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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended June 30, 2004

OR

Commission File Number: 000-30039

ADOLOR CORPORATION

(Exact Name of Registrant as Specified in its Charter)

700 Pennsylvania Drive

Exton, Pennsylvania 19341

(Address of Principal Executive Offices and Zip Code)

484-595-1500

(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:    x  Yes    ¨ No

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

Number of shares outstanding of the issuer’s Common Stock, par value $0.0001 per share, as of July 15, 2004: 38,873,286 shares.

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ADOLOR CORPORATION

INDEX

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

ADOLOR CORPORATION

(A Development Stage Company)

Consolidated Balance Sheets

Unaudited

June 30, 2004 and December 31, 2003

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

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ADOLOR CORPORATION

(A Development Stage Company)

Consolidated Statements of Operations

(Unaudited)

Three and Six months ended June 30, 2004 and 2003 and the period from August 9, 1993

(inception) to June 30, 2004

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

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ADOLOR CORPORATION

(A Development Stage Company)

Consolidated Statements of Cash Flows

(Unaudited)

Six months ended June 30, 2004 and 2003 and the

period from August 9, 1993 (inception) to June 30, 2004

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

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Adolor Corporation

(A Development Stage Company)

Notes to Consolidated Financial Statements

June 30, 2004

(Unaudited)

1. ORGANIZATION AND BUSINESS ACTIVITIES

Adolor Corporation (together with its subsidiary, “Adolor” or the “Company”) is a development stage biopharmaceutical corporation that was formed in 1993. The Company specializes in the discovery, development and commercialization of prescription pain management products. The Company has a number of small molecule product candidates that are in various stages of development ranging from preclinical studies to advanced stage clinical trials. The Company’s lead product candidate, Entereg^™ (alvimopan), is designed to selectively block the unwanted effects of opioid analgesics on the gastrointestinal tract. The Company’s next product candidate is a sterile lidocaine patch in clinical development for treating postoperative incisional pain. The Company’s other product candidates are analgesics in preclinical development for treating moderate-to-severe pain conditions.

The Company has not generated any product sales revenues, has incurred operating losses since inception, and has not achieved profitable operations. The Company’s deficit accumulated during the development stage through June 30, 2004 aggregated approximately $229.7 million, and the Company expects to continue to incur substantial losses in future periods. A significant portion of the Company’s revenue recognized in 2003 and to date in 2004 has been from reimbursement of expenses by Glaxo Group Limited (“Glaxo”) under the Company’s collaboration agreement with Glaxo. The Company is highly dependent on the success of the Company’s research, development and licensing efforts and, ultimately, upon regulatory approval and market acceptance of its products under development, particularly its lead product candidate, Entereg^™. There is no assurance that the Company will ever receive regulatory approval for any of its product candidates, generate product sales revenues or achieve profitable operations, or that profitable operations, if achieved, could be sustained on a continuing basis.

The Company does not expect to generate a positive cash flow from operations for at least the next several years, if ever. The Company will need to raise additional funds to finance its operating activities prior to exhausting its current cash, cash equivalents and short-term investments. There are no assurances that the Company will be successful in obtaining an adequate level of financing for the long-term development and potential commercialization of its product candidates.

Principles of Consolidation

The consolidated financial statements include the accounts of Adolor Corporation and its wholly owned subsidiary. All significant intercompany accounts and transactions have been eliminated in consolidation. The information at June 30, 2004 and for periods ended June 30, 2004 and 2003, is unaudited but includes all adjustments (consisting only of normal recurring adjustments) which, in the opinion of management, are necessary to state fairly the financial information set forth in accordance with accounting principals generally accepted in the United States of America. The interim results are not necessarily indicative of results to be expected for the full fiscal year. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2003 included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission.

2. COMPREHENSIVE LOSS

The following is the reconciliation of net loss to comprehensive loss for the three and six months ended June 30, 2004 and June 30, 2003:

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Adolor Corporation

(A Development Stage Company)

Notes to Consolidated Financial Statements

June 30, 2004

(Unaudited)

3. SHORT-TERM INVESTMENTS

All investments are classified as “available for sale”, as management has the option to sell them at any time. Therefore all investments are considered short-term and are classified as current, including securities with maturities in excess of one year. Short-term investments consist of investment grade fixed income securities with original maturities of greater than three months.

The following summarizes the short-term investments at June 30, 2004 and December 31, 2003:

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Adolor Corporation

(A Development Stage Company)

Notes to Consolidated Financial Statements

June 30, 2004

(Unaudited)

4. CONTRACT REVENUES

The following summarizes revenues for the three and six months ended June 30, 2004 and 2003:

In April 2002, the Company entered into a collaboration agreement with Glaxo for the exclusive worldwide development and commercialization of Entereg^™ for certain indications. Under the terms of the agreement, Glaxo paid the Company a non-refundable and non-creditable signing fee of $50.0 million during the quarter ended June 30, 2002. The $50.0 million signing fee is reflected in deferred licensing fees and is expected to be recognized as revenue on a straight-line basis through April 2014, the estimated performance period under the collaboration agreement. Revenue of approximately $1,042,000 and $2,083,000, respectively, was recognized in the three and six month periods ended June 30, 2004 related thereto.

External expenses for research and development and marketing activities incurred by each company in the United States are reimbursed by the other party pursuant to contractually agreed percentages. Contract reimbursement amounts owed to the Company by Glaxo are recorded gross on its consolidated statements of operations as contract reimbursement revenue. The Company recorded contract reimbursement revenues of approximately $2,665,000 and $5,269,000, respectively, in the three and six months ended June 30, 2004 under this arrangement. As of June 30, 2004 and December 31, 2003, approximately $2,665,000 and $3,080,000, respectively, were receivable from Glaxo for reimbursement of expenses incurred by the Company pursuant to the collaboration agreement.

In April 2000, the Company entered into a license agreement with Santen Pharmaceutical Co., Ltd. granting Santen an exclusive royalty bearing license to develop and sell products in the field of ophthalmic pain in all countries other than South Korea and North Korea. A $500,000 non-refundable payment was paid to the Company upon execution of the agreement. Such amount was recorded as deferred revenue and was being recognized over the remaining patent life. In February 2003, Santen terminated this agreement and as a result, the Company recognized $418,046 as revenue in the first quarter of 2003.

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Adolor Corporation

(A Development Stage Company)

Notes to Consolidated Financial Statements

June 30, 2004

(Unaudited)

5. STOCK-BASED COMPENSATION

The Financial Accounting Standards Board (“FASB”) issued Statement No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure”, which amended FASB Statement No. 123, “Accounting for Stock-Based Compensation”, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this statement amended the disclosure requirements of Statement 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The disclosure requirements of Statement No. 148 have been incorporated herein.

Had the Company determined compensation cost under Statement No. 123 for options granted based on the fair value method the Company’s net loss and net loss per share would have been increased to the pro forma amounts indicated below:

6. LEGAL PROCEEDINGS

On April 21, 2004, a lawsuit was filed in the United States District Court for the Eastern District of Pennsylvania against the Company, one of its directors and certain of its officers seeking unspecified damages on behalf of a putative class of persons who purchased Company common stock between September 23, 2003 and January 14, 2004. The complaint alleges violations of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), Rule 10b-5 under the Exchange Act and Section 20(a) of the Exchange Act in connection with the announcement of the results of certain studies in the Company’s Phase III clinical trials for Entereg^™, which allegedly had the effect of artificially inflating the price of the Company’s common stock. Three additional complaints asserting similar claims were filed shortly after the initial complaint. These actions have been consolidated for filing purposes under the caption: In re Adolor Corporation Securities Litigation, No. 2:04-cv-01728. Two parties have separately moved to be appointed as Lead Plaintiff and to consolidate the actions for purposes of trial. Following the district court’s ruling on those motions, the Company anticipates that the appointed Lead Plaintiff will file a consolidated amended complaint to which the Company must respond sixty days later. The Company believes that the allegations are without merit and intends to vigorously defend the litigation.

On August 2, 2004, two shareholder derivative lawsuits were filed in the United States District Court for the Eastern District of Pennsylvania, purportedly on behalf of the Company, against its directors and certain of its officers seeking unspecified damages for various alleged breaches of fiduciary duty and waste. The allegations are similar to those set forth in the class action complaints, involving the announcement of the results of certain studies in the Company’s Phase III clinical trials for Entereg™. The Company believes that the allegations are without merit and intends to vigorously defend the derivative litigation.

