Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended March 31, 2004

OR

For the transition period from              to             

Commission file number 0-23280

NEUROBIOLOGICAL TECHNOLOGIES, INC.

(Exact name of Registrant as specified in its charter)

3260 Blume Drive, Suite 500

Richmond, California 94806

(Address of principal executive offices)

(510) 262-1730

(Registrant’s telephone number, including area code)

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of the common stock, as of the latest practical date:

Common Stock, $.001 Par Value: 23,878,550 shares outstanding as of April 30, 2004.

Table of Contents

NEUROBIOLOGICAL TECHNOLOGIES, INC.

FORM 10-Q

TABLE OF CONTENTS

2

Table of Contents

PART 1. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

NEUROBIOLOGICAL TECHNOLOGIES, INC.

(A development stage company)

CONDENSED BALANCE SHEETS

See accompanying notes.

3

Table of Contents

NEUROBIOLOGICAL TECHNOLOGIES, INC.

(A development stage company)

CONDENSED STATEMENTS OF OPERATIONS

(Unaudited)

See accompanying notes.

4

Table of Contents

NEUROBIOLOGICAL TECHNOLOGIES, INC.

(A development stage company)

CONDENSED STATEMENTS OF CASH FLOWS

(Unaudited)

See accompanying notes.

5

Table of Contents

NEUROBIOLOGICAL TECHNOLOGIES, INC.

(A development stage company)

NOTES TO CONDENSED FINANCIAL STATEMENTS

(Unaudited)

March 31, 2004

NOTE 1-BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

BASIS OF PRESENTATION

The accompanying unaudited condensed financial statements have been prepared in accordance with generally accepted accounting principles for interim financial reporting and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnote disclosures required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three- and nine-month periods ended March 31, 2004 are not necessarily indicative of the results that may be expected for the fiscal year ended June 30, 2004.

The balance sheet at June 30, 2003 has been derived from the audited financials at that date but does not include all the information and notes required by generally accepted accounting principles for complete financial statements. For further information, refer to the financial statements and notes included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2003.

BASIC AND DILUTED NET INCOME (LOSS) PER SHARE

Net income (loss) per share is presented under the requirements of Financial Accounting Standards Board (“FAS”) No. 128, “Earnings per Share.” Basic net income (loss) per share is computed based on the weighted average shares of common stock outstanding and excludes any options, warrants, and convertible securities. For the three months ended March 31, 2004, diluted earnings per share is computed in the same manner and also gives effect to all dilutive common equivalent shares consisting of employee stock options, warrants, and the assumed conversion of convertible preferred stock. Potentially dilutive securities, such as options, warrants, and convertible preferred stock, have been excluded from the computation of diluted net loss per share for the three- months ended March 31, 2003 as their effect is antidilutive. The following table sets forth the computation of basic and diluted earnings per share.

REVENUE RECOGNITION

Revenue related to license fees with non-cancelable, non-refundable terms and no future performance obligations are recognized when collection is assured. Such revenues are deferred and recognized over the

6

Table of Contents

performance period if future performance obligations exist. Non-refundable up-front payments received in connection with research and development activities are deferred and recognized on a straight-line basis over the relevant periods specified in the agreement, generally the research term. Revenue associated with milestones are recognized as earned, based on completion of development milestones, either upon receipt, or when collection is assured.

STOCK-BASED COMPENSATION

The Company grants stock options for a fixed number of shares to employees with an exercise price equal to the fair value of the shares at the date of the grant. The Company accounts for stock option grants in accordance with APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related Interpretations because the alternative fair value accounting provided under FASB Statement No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”) requires the use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, when the exercise price of our employee stock options equals the market price of the underlying stock on the date of the grant, no compensation expense is recognized.

Stock-based compensation arrangements to non-employees are accounted for in accordance with FAS 123, EITF 96-18, and related Interpretations, using a fair value approach, and the compensation costs of such arrangements are subject to re-measurement over their vesting terms, as earned.

As permitted by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (SFAS 123), as amended by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” (SFAS 148), the Company elected to continue to apply the provisions of Accounting Principle Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (APB 25) and related interpretations in accounting for its employee stock option and stock purchase plans. The Company is generally not required under APB 25 and related interpretations to recognize compensation expense in connection with its employee stock option and stock purchase plans when exercise prices are not less than fair value.

