent claims directed to methods of treating humans, and in these countries patent protection may not be available at all to protect our product candidates.

PART II

Item 1 - Legal Proceedings

From time to time we are involved in certain litigation arising out of our operations. We are not currently engaged in any legal proceedings that we expect would materially harm our business or financial condition.

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

Not applicable

Item 3 - Defaults Upon Senior Securities

Not applicable

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

The Annual Meeting of Stockholders, or the Annual Meeting, of the Company was held on August 17, 2004. The Company had 29,567,872 shares of common stock outstanding and entitled to vote as of June 23, 2004, the date of record of the meeting. At the meeting, holders of a total of 24,432,960 shares of common stock were present in person or represented by proxy. The following sets forth a brief description of each matter voted upon at the Annual Meeting and the results of the voting on each such matter:

(1) For the elections of the nominee directors that will hold office until the annual meeting of stockholders in 2007:

	For	Withheld Authority or Against
Samuel D. Anderson	24,065,392	367,568
Jack H. Vaughn	23,895,247	537,713

The Company’s Board of Directors is comprised of the individuals elected this year and the following directors for completing the following terms: Jon McGarity, Jean-Pierre Millon and Gary Tollefson whose terms expire in 2005 and Jay Kranzler, Perry Molinoff and Daniel Petree whose terms expire in 2006.

(2) To ratify the selection of Ernst & Young LLP by the Audit Committee of our Board of Directors to continue as the Company’s independent registered public accounting firm for the fiscal year ending December 31, 2004.

For		Against		Abstained
24,322,383		92,214		18,363

Item 5 - Other Information

Not applicable

DELAWARE		22-2389839
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

4350 Executive Drive, Suite 325, San Diego, California 92121
(Address of principal executive offices) (zip code)

(858) 452-2323
(Registrant’s telephone number including area code)

PART I - FINANCIAL INFORMATION

	Item 1 –	Condensed Financial Statements (Unaudited)

		Balance Sheets as of September 30, 2004 (unaudited) and December 31, 2003

		Statements of Operations for the three and nine months ended September 30, 2004 and 2003 (unaudited)

		Statements of Cash Flows for the nine months ended September 30, 2004 and 2003 (unaudited)

		Notes to Financial Statements (unaudited)

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

	Item 3 –	Quantitative and Qualitative Disclosures About Market Risk

	Item 4 –	Controls and Procedures

		Risk Factors

PART II - OTHER INFORMATION

	Item 1 –	Legal Proceedings

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

	Item 3 –	Defaults Upon Senior Securities

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

	Item 5 –	Other Information

	Item 6 –	Exhibits

	Signatures

	3.1	Second Amended and Restated Certificate of Incorporation. (1)

	3.3	Second Amended and Restated By-Laws. (2)

	4.1	Form of Stock Certificate. (3)

	31.1	Certification of Chief Executive Officer pursuant to Rule 13a – 14(a) or Rule 15d – 14(a) of the Securities Exchange Act of 1934, as amended.

	31.2	Certification of Chief Financial Officer pursuant to to Rule 13a – 14(a) or Rule 15d – 14(a) of the Securities Exchange Act of 1934, as amended.

	32.1	Certification of Chief Executive Officer and Chief Financial Officer pursuant to Rule 13a – 14(b) or Rule 15d – 14(b) of the Securities Exchange Act of 1934, as amended, and Section 1350 of Chapter 63 of Title 18 of the United States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

		Cypress Bioscience, Inc.


Date: November 9, 2004	By:	/s/ JAY D. KRANZLER
		Chief Executive Officer and Chairman of the Board (Principal Executive Officer)

Date: November 9, 2004	By:	/s/ SABRINA MARTUCCI JOHNSON
		Chief Financial Officer and Vice President (Principal Financial Officer)