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

Forward-Looking Statements

This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements include those which express plan, anticipation, intent, contingency, goals, targets or future development and/or otherwise are not statements of historical fact. We have based these forward-looking statements on our current expectations and projections about future events and they are subject to risks and uncertainties known and unknown which could cause actual results and developments to differ materially from those expressed or implied in such statements. These forward-looking statements include statements about the following:

In some cases, you can identify forward-looking statements by terminology such as “may”, “will”, “should”, “could”, “would”, “expect”, “plan”, “anticipate”, “believe”, “estimate”, “target”, “goal”, “continue”, or the negative of such terms or other similar expressions. Factors that might cause or contribute to differences include, but are not limited to, those discussed elsewhere in this Report in Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” (including a subsection thereof entitled “Certain Risks Related to our Business”) and discussed in our other Securities and Exchange Commission (“SEC”) filings.

We urge you to carefully review and consider the disclosures found in these filings, all of which are available in the SEC EDGAR database at www.sec.gov. Given the uncertainties affecting pharmaceutical companies in the development stage, you are cautioned not to place undue reliance on any such forward looking statements, any of which may turn out to be wrong due to inaccurate assumptions, unknown risks, uncertainties or other factors. We undertake no obligation to (and expressly disclaim any such obligation to) publicly update or revise the statements made herein or the risk factors that may relate thereto whether as a result of new information, future events or otherwise.

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Company

Overview

We are a development stage biopharmaceutical corporation that was formed in 1993. We specialize in the discovery, development and commercialization of prescription pain management products. We have a number of small molecule product candidates that are in various stages of development ranging from preclinical studies to advanced stage clinical trials. Our lead product candidate, Entereg^™ (alvimopan), is designed to selectively block the unwanted effects of opioid analgesics on the gastrointestinal (GI) tract. Our next product candidate is a sterile lidocaine patch in clinical development for treating postoperative incisional pain. Our other product candidates are analgesics in preclinical development for treating moderate-to-severe pain conditions.

We have invested a significant portion of our time and financial resources since our inception in the development of Entereg^™, and our potential to achieve revenues from product sales in the foreseeable future is dependent largely upon obtaining regulatory approval for and successfully commercializing Entereg^™, especially in the United States. We have completed four Phase III clinical studies of Entereg^™ for the management of postoperative ileus (“POI”), and submitted a New Drug Application (“NDA”) for Entereg^™ to the FDA in June 2004. There can be no assurance that the FDA will accept our NDA for filing, and even if accepted, there can be no assurance that the FDA will approve our NDA for Entereg^™. FDA approval is contingent on many factors, including review and approval of our NDA, including information with respect to the manufacture of Entereg^™. Even if Entereg^™ is approved by the FDA, we will not be successful unless Entereg^™ gains market acceptance. We do not expect to generate positive cash flows from operations for at least the next several years, if at all.

Entereg^™ (alvimopan)

Entereg^™ is being clinically evaluated in both acute and chronic indications. Our Entereg^™ POI Phase III program included four studies which have been completed. Three of these studies (POI 14CL302, POI 14CL308 and POI 14CL313) were double-blind, placebo-controlled multi-center studies each designed to enroll patients scheduled to undergo certain types of major abdominal surgery and receiving opioids for pain relief. Under the protocols, patients were randomized into three arms to receive placebo, 6 mg or 12 mg doses of Entereg^™. The primary endpoint in these three efficacy studies was time to recovery of GI function, a composite measure of the time to recovery of both upper and lower GI function, as defined by time to tolerability of solid foods, and time to first flatus or first bowel movement, whichever occurred last. The fourth POI clinical study in our Phase III program, POI 14CL306, was a double-blind, placebo-controlled multi-center observational safety study under which patients were randomized to receive either Entereg^™ 12 mg (413 patients) or placebo (106 patients). The four Phase III clinical trials enrolled over 2,100 patients in total.

In April 2003, we announced top-line results of our first POI Phase III clinical study, POI 14CL302. Study POI 14CL302 enrolled 451 patients and was designed to include large bowel resection patients and radical hysterectomy patients, as well as simple hysterectomy patients (22% of enrolled patients). A statistically significant difference was achieved in the primary endpoint of the study, time to recovery of GI function, in patients in the Entereg^™ 6 mg treatment group compared to patients in the placebo group (Cox proportional hazard model, hazard ratio = 1.44; P<0.01). A difference in favor of the Entereg^™ 6 mg treatment group versus placebo was observed for all secondary endpoints, including time to hospital discharge order written. A positive trend was observed in the primary endpoint of the study for the Entereg^™ 12 mg treatment group; however, the difference from placebo was not statistically significant (Cox proportional hazard model, hazard ratio = 1.23; P = 0.059). The most frequently observed adverse events in both the placebo and treatment groups were nausea, vomiting and abdominal distension.

The hazard ratio measures the degree of difference between the study drug group and the placebo group. A hazard ratio of 1 would indicate no difference between the study drug group and the placebo group in achieving the endpoint. A hazard ratio of 1.5 means that, on the average during the course of the data collection period, the subjects receiving test drug are 50% more likely to achieve the endpoint. Statistical analyses estimate the probability that a positive effect is actually produced by the drug. This probability is expressed as a “P value” which refers to the likelihood that the difference measured between the drug group and the placebo group occurred just “by chance.” For example, when a P value is reported as P<0.05, the probability that the drug produced an effect “by chance” is less than 5%.

In September 2003, we announced top-line results of our second POI Phase III clinical study, POI 14CL313. Study POI 14CL313 enrolled 510 patients and was designed to include large bowel resection patients, small bowel resection patients and radical hysterectomy patients, and exclude simple hysterectomy patients. A statistically significant difference was achieved in the primary endpoint of the study, time to recovery of GI function, in both the Entereg^™ 6 mg and 12 mg treatment groups compared to the placebo group (Cox proportional hazard model; for 6 mg group, hazard ratio = 1.28; P < 0.05; for 12 mg group, hazard ratio = 1.54; P < 0.01). A difference in favor of Entereg^™ was observed for all of the secondary endpoints in both the 6 mg and 12 mg treatment groups, including time to hospital discharge order written. The most frequently observed adverse events in both the placebo and treatment groups were nausea, vomiting and hypotension.

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In October 2003, we announced top-line results of our third POI Phase III clinical study, POI 14CL306, which enrolled 519 patients. This study was designed to assess safety as its primary endpoint, and to assess efficacy as a secondary endpoint and to only enroll patients scheduled to undergo simple hysterectomy procedures. Study POI 14CL306 was the first study where dosing continued on an out-patient basis after patients were discharged from the hospital. Entereg^™ was generally well tolerated in this observational safety study with 93% of patients completing treatment in the Entereg^™ 12 mg treatment group and 92% of patients completing treatment in the placebo group. The most frequently observed adverse events in both the placebo and treatment groups were nausea, vomiting and constipation.

In January 2004, we announced top-line results of our fourth POI Phase III clinical study, POI 14CL308. Study POI 14CL308 enrolled 666 patients, and was designed to include large bowel resection patients, small bowel resection patients and radical hysterectomy patients, as well as simple hysterectomy patients (14% of enrolled patients). A positive trend was observed in the primary endpoint of the study when each of the Entereg^™ 6 mg and 12 mg treatment groups were compared to the placebo group (Cox proportional hazard model; for 6 mg group, hazard ratio = 1.20, P=0.08; for 12 mg group, hazard ratio = 1.24, P=0.038). Due to the multiple dose comparison to a single placebo group a P-value of less than 0.025 would be required in the 12 mg dose group to be considered statistically significant. A difference in favor of Entereg^™ was observed for all of the secondary endpoints in both the 6 mg and 12 mg treatment groups. The most frequently observed adverse events in both the placebo and treatment groups were nausea, vomiting and pruritis.

In February 2004, the FDA designated Entereg^™ as a “Fast Track” product. The FDA’s Fast Track Programs are designed to facilitate the development and expedite the review of new drugs that are intended to treat serious or life threatening conditions and that demonstrate the potential to address unmet medical needs. We submitted an NDA for Entereg^™ in June 2004 for use of Entereg^™ in POI. There can be no assurance that the FDA will accept our NDA, and even if accepted, there can be no assurance that Entereg^™ will obtain FDA approval.