Pro forma information regarding net loss and net loss per common share is required by SFAS 148 and has been determined as if the Company had accounted for its employee stock options under the fair value method prescribed by the SFAS 123.

For purposes of pro forma disclosures, the estimated fair value of the options is amortized over the vesting period of the options using the straight-line method. The Company’s pro forma information follows (in thousands).

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because the

7

Table of Contents

Company’s employee stock options and employee stock purchase plans have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair market value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options, nor do they necessarily represent the effects of employee stock options on reported net income (loss) for future years.

NOTE 2-INVESTMENTS

The following is a summary of available-for-sale investments (in thousands).

At March 31, 2004 approximately $13,484,000 of investments are included in cash equivalents.

NOTE 3-EQUITY TRANSACTIONS

Warrants were exercised through a cashless exercise in accordance with the terms of the warrants, and 382,950 shares of common stock were issued to the warrant holders during the nine months ended March 31, 2004.

Warrants were exercised in accordance with the terms of the warrants, and 272,600 shares of common stock were issued to the warrant holders for an aggregate purchase price of $349,850 during the nine months ended March 31, 2004.

A warrant to purchase 10,000 shares of common stock at $5.14 per share was issued in the quarter ended December 31, 2003 for consulting services and will expire December 22, 2006. The warrant valuation of $28,200 is reflected in general and administrative expense for the nine months ended March 31, 2004.

In March 2004, we raised $19.4 million in gross offering proceeds from the sale of 3,880,000 shares of common stock at a price of $5.00 per share. Investors also received warrants to purchase an additional 582,000 shares of common stock at a price of $6.73 per share. Our net offering proceeds after fees and commissions were approximately $18.4 million. We also issued warrants to our placement agent to purchase 155,200 shares of common stock at a purchase price of $6.00 per share and 23,280 shares at $8.08 per share.

The common stock and warrants issued in the private placement were initially unregistered. We filed a registration statement on Form S-3 with the Securities and Exchange Commission on April 14, 2004 to register the shares issued in the private placement as well as the shares to be issued upon exercise of the warrants. In accordance with EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and

8

Table of Contents

Potentially Settled in, a Company’s Own Stock,” the warrants have been included as a liability and valued at fair value on the date of issuance. The warrants are revalued each period until the effective date of the registration statement. The change in fair value from the date of issuance to March 31, 2004 of $430,680 has been recorded as non-cash other income. The warrants will be transferred to permanent equity when they are registered.

Shares of convertible Series A preferred stock were converted to common stock on a one-for-one basis for 520,000 shares of common stock in the nine months ended March 31, 2004.

Employees purchased 5,992 shares of common stock in the nine months ended March 31, 2004 in accordance with the Employee Stock Purchase Plan for an aggregate purchase price of $14,970.

NOTE 4-COMPREHENSIVE INCOME (LOSS)

Comprehensive income (loss) is comprised of net loss and unrealized holding gains and losses on available-for-sale investments.

NOTE 5-SUBSEQUENT EVENTS

In April 2004, we received approximately $175,000 from Merz under our 1998 strategic research and marketing cooperation agreement. This payment represents a portion of the royalties received by Merz on sales of Memantine by its marketing partners during the quarter ended March 31, 2004.

9

Table of Contents

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

Except for the historical information contained herein, the matters discussed in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and elsewhere in this Form 10-Q are forward-looking statements that involve risks and uncertainties. The factors listed in the section captioned “Risk Factors,” as well as any cautionary language in this Form 10-Q, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from those projected. These forward-looking statements represent our judgment as of the date of the filing. Except as may be required by law, we undertake no obligation to update any forward-looking statements to reflect events after the date of this report.

OVERVIEW

Neurobiological Technologies, Inc. (“NTI^®”, “we”, “us”, “our” or the “Company”) is an emerging drug development company focused on the clinical evaluation and regulatory approval of neuroscience drugs. We develop neuroprotective and neuromodulatory agents to treat progressive neurological impairments characteristic of various nervous system disorders, including diabetic neuropathy and brain cancer. Our strategy is to in-license and develop early- and later-stage drug candidates that target major medical needs and which can be rapidly commercialized.