In April 2002, we entered into a collaboration agreement with Glaxo for the exclusive worldwide development and commercialization of Entereg^™ for certain indications. The companies have agreed to co-develop Entereg^™ for a number of indications, both acute and chronic, which would potentially involve the use of Entereg^™ in in-patient and out-patient settings. Under the terms of the collaboration agreement, Glaxo paid us a non-refundable and non-creditable signing fee of $50.0 million during the quarter ended June 30, 2002 and we may receive milestone payments of up to $220.0 million over the term of the agreement upon the successful achievement, if any, of certain clinical and regulatory objectives.

Under the terms of the collaboration agreement, Glaxo has overall responsibility for the development of Entereg^™ in chronic indications. Glaxo is conducting two Phase IIb studies studying the use of Entereg^™ for the reversal of severe constipating effects associated with the chronic use of opioids, as well as an early stage study evaluating Entereg^™ in chronic constipation. Outside the United States, Glaxo has responsibility for the development of Entereg^™ for all indications, and is currently conducting a substantial Phase III study evaluating Entereg^™ in POI in support of a proposed Marketing Authorization Application (“MAA”) filing. This study is designed with similar endpoints to the POI studies conducted by Adolor in the United States, and the primary analysis group in the study is the bowel resection patient group.

In Licensing/Research

We believe there are opportunities to expand our product portfolio by the acquisition or in-licensing of products and/or product development candidates, and intend to explore and evaluate such opportunities.

In July 2003, we entered into an agreement with EpiCept Corporation (“EpiCept”), under which we obtained exclusive rights to develop and commercialize in North America a sterile lidocaine patch, which is being developed for the management of postoperative incisional pain. We made a $2.5 million payment to EpiCept upon execution of the agreement and may make up to $20.0 million in additional development milestone payments if certain clinical and regulatory achievements are reached.

We also have other compounds that are being designed to elicit potential analgesic effects by targeting peripheral and central opioid receptors, including the delta, kappa and mu receptors. Additionally, we are exploring the development of an analgesic product candidate that would be a combination of Entereg^™ and an opioid. This combination is intended to produce the pain relief of an opioid while reducing side effects, such as constipation, nausea and vomiting.

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License Agreements

In November 1996, Roberts Laboratories Inc. (“Roberts”) licensed from Eli Lilly certain intellectual property rights relating to Entereg^™. In June 1998, we entered into an Option and License Agreement with Roberts under which we licensed from Roberts the rights Roberts had licensed from Eli Lilly for Entereg^™. We have made license and milestone payments under that agreement totaling $1.1 million. We are obligated to pay additional milestone payments in the aggregate amount of $1.4 million to Roberts and Eli Lilly upon receiving notice of acceptance of a first NDA or similar filing in the United States, Canada, Japan or the European Community. If Entereg^™ receives regulatory approval, we are obligated to pay royalties to Roberts and Eli Lilly on commercial sales of Entereg^™. Under the terms of our arrangements, the license to Entereg^™ expires on the later of either the life of the last to expire of the licensed Eli Lilly patents or fifteen years from November 5, 1996, following which we will have a fully paid up license.

In August 2002, we expanded our intellectual property rights related to Entereg^™ by entering into a separate exclusive license agreement with Eli Lilly under which we obtained an exclusive license to six issued U.S. patents and related foreign equivalents and know-how relating to peripherally selective opioid antagonists. We paid Eli Lilly $4.0 million upon signing the agreement and are subject to additional clinical and regulatory milestone payments and royalty payments to Eli Lilly on sales, if any, of new products utilizing the licensed technology. Under this license agreement, we agreed to pay Eli Lilly a $4.0 million payment upon acceptance by a regulatory authority of the first application for marketing authorization for Entereg^™.

Commercialization

We have a small manufacturing organization to manage our relationships with third parties for the manufacture and supply of products for preclinical, clinical and commercial purposes. We maintain commercial supply agreements with certain of these third party manufacturers. We presently do not maintain our own manufacturing facilities.

We have a small marketing organization to support our development efforts. We plan to build a field force in the United States to co-promote Entereg^™ along with Glaxo in hospital-care settings, if regulatory approval is received. In June 2004 we entered into a Distribution Agreement with Glaxo under which Glaxo will perform certain distribution and contracting services on our behalf for a fee. Outside of the United States we intend to rely on Glaxo for sales and marketing of Entereg^™, and expect to supply Glaxo with bulk capsules for sale. As we develop additional product candidates we may enter into strategic marketing or co-promotion agreements with, and grant additional licenses to, pharmaceutical companies to gain access to additional markets both domestically and internationally.

Financial

We have not generated any product sales revenues, have incurred operating losses since inception and have not achieved profitable operations. Our deficit accumulated during the development stage through June 30, 2004 aggregated approximately $229.7 million, and we expect to continue to incur substantial losses in future periods. A significant portion of our revenue recognized in 2003 and to date in 2004 has been from reimbursement of expenses by Glaxo under our collaboration agreement with Glaxo and we expect such revenues to decrease in future annual periods as we expect the related reimbursable expenses to decrease. We are highly dependent on the success of our research, development and licensing efforts and, ultimately, upon regulatory approval and market acceptance of our proposed future products under development, particularly our lead product candidate, Entereg^™. There is no assurance that we will ever receive regulatory approval for any of our product candidates, generate product sales revenues or achieve profitable operations, or that profitable operations, if achieved, could be sustained on a continuing basis.

We do not expect to generate a positive cash flow from operations for at least the next several years, if ever. Prior to exhausting our current cash, cash equivalents and short term investments, we will need to raise additional funds to finance our operating activities. There are no assurances that we will be successful in obtaining an adequate level of financing for the long-term development and commercialization of our product candidates.

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Collaboration Agreement with Glaxo

In April 2002, we entered into a collaboration agreement with Glaxo for the exclusive worldwide development and commercialization of Entereg^™ for certain indications. Under the terms of the collaboration agreement, Glaxo paid us a non-refundable and non-creditable signing fee of $50.0 million during the quarter ended June 30, 2002. The $50.0 million signing fee is reflected in deferred licensing fees and is expected to be recognized on a straight-line basis through April 2014, the estimated performance period under the collaboration agreement. We recognized revenue of approximately $1,042,000 and $2,083,000, respectively, in the three and six months ended June 30, 2004 related thereto. We may receive milestone payments of up to $220.0 million over the term of the agreement upon the successful achievement, if any, of certain clinical and regulatory objectives. The milestone payments relate to substantive achievements in the development lifecycle and it is anticipated that these will be recognized as revenue if and when the milestones are achieved.

We and Glaxo have agreed to develop Entereg^™ for a number of acute and chronic indications which would potentially involve the use of Entereg^™ in in-patient and out-patient settings. In the United States, we and Glaxo intend to co-develop and intend to co-promote Entereg^™ and share development expenses and commercial returns, if any, pursuant to contractually agreed percentages. We have overall responsibility for development activities for acute care indications such as POI, and Glaxo has overall responsibility for development activities for chronic care indications such as opioid bowel dysfunction (“OBD”). Outside the United States, Glaxo will be responsible for the development and commercialization of Entereg^™ for all indications, and we will receive royalties on sales revenues, if any.

Glaxo has certain rights to terminate the collaboration agreement. Glaxo also has the right to terminate its rights and obligations with respect to the acute-care indications, or its rights and obligations for the chronic-care indications. Glaxo has the right to terminate the collaboration agreement for breach of the agreement by us or for safety related reasons as defined in the collaboration agreement. Glaxo’s rights to terminate the acute-care indications or the chronic-care indications are generally triggered by failure to achieve certain milestones within certain timeframes, adverse product developments or adverse regulatory events. If Glaxo exercises its termination rights under the collaboration agreement, we may not be able to find a new collaborator to replace Glaxo, and our business will be adversely affected.

External expenses for research and development and marketing activities incurred by each company in the United States are reimbursed by the other party pursuant to contractually agreed percentages. Contract reimbursement amounts owed to us by Glaxo are recorded gross on our consolidated statements of operations as contract reimbursement revenue. Amounts reimbursable to Glaxo by us are recorded as research and development or marketing expense, as appropriate, on our consolidated statements of operations.

We recorded contract reimbursement revenue of approximately $2.7 million and $5.3 million respectively, in the three and six months ended June 30, 2004 under the Glaxo arrangement. These revenues represent reimbursement of expenses incurred by us primarily in our POI development program. Additionally, we recorded research and development and marketing expenses of approximately $0.8 million and $2.1 million, respectively, in the three and six months ended June 30, 2004, representing reimbursement by us to Glaxo of expenses incurred by Glaxo primarily in the OBD development program.

Liquidity and Capital Resources

We have experienced negative operating cash flows since our inception, and have funded our operations primarily from the proceeds received from the sale of our equity securities as well as from contract revenues. Cash, cash equivalents and short-term investments were approximately $180.0 million at June 30, 2004, and approximately $210.2 million at December 31, 2003, representing 93.1% and 93.6% of our total assets, respectively. We invest excess cash in investment-grade fixed income securities, including United States Treasury obligations and corporate securities.

We believe that our current financial resources and sources of liquidity are adequate to fund operations into 2007 based upon our expectations of the level of research and development, marketing and administrative activities necessary to achieve our strategic objectives.

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The following is a summary of selected cash flow information for the six months ended June 30, 2004 and 2003:

Net Cash Used in Operating Activities and Operating Cash Flow Requirements Outlook

Net operating cash outflows for the six months ended June 30, 2004 have resulted primarily from research and development expenditures associated with our product candidates, including clinical development and manufacturing costs for Entereg^™, and from the compensation of our employees. These outflows were partially offset by cost reimbursement amounts received from Glaxo.

We expect to continue to use cash resources to fund operating losses. We expect that our operating expenses in future quarters will increase substantially as a result of manufacturing scale-up efforts and other costs and in preparation for the potential commercialization of Entereg^™, as well as additional Entereg^™ development and licensing costs. We expect to incur expenses of approximately $5.5 million in the third quarter of 2004 if our NDA is accepted by the FDA for filing in connection with payments under license agreements relating to Entereg^™. We expect that as Glaxo incurs increasing expenses related to the OBD program in the United States, we will incur substantial expenses relating to reimbursements owed to Glaxo. Further, we may in-license or acquire product candidates which will require additional cash outlays.

Upon acceptance of our NDA by the FDA, we are due a $10.0 million milestone payment under our collaboration agreement with Glaxo.

Net Cash Provided By / (Used In) Investing Activities and Investing Requirements Outlook

Cash provided by investing activities for the six months ended June 30, 2004 relates primarily to maturities of investments, partially offset by expenditures for laboratory equipment and information technology to support our research and development activities.

Operations are expected to continue to be funded through the maturities of investments in our portfolio. We expect to continue to require investments in information technology, laboratory and office equipment to support our research and development activities, and potential commercialization activities.

Net Cash Provided By Financing Activities and Financing Requirements Outlook

We do not expect to generate sales and positive cash flows from operations for at least the next several years, if ever. We expect to continue to use our cash, cash equivalents and short-term investments to fund operating and investing activities. We believe that our existing cash, cash equivalents and short-term investments of approximately $180.0 million as of June 30, 2004 will be sufficient to meet our currently estimated operating and investing requirements into 2007. Prior to exhausting our current cash reserves, we will need to raise additional funds to finance our operating activities. If we do not raise additional cash, we may be required to curtail or limit certain marketing support and research and development activities. A curtailment of certain activities would delay or possibly prevent development of certain of our products. We may seek to obtain additional funds through equity or debt financings or strategic alliances with third parties. These financings could result in substantial dilution to the holders of our common stock. Any such required financing may not be available in amounts or on terms acceptable to us.

Results of Operations

This section should be read in conjunction with the more detailed discussion under “Liquidity and Capital Resources.”

Contract revenues. Our contract revenues were approximately $3.7 million and $5.1 million for the three months ended June 30, 2004 and 2003, respectively and were approximately $7.4 million and $11.8 million for the six months ended June 30, 2004 and 2003, respectively. These decreases in revenue in 2004 compared to 2003 related principally to a decrease in expenses incurred and reimbursed pursuant to our collaboration agreement with Glaxo primarily in the POI program. Additionally, in the six months ended June 30, 2003 approximately $0.4 million was recorded as revenue related to the termination of a license agreement we had with Santen Pharmaceutical Co., Ltd.

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Research and development expenses. Research and development expenses decreased to approximately $11.8 million for the three months ended June 30, 2004 from approximately $13.5 million for the three months ended June 30, 2003. Research and development expenses for the six months ended June 30, 2004 decreased to approximately $21.4 million from approximately $28.7 million for the six months ended June 30, 2003. These decreases in 2004 are principally related to a decrease in expenditures associated with our Entereg^™ Phase III clinical trial program, offset partially by increases in expenses reimbursable to Glaxo by us for expenses incurred by Glaxo primarily in the OBD development program.

Our research and development expenses can be identified as internal or external expenses. Internal expenses include expenses such as personnel, laboratory operating and overhead related expenses. Internal research and development expenses totaled approximately $5.5 million and $5.0 million in the three months ended June 30, 2004 and 2003 respectively, and approximately $10.6 million and $10.5 million in the six months ended June 30, 2004 and 2003, respectively. These internal research and development expenses are largely related to our Entereg^™ development efforts. External expenses include expenses incurred with clinical research organizations, contract manufacturers, and other third party vendors and can be allocated to significant research and development programs as follows:

There are significant risks and uncertainties inherent in the preclinical and clinical studies associated with each of our research and development programs. These studies may yield varying results that could delay, limit or prevent a program’s advancement through the various stages of product development, and significantly impact the costs to be incurred, and time involved, in bringing a program to completion. As a result, the cost to complete such programs, as well as the period in which net cash inflows from such programs are expected to commence, are not reasonably estimable.

Marketing, general and administrative expenses. Our marketing, general and administrative expenses increased to approximately $5.3 million for the three months ended June 30, 2004 from approximately $3.7 million in the three months ended June 30, 2003. Our marketing, general and administrative expenses increased to approximately $10.4 million for the six months ended June 30, 2004 from approximately $7.4 million in the six months ended June 30, 2003. These increases in 2004 are principally related to increased personnel expenses, marketing related expenses, legal expenses and other professional fees.

Other income (expense). Our other income decreased to approximately $0.4 million and $1.2 million for the three and six months ended June 30, 2004, respectively, from approximately $0.7 million and $1.5 million, respectively, for the same periods in 2003 due to lower interest rates in 2004, and losses realized on the sale of certain securities.

Net Loss Outlook

We have not generated any product sales revenues, have incurred operating losses since inception and have not achieved profitable operations. Our deficit accumulated during the development stage through June 30, 2004 aggregated approximately $229.7 million, and we expect to continue to incur substantial losses in future periods. We are highly dependent on the success of our research, development and licensing efforts and, ultimately, upon regulatory approval and market acceptance of our products under development, particularly our lead product candidate, Entereg^™. There is no assurance that we will ever receive regulatory approval for any of our product candidates, generate product sales revenues or achieve profitable operations, or that profitable operations, if achieved, could be sustained on a continuing basis.

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Certain Risks Related to Our Business

As further described herein, our performance and financial results are subject to risks and uncertainties including, but not limited to, the following specific risks:

We are highly dependent on achieving success in the clinical testing, regulatory approval and commercialization of our lead product candidate, Entereg^TM, which may never be approved for commercial use.

We have invested a significant portion of our time and financial resources since our inception in the development of Entereg^™, and our potential to achieve revenues from product sales in the foreseeable future is dependent upon obtaining regulatory approval for and successfully commercializing Entereg^™, especially in the United States. Prior to commercialization of Entereg^™ in the United States, the FDA would have to approve our NDA for Entereg^™. There is no assurance that the FDA will accept our NDA for Entereg^™, or that, if accepted, the FDA will approve Entereg^™ in the United States, or that approval of Entereg^™ in any country outside of the United States will be obtained. Drug development is a highly uncertain process. We or Glaxo, with whom we are collaborating to develop Entereg^™, may suffer significant setbacks in advanced clinical trials of Entereg^™, even after achieving potentially promising results in earlier clinical trials.

Certain results from our clinical trials show that the differences between our product candidates and placebos are not statistically significant.

Our Entereg^™ POI Phase III program consists of four studies, POI 14CL302, POI 14CL313, POI 14CL308 and POI 14CL306. In study POI 14CL302, the difference from placebo in the Entereg^™ 12 mg treatment group was not statistically significant. In study POI 14CL308, the difference from placebo was not statistically significant in either the Entereg^™ 6 mg or the 12 mg treatment groups. Even though the P-value for the 12mg dose group of study POI 14CL308 was below 0.05, it is not considered formally statistically significant because of the multiple dose comparison. In studies involving multiple comparisons, statisticians control the overall study error rate (i.e. the likelihood that the drug response occurred by chance) by requiring that each of the multiple dose comparisons meet a P-value of P < 0.05 to show statistical significance. In the event that one of the dose comparisons in any of these POI Phase III studies does not reach a significance level of P < 0.05, the other dose comparison in that study needs to reach a significance level of P < 0.025 to be considered statistically significant.