In April 1998, we entered into a strategic research and marketing cooperation agreement with Merz Pharmaceuticals GmbH, or Merz, and Children’s Medical Center Corporation to further the clinical development and commercialization of Memantine. Pursuant to this agreement, NTI and Merz share scientific, clinical and regulatory information about Memantine to facilitate regulatory review and marketing approval by the Food and Drug Administration, or FDA, and foreign regulatory authorities. Pursuant to this agreement, we will share in future revenues from sales of Memantine for all indications in certain geographic markets.

In June 2000, Merz entered into an agreement with Forest Laboratories, Inc., or Forest, for the development and marketing of Memantine in the United States for the treatment of Alzheimer’s disease, neuropathic pain and AIDS-related dementia. In August 2000, Merz entered into a strategic license and cooperation agreement with H. Lundbeck A/S of Copenhagen, Denmark, or Lundbeck, for the further development and marketing of Memantine for the treatment of Alzheimer’s disease, neuropathic pain and AIDS-related dementia. Lundbeck acquired exclusive rights to Memantine in certain European markets, Canada, Australia and South Africa, as well as semi-exclusive rights to co-market Memantine with Merz in other markets worldwide, excluding the United States, where Forest has development rights, and Japan, where Merz has granted development rights to Daiichi Suntory Pharma Co., Ltd.

In May 2002, Merz announced that Memantine (Ebixa^®) was approved by the regulatory authorities in the European Union for the treatment of Alzheimer’s disease. We received a payment of $51,700 in January 2004 from Merz, which represented a portion of the royalties received by Merz on sales of Memantine by Lundbeck during the quarter ended December 31, 2003.

In October 2003, Forest announced that it received FDA approval of Memantine (Namenda) for the treatment of moderate-to-severe Alzheimer’s disease. Namenda became available for patients in the United States starting in January 2004. Under our strategic research and marketing cooperation agreement with Merz, the approval of Namenda triggered a payment of $2.25 million from Merz, which we received in January 2004, and is expected to result in royalty payments from sales of Namenda in the United States beginning in the fourth quarter of fiscal 2004.

In May 2003, Forest announced that Memantine had failed to demonstrate a statistically significant difference versus placebo with regards to the primary endpoint of its Phase II clinical trial for neuropathic pain. In October 2003, based on the completed analysis of its Phase III trial, Forest announced that it had decided to proceed with an expanded clinical program, with the objective of obtaining approval of Memantine for neuropathic pain. The expanded clinical program will include new Phase II trials that will examine various neuropathic pain conditions at different dosages. Based on the outcome of these trials, Forest may initiate additional Phase III trials, with the goal of generating sufficient clinical data for submission of a New Drug Application, or NDA, for the treatment of neuropathic pain. We conducted the first Phase II trial of Memantine for neuropathic pain with an enrollment of over 400 patients and reported positive results in January 2000.

10

Table of Contents

We are also developing XERECEPT^™, a synthetic preparation of the natural human peptide, Corticorelin Human Acetate, as a treatment for brain swelling due to brain tumors (peritumoral brain edema). In April 1998, XERECEPT received orphan drug designation for this indication from the FDA. Orphan drug designation provides us with seven years market exclusivity and makes us eligible to receive Orphan Drug Grants to fund clinical research. XERECEPT has undergone a special protocol assessment with the FDA. We enrolled our first patient in April 2004 for the first trial, which is expected to last 18 months. The second trial is expected to start in the Summer 2004 and is expected to last 12 months.

In March 2004, we raised $19.4 million in gross offering proceeds from the sale of 3,880,000 shares of common stock at a price of $5.00 per share. Investors also received warrants to purchase an additional 582,000 shares of common stock at a price of $6.73 per share. Our net offering proceeds after fees and commissions were approximately $18.4 million. We also issued warrants to our placement agent to purchase 155,200 shares of common stock at a purchase price of $6.00 per share and 23,280 shares at $8.08 per share.