These results may make it more difficult to achieve regulatory approval of Entereg^™.

Even if we conclude that the results from our preclinical studies and clinical trials of Entereg^™ are positive, the FDA may not agree with us.

While we believe the results of studies POI 14CL302, POI 14CL313, POI 14CL306 and POI 14CL308 support our goal of obtaining approval for Entereg^™in the United States, there can be no assurance that the FDA will concur with that assessment. The FDA may evaluate the results by different methods or conclude that the clinical trial results are not statistically significant or clinically meaningful, or that there were human errors in the conduct of the clinical trials or otherwise. Even if we believe we have met the FDA guidelines for submission of data and information to the NDA, there is a risk that the FDA will require additional data and information that may require additional time to accumulate, or that we are unable to provide.

While the FDA has designated Entereg^™ as a Fast Track product, there is no assurance that such designation will expedite the review of our NDA by the FDA, and such designation does not increase the likelihood of approval of our NDA. There can also be no assurance that Entereg^™ will be granted priority review status by the FDA.

Unfavorable results or adverse safety findings from any clinical study will adversely affect our ability to obtain regulatory approval for Entereg^™.

We and Glaxo expect to continue to clinically evaluate Entereg^™ in both acute and chronic conditions. Glaxo is currently conducting a Phase III clinical study in POI outside the United States which is scheduled to enroll a substantial number of patients, and additional studies in chronic indications. We are conducting, or planning to conduct, additional studies in the United States of Entereg^™. Unfavorable results in these studies may adversely affect our ability to obtain FDA or other regulatory approval or market acceptance for Entereg^™.

The most frequent adverse events in both the placebo and treatment groups in study POI 14CL302 were nausea, vomiting and abdominal dystension. The most frequent adverse events in both the placebo and treatment groups in study POI 14CL313 were nausea, vomiting and hypotension. The most frequent adverse events in both the placebo and treatment groups in study POI 14CL306 were nausea, vomiting and constipation. The most frequent adverse events in both the placebo and treatment groups in study POI 14CL308 were nausea, vomiting and pruritis.

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Additional clinical trials of Entereg^™, conducted by us or our collaborator, Glaxo, could produce undesirable or unintended side effects that have not been evident in our clinical trials conducted to date. In addition, in patients who take multiple medications, drug interactions with Entereg^™ could occur that can be difficult to predict. Our Entereg^™ clinical trials are testing whether Entereg^™ is able to selectively block the effects of narcotic analgesics in the GI tract, and they are subject to the risk that the use of Entereg^™ with narcotic analgesics may result in unexpected toxicity, or increase the side effects associated with the individual products to an unacceptable level, or interfere with the efficacy of the narcotic analgesic. In addition, assessing clinical trial results of Entereg^™ in combination with narcotic analgesics may add to the complexity of interpreting the study results. These events, among others, may make it more difficult for us to obtain regulatory approval for Entereg^™.

If we are unable to commercialize Entereg^™, our ability to generate revenues will be impaired and our business will be harmed.

We have not yet commercialized any products, and we may never be able to do so. If our NDA for Entereg^™ is not approved by the FDA, or if approval is delayed, our ability to achieve revenues from product sales will be impaired and our stock price will be materially and adversely affected. FDA approval is contingent on many factors, including clinical trial results and the evaluation of those results. Even if Entereg^™ is approved by the FDA for marketing, we will not be successful unless Entereg^™ gains market acceptance. The degree of market acceptance of Entereg^™ will depend on a number of factors, including:

Physicians, patients, payors or the medical community in general may be unwilling to accept, utilize or recommend Entereg^™.

We may not be able to successfully develop Entereg^™ for use in treating chronic opioid bowel dysfunction (“OBD”).

We have completed several Phase II trials and one Phase III clinical trial studying the use of Entereg^™ for the reversal of the severe constipating effects associated with chronic use of opioids. The overall responsibility for the development of Entereg^™ in chronic indications is now carried on by Glaxo. The long-term animal toxicity studies necessary to support further development of Entereg^™ in OBD are on-going. Adverse safety findings in these long-term animal toxicity studies could adversely affect our prospects for Entereg^™, including its prospects for use in POI. Results from the clinical studies conducted to date in OBD are not necessarily indicative of the results that may be obtained in further OBD studies, or in the on-going clinical studies in the POI indication. Additional studies for chronic OBD investigating longer duration of patient exposure and different dosing strategies, as well as preclinical toxicology studies, will be required prior to initiating the clinical studies required to be successfully completed before any NDA could be filed for use of Entereg^™ in OBD.

Patients may discontinue their participation in our clinical studies, which may negatively impact the results of these studies, and extend the timeline for completion of our development programs.

The time required to complete clinical trials is dependent upon, among other factors, the rate of patient enrollment. Patient enrollment is a function of many factors, including:

We are subject to the risk that patients enrolled in our clinical studies may discontinue their participation at any time during the study as a result of a number of factors, including, withdrawing their consent or experiencing adverse clinical events which may or may not be related to our product candidates under evaluation. We are subject to the risk that if a large number of patients in any one of our studies discontinue their participation in the study, the results from that study may not be positive or may not support an NDA for regulatory approval of our product candidates.

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In clinical study POI 14CL302, discontinuation rates were 21%, 16% and 27% in the placebo group, 6 mg dose group and 12 mg dose group, respectively. This resulted in fewer efficacy evaluable patients in the placebo and 12 mg treatment groups compared to the 6 mg treatment group. Following the analysis of study POI 14CL302, we increased enrollment in studies POI 14CL313 and POI 14CL308, with the objective of potentially increasing the number of efficacy evaluable patients in each dose group in our ongoing studies. In study POI 14CL313 discontinuation rates were 30%, 23% and 19% in the placebo, 6 mg and 12 mg dose groups, respectively. In study POI 14CL308 discontinuation rates were 13%, 14% and 14% in the placebo, 6 mg and 12 mg treatment groups, respectively.

We may suffer significant setbacks in advanced clinical trials, even after promising results in earlier trials.

Product candidates that appear to be promising at earlier stages of development may not reach the market or be marketed successfully for a number of reasons, including, but not limited to, the following:

Our stock price may be volatile, and your investment in our stock could decline in value.

The market price for our common stock has been highly volatile and may continue to be highly volatile in the future. For example, in the calendar year ended December 31, 2003, the closing price of our common stock reached a low of $9.55 per share in March 2003 and a high of $21.75 per share in December 2003. During the first six months of 2004, the closing price of our common stock was $11.96 per share at its low point in June 2004 and $22.24 per share at its high point in January 2004.

The market price for our common stock is highly dependent on the success of our product development efforts, and in particular, clinical trial results, and regulatory review results.

The following additional factors may have a significant impact on the market price of our common stock:

Following periods of volatility and decline in the market price of a particular company’s securities, securities class action litigation has often been brought against that company.

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We have been named in a purported class action lawsuit and related derivative lawsuits.

On April 21, 2004, a lawsuit was filed in the United States District Court for the Eastern District of Pennsylvania against us, one of our directors and certain of our officers seeking unspecified damages on behalf of a putative class of persons who purchased our common stock between September 23, 2003 and January 14, 2004. The complaint alleges violations of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), Rule 10b-5 under the Exchange Act and Section 20(a) of the Exchange Act in connection with the announcement of the results of certain studies in our Phase III clinical trials for Entereg^™ , which allegedly had the effect of artificially inflating the price of our common stock. Three additional complaints asserting similar claims were filed shortly after the initial complaint. These actions have been consolidated for filing purposes under the caption: In re Adolor Corporation Securities Litigation, No. 2:04-cv-01728. Two parties have separately moved to be appointed as Lead Plaintiff and to consolidate the actions for purposes of trial. Following the district court’s ruling on those motions, the Company anticipates that the appointed Lead Plaintiff will file a consolidated amended complaint to which the Company must respond sixty days later. The Company believes that the allegations are without merit and intends to vigorously defend the litigation.

On August 2, 2004, two shareholder derivative lawsuits were filed in the United States District Court for the Eastern District of Pennsylvania, purportedly on our behalf, against our directors and certain of our officers seeking unspecified damages for various alleged breaches of fiduciary duty and waste. The allegations are similar to those set forth in the class action complaints, involving the announcement of the results of certain studies in our Phase III clinical trials for Entereg™. We believe that the allegations are without merit and intend to vigorously defend the derivative litigation.

We may become involved in additional litigation of this type in the future. Litigation of this type is often extremely expensive, highly uncertain and diverts management’s attention and resources.

If we continue to incur operating losses for a period longer than anticipated, we may be unable to continue our operations.

We believe our existing cash, cash equivalents and short-term investments as of June 30, 2004 of approximately $180.0 million will be sufficient to meet our currently estimated operating and investing requirements into 2007. We have generated operating losses since we began operations in November 1994. We expect to continue to generate such losses and will need additional funds that may not be available in the future. We have no products that have generated any sales revenue, and as of June 30, 2004, we have incurred a cumulative net loss of approximately $229.7 million. During the calendar years ended December 31, 2003 and 2002, we incurred operating losses of approximately $53.6 million and $65.0 million, respectively, and net losses of approximately $51.2 million and $60.5 million, respectively. During the six month period ended June 30, 2004 we incurred operating losses of approximately $24.5 million and net losses of approximately $23.3 million. Even if we succeed in securing regulatory approval of Entereg^™, we expect to incur substantial losses for at least the next several years and expect that these losses will increase as we expand our research and development and sales and marketing activities. If we fail to obtain the capital necessary to fund our operations, we will be forced to curtail our operations and we will be unable to develop products successfully. We do not know whether additional financing will be available when needed, or that, if available, we will obtain financing on terms favorable to our stockholders or to us. If adequate funds are not available on acceptable terms, our ability to fund our operations, products or technologies or otherwise respond to competitive pressures could be significantly delayed or limited, and we may have to reduce or cease our operations. If additional funds become available there can be no assurance that we can predict the time and costs required to complete development programs or that we will not substantially exceed our budgets.

We are dependent on our collaborators to perform their obligations under our collaboration agreements.

In April 2002, we and Glaxo entered into a collaboration agreement for the exclusive worldwide development and commercialization of Entereg^™ for certain indications. We and Glaxo agreed to develop Entereg^™ for a number of indications, both acute and chronic, which would potentially involve the use of Entereg^™ in in-patient and out-patient settings. In the United States, we have the right to co-develop and co-promote Entereg^™ with Glaxo, and share development expenses and commercial returns, if any, pursuant to contractually agreed percentages. We have overall responsibility for the development of acute care indications such as POI, and Glaxo has overall responsibility for the development of chronic-care indications such as OBD. We and Glaxo are required to use commercially reasonable efforts to develop the indications for which we and they are respectively responsible. We and Glaxo have established numerous joint committees to collaborate in the development of Entereg^™. These committees meet at regularly scheduled intervals. We depend on Glaxo to provide us with substantial assistance and expertise in the development of Entereg^™. Any failure of Glaxo to perform its obligations under our agreement could negatively impact our product candidate, Entereg^™, and could lead to our loss of potential revenues from product sales and milestones that may otherwise become due under our collaboration agreement and would delay our achievement, if any, of profitability. Glaxo has extensive experience in the successful commercialization of product candidates which it would be difficult for us to replace if the collaboration agreement was not in place. In the near term, our success will largely depend upon the success of our collaboration with Glaxo to further develop Entereg^™ and our success in obtaining regulatory approval to commercialize Entereg^™.

The term of the collaboration agreement varies depending on the indication and the territory. The term of the collaboration agreement for the POI indication in the United States is ten years from the first commercial sale of Entereg^™ in that indication, if any. Generally, the term for the OBD indication in the United States is fifteen years from the first commercial sale of Entereg^™ in that indication, if any. In the rest of the world, the term is generally fifteen years from the first commercial sale of Entereg^™, if any, on a country-by-country and indication-by-indication basis.

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Glaxo has certain rights to terminate the collaboration agreement. Glaxo also has the right to terminate its rights and obligations with respect to the acute-care indications, or its rights and obligations for the chronic-care indications. Glaxo has the right to terminate the collaboration agreement for breach of the agreement by us or for safety related reasons as defined in the collaboration agreement. Glaxo’s rights to terminate the acute-care indications or the chronic-care indications are generally triggered by failure to achieve certain milestones within certain timeframes, adverse product developments or adverse regulatory events. If Glaxo terminates the collaboration agreement, we may not be able to find a new collaborator to replace Glaxo, and our business will be adversely affected.

Our corporate collaborators, including Glaxo, may determine not to proceed with one or more of our drug discovery and development programs. If one or more of our corporate collaborators reduces or terminates funding, we will have to devote additional internal resources to product development or scale back or terminate some development programs or seek alternative corporate collaborators.

We have limited commercial manufacturing capability and expertise. If we are unable to contract with third parties to manufacture our products in sufficient quantities, at an acceptable cost and in compliance with regulatory requirements, we may be unable to obtain regulatory approvals, or to meet demand for our products.

Completion of our clinical trials and commercialization of our product candidates require access to, or development of, facilities to manufacture a sufficient supply of our product candidates. We have depended and expect to continue to depend on third parties for the manufacture of our product candidates for preclinical, clinical and commercial purposes. It is difficult and expensive to change contract manufacturers for pharmaceutical products, particularly when the products are under regulatory review in an NDA process. We may not be able to contract for the manufacture of sufficient quantities of the products we develop, or even to meet our needs for pre-clinical or clinical development. Our products may be in competition with other products for access to facilities of third parties and suitable alternatives may be unavailable. Consequently, our products may be subject to delays in manufacture if outside contractors give other products greater priority than our products. Our dependence upon others for the manufacture of our products may adversely affect our future profit margin and our ability to commercialize products, if any are approved, on a timely and competitive basis.

To receive regulatory approval for Entereg^™, our contract manufacturers will be required to obtain approval for their manufacturing facilities to manufacture Entereg^™, and there is a risk that such approval may not be obtained. We are required to submit, in an NDA, information and data regarding chemistry, manufacturing and controls which satisfies the FDA that our contract manufacturers are able to make Entereg^™ in accordance with current Good Manufacturing Practices (“cGMPs”). Under cGMPs, we and our manufacturers will be required to manufacture our products and maintain records in a prescribed manner with respect to manufacturing, testing and quality control activities. We are dependent on our third party manufacturers to comply with these regulations in the manufacture of our products and these parties may have difficulties complying with cGMPs. The failure of any third party manufacturer to comply with applicable government regulations could substantially harm and delay or prevent regulatory approval and marketing of Entereg^™.

We maintain a relationship with Torcan Chemical Ltd. for the supply of the active pharmaceutical ingredient (“API”) in Entereg^™. We also maintain a relationship with Girindus AG as an additional supplier of API for Entereg^™. We maintain a relationship with Pharmaceutics International Inc. for the supply of Entereg^™ finished capsules, and a relationship with Sharp Corporation for the packaging of Entereg^™ finished capsules. We also rely upon these parties for the performance of scale-up and other development activities, and for the maintenance and testing of product pursuant to applicable stability programs.

Clinical trials in our Phase III Entereg^™ program use drug product incorporating active pharmaceutical ingredient manufactured by two different contract manufacturing facilities, one of which is no longer in business. Our efforts to obtain regulatory approval for Entereg^™ may be impaired as a result of using material from two different contract manufacturing facilities.

We also expect to depend on third parties to manufacture product candidates we may acquire or in-license, including the sterile patch product we in-licensed from EpiCept. We have no experience in manufacturing sterile patch products and will need to develop our own internal capabilities and external relationships in that regard, as well as assess the capabilities of third party manufacturers that have been involved in the manufacture of this product candidate to date.

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If we are unable to develop sales, marketing and distribution capabilities or enter into agreements with third parties to perform these functions, we will not be able to commercialize products.

We currently have no sales or distribution capability and limited marketing capabilities. In order to commercialize products, if any are approved, we must internally develop sales, marketing and distribution capabilities or make arrangements with third parties to perform these services. If we obtain regulatory approval, we intend to sell some products directly in certain markets and rely on relationships with established pharmaceutical companies to sell products in certain markets. To sell any of our products directly, we must develop a marketing and sales force with technical expertise and with supporting distribution capabilities. We may not be able to establish in-house sales and distribution capabilities or relationships with third parties. To the extent that we enter into co-promotion or other licensing arrangements, our product revenues may 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 have limited experience in conducting and managing the clinical trials necessary to obtain regulatory approval and depend on third parties to conduct our clinical trials.