Since our founding in 1987, we have applied a majority of our resources to our research and development programs and have generated only limited operating revenue. Except for fiscal 2001, we have incurred losses in each year since our inception and, although we were profitable during the quarter ended March 31, 2004, we expect to incur losses for fiscal 2004 and 2005 due to ongoing research and development efforts. As of March 31, 2004, our deficit accumulated during the development stage was $41.3 million.

RESULTS OF OPERATIONS

We had license fee revenue of $2,250,000 and $2,531,000 for the three and nine months ended March 31, 2004 and royalty revenue of $52,000 and $80,000 for the three and nine months ended March 31, 2004. We had license fee revenue of $281,000 and $1,687,000 for the three and nine months ended March 31, 2003. All of the license fee and royalty revenue came from Merz under our 1998 strategic research and marketing cooperation agreement.

Our research and development expenses increased to approximately $725,000 for the three months ended March 31, 2004 from approximately $435,000 for the three months ended March 31, 2003 and decreased to approximately $1,566,000 for the nine months ended March 31, 2004, from approximately $2,020,000 for the nine months ended March 31, 2003. The three-month increase is primarily due to cost of manufacturing a new batch of XERECEPT^™. The nine-month decrease reflects the conclusion to some of the costs for the completion of long-term toxicology studies, which was partially offset by increased costs attributable to manufacturing initial clinical supplies of XERECEPT. General and administrative expenses increased to approximately $890,000 and $2,321,000 in the three and nine months ended March 31, 2004, from $624,000 and $1,800,000 in the same periods of the prior year. The increases were primarily due to increased insurance costs, employee benefit costs and costs related to exploring strategic partnership activities. Interest income decreased to approximately $21,000 and $52,000 in the three and nine months ended March 31, 2004, from approximately $30,000 and $116,000 in the same period of the prior year due to lower average interest rates and lower average invested cash balances.

Our two product candidates, Memantine and XERECEPT, have completed or are in Phase II or Phase III human clinical testing. To date, we have incurred costs of approximately $8.9 million in the development of Memantine and $17.7 million in the development of XERECEPT. All future costs for the development and commercialization of Memantine will be borne by Merz and its marketing partners, Forest and Lundbeck. We expect to incur ongoing costs for Phase III clinical trials for XERECEPT and related administrative support. We estimate the costs of completing our two planned Phase III human clinical trials for XERECEPT to be approximately $4 million.

Research and development expenditures are charged to operations, as incurred. Research and development expenses, including direct and allocated expenses, consist of independent research and development costs and costs associated with sponsored research and development.

11

Table of Contents

LIQUIDITY AND CAPITAL RESOURCES

From inception through March 31, 2004, we have raised a total of approximately $63 million in net proceeds from the sale of common and preferred stock, including the $19.4 million we raised through the sale of common stock and warrants in March 2004.

We had available cash and cash equivalents and investments of approximately $22.2 million as of March 31, 2004, compared to approximately $4.4 million at June 30, 2003. We believe that our capital resources will be adequate to fund our planned operations through at least the next twelve months. In the course of our development activities, we have incurred significant losses, and, although we were profitable in the fiscal year ended June 30, 2001 and the quarters ended September 30, 2002 and March 31, 2004 due to revenue from license payments, we expect fluctuations in our quarterly operating results to incur, which will result in some additional operating losses over the next twelve months as we continue to expand our research and development efforts. We expect to continue to incur substantial costs in fiscal 2004 primarily for Phase III clinical trials of XERECEPT and related administrative support. Merz and Merz’s marketing partners will pay all future development costs of Memantine.

We may seek to raise additional funds when market conditions permit. However, there can be no assurance that funding will be available or that, if available, will be on acceptable terms. Our future capital requirements will depend on a number of factors, including:

Our only long-term capital obligation relates to our leased facility in Richmond, California. The minimum payment is approximately $91,000 for the one-year term of the lease, which expires July 2004. We expect to renew this lease on substantially similar terms or obtain another lease on comparable terms.

RISK FACTORS

We are dependent on Merz and its marketing partners Forest and Lundbeck for the successful commercialization of Memantine.

All of our revenues to date have been license fees and royalty payments from Merz related to our portion of payments received by Merz pursuant to its agreements with Forest and Lundbeck, its marketing partners. The only revenues that we expect to receive in the foreseeable future are our share of payments received by Merz from Forest and Lundbeck and royalties on sales of Memantine made by Merz or its marketing partners. This depends, among other things, on the continuation of our research and marketing cooperation agreement with Merz and Children’s Medical Center. Although Merz has received approval to market Memantine for Alzheimer’s disease in Europe, we are not entitled to receive royalty payments for Memantine sales for Alzheimer’s disease in many European countries and any commercialization efforts in these countries, or the importation of Memantine into the United States from these countries, would not directly benefit us. Although Forest has received marketing approval for Namenda for Alzheimer’s disease in the United States, revenue projections for Namenda may not be attained. If Merz or Forest is unable to successfully commercialize Memantine, or if Memantine is not commercialized for indications or in markets where we are entitled to royalty payments, our revenues would be adversely affected.

Under our research and marketing cooperation agreement with Merz, we are entitled to receive a substantially higher royalty rate on sales of Memantine for neuropathic pain and indications other than Alzheimer’s disease. However, the agreement is not clear as to whether we will receive this higher royalty rate if such sales are a result of the “off label” usage of Memantine marketed for Alzheimer’s disease. If there is significant “off label” usage of Memantine and, contrary to our position, it is determined that we are not entitled to the higher royalty rate on these sales, our revenues would be adversely affected.

12

Table of Contents

Under certain circumstances, Merz or Children’s Medical Center can terminate our research and marketing cooperation agreement upon six months’ notice. The termination of this agreement or any failure by Merz or its partners to successfully commercialize Memantine could reduce or terminate our future royalties under the research and marketing cooperation agreement and would have a material adverse effect on our business, financial condition and results of operations.

Our product candidates are based on new technologies and therefore are subject to numerous inherent risks of failure.

Our product candidates are based on new and relatively unproven technologies. As a result, these candidates face numerous risks of failure, including the possibility that these candidates may:

Further, our development activities may not result in any commercially viable products. Although Merz has received approval to market Memantine for the treatment of Alzheimer’s disease in Europe, and Forest has recently received approval to market Namenda for the treatment of Alzheimer’s disease in the United States, Merz and its marketing partners may not receive approval to market Memantine for neuropathic pain or other indications. The failure of Merz or its marketing partners to receive approval to market Memantine for neuropathic pain or indications other than Alzheimer’s disease could adversely affect our rights under our research and marketing cooperation agreement with Merz and Children’s Medical Center.

Other than Memantine, we have one potential product that is in clinical development and we may not develop another candidate product that will receive required regulatory approval or be successfully commercialized.

We are still a development-stage company and, except for Memantine, we currently have only one other product, XERECEPT, in clinical development. The results of our preclinical studies and early-stage clinical trials are not necessarily indicative of those that will be obtained upon further clinical testing in later-stage clinical trials. For example, although our Phase II clinical trials for Memantine for the treatment of neuropathic pain yielded positive results, subsequent clinical trials conducted by Forest did not replicate these results. Similar variations in later-stage clinical trial results may also be seen in XERECEPT as longer trials and larger patient populations are used. Further, although we began the first Phase III clinical trail of XERECEPT, enrolling the first patient in April 2004, and expect both Phase III trials to be completed by mid calendar year 2005, patient enrollment in these trials may be slow, as it was in our Phase II clinical trials of XERECEPT. Any delays in patient enrollment could delay the development of XERECEPT. It is also possible that XERECEPT will not be further developed or successfully commercialized.

Our quarterly operating results may fluctuate significantly in future periods, and, as a result, our stock price may fluctuate or decline.

To date, our revenues have primarily come from licensing fee payments from Merz. Licensing fee payments and, therefore, our results of operations, may vary significantly from quarter to quarter. Accordingly, we believe that quarter-to-quarter comparisons of our historical results of operations are not indicative of our future performance.

We have relied and will continue to rely on others for research, development, and commercialization of our potential products.

We have entered into various contractual arrangements (which are generally non-exclusive) with consultants, academic collaborators, licensors, licensees and others, and we are dependent upon the level of commitment and subsequent success of these outside parties in performing their responsibilities. Certain of these agreements place significant responsibility for preclinical testing and human clinical trials and for preparing and submitting submissions for regulatory approval for potential products on the collaborator, licensor or contractor. If the collaborator, licensor or contractor fails to perform, our business, financial conditions and results may be adversely affected.

13

Table of Contents

We have also relied on scientific, mechanical, clinical, commercial and other data supplied and disclosed by others in entering into these agreements. We have relied on this data in support of applications for human clinical trials for our potential products. Although we have no reason to believe that this information contains errors or omissions of fact, it is possible that there are errors or omissions of fact that would change materially our view of the future likelihood of FDA approval or commercial viability of these potential products.

We have agreements and licenses with third parties that require us to meet certain due diligence obligations, provide regular reports and make royalty and other payments to such parties. Our failure to satisfy these obligations could cause us to lose rights to technology or data under these agreements.

Because we do not have our own manufacturing facilities, we face risks from outsourcing.

Merz and Merz’s marketing partners have the responsibility of supplying Memantine for their clinical trials. Our initial clinical supply of XERECEPT has been manufactured by established methods using chemical synthesis to our specifications. We will need additional supplies of XERECEPT to complete our clinical trials. We perform audits on our contractors who supply XERECEPT to assess compliance with the current Good Manufacturing Practice, or cGMP, regulations. Alternative cGMP suppliers of the bulk drugs and of finished dosage form products are available to us. We currently have no plans to build or develop an in-house manufacturing capability.

We face certain risks by outsourcing manufacturing, including:

Because of these risks, our dependence on third parties for the manufacture of products may adversely affect our results of operations and our ability to develop and deliver products on a timely and competitive basis.

The FDA and state and local agencies, and comparable agencies and entities in foreign countries impose substantial requirements on the manufacturing and marketing of human therapeutics through lengthy and detailed laboratory and clinical testing procedures, sampling activities and other costly and time consuming procedures.

Fulfillment of regulatory requirements for marketing human therapeutics typically takes many years and varies substantially based on the type, complexity, and novelty of the drug for which approval is sought. Government regulation may:

Either of these effects of government regulation may provide an advantage to our competitors.

There can be no assurance that FDA or other regulatory approval for any products developed by us will be granted on a timely basis or at all. Any delay in obtaining, or failure to obtain, required approvals would adversely affect the marketing of our proposed products and our ability to earn product revenues or royalties.

In addition, success in preclinical or early-stage clinical trials does not assure success in later-stage clinical trials. For example, although our Phase II clinical trials for Memantine for the treatment of diabetic neuropathy produced positive results, subsequent clinical trials conducted by Forest did not replicate these

14

Table of Contents

results. As with any regulated product, additional government regulations may be instituted which could delay regulatory approval of our potential products. Additional government regulations that might result from future legislation or administrative action cannot be predicted.

Our success will depend, in large part, on our ability to obtain or license patents, protect trade secrets and operate without infringing upon the proprietary rights of others.

The patent position of biotechnology firms generally is highly uncertain because:

In addition, because of the time delay in patent approval and the secrecy afforded United States patent applications, we do not know if other applications, which might have priority over our applications, have been filed. Further, because we have non-exclusive licenses to patent rights covering certain uses of XERECEPT, others may develop, manufacture and market products that could compete with those we develop.

As a result of all of these factors, there can be no assurance that patent applications relating to our potential products or processes will result in patents being issued, or that patents, if issued, will provide protection against competitors who successfully challenge our patents, obtain patents that may have an adverse effect on our ability to conduct business, or be able to circumvent our patent position.

In addition to patent protection, we rely upon trade secret protection for our confidential and proprietary information. It is our policy that each employee enter into a confidentiality agreement which contains provisions generally prohibiting the disclosure of confidential information to anyone outside our company and requiring disclosure to us of ideas, developments, discoveries or inventions conceived during employment and assignment to us of proprietary rights to such matters related to our business and technology. However, it is possible that these agreements could be breached. In addition, others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets or disclose such technology.

Clinical trials or marketing of any of our potential products may expose us to liability claims from the use of such products which our insurance may not cover.

We currently have a limited amount of product liability insurance that only covers liabilities arising from clinical trials. It is possible that our current insurance may not be adequate to cover liabilities arising from our clinical trials.

Our current product liability insurance does not cover commercial sales of products. We cannot be sure that we will be able to obtain product liability insurance covering commercial sales or, if such insurance is obtained, that sufficient coverage can be acquired at a reasonable cost. An inability to obtain insurance at acceptable cost or otherwise protect against potential product liability claims could prevent or inhibit commercialization of any products we develop.

Reductions in our staff might delay the achievement of planned development objectives.

We operate with a small staff and each person currently employed by us serves an essential function. Any reductions in our staff could impair our ability to manage ongoing clinical trials and may have a material adverse effect on our operations.

The market price of our common stock has been, and is likely to continue to be, highly volatile.

The average daily trading volume of our common stock has historically been low compared to that of other biopharmaceutical companies. Because of our relatively low trading volume, our stock price can be highly volatile.

Factors that may cause volatility in our stock price include:

15

Table of Contents

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

In the normal course of business, our financial position is subject to a variety of risks, including market risk associated with interest rate movements. We regularly assess these risks and have established policies and business practices to protect against these and other exposures. As a result, we do not anticipate material potential losses in these areas.

The primary objective for our investment activities is to preserve principal while maximizing yields without significantly increasing risk. This is accomplished by investing in widely diversified short-term investments, consisting primarily of investment grade securities. As of March 31, 2004, the fair value of our investments was $22.2 million and 92% of our portfolio will mature in one year or less. A hypothetical 50 basis point increase in interest rates would not result in a material decrease or increase in the fair value of our available-for-sale securities. We have no investments denominated in foreign country currencies and therefore our investments are not subject to foreign currency exchange risk. We do not use or hold derivative financial instruments.

ITEM 4. CONTROLS AND PROCEDURES

An evaluation was performed under the supervision and with the participation of President and Chief Executive Officer of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on that evaluation, the Company and the President and Chief Executive Officer concluded that the Company’s disclosure controls and procedures were effective.

We intend to review and evaluate the design and effectiveness of our disclosure controls and procedures on an ongoing basis and to improve our controls and procedures over time and to correct any deficiencies that we may discover in the future. Our goal is to ensure that our senior management has timely access to all material financial and non-financial information concerning our business. While we believe the present design of our disclosure controls and procedures is effective to achieve our goal, future events affecting our business may cause us to modify our disclosure controls and procedures.

16

Table of Contents

PART II. OTHER INFORMATION

ITEM 2. RECENT SALES OF UNREGISTERED SECURITIES

In March 2004, we raised $19.4 million in gross offering proceeds from the sale of 3,880,000 shares of common stock at a price of $5.00 per share. Investors also received warrants, which are exercisable for five years, to purchase an additional 582,000 shares of common stock at a price of $6.73 per share. Our net offering proceeds after fees and commissions were approximately $18.4 million. We also issued warrants, which are exercisable for three years, to Merriman Curhan Ford & Co., our placement agent in the offering, to purchase 155,200 shares of common stock at a purchase price of $6.00 per share and 23,280 shares at $8.08 per share.

The offering was made to selected institutional and accredited investors pursuant to Regulation D under the Securities Act of 1933, as amended. In connection with this offering, we incurred total expenses of approximately $1,053,507, consisting of $970,000 for commissions, and approximately $83,507 for other expenses. None of these expenses were paid directly or indirectly to any of our directors, officers, or their associates, persons owning 10% or more of any class of the our securities, or affiliates of the Company.

We have applied the proceeds of the above offerings to diversified short-term investments, consisting primarily of investment grade securities.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits:

(b) Reports:

On February 9, 2004, we filed a Current Report on Form 8-K furnishing our press release announcing the results of operations for the quarter ended December 31, 2003.

On March 4, 2004, we filed a Current Report on Form 8-K furnishing our press release announcing $19.4 million raised in a private equity financing.

17

Table of Contents

SIGNATURE

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

18