We have limited experience in managing clinical trials, and delays or terminations of clinical trials we are conducting or may undertake in the future could impair our development of product candidates. Delay or termination of any clinical trials could result from a number of factors, including adverse events, stringent enrollment requirements, slow rate of enrollment, competition with other clinical trials for eligible patients and other factors. We are subject to the risk that subjects enrolled in our clinical studies may discontinue their participation at any time during the study as a result of a number of factors, including, withdrawing their consent or experiencing adverse clinical events which may or may not be judged related to our product candidates under evaluation.

We contract with third parties to conduct our clinical trials, and are subject to the risk that these third parties fail to perform their obligations properly and in compliance with applicable FDA and other governmental regulations. The failure of any third party to comply with any governmental regulations would substantially harm our development efforts and delay or prevent regulatory approval of our product candidates.

Our ability to enter into new collaborations and to achieve success under existing collaborations is uncertain.

We have entered into, and may in the future enter into, collaborative arrangements, like our arrangement with Glaxo, for the marketing, sale and distribution of our product candidates, which require, or may require, us to share profits or revenues. We may be unable to enter into additional collaborative licensing or other arrangements that we need to develop and commercialize our product candidates. Moreover, we may not realize the contemplated benefits from such collaborative licensing or other arrangements. These arrangements may place responsibility on our collaborative partners for preclinical testing, human clinical trials, the preparation and submission of applications for regulatory approval, or for marketing, sales and distribution support for product commercialization. These arrangements may also require us to transfer certain material rights or issue our equity securities to corporate partners, licensees and others. Any license or sublicense of our commercial rights may reduce our product revenue. Moreover, we may not derive any revenues or profits from these arrangements.

We cannot be certain that any of these parties, including Glaxo, will fulfill their obligations in a manner consistent with our best interests. Collaborators may also pursue alternative technologies or drug candidates, either on their own or in collaboration with others, that are in direct competition with us.

Our quarterly operating results may fluctuate significantly depending on the initiation of new corporate collaboration agreements, the activities under current corporate collaboration agreements or the termination of existing corporate collaboration agreements.

We may not be able to successfully develop in-licensed product candidates, which could prevent us from commercializing any such candidates.

We intend to explore opportunities to expand our product portfolio by acquiring or in-licensing products and/or product development candidates. In July 2003, we entered into an agreement with EpiCept, under which we obtained exclusive rights to develop and commercialize in North America a sterile lidocaine patch which is being developed for the management of postoperative incisional pain. Although we conduct extensive evaluations of product candidate opportunities as part of our due diligence efforts, there can be no assurance that our product development efforts related thereto will be successful or that we will not become aware of issues or complications that will cause us to alter, delay or terminate our product development efforts. Additionally, while we have built certain capabilities as an organization in executing the development plan for Entereg^™, in-licensed products such as this sterile patch product will require capabilities and expertise which we do not currently possess, and there is no assurance that we will be able to develop or acquire these capabilities. If we do not develop or acquire these capabilities, we may not be able to commercialize our in-licensed products and technologies.

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Because our product candidates are in development, there is a high risk that further development and testing will demonstrate that our product candidates are not suitable for commercialization.

We have no products that have received regulatory approval for commercial sale. All of our product candidates, including Entereg^™, are in development, and we face the substantial risks of failure inherent in developing drugs based on new technologies. Our product candidates must satisfy rigorous standards of safety and efficacy before the FDA and foreign regulatory authorities will approve them for commercial use. To satisfy these standards, we will need to conduct significant additional research, animal testing, or preclinical testing, and human testing, or clinical trials.

Preclinical testing and clinical development are long, expensive and uncertain processes. Failure can occur at any stage of testing. Success in preclinical testing and early clinical trials does not ensure that later clinical trials will be successful. Based on results at any stage of clinical trials, we may decide to discontinue development of our product candidates.

The concept of developing peripherally acting opioid antagonist drugs is relatively new and may not lead to commercially successful drugs.

Peripherally acting compounds given to patients as potential drugs are designed to exert their effects outside the brain and spinal cord, in contrast to centrally acting compounds which are designed to exert their effects on the brain or spinal cord. We are developing Entereg^™ as a peripherally acting opioid antagonist. An opioid antagonist is designed to block the effects of the opioid at the receptor level; in the case of Entereg^™, it is designed to block the unwanted effects of opioid analgesics on the gastrointestinal tract. Since there are no products on the market comparable to our product candidates, we do not have any historical or comparative sales data to rely upon to indicate that peripherally acting opioid antagonist drugs will achieve commercial success in the marketplace. Market acceptance of our product candidates will depend on a number of factors, including:

Other products that are currently sold for pain management are already recognized as safe and effective and have a history of successful sales in the United States and elsewhere. Our new products in this area, if any, will be competing with drugs that have been approved by the FDA and have demonstrated commercial success in the United States and elsewhere.

Reduction in the use of opioid analgesics would reduce the potential market for Entereg^™.

If the use of drugs or techniques which reduce the requirement for mu-opioids increases, the demand for Entereg^™ would be decreased. Various techniques to reduce the use of opioids are used in an attempt to reduce the impact of opioid side effects. The use of local anesthetics in epidural catheters during and after surgery with the continuation of the epidural into the post-operative period can reduce or eliminate the use of opioids. Non-steroidal inflammatory agents may also reduce total opioid requirements. Continuous infusion of local anesthetic into a wound or near major nerves can reduce the use of opioids in limited types of procedures and pain states. Novel analgesics which act at non-mu-opioid receptors are under development. Many companies have developed and are developing analgesic products which, if approved, would compete with opioids. If these analgesics reduce the use of opioids, it would have a negative impact on the potential market for Entereg^™.

If competitors develop and market products that are more effective, have fewer side effects, are less expensive than our product candidates or offer other advantages, our commercial opportunities will be limited.

Other companies have product candidates in development to treat the conditions we are seeking to ultimately treat and they may develop effective and commercially successful products. Our competitors may succeed in developing products either that are more effective than those that we may develop, or that they market before we market any products we may develop.

We believe that Progenics Pharmaceuticals, Inc. is developing methylnaltrexone for the treatment of opioid bowel dysfunction and POI. There are products already on the market for use in treating irritable bowel syndrome which may be evaluated for utility in opioid induced bowel dysfunction. There may be additional competitive products about which we are not aware. If our competitors are able to reach the commercial market before we are, this could have a material adverse effect on our ability to reach the commercial market and sell our products.

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Our competitors include fully integrated pharmaceutical companies and biotechnology companies, universities and public and private research institutions. Many of the organizations competing with us have substantially greater capital resources, larger research and development staffs and facilities, greater experience in drug development and in obtaining regulatory approvals, and greater manufacturing and marketing capabilities than we do. These organizations also compete with us to:

Our business could suffer if we cannot attract, retain and motivate skilled personnel and cultivate key academic collaborations.

We are a small company, and our success depends on our continued ability to attract, retain and motivate highly qualified management and scientific personnel, including our president and chief executive officer, Bruce A. Peacock. Our success also depends on our ability to develop and maintain important relationships with leading academic institutions and scientists. Competition for personnel and academic collaborations is intense. In particular, our product development programs depend on our ability to attract and retain highly skilled chemists, biologists and clinical development personnel. If we lose the services of any of these personnel it could impede significantly the achievement of our research and development objectives. In addition, we will need to hire additional personnel and develop additional academic collaborations as we continue to expand our research and development activities. We do not know if we will be able to attract, retain or motivate personnel or maintain relationships. We do not maintain key man life insurance on any of our employees.

Companies and universities that have licensed technology and product candidates to us are sophisticated entities that could develop similar products to compete with products we hope to develop.

Licensing product candidates from other companies, universities, or individuals does not prevent such parties from developing competitive products for their own commercial purposes, nor from pursuing patent protection in areas that are competitive with us. The individuals who created these technologies are sophisticated scientists and business people who may continue to do research and development and seek patent protection in the same areas that led to the discovery of the product candidates that they licensed to us. The development and commercialization by us of successful products is also likely to attract additional research by our licensors and by other investigators who have experience in developing products for the pain management market. By virtue of their previous research activities these companies, universities or individuals may be able to develop and market competitive products in less time than might be required to develop a product with which they have no prior experience.

If we breach our licensing agreements, we will lose significant benefits and may be exposed to liability for damages.

We may breach our license agreements and may thereby lose rights that are important. We are subject to various obligations with respect to license agreements, including development responsibilities, royalty and other payments and regulatory obligations. If we fail to comply with these requirements or otherwise breach a license agreement or contract, the licensor or other contracting party may have the right to terminate the license or contract in whole or in part or change the exclusive nature of the arrangement. In such event we would not only lose all or part of the benefit of the arrangement but also may be exposed to potential liabilities for breach in the form of damages or other penalties.

Because we are not certain we will obtain necessary regulatory approvals to market our products in the United States and foreign jurisdictions, we cannot predict whether or when we will be permitted to commercialize any of our products.

The pharmaceutical industry is subject to stringent regulation by a wide range of authorities. We cannot predict whether we will obtain regulatory clearance for any product candidate we develop. We cannot market a pharmaceutical product in the United States until it has completed rigorous preclinical testing and clinical trials and the FDA’s extensive regulatory clearance process. Satisfaction of regulatory requirements typically takes many years, is dependent upon the type, complexity and novelty of the product and requires the expenditure of substantial resources for research and development, testing, manufacturing, quality control, labeling and promotion of drugs for human use. Since neither the FDA nor international regulatory authorities have approved peripherally restricted narcotic antagonist drugs for marketing, there is additional uncertainty as to whether our research and clinical approaches to developing new products for the pain management market will lead to drugs that the FDA will consider safe and effective for indicated uses. Before receiving FDA approval to market a product, we must demonstrate that the product candidate is safe and effective in the patient population that will be treated. Outside the United States, our ability to market a product is also contingent upon receiving a marketing authorization from the appropriate regulatory authorities, and is subject to similar risks and uncertainties.

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We do not know whether our current or future preclinical and clinical studies will demonstrate sufficient safety and efficacy necessary to obtain the requisite regulatory approvals, or will result in marketable products. Any failure to adequately demonstrate the safety and efficacy of our product candidates will prevent receipt of FDA and foreign regulatory approvals and, ultimately, commercialization of our product candidates. Regulatory authorities may refuse or delay approval as a result of many other factors, including changes in regulatory policy during the period of product development and regulatory interpretations of clinical benefit and clinical risk. Regulatory clearance that we may receive for a product candidate will be limited to those diseases and conditions for which we have demonstrated in clinical trials that the product candidate is safe and efficacious. Even if we receive regulatory approval for our product candidates we must comply with applicable FDA post marketing regulations and other regulatory requirements. Failure to comply with applicable regulatory requirements could subject us to criminal prosecution, civil penalties, recall or seizure of products, total or partial suspension of production or injunction, as well as other regulatory actions against our product or us.

If we market our products in a manner that violates health care fraud and abuse laws, we may be subject to civil or criminal penalties.

In addition to FDA restrictions on marketing of pharmaceutical products, several other types of state and federal health care fraud and abuse laws have been applied to restrict certain marketing practices in the pharmaceutical industry in recent years. These laws include antikickback statutes and false claims statutes.

The federal health care program antikickback statute prohibits, among other things, knowingly and willfully offering, paying, soliciting, or receiving remuneration to induce or in return for purchasing, leasing, ordering, or arranging for the purchase, lease, or order of any health care item or service reimbursable under Medicare, Medicaid, or other federally financed healthcare programs. This statute has been interpreted to apply to arrangements between pharmaceutical manufacturers on one hand and prescribers, purchasers, and formulary managers on the other. Although there are a number of statutory exemptions and regulatory safe harbors protecting certain common activities from prosecution, the exemptions and safe harbors are drawn narrowly, and practices that involve remuneration intended to induce prescribing, purchases, or recommendations may be subject to scrutiny if they do not qualify for an exemption or safe harbor. Our practices may not in all cases meet all of the criteria for safe harbor protection from antikickback liability.

Federal false claims laws prohibit any person from knowingly presenting, or causing to be presented, a false claim for payment to the federal government, or knowingly making, or causing to be made, a false statement to get a false claim paid. Recently, several pharmaceutical and other health care companies have been prosecuted under these laws for allegedly providing free product to customers with the expectation that the customers would bill federal programs for the product. The majority of states also have statutes or regulations similar to the federal antikickback law and false claims laws, which apply to items and services reimbursed under Medicaid and other state programs, or, in several states, apply regardless of the payor. Sanctions under these federal and state laws may include civil monetary penalties, exclusion of a manufacturer’s products from reimbursement under government programs, criminal fines, and imprisonment.

Because of the breadth of these laws and the narrowness of the safe harbors, it is possible that some of our business activities could be subject to challenge under one or more of such laws. Such a challenge could have a material adverse effect on our business, financial condition and results of operations.

The federal Controlled Substances Act might impose significant restrictions, licensing and regulatory requirements on the manufacturing, distribution and dispensing of certain of our product candidates.

The federal Controlled Substances Act imposes significant licensing, recordkeeping, reporting, prescribing and other regulatory requirements on the manufacturing, distribution and dispensing of controlled substances. Therefore, we must determine whether the Drug Enforcement Administration (“DEA”) would consider any of our product candidates to be a controlled substance.

Facilities that conduct research, manufacture or distribute controlled substances must be registered with DEA to perform these activities and have the security, control and accounting systems required by the DEA to prevent loss and diversion. Failure to maintain compliance, particularly as manifested in loss or diversion, can result in significant regulatory action. In addition, individual state laws may also impose separate regulatory restrictions and requirements, including licenses, recordkeeping and reporting. We believe that it is unlikely that any of our product candidates other than those which may act on the central nervous system may be subject to regulation as controlled substances.

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We may not obtain FDA approval to conduct clinical trials that are necessary to satisfy regulatory requirements.

Clinical trials are subject to oversight by institutional review boards and the FDA and:

Before commencing clinical trials in humans, we must submit and receive approval from the FDA of an Investigational New Drug Application, or IND. We, or the FDA, may suspend clinical trials at any time if the subjects participating in the trials are exposed to unacceptable health risks, or if the FDA finds deficiencies in the IND application or the conduct of the trials.

It is difficult and costly to protect our intellectual property rights, and we cannot ensure the protection of these rights; we may be sued by others for infringing their intellectual property rights.

Our commercial success will depend in part on obtaining patent protection on our products and successfully defending these patents against third party challenges. The patent positions of pharmaceutical and biotechnology companies can be highly uncertain and involve complex legal and factual questions. Accordingly, we cannot predict the breadth of claims allowed in our patents or those of our collaborators.

Others have filed and in the future are likely to file patent applications covering products and technologies that are similar, identical or competitive to ours, or important to our business. We cannot be certain that any patent application owned by a third party will not have priority over patent applications filed or in-licensed by us, or that we or our licensors will not be involved in interference proceedings before the United States Patent and Trademark Office.

Although no third party has asserted a claim of infringement against us, others may hold proprietary rights that will prevent our product candidates from being marketed unless we can obtain a license to those proprietary rights. Any patent related legal action against our collaborators or us claiming damages and seeking to enjoin commercial activities relating to our products and processes could subject us to potential liability for damages and require our collaborators or us to obtain a license to continue to manufacture or market the affected products and processes. We cannot predict whether we or our collaborators would prevail in any of these actions or that any license required under any of these patents would be made available on commercially acceptable terms, if at all. There has been, and we believe that there will continue to be, significant litigation in the industry regarding patent and other intellectual property rights. If we become involved in litigation, it could consume substantial managerial and financial resources.

We rely on trade secrets to protect technology in cases when we believe patent protection is not appropriate or obtainable. However, trade secrets are difficult to protect. While we require employees, academic collaborators and consultants to enter into confidentiality agreements, we may not be able to protect adequately our trade secrets or other proprietary information. Our research collaborators and scientific advisors have rights to publish data and information in which we have rights. If we cannot maintain the confidentiality of our technology and other confidential information in connection with our collaborations, our ability to receive patent protection or protect our proprietary information may be imperiled.

Others may hold proprietary rights that will prevent our product candidates from being marketed unless we are able to obtain a license to those proprietary rights. We are a party to various license agreements that give us rights to use specified technologies in our research and development processes. If we are not able to continue to license such technology on commercially reasonable terms, our product development and research may be delayed. In addition, we generally do not fully control the prosecution of patents relating to in-licensed technology, and accordingly are unable to exercise the same degree of control over this intellectual property as we exercise over our internally developed technology.

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Our ability to generate revenues will be diminished if we fail to obtain acceptable prices or an adequate level of reimbursement for our products from third-party payors.

Our ability to commercialize pharmaceutical products, alone or with collaborators, may depend in part on the extent to which reimbursement for the products will be available from: