INSPIRE PHARMACEUTICALS INC - FORM 10-Q

INSPIRE PHARMACEUTICALS INC - FORM 10-Q - November 6, 2009

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EX-10.2 - TECHNOLOGY LICENSE AGREEMENT - INSPIRE PHARMACEUTICALS INC	dex102.htm
EX-32.1 - SECTION 906 CEO CERTIFICATION - INSPIRE PHARMACEUTICALS INC	dex321.htm
EX-31.2 - SECTION 302 CFO CERTIFICATION - INSPIRE PHARMACEUTICALS INC	dex312.htm
EX-32.2 - SECTION 906 CFO CERTIFICATION - INSPIRE PHARMACEUTICALS INC	dex322.htm
EX-31.1 - SECTION 302 CEO CERTIFICATION - INSPIRE PHARMACEUTICALS INC	dex311.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2009

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number: 000-31135

INSPIRE PHARMACEUTICALS, INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware

04-3209022

(State or Other Jurisdiction of

Incorporation or Organization)

(I.R.S. Employer

Identification No.)

4222 Emperor Boulevard, Suite 200

Durham, North Carolina

27703

(Address of Principal Executive Offices)

(Zip Code)

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

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES ¨ NO ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES ¨ NO x

As of September 30, 2009, there were 82,300,128 shares of Inspire Pharmaceuticals, Inc. common stock outstanding.

TABLE OF CONTENTS


		Page

PART I: FINANCIAL INFORMATION

Item 1. Financial Statements (unaudited)		3

Condensed Balance Sheets – September 30, 2009 and December 31, 2008		3

Condensed Statements of Operations – Three and Nine months ended September 30, 2009 and 2008		4

Condensed Statements of Cash Flows – Nine months ended September 30, 2009 and 2008		5

Notes to Condensed Financial Statements		6

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		20

Item 3. Quantitative and Qualitative Disclosures about Market Risk		43

Item 4. Controls and Procedures		44

PART II: OTHER INFORMATION

Item 1A. Risk Factors.		45

Item 6. Exhibits		66

SIGNATURES		67

We own or have rights to various trademarks, copyrights and trade names used in our business. AzaSite^® is a trademark owned by InSite Vision Incorporated. Restasis^®, Elestat^® and Prolacria^TM are trademarks owned by Allergan, Inc. This report also includes trademarks, service marks and trade names of other companies.

PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

INSPIRE PHARMACEUTICALS, INC.

Condensed Balance Sheets

(in thousands, except per share amounts)

(Unaudited)


	September 30, 2009			December 31, 2008
Assets
Current assets:
Cash and cash equivalents	$	84,364		$	58,488
Investments		31,654			13,663
Trade receivables, net		20,358			16,544
Prepaid expenses and other receivables		4,725			4,186
Inventories, net		1,417			689
Other assets		206			357

Total current assets		142,724			93,927

Property and equipment, net		3,600			2,925
Investments		24,250			815
Intangibles, net		15,147			16,343
Other assets		80			214

Total assets	$	185,801		$	114,224


Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	12,406		$	9,843
Accrued expenses		18,949			13,142
Deferred revenue		1,219			—
Short-term debt and capital leases		19,551			18,430

Total current liabilities		52,125			41,415

Long-term debt		10,369			25,175
Other long-term liabilities		3,156			3,247

Total liabilities		65,650			69,837

Stockholders’ equity:
Preferred stock, $0.001 par value, 1,860 shares authorized; no shares issued and outstanding		—			—
Common stock, $0.001 par value, 100,000 shares authorized; 82,300 and 56,672 shares issued and outstanding, respectively		82			57
Additional paid-in capital		517,965			404,991
Accumulated other comprehensive income/(loss)		(17	)		(193	)
Accumulated deficit		(397,879	)		(360,468	)

Total stockholders’ equity	$	120,151		$	44,387


Total liabilities and stockholders’ equity	$	185,801		$	114,224

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

INSPIRE PHARMACEUTICALS, INC.

Condensed Statements of Operations

(in thousands, except per share amounts)

(Unaudited)


	Three Months Ended						Nine Months Ended
	September 30, 2009			September 30, 2008			September 30, 2009			September 30, 2008
Revenues:
Product sales, net	$	9,041		$	4,721		$	22,814		$	11,076
Product co-promotion and royalty		16,127			15,231			39,736			39,313
Collaborative research and development		—			—			—			1,250


Total revenue		25,168			19,952			62,550			51,639

Operating expenses:
Cost of sales		3,032			1,624			7,277			4,274
Research and development		15,300			9,796			41,124			34,401
Selling and marketing		11,323			13,817			36,132			42,937
General and administrative		3,410			3,748			11,463			10,787
Restructuring		35			—			2,014			—


Total operating expenses		33,100			28,985			98,010			92,399


Loss from operations		(7,932	)		(9,033	)		(35,460	)		(40,760	)

Other income/(expense):
Interest income		151			534			470			2,431
Interest expense		(712	)		(1,120	)		(2,421	)		(3,565	)


Other expense, net		(561	)		(586	)		(1,951	)		(1,134	)


Net loss	$	(8,493	)	$	(9,619	)	$	(37,411	)	$	(41,894	)


Basic and diluted net loss per common share	$	(0.12	)	$	(0.17	)	$	(0.61	)	$	(0.74	)


Weighted average common shares used in computing basic and diluted net loss per common share		71,168			56,621			61,564			56,592

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

INSPIRE PHARMACEUTICALS, INC.

Condensed Statements of Cash Flows

(in thousands)

(Unaudited)


	Nine Months Ended
	September 30, 2009			September 30, 2008
Cash flows from operating activities:
Net loss	$	(37,411	)	$	(41,894	)
Adjustments to reconcile net loss to net cash used in operating activities:
Amortization expense		1,481			1,616
Depreciation of property and equipment		571			699
Asset impairment		484			—
Loss/(gain) on disposal of property and equipment		(1	)		6
Allowance for doubtful accounts		3			—
Increase in inventory valuation reserve		—			200
Stock-based compensation expense		3,738			3,251
Changes in operating assets and liabilities:
Trade receivables		(3,817	)		(5,138	)
Prepaid expenses and other receivables		(632	)		197
Inventories		(728	)		308
Other assets		—			(45	)
Accounts payable		2,136			(7,964	)
Accrued expenses and other liabilities		5,665			(646	)
Deferred revenue		1,219			(371	)


Net cash used in operating activities		(27,292	)		(49,781	)


Cash flows from investing activities:
Purchase of investments		(60,776	)		(2,580	)
Proceeds from sale of investments		19,526			30,693
Purchase of property and equipment		(1,158	)		(636	)

Net cash provided by/(used in) investing activities		(42,408	)		27,477


Cash flows from financing activities:
Proceeds from the sale of common stock, net		109,000			—
Issuance of common stock, net		261			53
Payments on notes payable and capital lease obligations		(13,685	)		(9,695	)

Net cash provided by/(used in) financing activities		95,576			(9,642	)


Increase/(decrease) in cash and cash equivalents		25,876			(31,946	)
Cash and cash equivalents, beginning of period		58,488			101,892


Cash and cash equivalents, end of period	$	84,364		$	69,946

Supplemental disclosure of non-cash investing activities:
Capitalized equipment acquired, not paid	$	555		$	—

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

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

1.	Organization

Inspire Pharmaceuticals, Inc. (the “Company” or “Inspire”) was incorporated in October 1993 and commenced operations in March 1995. Inspire is located in Durham, North Carolina, adjacent to the Research Triangle Park.

Inspire has incurred losses and negative cash flows from operations since inception. Based on current operating plans, the Company expects it has sufficient liquidity to continue its planned operations beyond 2010. The Company’s liquidity needs will largely be determined by the commercial success of its products and key development and regulatory events. In order to continue its operations substantially beyond 2010 it will need to: (1) successfully increase revenues; (2) obtain additional product candidate approvals; (3) out-license rights to certain of its product candidates; (4) raise additional capital through equity or debt financings or from other sources; (5) reduce spending on one or more research and development programs; and/or (6) further restructure its operations. The Company currently receives revenue from sales of AzaSite (azithromycin ophthalmic solution) 1%, its co-promotion of Elestat (epinastine HCl ophthalmic solution) 0.05% and royalties on Restasis (cyclosporine ophthalmic emulsion) 0.05%. The Company will continue to incur operating losses until revenues reach a level sufficient to support ongoing operations.

2.	Basis of Presentation

The accompanying unaudited Condensed Financial Statements have been prepared in accordance with generally accepted accounting principles in the United States of America and applicable Securities and Exchange Commission (“SEC”) regulations for interim financial information. These financial statements do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. It is presumed that users of this interim financial information have read or have access to the audited financial statements from the preceding fiscal year contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair statement of the Company’s financial position and operations for the interim periods presented have been made.

Revenue, expenses, assets and liabilities can vary during each quarter of the year. Therefore, the results and trends in the unaudited Condensed Financial Statements and accompanying notes may not be indicative of the results for the full year or any future period.

Use of Estimates

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

Net Loss Per Common Share

Basic net loss per common share is computed by dividing net loss by the weighted average number of common shares outstanding. Diluted net loss per common share is computed by dividing net loss by the weighted average number of common shares outstanding and dilutive potential common shares then outstanding. Dilutive potential common shares consist of shares issuable upon the exercise of stock options and restricted stock units that are paid in shares of the Company’s stock upon conversion. The calculation of diluted earnings per share for the three

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

months ended September 30, 2009 and 2008 does not include 535 and 198, respectively, and for the nine months ended September 30, 2009 and 2008 does not include 219 and 213, respectively, of potential common shares, as their impact would be antidilutive.

Intangible Assets

Costs associated with obtaining patents on the Company’s product candidates and license initiation and preservation fees, including milestone payments by the Company to its licensors, are evaluated based on the stage of development of the related product candidate and whether the underlying product candidate has an alternative use. Costs of these types incurred for product candidates not yet approved by the U.S. Food and Drug Administration (“FDA”) and for which no alternative future use exists are recorded as expense. In the event a product candidate has been approved by the FDA or an alternative future use exists for a product candidate, patent and license costs are capitalized and amortized over the expected life of the related product candidate. Milestone payments to the Company’s collaborators are recognized when the underlying requirement is met.

Upon FDA approval of AzaSite in April 2007, the Company paid a $19,000 milestone to InSite Vision Incorporated (“InSite Vision”). The $19,000 is being amortized ratably on a straight-line basis through the term of the underlying patent coverage for AzaSite, or March 2019, which represents the expected period of commercial exclusivity. As of September 30, 2009 and December 31, 2008, the Company had $3,853 and $2,657, respectively, in accumulated amortization related to this milestone.

The carrying values of intangible assets are periodically reviewed to determine if the facts and circumstances suggest that a potential impairment may have occurred. The review includes a determination of the carrying values of intangible assets based on an analysis of undiscounted cash flows over the remaining amortization period. If the review indicates that carrying values may not be recoverable, the Company will reduce the carrying values to the estimated fair value. The Company had no impairments of its intangible assets for the nine months ended September 30, 2009 and 2008.

Debt

In December 2006, the Company entered into a loan and security agreement with two participating financial institutions, which provided a term loan facility to the Company in an aggregate amount of $40,000. In June 2007, the Company amended the loan and security agreement with the two participating financial institutions to enable the Company to draw upon a new supplemental term loan facility in the amount $20,000, effectively increasing the total term loan facility to $60,000. The Company has borrowed the full $60,000 available under the term loan facility. The interest rates associated with the individual borrowings under the facility range from approximately 7.6% to 8.0%. As of September 30, 2009, the Company had net borrowings under the term loan facility of $29,920. The final maturity date for all loan advances under the original term loan facility and the supplemental term loan facility is March 2011.

The loan and security agreement contains a financial covenant that requires the Company to maintain certain levels of liquidity based on its cash, investment and account receivables balances, as well as negative covenants that may limit the Company from assuming additional indebtedness and entering into other transactions as defined in the agreement. In addition to other financial and non-financial covenants within the agreement, the agreement contains a subjective acceleration clause such that repayment could be accelerated upon a material adverse change to the business, properties, assets, financial condition or results of operations of the Company. At September 30, 2009, the Company was in compliance with all of the covenants under its loan and security agreement.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

Revenue Recognition

The Company records all of its revenue from: (1) sales of AzaSite; (2) product co-promotion activities and earned royalties; and (3) collaborative research agreements when realized or realizable and earned. Revenue is realized or realizable and earned when all of the following criteria are met: 1) persuasive evidence of an arrangement exists; 2) delivery has occurred or services have been rendered; 3) the seller’s price to the buyer is fixed or determinable; and 4) collectibility is reasonably assured.

Product Revenues

The Company recognizes revenue for sales of AzaSite when title and substantially all the risks and rewards of ownership have transferred to the customer, which generally occurs on the date of shipment. In the United States, the Company sells AzaSite to wholesalers and distributors, who, in turn, sell to pharmacies and federal, state and commercial health care organizations. Accruals, or reserves, for estimated rebates, discounts, chargebacks and other sales incentives (collectively, “sales incentives”) are recorded in the same period that the related sales are recorded and are recognized as a reduction in sales of AzaSite. Sales incentive accruals, or reserves, are based on reasonable estimates of the amounts earned or claimed on the sales of AzaSite. These estimates take into consideration current contractual and statutory requirements, specific known market events and trends, internal and external historical data and experience, and forecasted customer buying patterns. Amounts accrued or reserved for sales incentives are adjusted for actual results and when trends or significant events indicate that an adjustment is appropriate. As of September 30, 2009 and December 31, 2008, the Company had net reserves of approximately $3,690 and $1,302, respectively, for sales incentives.

The Company’s ability to recognize revenue for sales of AzaSite is subject to Financial Accounting Standards Board (“FASB”) authoritative guidance regarding revenue recognition when the right of return exists. The guidance states that revenue from sales transactions where the buyer has the right to return the product will be recognized at the time of sale only if: (1) the seller’s price to the buyer is substantially fixed or determinable at the date of sale; (2) the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product; (3) the buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product; (4) the buyer acquiring the product for resale has economic substance apart from that provided by the seller; (5) the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer; and (6) the amount of future returns can be reasonably estimated. Customers are able to return short-dated or expired AzaSite that meet the guidelines set forth in the Company’s return goods policy. The Company’s return goods policy generally allows for returns of AzaSite within an 18-month period, from six months prior to the expiration date and up to 12 months after the expiration date, but may differ from customer to customer, depending on certain factors. The Company estimates the level of sales that will ultimately be returned pursuant to its return policy and records a related reserve at the time of sale. These amounts are deducted from the Company’s gross sales of AzaSite in determining its net sales. Future estimated returns of AzaSite are based primarily on the return data for comparative products and the Company’s own historical experience with AzaSite. The Company also considers other factors that could impact sales returns of AzaSite. These factors include levels of inventory in the distribution channel, estimated remaining shelf life, price changes of competitive products, and current and projected product demand that could be impacted by introductions of generic products and introductions of competitive new products, among others. As of September 30, 2009 and December 31, 2008, the Company had net reserves of approximately $1,141 and $701, respectively, for potential returns of AzaSite.

The Company utilizes data from external sources to help it estimate its gross to net sales adjustments as they relate to the sales incentives and recognition of revenue for AzaSite sold. External sourced data includes, but is not limited to, information obtained from certain wholesalers with respect to their inventory levels and sell-through to customers as well as data from IMS Health, a third-party supplier of market research data to the pharmaceutical

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

industry. The Company also utilizes this data to help estimate and identify prescription trends and patient demand, as well as product levels in the supply chain.

Product Co-promotion and Royalty Revenues

The Company recognizes co-promotion revenue based on net sales of Elestat and royalty revenue based on net sales of Restasis, as defined in the co-promotion agreements, and as reported to Inspire by Allergan, Inc. (“Allergan”). Through the year ended December 31, 2008, the Company actively promoted both Restasis and Elestat through its commercial organization. As of January 1, 2009, the Company is no longer responsible for the co-promotion of Restasis, but the Company continues to receive royalties on Allergan’s net sales of Restasis. The Company’s co-promotion and royalty revenues are based upon Allergan’s revenue recognition policy and other accounting policies over which the Company has limited or no control and on the underlying terms of the co-promotion agreements. Allergan recognizes revenue from product sales when goods are shipped and title and risk of loss transfers to the customer. The co-promotion agreements provide for gross sales to be reduced by estimates of sales returns, credits and allowances, normal trade and cash discounts, managed care sales rebates and other allocated costs as defined in the agreements, all of which are determined by Allergan and are outside the Company’s control. The Company records a percentage of Allergan’s reported net sales to Inspire for Elestat and Restasis, as co-promotion revenue and royalty revenue, respectively. The Company receives monthly sales information from Allergan and performs analytical reviews and trend analyses using prescription information that it receives from IMS Health. In addition, the Company exercises its audit rights under the contractual agreements with Allergan to annually perform an examination of Allergan’s sales records of both Restasis and Elestat. The Company makes no adjustments to the amounts reported to it by Allergan other than reductions in net sales to reflect the incentive programs managed by the Company. The Company offers and manages certain incentive programs associated with Elestat, which are utilized by it in addition to those programs managed by Allergan. The Company reduces revenue by estimating the portion of Allergan’s sales that are subject to these incentive programs based on information reported to it by a third-party administrator of the incentive program. The rebates associated with the programs that the Company manages represent an insignificant amount, as compared to the rebate and discount programs administered by Allergan and as compared to the Company’s aggregate co-promotion and royalty revenue. Under the co-promotion agreement for Elestat, the Company is obligated to meet predetermined minimum calendar year net sales target levels. If the annual minimum is not achieved, the Company records revenues using a reduced percentage of net sales based upon its level of achievement of the predetermined calendar year net sales target levels. Amounts receivable from Allergan in excess of recorded co-promotion revenue are recorded as deferred revenue. Calendar year 2009 is the last year in which there is a minimum annual net sales target level for Elestat under the co-promotion agreement. As of September 30, 2009 the Company had deferred revenue associated with sales of Elestat of $1,219.

Collaborative Research and Development Revenues

The Company recognizes revenue under its collaborative research and development agreements when it has performed services under such agreements or when the Company or its collaborative partner have met a contractual milestone triggering a payment to the Company. The Company recognizes revenue from its research and development service agreements ratably over the estimated service period as related research and development costs are incurred and the services are substantially performed. Upfront non-refundable fees and milestone payments received at the initiation of collaborative agreements for which the Company has an ongoing research and development commitment are deferred and recognized ratably over the period in which the services are substantially performed. This period, if not defined in the collaborative agreement, is based on estimates by the Company’s management and the progress towards agreed upon development events as set forth in the collaborative agreements. These estimates are subject to revision as the Company’s development efforts progress and it gains knowledge regarding required additional development. Revisions in the commitment period are made in the period that the facts related to the change first become known. If the estimated service period is subsequently modified, the period over which the upfront fee or

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

revenue related to ongoing research and development services is modified on a prospective basis. The Company is also entitled to receive milestone payments under its collaborative research and development agreements based upon the achievement of agreed upon development events that are substantively at-risk by its collaborative partners or the Company. This collaborative research and development revenue is recognized upon the achievement and acknowledgement of the Company’s collaborative partner of a development event, which is generally at the date payment is received from the collaborative partner or is reasonably assured. Accordingly, the Company’s revenue recognized under its collaborative research and development agreements may fluctuate significantly from period to period. No collaborative research and development revenues were recognized in the nine months ended September 30, 2009. For the nine months ended September 30, 2008, the Company recognized $1,250 of collaborative research and development revenue from Santen Pharmaceutical Co., Ltd. upon the completion of its Phase 3 clinical testing relating to its formulation of diquafosol tetrasodium.

Comprehensive Loss

Accumulated other comprehensive loss is comprised of unrealized gains and losses on marketable securities and is disclosed as a component of stockholders’ equity. The Company had $17 and $193 of unrealized losses on its investments that are classified as accumulated other comprehensive loss at September 30, 2009 and December 31, 2008, respectively. Comprehensive loss consists of the following components:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2009			2008			2009			2008
Net loss	$	(8,493	)	$	(9,619	)	$	(37,411	)	$	(41,894	)
Change in unrealized gains/(losses) on investments		(14	)		(482	)		176			(536	)


Total comprehensive loss	$	(8,507	)	$	(10,101	)	$	(37,235	)	$	(42,430	)

Risks from Third Party Manufacturing and Distribution Concentration

The Company relies on single source manufacturers for its commercial products and product candidates. Allergan is responsible for the manufacturing of both Restasis and Elestat and relies on single source manufacturers for the active pharmaceutical ingredients in both products. The Company relies on InSite Vision for the supply of the active pharmaceutical ingredient for AzaSite, which InSite Vision obtains from a single source manufacturer. The Company is responsible for the remaining finished product manufacturing of AzaSite, for which it relies on a single source manufacturer. Additionally, the Company relies upon a single third party to provide distribution services for AzaSite.

The Company relies upon one vendor as the sole manufacturer of the supply of active pharmaceutical ingredients for both Prolacria and denufosol; however, the Company has initiated development of a secondary supplier for denufosol.

Delays in the manufacture or distribution of any product or manufacture of any product candidate could adversely impact the marketing of the Company’s products or the development of the Company’s product candidates. Furthermore, the Company has no control over the manufacturing or the overall product supply chain of Restasis and Elestat.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

Significant Customers and Risk

The Company relies primarily on three pharmaceutical wholesalers to purchase and supply the majority of AzaSite at the retail level. These three pharmaceutical wholesalers accounted for greater than 85% of all AzaSite product sales in the nine months ended September 30, 2009 and fiscal 2008, respectively, and account for 29% of the Company’s outstanding trade receivables as of September 30, 2009. The loss of one or more of these wholesalers as a customer could negatively impact the commercialization of AzaSite. All co-promotion and royalty revenues recognized and recorded were from one collaborative partner, Allergan. The Company is entitled to receive co-promotion revenue from net sales of Elestat and royalty revenue from net sales of Restasis under the terms of its collaborative agreements with Allergan, and accordingly, all trade receivables for these two products are solely due from Allergan and account for 69% of the Company’s outstanding trade receivables as of September 30, 2009. Due to the nature of these agreements, Allergan has significant influence over the commercial success of Restasis and Elestat.

Risk from Generic Competition

The Company’s revenues are subject to risk due to generic product entrants. The Elestat co-promotion agreement provides that unless earlier terminated, the term of such agreement will be in effect until the earlier of (i) the approval and launch of the first generic epinastine product after expiration of the FDA exclusivity period covering Elestat in the United States, or (ii) the approval and launch of the first over-the-counter epinastine product after expiration of the listing of Elestat in the FDA’s Orange Book. Following the termination of such co-promotion agreement, the Company will no longer have rights to co-promote Elestat. The Company will be entitled to receive post-termination payments from Allergan, based on any remaining net sales of Elestat for a period of 36 months. The Company has been notified that Boehringer Ingelheim and Allergan received notices from four companies, advising that each company filed an Abbreviated New Drug Application (“ANDA”) for a generic version of Elestat. The date of submission of the first ANDA filing to the FDA Office of Generic Drugs was October 14, 2008.

Following the expiration of a use patent in August 2009, the manufacture and sale of Restasis is protected in the United States by a formulation patent that expires in May 2014. While a formulation patent may afford certain limited protection, a competitor may attempt to gain FDA approval for a cyclosporine product using a different formulation. Furthermore, following the expiration of the formulation patent in 2014, a generic form of Restasis could be introduced into the market. If and when Restasis experiences competition from a cyclosporine product, including a generic cyclosporine product, the Company’s revenues attributable to Restasis may be significantly impacted.

3.	Stockholders’ Equity – Common Stock Sale

In August 2009, the Company completed a public offering of 25,556 shares of its common stock at a price of $4.50 per share, which included the underwriter’s over-allotment allocation of an additional 3,333 shares, for gross proceeds of $115,000. Net proceeds were $109,000, after deducting underwriting discounts and estimated offering expenses, including reimbursing Warburg Pincus Private Equity IX, L.P. (“Warburg”), a related party, for $500 of expenses incurred. Warburg purchased $40,000, or 8,889 shares, of the common stock offering for total holdings of 22,907 shares of the Company’s common stock, which represented approximately 28% of the Company’s outstanding stock as of September 30, 2009.

The sale of the shares was made pursuant to the Company’s registration statement on Form S-3 filed with the SEC on March 9, 2007, which provided the Company the ability to sell approximately $130,000 of securities, including common stock, preferred stock, debt securities, depositary shares and securities warrants.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

Amendment No. 1 to Standstill Agreement

In connection with its initial investment in Inspire, on July 20, 2007, the Company and Warburg entered into a Standstill Agreement pursuant to which Warburg and certain of its affiliates agreed for three years not to increase their holdings of Inspire’s voting securities beyond the lesser of: (x) 32.5% of Inspire’s voting securities on a fully diluted basis and (y) 34.9% of Inspire’s then outstanding voting securities. On August 4, 2009, the Company and Warburg entered into Amendment No. 1 to the Standstill Agreement extending its term until August 4, 2012.

4.	Inventories

The Company’s inventories are related to AzaSite and are valued at the lower of cost or market using the first-in, first-out (i.e., FIFO) method. Cost includes materials, labor, overhead, shipping and handling costs. The Company’s inventories are subject to expiration dating and the Company has reserved for potential overstocking. The Company’s inventories consisted of the following:


	As of
	September 30, 2009			December 31, 2008
Finished Goods	$	166		$	47
Work-in-Process		317			160
Raw Materials		944			492

Total Inventories	$	1,427		$	699
Less Valuation Reserve		(10	)		(10	)


Total Inventories, net	$	1,417		$	689

5.	Recent Accounting Pronouncements

In October 2009, the FASB issued authoritative guidance regarding revenue arrangements with multiple deliverables. The guidance requires entities to allocate revenue in an arrangement using estimated selling prices of the delivered goods and services based on a selling price hierarchy. The guidance further eliminates the residual method of revenue allocation and requires revenue to be allocated using the relative selling price method. The new guidance should be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted. The Company is currently assessing the impact of adopting this new guidance.

In August 2009, the FASB issued authoritative guidance regarding measuring liabilities at fair value. The authoritative guidance sets forth the types of valuation techniques to be used to value a liability when a quoted price in an active market for the identical liability is not available. It also clarifies transfer restrictions on the fair value of a liability and the ability to use the fair value of a liability that is traded as an asset as an input to the valuation of the underlying liability. The authoritative guidance is effective for interim and annual periods beginning after August 26, 2009. The Company has assessed the impact of this new guidance and expects no material impact to its financial statements upon adoption.

In May 2009, the FASB issued authoritative guidance regarding subsequent events. The authoritative guidance establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. The authoritative guidance requires disclosure of the date through which subsequent events have been evaluated and whether that date represents the date

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

the financial statements were issued or were available to be issued. The authoritative guidance is effective for interim and annual periods ending after June 15, 2009. The Company has evaluated subsequent events through November 6, 2009, the date of issuance of the accompanying condensed financial statements.

In April 2009, the FASB issued authoritative guidance to aid in determining fair value when the volume and level of activity for the assets or liabilities have significantly decreased and when identifying transactions are not orderly, such as a forced liquidation or distressed sale. The authoritative guidance became effective for the Company on April 1, 2009, and the adoption of the guidance did not have a material impact on the Company’s consolidated financial statements.

In April 2009, the FASB issued authoritative guidance on the recognition and presentation of other-than-temporary impairments. The authoritative guidance incorporates impairment guidance for debt securities from various sources of authoritative literature and clarifies the interaction of the factors that should be considered when determining whether a debt security is other than temporarily impaired. The authoritative guidance became effective for the Company on April 1, 2009 and the adoption of the guidance did not have a material impact on the Company’s consolidated financial statements.

6.	Restructuring

In March 2009, the Company announced that it had restructured its operations during the first quarter of 2009, eliminating preclinical and drug discovery activities and refocusing its resources on the development of existing later-stage clinical programs and commercially available products. In connection with the restructuring, the Company recorded restructuring charges of $2,014 for the nine months ended September 30, 2009, which are reported as a separate line item in the accompanying Condensed Statement of Operations. The Company recorded its restructuring activities in accordance with FASB authoritative guidance regarding the accounting for the impairment and disposal of long-lived assets and the accounting for costs associated with exit or disposal activities.

The following table summarizes the components of the restructuring charges:


	Nine months ended September 30, 2009
	Accruals		Non-cash items		Total
Facilities related	$	255	$	—	$	255
Employee separation costs		1,072		—		1,072
Asset impairment		—		484		484
Contracts		203		—		203


Total Restructuring Charges	$	1,530	$	484	$	2,014

Employee separation costs consist of one-time termination benefits, primarily severance costs, associated with the reduction in the Company’s workforce.

Asset impairments consist of property and equipment, primarily lab equipment, that was used for discovery and preclinical research activities at the Company’s facility. The Company performed an impairment analysis and determined that the carrying value of these idle assets exceeded their fair value and recorded an impairment charge of $484 to reduce these assets to estimated fair value of $305. Fair value was based on internally established estimates and the selling prices of similar assets.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

Contract charges consist of costs associated with contractual commitments and work performed subsequent to the restructuring related to programs the Company no longer supports as part of its planned ongoing research and development activities.

Facility related charges consist of estimated losses associated with leased facility space, primarily lab space, at the Company’s Durham, North Carolina headquarters that the Company no longer uses in its planned operations. The unoccupied leased space is approximately 14,000 square feet and the lease term is through January 2011. The Company used a discounted cash-flow analysis to calculate the amount of this liability. The probability-weighted discounted cash-flow analysis is based on management’s assumptions and estimates of its ongoing lease obligations, including contractual rental commitments, build-out commitments and building operating costs, estimates of income from subleases, and market conditions for similar rental properties in its geographic area. The estimated cash flows were discounted using a credit-adjusted risk free rate of approximately 15%. The Company expects to incur approximately $45 of accretion expense over the term of the lease.

The following table sets forth activity in the restructuring liability for the nine months ended September 30, 2009:


	Employee separation costs			Facilities related charges			Other restructuring charges			Total
Balance at December 31, 2008	$	—		$	—		$	—		$	—
Accruals		1,072			255			203			1,530
Payments		(1,016	)		(82	)		(203	)		(1,301	)


Balance at September 30, 2009	$	56		$	173		$	—		$	229

The liability associated with employee separation costs will be fully paid by the end of fiscal 2009. The liability associated with facilities will be reduced as monthly rental payments are made through the lease term, which ends in January 2011.

7.	Fair Value Measurements

The Company’s assets recorded at fair value have been categorized based upon a fair value hierarchy in accordance with FASB authoritative guidance. Under the guidance, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (the “exit price”) in an orderly transaction between market participants at the measurement date. The guidance establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s own assumptions about the market participant assumptions that would be used in pricing the asset or liability based on the best information available in the circumstances. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurements) and the lowest priority to unobservable inputs (level 3 measurements). As of January 1, 2009, the Company adopted the guidance for its fair value measure of non-financial assets and liabilities and there was no material impact.

The Company has not elected the fair value option for financial assets and liabilities existing at January 1, 2008 that were not already measured at fair value or newly transacted in the nine months ended September 30, 2009 and the year ended December 31, 2008. Any future transacted financial assets or liabilities will be evaluated for the fair value election.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

The following fair value hierarchy tables present information about the Company’s assets measured at fair value on a recurring basis as of September 30, 2009 and December 31, 2008:


	Total Balance as of September 30, 2009		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)

Cash equivalents	$	76,959	$	76,959	$	—
Investments:
Available-for-sale securities		55,089		7,201		47,888


Total	$	132,048	$	84,160	$	47,888


	Total Balance as of December 31, 2008		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)
Cash equivalents	$	53,062	$	51,066	$	1,996
Investments:
Available-for-sale securities		13,663		5,000		8,663


Total	$	66,725	$	56,066	$	10,659

Level 1 fair value measurements are based on quoted market prices in active markets and include U.S. government and agency securities. Level 1 cash equivalents consist of investments concentrated in money market funds which are primarily invested in U.S. Treasury securities. Level 1 available-for-sale securities consisted of investments in U.S. Government and Agency securities.

Level 2 fair value measurements are based on quoted prices in markets that are not active, broker dealer quotations, or other methods by which all significant inputs are observable, either directly or indirectly. Level 2 cash equivalents and available-for-sale securities consist of investments in corporate bonds and commercial paper.

The Company does not have any direct investments in auction-rate securities or securities that are collateralized by assets that include mortgages or subprime debt. The Company’s investment policy dictates that investments in money market instruments are limited to those that have a rating of at least A-1 and P-1 according to Standard & Poor’s and Moody’s Investor Services, respectively. Likewise, for investments made in corporate obligations, the Company’s investment policy requires ratings of at least A and A-2 according to Standard & Poor’s and Moody’s Investor Services.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

The following is a summary of the Company’s marketable debt securities which are classified as available-for-sale:


	September 30, 2009
	Cost		Gross Unrealized Gain		Gross Unrealized Loss			Fair Value
Corporate bonds and commercial paper	$	51,405	$	38	$	(55	)	$	51,388
U.S. Government and agencies		3,701		—		—			3,701


Total	$	55,106	$	38	$	(55	)	$	55,089


	December 31, 2008
	Cost		Gross Unrealized Gain		Gross Unrealized Loss			Fair Value
Corporate bonds and commercial paper	$	8,858	$	5	$	(200	)	$	8,663
U.S. Government and agencies		4,998		2		—			5,000


Total	$	13,856	$	7	$	(200	)	$	13,663

The Company does not consider its available-for-sale investments to be other-than-temporarily impaired at September 30, 2009.

The following fair value hierarchy table presents information about the Company’s assets measured at fair value on a non-recurring basis as of September 30, 2009:


	Total Balance as of September 30, 2009		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Other Unobservable Inputs (Level 3)		Total Loss
Property and Equipment Impairments	$	305	$	—	$	—	$	305	$	484

As a result of its restructuring activity, the Company assessed the fair value of assets, primarily property and equipment associated with idle lab facilities, on a non-recurring basis. The fair value of these idle assets as of September 30, 2009 was based on internally established estimates and the selling prices of similar assets.

8.	Fair Value of Financial Instruments

In April 2009, the FASB issued authoritative guidance to require disclosures about fair value of financial instruments in interim financial statements as well as in annual financial statements. The authoritative guidance is effective for interim periods ending after June 15, 2009 and the Company has provided the additional disclosures as required.

The fair values of the Company’s current assets and current liabilities (excluding the current portion of the Company’s long-term debt) approximate their reported carrying amounts. Please see Footnote No. 7, “Fair Value

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

Measurements,” for additional information on the methods and assumptions used to estimate the fair value of the Company’s cash equivalents and available-for-sale securities.

Restricted deposits of $615 consist of cash and cash equivalents which collateralize letters of credit that are required under the terms of certain agreements to which the Company is involved. The carrying amount of these restricted deposits approximates fair value. The Company’s common stock investment of $200 is in a non-public entity for which fair value is not readily determinable. The investment is carried at cost and is subject to potential write-down for impairment whenever events or changes in circumstances indicate that the carrying value is not recoverable. Other long-term liabilities primarily represent deferred fees, credits and cost reimbursement arrangements. The carrying value of these liabilities approximates their fair values.

For the long-term debt that is not actively traded, fair values were estimated using discounted cash flow analyses based on the Company’s current estimated incremental borrowing rates for similar types of borrowing arrangements. As of September 30, 2009 and December 31, 2008, the carrying amount of the Company’s long-term debt was $29,920 and $43,600, respectively. Based upon the discounted cash flow analyses, the estimated fair value of the Company’s long-term debt as of September 30, 2009 and December 31, 2008 was $28,786 and $41,221, respectively.

9.	Stock-Based Compensation

The Company accounts for stock-based compensation in accordance with FASB authoritative guidance regarding share-based payments. Total stock-based compensation was as follows:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2009		2008		2009		2008
Research and development	$	317	$	331	$	960	$	973
Selling and marketing		476		368		1,360		996
General and administrative		502		426		1,418		1,282


Total stock-based compensation expense	$	1,295	$	1,125	$	3,738	$	3,251

Equity Compensation Plans

The Company has two stock-based compensation plans, the Amended and Restated 1995 Stock Plan (the “1995 Plan”) and the Amended and Restated 2005 Equity Compensation Plan (the “2005 Plan”), that allow for share-based payments to be granted to directors, officers, employees and consultants. The 1995 Plan allows for the granting of non-qualified stock options and restricted stock to directors, officers, employees and consultants. The 2005 Plan allows for the granting of both incentive and non-qualified stock options, stock appreciation rights, restricted stock and restricted stock units to directors, officers, employees and consultants. At September 30, 2009, there were 443 and 1,311 shares available for grant as options or other forms of share-based payments under the 1995 Plan and 2005 Plan, respectively.

Basis for Fair Value Estimate of Share-Based Payments

The Company uses its own historical volatility to estimate its future volatility. Actual volatility, and future changes in estimated volatility, may differ substantially from the Company’s current estimates.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

The Company utilizes the simplified method of calculating the expected life of options for grants made to its employees under the 1995 Plan and 2005 Plan in accordance with authoritative guidance due to the lack of adequate historical data with regard to exercise activity on options. For options granted to directors under the 1995 Plan or the 2005 Plan, the Company uses the contractual term of seven years as the expected life of options. The Company will continue with these assumptions in determining the expected life of options under the 1995 Plan and the 2005 Plan until such time that adequate historical data is available. The Company estimates the forfeiture rate based on its historical experience. These estimates will be revised in future periods if actual forfeitures differ from the estimate. Changes in forfeiture estimates impact compensation cost in the period in which the change in estimate occurs.

The table below presents the weighted average expected life in years of options granted under the two plans as described above. The risk-free rate of the stock options is based on the U.S. Treasury yield curve in effect at the time of grant, which corresponds with the expected term of the option granted. The fair value of share-based payments, granted during the period indicated, was estimated using the Black-Scholes option pricing model with the following assumptions and weighted average fair values as follows:


	Stock Options for
	Three Months Ended September 30,						Nine Months Ended September 30,
	2009			2008			2009			2008
Risk-free interest rate		1.94	%		2.78	%		1.78	%		2.64	%
Dividend yield		0	%		0	%		0	%		0	%
Expected volatility		71	%		66	%		71	%		64	%
Expected life of options (years)		3.6			3.6			4.0			4.0

Weighted average fair value of grants	$	2.35		$	2.15		$	2.25		$	2.06

The following table summarizes the stock option activity for both the 1995 Plan and 2005 Plan:


	Number of Shares		Weighted Average Exercise Price (per share)			Weighted Average Remaining Contractual Term (in Years)	Aggregate Intrinsic Value
Outstanding at December 31, 2008	9,531		$	8.16		4.2	$	253
Granted	1,638			4.21
Exercised	(64	)		(4.06	)
Forfeited/cancelled/expired	(529	)		(8.47	)

Outstanding at September 30, 2009	10,576		$	7.56		3.7	$	4,873

Vested and exercisable at September 30, 2009	7,182		$	9.04		3.3	$	1,688

Total intrinsic value of stock options exercised for the nine months ended September 30, 2009 was $99. Cash received from stock option exercises for the nine months ended September 30, 2009 was $261. Due to the Company’s net loss position, no windfall tax benefits have been realized during the nine months ended September 30, 2009. As of September 30, 2009, approximately $7,010 of total unrecognized compensation cost related to unvested stock options is expected to be recognized over a weighted-average period of 2.0 years.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

Information pertaining to the Company’s restricted stock units is provided in the table below:


	As of September 30, 2009

Outstanding restricted stock units		175
Vested restricted stock units		105
Fair value of vested restricted stock units	$	548

The value of restricted stock units granted is based on the closing market price of the Company’s common stock on the date of grant and is amortized on a straight-line basis over the five year requisite service period. At the date of grant, the 175 outstanding restricted stock units had a total fair value of $728. Additionally, approximately $243 of unrecognized share-based compensation expense related to unvested restricted stock units is expected to be recognized over the next 1.8 years.

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

CAUTIONARY STATEMENT

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

We operate in a highly competitive environment that involves a number of risks, some of which are beyond our control. We are subject to risks common to biopharmaceutical companies, including risks inherent in our research, development and commercialization efforts, clinical trials, uncertainty of regulatory actions and marketing approvals, reliance on collaborative partners, enforcement of patent and proprietary rights, the need for future capital, competition associated with products, potential competition associated with our product candidates and retention of key employees. In order for any of our product candidates to be commercialized, it will be necessary for us, or our collaborative partners, to conduct clinical trials, demonstrate efficacy and safety of the product candidate to the satisfaction of regulatory authorities, obtain marketing approval, enter into manufacturing, distribution and marketing arrangements, obtain market acceptance and adequate reimbursement from government and private insurers. We cannot provide assurance that we will generate significant revenues or achieve and sustain profitability in the future. In addition, we can provide no assurance that we will have sufficient funding to meet our future capital requirements. Statements contained in Management’s Discussion and Analysis of Financial Condition and Results of Operations which are not historical facts are, or may constitute, forward-looking statements. Forward-looking statements involve known and unknown risks that could cause our actual results to differ materially from expected results. The most significant known risks are discussed in the section entitled “Risk Factors.” Although we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements.

Our revenues are difficult to predict and depend on numerous factors. The effectiveness of our ability and the ability of third parties on which we rely to help us manufacture, distribute and market AzaSite; physician and patient acceptance of AzaSite; competitor response to AzaSite; as well as discounts, pricing and coverage on governmental and commercial formularies; are all factors, among others, that will impact the level of revenue recorded for AzaSite in subsequent periods. Through the year ended December 31, 2008, we actively promoted both Restasis and Elestat through our commercial organization. As of January 1, 2009, we are no longer responsible for the co-promotion of Restasis, but we continue to receive royalties on Allergan’s net sales of Restasis. Our co-promotion and royalty revenues are based upon Allergan’s revenue recognition policy and other accounting policies, over which we have limited or no control, and on the underlying terms of our co-promotion agreements. Our co-promotion and royalty revenues are impacted by the number of governmental and commercial formularies upon which Restasis and Elestat are listed, the discounts and pricing under such formularies, as well as the estimated and actual amount of rebates, all of which are managed by Allergan. Other factors that are difficult to predict and that impact our co-promotion and royalty revenues are the extent and effectiveness of Allergan’s sales and marketing efforts, our sales and marketing efforts, coverage and reimbursement under Medicare Part D and Medicaid programs, and the sales and marketing activities of competitors. Additionally, our ability to receive revenues on future sales of AzaSite, Restasis and Elestat are dependent upon the duration of market exclusivity and strength of patent protection. Revenues related to development activities are dependent upon the progress toward and the achievement of developmental milestones by us or our collaborative partners.

Our operating expenses are also difficult to predict and depend on several factors. Cost of sales related to AzaSite contain variable and fixed cost components. Research and development expenses, including expenses for development milestones, drug manufacturing, and clinical research activities, depend on the ongoing requirements of

our development programs, completion of business development transactions, availability of capital and direction from regulatory agencies, which are difficult to predict. Management may in some cases be able to control the timing of research and development expenses, in part by accelerating or decelerating clinical development activities, but many of these expenditures will occur irrespective of whether our product candidates are approved when anticipated or at all. We have incurred and expect to continue to incur significant selling and marketing expenses to commercialize our products. Again, management may in some cases be able to control the timing and magnitude of these expenses.

As a result of these factors, we believe that period to period comparisons are not necessarily meaningful and you should not rely on them as an indication of future performance. Due to all of the foregoing factors, it is possible that our operating results will be below the expectations of market analysts and investors. In such event, the prevailing market price of our common stock could be materially adversely affected.

OVERVIEW

We are a biopharmaceutical company focused on researching, developing and commercializing prescription pharmaceutical products for ophthalmic and pulmonary diseases. Our goal is to build and commercialize a sustainable portfolio of innovative new products based on our technical and scientific expertise. The most advanced compounds in our clinical pipeline are Prolacria for dry eye and denufosol tetrasodium for cystic fibrosis, which are both in Phase 3 development, and AzaSite for blepharitis, which is in Phase 2 development. We receive revenue related to the promotion of AzaSite for bacterial conjunctivitis, co-promotion of Elestat for allergic conjunctivitis and royalties on Restasis for dry eye. Our portfolio of products and product candidates include:


PRODUCTS AND PRODUCT CANDIDATES	THERAPEUTIC AREA/ INDICATION	COLLABORATIVE PARTNER ⁽¹⁾	CURRENT STATUS IN THE UNITED STATES

Products

AzaSite	Bacterial conjunctivitis	InSite Vision	Promoting

Elestat	Allergic conjunctivitis	Allergan	Co-promoting

Restasis	Dry eye disease	Allergan	Receiving royalty ⁽²⁾

Product Candidates in Clinical Development

Prolacria (diquafosol tetrasodium)	Dry eye disease	Allergan; Santen Pharmaceutical	Phase 3 ⁽³⁾

Denufosol tetrasodium	Cystic fibrosis	None	Phase 3

AzaSite	Blepharitis	InSite Vision	Phase 2

INS115644, INS117548	Glaucoma	Wisconsin Alumni Research Foundation	Phase 1

(1)	See “Collaborative Agreements” in Item 1 of our Annual Report on Form 10-K for the year ended December 31, 2008 for a detailed description of our agreements with these collaborative partners.

(2)	Under our agreement with Allergan, the royalty that we receive on the net sales of Restasis is based upon a percentage of net sales of Restasis in the United States, and upon a percentage of net sales of Restasis outside the United States, except in Japan, Taiwan, Korea, Hong Kong and China.

(3)

In June 2003, we filed an NDA with the FDA for Prolacria for the treatment of dry eye disease. We have received two approvable letters from the FDA (in December 2003 and December 2005). In May 2008, Santen filed an application for manufacturing and marketing approval of a different formulation of diquafosol tetrasodium with the Japanese Ministry of Health, Labor and Welfare.

We were incorporated as a Delaware corporation in October 1993 and commenced operations in March 1995. We are located in Durham, North Carolina, adjacent to the Research Triangle Park.

PRODUCTS

AzaSite

AzaSite (azithromycin ophthalmic solution) 1% is a topical anti-infective, in which azithromycin is formulated into an ophthalmic solution utilizing DuraSite^®, a novel ocular drug delivery system. Azithromycin is a semi-synthetic antibiotic that is derived from erythromycin and since 1992, has been available via oral administration by Pfizer Inc. under the trade name Zithromax^®. In April 2007, AzaSite was approved by the U.S. Food and Drug Administration, or FDA, for the treatment of bacterial conjunctivitis in adults and children one year of age and older.

In February 2007, we entered into a license agreement with InSite Vision Incorporated, or InSite Vision, pursuant to which we acquired exclusive rights to commercialize AzaSite, as well as other potential topical anti-infective products containing azithromycin as the sole active ingredient, for use in the treatment of human ocular or ophthalmic indications. The license agreement grants us exclusive rights to develop, make, use, market, commercialize and sell the products in the United States and Canada. We are obligated to pay InSite Vision royalties on net sales of AzaSite in the United States and Canada.

In August 2007, we launched AzaSite in the United States and are promoting it to eye care specialists. The manufacture and sale of AzaSite is protected in the United States under use and formulation patents that expire in March 2019.

Elestat

Elestat (epinastine HCl ophthalmic solution) 0.05%, a topical antihistamine with mast cell stabilizing and anti-inflammatory activity, was developed by Allergan, Inc., or Allergan, for the prevention of ocular itching associated with allergic conjunctivitis. Elestat was approved by the FDA in October 2003, is indicated for adults and children at least three years old, and is administered through one drop in each eye twice-a-day. Elestat is a seasonal product with product demand mirroring seasonal trends for topical allergic conjunctivitis products. Typically, demand is highest during the Spring months followed by moderate demand in the Summer and Fall months. The lowest demand is during the Winter months.

In December 2003, we entered into an agreement with Allergan to co-promote Elestat in the United States and launched Elestat in the United States in February 2004. Under the agreement, we have the responsibility for promoting and marketing Elestat to ophthalmologists, optometrists and allergists in the United States and paying the associated costs. We receive co-promotion revenue from Allergan on its U.S. net sales of Elestat. Allergan records sales of Elestat and is responsible for other product costs. When a generic form of Elestat or an over-the-counter form of epinastine ophthalmic solution is introduced into the market, our agreement with Allergan to co-promote Elestat will no longer be in effect, and our revenues from sales of Elestat will be minimal.

Subject to applicable law, competitors are permitted to submit to the FDA an Abbreviated New Drug Application, or ANDA, for a generic version of Elestat, due to the expiration of the marketing exclusivity period for Elestat provided under the Hatch-Waxman Act on October 15, 2008. We have been notified that Boehringer Ingelheim GmbH, or Boehringer Ingelheim, and Allergan received notices from four companies: Apotex, Inc., Cypress Pharmaceutical, Inc., Paddock Laboratories, Inc., and Sandoz Inc., advising that each company filed an ANDA for a generic version of Elestat. The date of submission of the first ANDA filing to the FDA Office of Generic Drugs was October 14, 2008, according to the FDA’s website (www.fda.gov). Furthermore, we have been notified by Allergan that Boehringer Ingelheim has decided not to file infringement lawsuits against the ANDA filers. Boehringer Ingelheim is the owner of a method of treatment patent related to Elestat, and we do not have a license to this patent.

We plan to continue co-promoting and receiving co-promotion revenues on Elestat sales during the FDA’s review period of these ANDAs. We do not know when the FDA will complete its review and we do not expect to be notified by any party prior to any approval. See the risk factor entitled—“When a generic form of Elestat or an over-the-counter form of epinastine ophthalmic solution is introduced into the market, our agreement with Allergan to co-

promote Elestat will no longer be in effect, and our revenues from sales of Elestat will be minimal”—for further discussion of the risk related to the ANDA filings pertaining to a generic version of Elestat.

Restasis

Restasis (cyclosporine ophthalmic emulsion) 0.05% is the first approved prescription product in the United States for the treatment of dry eye disease. It is indicated to increase tear production in adults and children at least 16 years old whose tear production is presumed to be suppressed due to ocular inflammation associated with keratoconjunctivitis sicca, or dry eye disease. Restasis was approved by the FDA in December 2002, and Allergan launched the product in the United States in April 2003.

In June 2001, we entered into an agreement with Allergan to develop and commercialize our product candidate, Prolacria (diquafosol tetrasodium), for the treatment of dry eye disease. The agreement also provides us with a royalty on worldwide (except most Asian markets) net sales of Allergan’s Restasis and granted us the right to co-promote Restasis in the United States. We co-promoted Restasis from 2004 through 2008, at which time we amended our agreement with Allergan such that we ceased co-promoting Restasis. Notwithstanding the fact that we are no longer co-promoting Restasis, Allergan remains obligated to pay us royalties in relation to net sales of Restasis at rates that were in effect prior to the December 2008 amendment.

Following the expiration of a use patent in August 2009, the manufacture and sale of Restasis is protected in the United States by a formulation patent that expires in May 2014.

For a more detailed discussion of the risks associated with these products, please see the Risk Factors located elsewhere in this report.

PRODUCT CANDIDATES IN CLINICAL DEVELOPMENT

Prolacria (diquafosol tetrasodium) for the treatment of dry eye disease

Overview. Diquafosol tetrasodium is a dinucleotide that we discovered, which functions as an agonist at the P2Y₂ receptor and is being developed for the treatment of dry eye disease. Prolacria, the proposed U.S. tradename for diquafosol tetrasodium ophthalmic solution 2%, is designed to stimulate the release of three components of natural tears – mucin, lipids and fluid. The manufacture and sale of Prolacria is protected in the United States under drug substance and formulation patents that expire in July 2016, as well as under use patents that expire in February 2017, subject to any applicable patent restoration that may extend protection up to an additional five years from the date of expiration of the applicable patent, if any, for which restoration is sought.

Under our agreement with Allergan, we are responsible for the development of Prolacria in the United States, and Allergan is responsible for the commercialization of Prolacria in the United States. If and when we receive FDA approval and Prolacria is launched, we expect to begin co-promoting this product. Pursuant to this agreement, Allergan is responsible for obtaining regulatory approval and for commercializing diquafosol tetrasodium in Europe and elsewhere globally with the exception of Asia.

Development Status. In June 2003, we filed a New Drug Application, or NDA, with the FDA for Prolacria for the treatment of dry eye disease. We have received two approvable letters from the FDA (in December 2003 and December 2005). Subsequently, we have held meetings with the FDA and conducted various studies to facilitate a clinical trial design that both the FDA and Inspire agree is appropriate and reasonable to continue our clinical development of Prolacria.

In September 2008, we submitted a clinical protocol and request for Special Protocol Assessment, or SPA, to the FDA for a pivotal Phase 3 environmental trial with Prolacria. In January 2009, we reached agreement with the FDA on the design of a Phase 3 clinical trial for Prolacria, initiated enrollment in the trial, and have recently completed patient enrollment in this clinical trial.

This trial, Trial 03-113, is a Phase 3, randomized, placebo-controlled, environmental clinical trial to evaluate the efficacy and safety of Prolacria in approximately 450 subjects with dry eye disease who have a fluorescein staining score of three in the central region of the cornea at baseline, using the National Eye Institute (NEI) scale of zero to three. Subjects are randomized to Prolacria or placebo administered as eye drops four-times daily for six weeks at approximately 60 U.S. and Canadian sites. The entry criteria for this trial is focused on dry eye patients with more severe disease, as measured by central corneal staining scores. We expect to have top-line results in the first quarter of 2010.

The agreed upon primary efficacy endpoint in Trial 03-113 is the proportion of subjects receiving Prolacria that achieve clearing of fluorescein staining of the central region of the cornea in the study eye (a score of zero on the NEI scale) at the six-week trial endpoint, compared to those receiving placebo. The FDA indicated, as part of the SPA review process, that even if this clinical trial is successful, the FDA’s review of the NDA for Prolacria will also take into account the robustness of the trial results, that a surrogate endpoint was used, the results from previous Prolacria trials and the overall risk/benefit.

Estimated subsequent costs necessary to amend our NDA submission for Prolacria and resubmit the application for commercial approval in the United States are projected to be in the range of $4 million to $8 million. This range includes costs for completing Trial 03-113, regulatory and consulting activities, salaries for development personnel, and other unallocated development costs, but excludes the cost of pre-launch inventory which is Allergan’s responsibility. If we are required to do, and if we elect to do any additional clinical work, our costs will be higher than the projected range. The projected costs associated with Prolacria are difficult to determine due to the uncertainty of the FDA’s scientific review and interpretation of what is required to demonstrate safety and efficacy sufficient for approval. Actual costs could be materially different from our estimate.

Our partner, Santen Pharmaceutical Co., Ltd., or Santen, is currently developing a different formulation of diquafosol tetrasodium, which it refers to as DE-089, in Japan. Our agreement with Santen allows Santen to develop diquafosol tetrasodium for the therapeutic treatment of ocular surface diseases, such as dry eye disease, in Japan and nine other Asian countries, and provides for certain milestone payments to be paid to us upon achievement of development milestones by Santen. In May 2008, Santen filed an application for manufacturing and marketing approval of DE-089 with the Japanese Ministry of Health, Labor, and Welfare (the Japanese equivalent of the FDA), which is pending review.

Denufosol tetrasodium for the treatment of cystic fibrosis

Overview. We are developing denufosol tetrasodium as an inhaled product candidate for the treatment of cystic fibrosis. Denufosol tetrasodium is a first-in-class receptor-mediated chloride channel activator that addresses the underlying ion transport defect in the lungs of patients with cystic fibrosis (CF). Denufosol is designed to enhance airway hydration and mucociliary clearance through receptor-mediated mechanisms that increase chloride secretion, inhibit sodium absorption and increase ciliary beat frequency. These integrated pharmacological actions are important to restoring airway clearance, maintaining lung function, and potentially delaying the progression of CF lung disease. We believe that our product candidate could be the first FDA-approved product that mitigates the underlying defect in the airways of patients with cystic fibrosis. If approved, we expect denufosol to be an early intervention therapy for cystic fibrosis. This product candidate has been granted orphan drug status and fast-track review status by the FDA, and orphan drug status by the European Medicines Agency.

The manufacture and sale of denufosol tetrasodium is protected in the United States under patents that have claims to the drug substance, the formulation, and method of use that expire in February 2017, subject to any applicable patent restoration that may extend protection up to an additional five years from the date of expiration of the applicable patent, if any, for which restoration is sought.

Development Status.

TIGER 1: Our first Phase 3 clinical trial, TIGER-1 (Trial 08-108), with denufosol tetrasodium inhalation solution for the treatment of cystic fibrosis was a 24-week, double-blind, placebo-controlled, randomized clinical trial comparing 60 mg of denufosol to placebo, administered three-times daily by jet nebulizer, in 352 patients with mild cystic fibrosis lung disease (FEV₁ (Forced Expiratory Volume in One Second) (in liters) ³ 75% predicted normal) at clinical centers across North America. This portion of the clinical trial was followed by a 24-week open-label denufosol-only safety extension.

In June 2008, we announced top-line results from the 24-week placebo-controlled portion of the clinical trial. The clinical trial demonstrated statistical significance for its primary efficacy endpoint, which was the change in FEV₁ from baseline at the clinical trial endpoint (at 24 weeks or last observation carried forward). Patients treated with denufosol had a statistically significant improvement in FEV₁ compared to placebo (45 milliliter treatment group difference in adjusted means, p = 0.047). On average, patients on denufosol improved in FEV₁ relative to baseline whereas patients on placebo remained essentially unchanged. Secondary endpoints were also evaluated during the placebo-controlled portion of TIGER-1. There was a trend in differences in FEF_25%-75% (Forced Expiratory Flow 25%-75%), a measure of small airway function, favoring denufosol over placebo (87.5 milliliters/second treatment group difference, p = 0.072). There were no statistically significant differences between denufosol and placebo relative to the frequency of pulmonary exacerbations.

In October 2008, we presented new data at the North American Cystic Fibrosis Conference which indicate that patients who continued to receive denufosol for an additional 24 weeks during the open-label extension experienced a progressive improvement in FEV₁. Those patients who received denufosol for 48 weeks during TIGER-1 experienced a mean change from baseline in FEV₁of 115 ml at the end of the open-label safety extension, almost a two-and-a-half fold increase compared to the initial 48 ml increase at the end of the 24-week placebo-controlled portion of the trial.

The patients who crossed over from placebo to denufosol at Week 24 also experienced improvements in FEV₁ when receiving denufosol during the open-label extension. In terms of observed means, these patients had a 78 ml increase from baseline, compared to a 16 ml increase at the end of the 24-week placebo-controlled portion of the trial. This differs from the 3 ml adjusted mean for placebo at the 24-week study endpoint which also accounted for discontinuations.

A total of 315/352 (89%) patients completed the 24-week placebo-controlled phase of TIGER-1 and had the option to participate in the open-label extension, or OLE, phase in which all patients received denufosol for an additional 24 weeks. All of the patients but one (n=314) entered the OLE extension. The objective of the OLE phase was to evaluate the long-term safety of denufosol treatment among cystic fibrosis patients with FEV₁ ³ 75% predicted normal. The nature and incidence of adverse events, or AEs, reported during the OLE phase were similar to the placebo-controlled phase. In the TIGER-1 trial, there was no evidence of adverse effects on growth, clinical laboratory values or vital sign assessments with long-term denufosol treatment. Denufosol was well-tolerated over 48 weeks of dosing in the TIGER-1 trial.

The retention rate during the OLE phase was approximately 96%, with 302 patients completing the full 48 weeks. Twelve patients withdrew during the OLE phase, with only four withdrawals related to AEs. In the OLE phase, the most commonly reported AEs, which included cough, condition aggravated and productive cough, were similar to those reported during the placebo-controlled phase. The incidence of Serious Adverse Events, or SAEs, in the OLE phase was under 20% and the majority of SAEs were pulmonary exacerbations.

In TIGER-1, there were two definitions of pulmonary exacerbations in the protocol. Based on the primary protocol definition of an exacerbation as a patient experiencing at least four out of 12 defined signs and symptoms regardless of treatment, the frequency of pulmonary exacerbations was 23% in both the placebo-controlled phase and the OLE phase. Based on the secondary protocol definition of an exacerbation as a patient requiring treatment with IV antibiotics for a respiratory sign or symptom, the frequency of pulmonary exacerbations was 8% in the placebo-controlled phase and 13% in the OLE phase.

TIGER 2: In February 2008, we initiated patient enrollment in TIGER-2 (Trial 08-110), our second planned pivotal Phase 3 clinical trial, and in July 2008, we announced modifications to the clinical protocol for this ongoing clinical trial. As modified, the TIGER-2 clinical trial is a 48-week, double-blind, placebo-controlled, randomized clinical trial comparing 60 mg of denufosol to placebo, administered three-times daily by jet nebulizer, in approximately 450 patients with FEV₁ greater than or equal to 75% and less than or equal to 110% of predicted normal. The primary efficacy endpoint is the change from baseline in FEV₁(in liters) at the 48-week trial endpoint. Secondary endpoints include other lung function parameters, pulmonary exacerbations, requirements for concomitant cystic fibrosis medications and health related quality of life. Patients aged five years and older are eligible for enrollment. The use of standard cystic fibrosis maintenance therapies is permitted during the trial. Hypertonic saline is not permitted to be used by those patients enrolled in the clinical trial.

We have approximately 100 participating clinical trial sites across the United States, Canada, Australia and New Zealand. As of November 2009, we have completed patient enrollment, and the patient retention rate in the trial is running similar to TIGER-1 (in the 90% range). Top-line results from this clinical trial are expected in the first quarter of 2011. Additionally, any patient who has successfully completed TIGER-2 may elect to participate in a follow-on, open-label denufosol-only 48-week clinical trial.

Other: In 2006, we completed a 52-week inhalation toxicology study in one animal species, and we have submitted the final study report to the FDA. There were no signs of pulmonary or systemic toxicity at doses well above the Phase 3 clinical dose. In 2009, we completed the required two-year inhalation carcinogenicity study in rats and the final study results confirm that there was no evidence of a carcinogenic effect with denufosol.

Yamasa: Effective September 25, 2009, Inspire and Yamasa Corporation entered into a Technology License Agreement for the Manufacture of Denufosol (the “Agreement”). During our denufosol development program, Yamasa has manufactured all of the denufosol used by Inspire in its related clinical trials. The purpose of the Agreement is to facilitate the transfer of the current denufosol manufacturing technology, including intellectual property, to an additional manufacturer and thus enable a two-supplier strategy for denufosol.

Pursuant to the terms and conditions of the Agreement, Yamasa granted to Inspire an exclusive, worldwide, royalty-free right and license to use, make, have made and sell denufosol and any pharmaceutical formulation containing denufosol as an active pharmaceutical ingredient, under certain intellectual property developed by Yamasa. During the term of the Agreement, Inspire may designate a single manufacturer (in addition to Yamasa) to use the rights licensed from Yamasa at any given time.

In consideration of the grant of rights under the Agreement, Inspire shall pay Yamasa as follows: (i) three hundred million Japanese Yen (¥ 300,000,000) within thirty (30) days of the effective date of the Agreement; (ii) three hundred million Yen (¥ 300,000,000) within thirty (30) days after the receipt of a process validation report by December 31, 2010 following the successful completion of three validation batches; and (iii) four hundred million Yen (¥ 400,000,000) within thirty (30) days after both (a) the acceptance of a pre-approval inspection of denufosol at Yamasa by the FDA, and (b) the approval of a New Drug Application of a formulated denufosol drug product at Inspire by the FDA.

Estimated subsequent costs necessary to submit an NDA for denufosol for the treatment of cystic fibrosis are projected to be in the range of $23 million to $32 million. This estimate includes completing TIGER-2, the subsequent open-label trial and the carcinogenicity study, as well as conducting any additionally required toxicology studies and other ancillary studies, manufacturing denufosol for clinical trials, producing qualification lots consistent with current Good Manufacturing Practices, or cGMP, standards, salaries for development personnel, other unallocated development costs and regulatory preparation and filing costs, but excludes any additional clinical trials, costs to secure a secondary supplier for denufosol, including the approximate $11 million total milestone payments under our technology license agreement with Yamasa Corporation, the cost of pre-launch inventory and any product approval milestones payable to Cystic Fibrosis Foundation Therapeutics, Inc. These costs are difficult to project and actual costs could be materially different from our estimate. For example, clinical trials, toxicology and carcinogenicity studies

may not proceed as planned, results from ongoing or future clinical trials may change our planned development program, additional Phase 3 clinical trials may be necessary, other parties may assist in the funding of our development costs, and an anticipated NDA filing could be delayed.

We intend to participate in the commercialization in North America for denufosol for the treatment of cystic fibrosis. We continue to seek a corporate partner to develop and commercialize this product candidate outside of North America.

AzaSite for the treatment of blepharitis

Overview. Blepharitis is an ocular disease characterized by inflammation of the eyelids, which is often secondary to infection. Blepharitis often involves significant patient discomfort associated with ocular surface inflammation, chronic ocular irritation, unstable tear film and damage to the ocular surface. Our market research and input from eye care specialists suggests that blepharitis is an under-diagnosed and under-treated disease, with no prescription pharmaceutical products approved for this indication. During 2008, we conducted a series of Phase 4 clinical trials with AzaSite evaluating the safety and efficacy of AzaSite in ocular conditions, such as blepharitis.

Development Status. In late 2008, we sought input from numerous medical experts and evaluated our Phase 4 data along with market research on the prevalence and awareness of the disease to evaluate AzaSite’s potential opportunity as it relates to the treatment of blepharitis. In addition, we had preliminary discussions with the FDA on potential regulatory pathways. Based on preliminary information gathered, we decided to pursue a Phase 2 program to study AzaSite for the treatment of blepharitis.

In May 2009, we initiated two Phase 2 clinical trials to pursue a potential indication for the treatment of blepharitis. These clinical trials will evaluate various signs and symptoms of blepharitis as well as safety and tolerability. One clinical trial (Trial 044-101) is a randomized, placebo-controlled, multi-center trial at approximately 30 clinical sites evaluating the safety and efficacy of two weeks of treatment with AzaSite compared to placebo in approximately 300 subjects with blepharitis. As of November 5, 2009, we had approximately 250 patients enrolled in this trial. We are targeting completion of enrollment in this trial in the first quarter of 2010.

The other clinical trial (Trial 044-102) is a randomized, placebo-controlled, multi-center trial at approximately 30 clinical sites evaluating the safety and efficacy of four weeks of treatment with AzaSite compared to placebo in approximately 300 subjects with blepharitis and has completed enrollment.

Given the limited data available and the early stage of development of this program, we are currently unable to reasonably project the future dates and costs that may be associated with clinical trials or a prospective NDA filing for this program.

Glaucoma product candidates

Overview. In November 2004, we licensed technology for use in developing and commercializing new treatments for glaucoma from Wisconsin Alumni Research Foundation, or WARF. In relation to this technology, we are evaluating new and existing compounds that are active in disrupting the acto-cytoskeleton of the trabecular meshwork as potential treatments for glaucoma. Our scientific hypothesis is that the mechanism of action may result in reduction of intraocular pressure, or IOP, by affecting the primary outflow pathway for aqueous humor.

Development Status. In the first quarter of 2007, we initiated a Phase 1 proof-of-concept placebo-controlled, dose-ranging clinical trial (Trial 032-101) for INS115644, the first compound in a series of compounds, in glaucoma patients to evaluate the safety and tolerability of INS115644, as well as changes in IOP. In September 2008, we initiated a Phase 1 proof-of-concept placebo-controlled, dose-ranging clinical trial (Trial 037-101) for a second compound, referred to as INS117548, to evaluate the safety, tolerability and IOP-lowering effects of INS117548 in approximately 80 subjects with early stage glaucoma or ocular hypertension.

In September 2009, we announced top-line results of these trials. In Trial 032-101 with INS115644, a Latrunculin B formulation, we observed dose-dependent IOP-lowering effects and the compound was well-tolerated. Trial 037-101 with INS117548, which is one of a series of Rho kinase molecules we have developed, showed mild IOP-lowering effects but had some dose-related tolerability issues, specifically with ocular discomfort such as burning and stinging. We are in the process of evaluating next steps for the overall glaucoma program, based on our clinical and preclinical data, expert opinions and resource availability.

For a discussion of the risks associated with our development programs, please see the Risk Factors located elsewhere in this report.

RESULTS OF OPERATIONS

Three Months Ended September 30, 2009 and 2008

Revenues

Total revenues were approximately $25.2 million for the three months ended September 30, 2009, as compared to approximately $20.0 million for the same period in 2008. The increase in 2009 revenue of approximately $5.2 million, or 26%, as compared to the same period in 2008, was primarily due to an increase in product revenue from net sales of AzaSite.

Product Sales, net

Product sales of AzaSite, net of rebates and discounts, for the three months ended September 30, 2009 were approximately $9.0 million, as compared to approximately $4.7 million for the same period in 2008. The increase in 2009 revenue for AzaSite of approximately $4.3 million, or 92%, as compared to the same period in 2008, was primarily due to increased patient and physician usage of AzaSite, evidenced by an increase of prescriptions year-over-year, as well as price increases for the product between the periods. Approximately $1.0 million to $1.5 million of revenue from sales of AzaSite for the three months ended September 30, 2009 was associated with hospital usage of AzaSite as a substitute therapy during a temporary supply shortage of erythromycin ophthalmic ointment (0.5%), as discussed below.

In September 2009, erythromycin ophthalmic ointment was placed on the FDA Drug Shortages website. Erythromycin ophthalmic ointment is a macrolide antibiotic routinely used in neonates for prophylaxis of ophthalmia neonatorum, a form of bacterial conjunctivitis that may be contracted by newborns during delivery. Due to this shortage, the Centers for Disease Control and Prevention (CDC) asked healthcare professionals to reserve erythromycin supplies for neonatal use and also recommended the use of AzaSite as an acceptable substitute for neonatal prophylaxis use when erythromycin was not available. We expect the erythromycin supply shortage to be resolved shortly and the favorable impact on fourth quarter 2009 sales to be limited.

For the three months ended September 30, 2009, based on prescription data from IMS Health, there were approximately 125,000 prescriptions written for AzaSite, excluding hospital usage, representing approximately 4% of all prescriptions in the single agent ocular anti-infective market, defined as both branded and generic single-entity ocular antibiotics. In comparison, approximately 83,000 prescriptions were written for AzaSite in the same period in 2008, representing approximately 3% of all prescriptions in the single agent ocular anti-infective market. In addition, our market share in our primary call audience of eye care specialists, mainly ophthalmologists and optometrists, was approximately 8% as of September 30, 2009, as compared to approximately 7% as of September 30, 2008. Since launch, actual units of AzaSite dispensed have been slightly higher than the number of prescriptions as reported by IMS Health due to the issuance of multiple unit prescriptions by some physicians. For the three months ended September 30, 2009, the single agent ocular anti-infective market, in terms of prescriptions, increased approximately 3%, compared to the same period in 2008, based on data as reported by IMS Health.

Product Co-Promotion and Royalty

Total co-promotion and royalty revenue was approximately $16.1 million for the three months ended September 30, 2009, as compared to approximately $15.2 million for the same period in 2008, representing an increase of approximately $896,000, or 6%.

Our royalty revenue from net sales of Restasis for the three months ended September 30, 2009 was $9.4 million, as compared to $7.8 million for the same period in 2008. On December 24, 2008, we amended our agreement with Allergan such that we ceased co-promoting Restasis as of December 31, 2008. Notwithstanding the fact that we are no longer co-promoting Restasis, Allergan remains obligated to pay us royalties in relation to net sales of Restasis at the rates in effect prior to the December 2008 amendment. For the three months ended September 30, 2009 and 2008,

Allergan recorded revenue from net sales of Restasis of approximately $129 million and $107 million, respectively. In October 2009, Allergan revised its 2009 guidance and expects net sales of Restasis to be in the range of $500-$510 million.

Co-promotion revenue from net sales of Elestat for the three months ended September 30, 2009 was approximately $6.7 million, as compared to approximately $7.4 million for the same period in 2008. The decrease in co-promotion revenue from net sales of Elestat of $663,000, or 9%, as compared to the same period in 2008, was primarily due to the deferral of approximately $1.2 million of co-promotion revenue, as compared to no revenue deferred for the three months ended September 30, 2008. When combining the deferred revenue of $1.2 million with the $6.7 million of co-promotion revenue recognized for the three months ended September 30, 2009, the total combined amount exceeds co-promotion revenue in the same period in 2008 by approximately $556,000, primarily due to an annual price increase that became effective in the first quarter of 2009 and a slight increase in the total U.S. allergic conjunctivitis market during the three months ended September 30, 2009.

Under our agreement with Allergan related to our co-promotion of Elestat, we are obligated to meet predetermined minimum calendar year net sales target levels. We are entitled to an escalating percentage of net sales based upon predetermined minimum calendar year net sales target levels that we are obligated to meet. If the annual minimum is not achieved, we record revenues using a reduced percentage of net sales based upon our level of achievement of the predetermined calendar year net sales target levels. Amounts receivable from Allergan in excess of our recorded co-promotion revenue are recognized as deferred revenue and will be realized in future quarters of 2009 to the extent additional minimum annual net sales target levels are achieved. We expect to achieve our annual 2009 net sales target level for Elestat and recognize the remaining deferred revenue in the fourth quarter of 2009. Under the co-promotion agreement with Allergan, calendar year 2009 is the last year that our co-promotion revenues of Elestat are subject to annual minimum target levels.

Elestat is a seasonal product with product demand mirroring seasonal trends for topical allergic conjunctivitis products. Typically, demand is highest during the Spring months followed by moderate demand in the Summer and Fall months. The lowest demand is during the Winter months. Based upon national prescription data from IMS Health, for the three months ended September 30, 2009 and 2008, Elestat prescriptions represented approximately 7% of the total U.S. allergic conjunctivitis market. Based on current trends in prescriptions for Elestat, we expect our 2009 market share to remain relatively constant with 2008. Based upon monthly data from IMS Health, the total U.S. allergic conjunctivitis market, in terms of prescriptions, increased approximately 1% for the three months ended September 30, 2009, as compared to the same period in 2008.

During the third quarter of 2009, ISTA Pharmaceuticals, Inc. received FDA approval for Bepreve^TM (bepotastine besilate ophthalmic solution) 1.5% as a twice-daily prescription eye drop treatment for ocular itching associated with allergic conjunctivitis, and began commercializing this product in October 2009.

Cost of Sales

Cost of sales related to the sales of AzaSite were approximately $3.0 million for the three months ended September 30, 2009, as compared to approximately $1.6 million for the same period in 2008. The increase in cost of sales of $1.4 million, or 87%, as compared to the same period in 2008, was primarily due to increased sales volume of AzaSite, which has resulted in increased royalties, as well as an increase in the royalty rate, paid to InSite Vision. Through June 30, 2009, we paid a 20% royalty to InSite Vision on net sales of AzaSite in accordance with our licensing agreement. In July 2009, our royalty rate to InSite Vision on net sales of AzaSite increased from 20% to 25% and will remain at 25% for the remaining term of the licensing agreement.

Cost of sales expense consists of variable and fixed cost components. Variable cost components include royalties to InSite Vision on net sales of AzaSite, the cost of AzaSite inventory sold, distribution, shipping and logistic service charges from our third-party logistics provider, and changes to our inventory reserve for overstocking or short-dated material. Fixed cost components are primarily the amortization of the $19.0 million approval milestone that we

paid InSite Vision as part of our licensing agreement. This approval milestone is being amortized ratably on a straight-line basis through the term of the underlying patent coverage for AzaSite, which expires in March 2019.

Research and Development Expenses

Research and development expenses were approximately $15.3 million for the three months ended September 30, 2009, as compared to approximately $9.8 million for the same period in 2008. The increase in research and development expenses of approximately $5.5 million, or 56%, for the three months ended September 30, 2009, as compared to the same period in 2008, was primarily due to increased costs associated with our cystic fibrosis program, including the recognition of an approximate $3.3 million milestone payable to Yamasa Corporation upon entering into an agreement to license certain technology related to manufacturing in support of this program. Effective September 25, 2009, we entered into a technology license agreement with Yamasa Corporation to facilitate the transfer of the current denufosol manufacturing technology, including intellectual property, to an additional manufacturer and thus enable a two-supplier strategy for denufosol. The remaining increase in research and development expenses was due to the initiation of our AzaSite for blepharitis Phase 2 program in the first quarter of 2009.

These increases in research and development expenses for the three months ended September 30, 2009 were partially offset by reduced spending on our glaucoma program as a result of the completion of Phase 1 trial activities, cost savings from our restructuring activities in the first quarter of 2009, as well as the reclassification of approximately $750,000 of expense previously recorded in the second quarter of 2009 related to equipment costs to be used to produce denufosol in commercial quantities as part of our initiative to develop a second supplier of denufosol. During the third quarter of 2009, our negotiations with a potential second supplier evolved such that we expect to own all equipment and retain exclusive use of this equipment, and have therefore capitalized costs associated with this equipment.

Research and development expenses include all direct and indirect costs, including salaries for our research and development personnel, consulting fees, clinical trial costs, including the development and manufacture of drug product for clinical trials, sponsored research costs, clinical trial insurance, upfront license fees, milestone and royalty payments relating to research and development, and other fees and costs related to the development of product candidates. Research and development expenses vary according to the number of programs in clinical development and the stage of development of our clinical programs. Later stage clinical programs tend to cost more than earlier stage programs due to the length of the clinical trials and the number of patients enrolled in later stage clinical trials.

Selling and Marketing Expenses

Selling and marketing expenses were approximately $11.3 million for the three months ended September 30, 2009, as compared to approximately $13.8 million for the same period in 2008. The decrease in selling and marketing expenses of approximately $2.5 million, or 18%, for the three months ended September 30, 2009, as compared to the same period in 2008, was due to an overall reduction in promotional and marketing activities, including Phase 4 clinical trial activities.

Our commercial organization currently focuses its promotional efforts on approximately 9,000 eye care specialists. Our selling and marketing expenses include all direct costs associated with the commercial organization, which include our sales force and marketing programs. Our sales force expenses include salaries, training and educational program costs, product sample costs, fleet management and travel. Our marketing and promotion expenses include product management, promotion, advertising, public relations, Phase 4 clinical trial costs, physician training and continuing medical education and administrative expenses. We adjust the timing, magnitude and targeting of our advertising, promotional, Phase 4 clinical trials and other commercial activities for our products based on seasonal trends and other factors, and accordingly, these costs can fluctuate from period to period.

General and Administrative Expenses

General and administrative expenses were approximately $3.4 million for the three months ended September 30, 2009, as compared to approximately $3.7 million for the same period in 2008. The decrease in general and administrative expenses of approximately $338,000, or 9%, for the three months ended September 30, 2009, as compared to the same period in 2008, was primarily due to the reimbursement of legal expenses associated with our defense of a shareholder litigation and SEC investigation, both of which were resolved during fiscal year 2008.

Our general and administrative expenses consist primarily of personnel, facility and related costs for general corporate functions, including business development, finance, accounting, legal, human resources, quality/compliance, facilities and information systems.

Other Income/(Expense)

Other expense, net was approximately $561,000 for the three months ended September 30, 2009, as compared to other expense, net of approximately $586,000 in the same period in 2008. For the three months ended September 30, 2009, decreases in interest expense were nearly entirely offset by decreases in interest income as compared to the same period in 2008. Interest income was negatively impacted due to a lower rate of return during the three months ended September 30, 2009, as compared to the same period in 2008. The decrease in interest expense is the result of a lower average outstanding principal balance of our term loan facility during the three months ended September 30, 2009, as compared to the same period in 2008.

Nine Months Ended September 30, 2009 and 2008

Revenues

Total revenues were approximately $62.5 million for the nine months ended September 30, 2009, as compared to approximately $51.6 million for the same period in 2008. The increase in 2009 revenue of approximately $10.9 million, or 21%, as compared to the same period in 2008, was primarily due to an increase in product revenue from net sales of AzaSite, as well as increased royalty revenue from net sales of Restasis. Total revenues for the 2008 period included the recognition of a development milestone of $1.25 million from Santen for its development of diquafosol tetrasodium in accordance with our development, license and supply agreement, as previously discussed in this report. No milestone revenue has been recorded in 2009.

Product sales of AzaSite, net of rebates and discounts, for the nine months ended September 30, 2009 were approximately $22.8 million, as compared to approximately $11.1 million for the same period in 2008, an increase of $11.7 million, or 106%.

Co-promotion and royalty revenue for the nine months ended September 30, 2009 was comprised of approximately $26.4 million of royalty revenue from net sales of Restasis and $13.3 million of co-promotion revenue from net sales of Elestat. This compares to approximately $24.1 million of royalty revenue on net sales of Restasis and $15.2 million of co-promotion revenue from net sales of Elestat for the same period in 2008. For the nine months ended September 30, 2009, Allergan recorded approximately $360 million of revenue from net sales of Restasis, as compared to approximately $327 million for the same period in 2008.

As previously discussed in this report, for the nine months ended September 30, 2009, we deferred approximately $1.2 million of co-promotion revenue associated with net sales of Elestat as the minimum annual 2009 net sales target level had not been achieved. By comparison, for the same period in 2008, we recognized the full amount of co-promotion revenue associated with net sales of Elestat as a result of achieving the minimum annual 2008 net sales target level.

Subject to applicable law, competitors are permitted to submit to the FDA an ANDA for a generic version of Elestat, due to the expiration of the marketing exclusivity period for Elestat provided under the Hatch-Waxman Act on October 15, 2008.

We have been notified that Boehringer Ingelheim and Allergan received notices from four companies: Apotex, Inc., Cypress Pharmaceutical, Inc., Paddock Laboratories, Inc., and Sandoz Inc., advising that each company filed an ANDA for a generic version of Elestat. The date of submission of the first filing to the FDA Office of Generic Drugs was October 14, 2008, according to the FDA’s website (www.fda.gov). Furthermore, we have been notified by Allergan that Boehringer Ingelheim has decided not to file infringement lawsuits against the ANDA filers. Boehringer Ingelheim is the owner of a method of treatment patent related to Elestat, and we do not have a license to this patent.

The Elestat co-promotion agreement provides that unless earlier terminated, the term of such agreement will be in effect until the earlier of (i) the approval and launch of the first generic epinastine product after expiration of the FDA exclusivity period covering Elestat in the United States, or (ii) the approval and launch of the first over-the-counter epinastine product after expiration of the listing of Elestat in the FDA’s Orange Book. Following the termination of such co-promotion agreement, we will no longer have rights to co-promote Elestat. We will be entitled to receive post-termination payments from Allergan, based on any remaining net sales of Elestat for a period of 36 months. During the three successive 12-month periods immediately following the termination of the agreement, Allergan will be obligated to pay to us 20%, 15% and 10%, respectively, on any net sales of Elestat in the United States. We plan to continue co-promoting and receiving co-promotion revenues on Elestat sales during the FDA’s review period of these ANDAs. We do not know when the FDA will complete its review and we do not expect to be notified by any party prior to any approval. Loss of our co-promotion revenue from Elestat will significantly impact our results of operations and cash flows.

Our future revenue will depend on various factors including the effectiveness of our commercialization of AzaSite and continued commercial success and duration of commercial exclusivity of Restasis and Elestat. In addition to the foregoing, pricing, rebates, discounts and returns for all products; the effect of competing products; coverage and reimbursement under commercial or government plans; and seasonality of sales of Elestat will impact future revenues. If Allergan significantly under-estimates or over-estimates rebate amounts, there could be a material effect on our revenue. In addition to the continuing sales of AzaSite, Restasis and Elestat, our future revenue will also depend on our ability to enter into additional collaboration agreements, and to achieve milestones under existing or future collaboration agreements, as well as whether we obtain regulatory approvals for our product candidates.

Cost of Sales

Cost of sales related to the sales of AzaSite were approximately $7.3 million for the nine months ended September 30, 2009, as compared to approximately $4.3 million for the same period in 2008. Through June 30, 2009, we paid a 20% royalty to InSite Vision on net sales of AzaSite in accordance with our licensing agreement. In July 2009, our royalty rate to InSite Vision on net sales of AzaSite increased from 20% to 25% and will remain at 25% for the remaining term of the licensing agreement.

Certain costs included in cost of sales are subject to annual increases for which we have limited control. We expect that cost of sales will increase in relation to, but not proportionately to, the increases in revenue from sales of AzaSite.

Research and Development Expenses

Research and development expenses were approximately $41.1 million for the nine months ended September 30, 2009, as compared to approximately $34.4 million for the same period in 2008. The increase in research and development expenses of approximately $6.7 million, or 20%, for the nine months ended September 30, 2009, as compared to the same period in 2008, was primarily due to increased costs associated with our cystic fibrosis program and the initiation of our AzaSite for blepharitis Phase 2 program in the first quarter of 2009, partially offset by the discontinuation of our allergic rhinitis program in the second quarter of 2008, reduced spending on our glaucoma

program as a result of the completion of Phase 1 trial activities, as well as cost savings from our restructuring activities in the first quarter of 2009.

Our research and development expenses for the nine months ended September 30, 2009 and 2008, and from the respective project’s inception are shown below and includes the percentage of overall research and development expenditures for the periods listed.


	(In thousands)
	Nine Months Ended September 30,						Cumulative from Inception to September 30, 2009
	2009		%	2008		%	Cumulative from Inception to September 30, 2009		%

Denufosol tetrasodium for cystic fibrosis ⁽¹⁾	$	24,306	59	$	14,147	41	$	89,086	25

Prolacria (diquafosol tetrasodium) for dry eye disease		5,420	13		6,078	18		56,371	16

AzaSite for blepharitis		4,519	11		—	—		4,602	1

AzaSite		1,643	4		1,119	3		17,862	5

INS115644 and INS117548 for glaucoma and related research and development		1,461	4		3,881	11		16,353	5

Epinastine nasal spray for allergic rhinitis ⁽²⁾		26	—		3,340	10		19,875	6

Other research, preclinical and development costs ⁽³⁾		3,749	9		5,836	17		149,816	42


Total	$	41,124	100	$	34,401	100	$	353,965	100

(1)	Includes the recognition of an approximate $3.3 million milestone in September 2009.

(2)	On April 23, 2008, we discontinued the development of epinastine nasal spray.

(3)

Other research, preclinical and development costs represent all unallocated research and development costs or those costs allocated to preclinical programs, discontinued and/or inactive programs. These unallocated costs include personnel costs of our research, preclinical programs, internal and external general research costs and other internal and external costs of other research, preclinical and development programs.

Our future research and development expenses will depend on the results and magnitude or scope of our clinical activities and requirements imposed by regulatory agencies. Year over year spending on active development programs can vary due to the differing levels and stages of development activity, the timing of certain expenses and other factors. Accordingly, our research and development expenses may fluctuate significantly from period to period. In addition, if we in-license or out-license rights to product candidates, our research and development expenses may fluctuate significantly from prior periods.

Selling and Marketing Expenses

Selling and marketing expenses were approximately $36.1 million for the nine months ended September 30, 2009, as compared to approximately $42.9 million for the same period in 2008. The decrease in selling and marketing expenses of approximately $6.8 million, or 16%, for the nine months ended September 30, 2009, as compared to the same period in 2008, was due to an overall reduction in promotional and marketing activities, including Phase 4 clinical trial activities.

Future selling and marketing expenses will depend on the level of our future commercialization activities. We expect selling and marketing expenses will increase in periods that immediately precede and follow product launches.

In addition, if we in-license or out-license rights to products, our selling and marketing expenses may fluctuate significantly from prior periods.

General and Administrative Expenses

General and administrative expenses were approximately $11.5 million for the nine months ended September 30, 2009, as compared to approximately $10.8 million for the same period in 2008. The increase in general and administrative expenses of approximately $676,000, or 6%, for the nine months ended September 30, 2009, as compared to the same period in 2008, was primarily due to an increase in consulting and general legal expenses.

Future general and administrative expenses will depend on the level and extent of support required to conduct our future research and development, commercialization, business development, and corporate activities.

Restructuring

In March 2009, we announced that we had restructured our operations during the first quarter of 2009, eliminating preclinical and drug discovery activities and refocusing our resources on the development of existing later-stage clinical programs and commercially available products. In connection with the restructuring, we recorded restructuring charges of approximately $2.0 million for the nine months ended September 30, 2009, which are reported in a separate line item in our Condensed Statement of Operations. Significant components of the restructuring charge were one-time termination benefits for employees impacted by the restructuring, estimated costs to write-down idle lab equipment to net realizable value, losses associated with leased facility space, primarily lab space that is now vacant, and costs to satisfy contract commitments related to activities and programs no longer associated with our supported programs and on-going operations. We expect that we may have some insignificant additional costs during 2009 associated with this restructuring related to fully decommissioning our lab facilities. As a result of this restructuring, cost savings for 2009 are expected to be approximately $3 million.

Other Income/(Expense)

Other expense, net was approximately $1.9 million for the nine months ended September 30, 2009, as compared to other expense, net of approximately $1.1 million in the same period in 2008. The increase in other expense, net of approximately $817,000 for the nine months ended September 30, 2009, as compared to the same period in 2008, was due to decreased interest income partially offset by a decrease in interest expense. Interest income was negatively impacted due to lower average cash and investment balances combined with a lower rate of return during the nine months ended September 30, 2009, as compared to the same period in 2008. The decrease in interest expense is the result of a lower average outstanding principal balance of our term loan facility during the nine months ended September 30, 2009, as compared to the same period in 2008.

Other income/(expense) fluctuates from year to year depending on the level of interest income earned on variable cash and investment balances, realized gains and losses on investments due to changes in fair market value and interest expense on debt and capital lease obligations. Future other income/(expense) will depend on our future cash and investment balances, the return and change in fair market value on these investments, as well as levels of debt and the associated interest rates.

LIQUIDITY AND CAPITAL RESOURCES

We have financed our operations primarily through the sale of equity securities, including private sales of preferred stock and public offerings of common stock and, to a lesser extent, through our term loan facility. We also currently receive co-promotion revenue from net sales of Elestat, royalty revenue from net sales of Restasis, and product revenue from net sales of AzaSite. We do not expect our revenue to exceed our operating expenses in 2009.

At September 30, 2009, we had net working capital of approximately $90.6 million, an increase of approximately $38.1 million from approximately $52.5 million at December 31, 2008. The increase in working capital was principally due to the sale of common stock described below, offset by the funding of normal operating expenses associated with commercialization activities and the development of our product candidates, as well as principal and interest payments on our term loan facility. Our principal sources of liquidity at September 30, 2009 were approximately $84.4 million in cash and cash equivalents, approximately $55.1 million in investments, which are considered available-for-sale, and approximately $20.4 million in trade receivables.

In August 2009, we completed a public offering of 25,555,555 shares of our common stock at a price of $4.50 per share, which included an additional 3,333,332 shares underwriter over-allotment option, for gross proceeds of $115 million. Net proceeds were $109 million, after deducting underwriting discounts and estimated offering expenses.

In December 2006, we entered into a loan and security agreement in order to obtain debt financing of up to $40.0 million to fund in-licensing opportunities and related development. In June 2007, we amended the loan and security agreement to enable us to draw upon a new supplemental term loan facility in the amount of $20.0 million. We have borrowed the full $60.0 million under the term loan facility of which $29.9 million was outstanding as of September 30, 2009. We make scheduled principal and interest payments on a monthly basis and all loan advances made under the agreement have a final maturity date in March 2011.

Our working capital requirements may fluctuate in future periods depending on many factors, including: the number, magnitude, scope and timing of our development programs; the commercial potential and success of our products; the potential loss of commercial exclusivity of any of our products; the loss of revenue from our products due to competition or loss of market share; the level of ongoing costs related to the commercialization of AzaSite and Elestat; the costs related to the potential FDA approval of our other product candidates; the cost, timing and outcome of regulatory reviews, regulatory investigations, and changes in regulatory requirements; the costs of obtaining patent protection for our product candidates; the timing and terms of business development activities; the rate of technological advances relevant to our operations; the timing, method and cost of the commercialization of our product candidates; the efficiency of manufacturing processes developed on our behalf by third parties; the level of required administrative support for our daily operations; the availability of capital to support product candidate development programs we pursue; and the commercial potential of our product candidates.

2009 Financial Guidance

Based upon current AzaSite, Restasis and Elestat sales trends, we expect to record 2009 aggregate revenue in the range of $80-$90 million. Total 2009 operating expenses are expected to be in the range of $120-$135 million. Cost of sales, which includes the amortization of the AzaSite approval milestone and royalty obligations to InSite Vision, is expected to be in the range of $8-$13 million. Total estimated selling and marketing, general and administrative, and research and development expenses are estimated to be in the range of $45-$50 million, $14-$18 million and $50-$60 million, respectively. Included within this operating expense guidance are projected stock-based compensation costs of approximately $5 million.

Our ability to remain within our operating expense target range is subject to multiple factors, including unanticipated cost overruns, the need to expand or reduce the magnitude or scope of existing development programs, the need to change the number or timing of clinical trials, unanticipated regulatory requirements, unanticipated costs to successfully commercialize our products and product candidates, the commercial success of our current products and other factors described under the Risk Factors located elsewhere in this report.

Excluding the impact of our financing in the third quarter, operating cash utilization in 2009 is expected to be in the range of $50-$65 million, which incorporates $18 million of principal repayment on our outstanding debt. Based on current operating plans, we expect our cash and investments to provide liquidity beyond 2010.

Our need for additional working capital will largely be determined by the commercial success of our products and the successful and timely completion of our development programs. In order for us to continue operations substantially beyond 2010 we will need to: (1) successfully increase revenues, (2) obtain additional product candidate approvals, (3) out-license rights to certain of our product candidates, (4) raise additional capital through equity or debt financings or from other sources, (5) reduce spending on one or more research and development programs and/or (6) further restructure our operations. Additionally, after deducting the $115 million of common stock sold in August 2009, we retain the ability to sell $15 million of securities, including common stock, preferred stock, debt securities, depositary shares and securities warrants from an effective shelf registration statement which we filed with the SEC on March 9, 2007. The loan and security agreement that we entered into in December 2006, as amended in June 2007, contains a financial covenant that requires us to maintain certain levels of liquidity based on our cash, investment and account receivables balances, as well as negative covenants that may limit us from assuming additional indebtedness and entering into other transactions as defined in the agreement. The agreement also includes a subjective acceleration clause which provides our lenders with the ability to accelerate repayment, even if we are in compliance with all conditions of the agreement, upon a material adverse change to our business, properties, assets, financial condition or results of operations. At September 30, 2009, we were in compliance with all of the covenants under our loan and security agreement and project that we will be throughout 2009.

CEO Succession Plan

We announced on July 31, 2009 that our President and CEO, Dr. Christy L. Shaffer, informed the Board of Directors that she plans to step down from her executive positions once a successor is in place. Our Board of Directors has initiated an external CEO search. Dr. Shaffer has committed to the Board that she will remain in place during the hiring of her successor, ensure a smooth and orderly transition process and be available in an advisory role, as needed.

Off Balance Sheet Arrangements

As of September 30, 2009, we were not a party to any off-balance sheet arrangements.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The accompanying discussion and analysis of our financial condition and results of operations are based upon our financial statements and the related disclosures, which have been prepared in accordance with generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. We evaluate our estimates, judgments and the policies underlying these estimates on a periodic basis, as situations change and regularly discuss financial events, policies, and issues with members of our audit committee and our independent registered public accounting firm. In addition, recognition of revenue from product co-promotion and earned royalties is affected by certain estimates and judgments made by Allergan on which we rely when recording this revenue. We routinely evaluate our estimates and policies regarding revenue recognition, product returns, rebates and incentives, inventory and manufacturing, taxes, stock-based compensation expense, clinical trial, preclinical/toxicology, research and other service liabilities.

We believe the following policies to be the most critical to an understanding of our financial condition and results of operations because they require us to make estimates and judgments about matters that are inherently uncertain.

Revenue Recognition

We record all of our revenue from: (1) sales of AzaSite; (2) product co-promotion activities and earned royalties; and (3) collaborative research agreements when realized or realizable and earned. Revenue is realized or realizable and earned when all of the following criteria are met: 1) persuasive evidence of an arrangement exists; 2) delivery has occurred or services have been rendered; 3) the seller’s price to the buyer is fixed or determinable; and 4) collectibility is reasonably assured.

Product Revenues

We recognize revenue for sales of AzaSite when title and substantially all the risks and rewards of ownership have transferred to the customer, which generally occurs on the date of shipment. In the United States, we sell AzaSite to wholesalers and distributors, who, in turn, sell to pharmacies and federal, state and commercial health care organizations. Accruals, or reserves, for estimated rebates, discounts, chargebacks and other sales incentives (collectively, “sales incentives”) are recorded in the same period that the related sales are recorded and are recognized as a reduction in sales of AzaSite. Sales incentive accruals, or reserves, are based on reasonable estimates of the amounts earned or claimed on the sales of AzaSite. These estimates take into consideration current contractual and statutory requirements, specific known market events and trends, internal and external historical data and experience, and forecasted customer buying patterns. Amounts accrued or reserved for sales incentives are adjusted for actual results and when trends or significant events indicate that an adjustment is appropriate. As of September 30, 2009 and December 31, 2008, we had net reserves of approximately $3.7 million and $1.3 million, respectively, for sales incentives.

Our ability to recognize revenue for sales of AzaSite is subject to Financial Accounting Standards Board, or FASB, authoritative guidance regarding revenue recognition when the right of return exists. The guidance states that revenue from sales transactions where the buyer has the right to return the product will be recognized at the time of sale only if: (1) the seller’s price to the buyer is substantially fixed or determinable at the date of sale; (2) the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product; (3) the buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product; (4) the buyer acquiring the product for resale has economic substance apart from that provided by the seller; (5) the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer; and (6) the amount of future returns can be reasonably estimated. Customers are able to return short-dated or expired AzaSite that meet the guidelines set forth in our return goods policy. Our return goods policy generally allows for returns of AzaSite within an 18-month period, from six months prior to the expiration date and up to 12 months after the expiration date, but may differ from customer to customer, depending on certain factors. We estimate the level of sales that will ultimately be returned pursuant to our return policy and record a related reserve at the time of sale. These amounts are deducted from our gross sales of AzaSite in determining our net sales. Future estimated returns of AzaSite are based primarily on the return data for comparative products and our own historical experience with AzaSite. We also consider other factors that could impact sales returns of AzaSite. These factors include levels of inventory in the distribution channel, estimated remaining shelf life, price changes of competitive products, and current and projected product demand that could be impacted by introductions of generic products and introductions of competitive new products, among others. As of September 30, 2009 and December 31, 2008, we had net reserves of approximately $1.1 million and $701,000, respectively, for potential returns of AzaSite.

We utilize data from external sources to help us estimate our gross to net sales adjustments as they relate to the sales incentives and recognition of revenue for AzaSite sold. External sourced data includes, but is not limited to, information obtained from certain wholesalers with respect to their inventory levels and sell-through to customers as well as data from IMS Health, a third-party supplier of market research data to the pharmaceutical industry. We also utilize this data to help estimate and identify prescription trends and patient demand, as well as product levels in the supply chain.

Product Co-promotion and Royalty Revenues

We recognize co-promotion revenue based on net sales of Elestat and royalty revenue based on net sales of Restasis, as defined in the co-promotion agreements, and as reported to us by Allergan. Through the year ended December 31, 2008, we actively promoted both Restasis and Elestat through our commercial organization. As of January 1, 2009, we are no longer responsible for the co-promotion of Restasis, but we continue to receive royalties on Allergan’s net sales of Restasis. Our co-promotion and royalty revenues are based upon Allergan’s revenue recognition policy and other accounting policies over which we have limited or no control and on the underlying terms of our co-promotion agreements. Allergan recognizes revenue from product sales when goods are shipped and title and risk of loss transfers to the customer. The co-promotion agreements provide for gross sales to be reduced by estimates of sales returns, credits and allowances, normal trade and cash discounts, managed care sales rebates and other allocated costs as defined in the agreements, all of which are determined by Allergan and are outside our control. We record a percentage of Allergan’s reported net sales to us for Elestat and Restasis, as co-promotion revenue and royalty revenue, respectively. We receive monthly net sales information from Allergan and perform analytical reviews and trend analyses using prescription information that we receive from IMS Health. In addition, we exercise our audit rights under the contractual agreements with Allergan to annually perform an examination of Allergan’s sales records of both Restasis and Elestat. We make no adjustments to the amounts reported to us by Allergan other than reductions in net sales to reflect the incentive programs managed by us. We offer and manage certain incentive programs associated with Elestat, which are utilized by us in addition to those programs managed by Allergan. We reduce revenue by estimating the portion of Allergan’s sales that are subject to these incentive programs based on information reported to us by our third-party administrator of the incentive programs. The rebates associated with the programs we manage represent an insignificant amount, as compared to the rebate and discount programs administered by Allergan and as compared to our aggregate co-promotion and royalty revenue. Under the co-promotion agreement for Elestat, we are obligated to meet predetermined minimum calendar year net sales target levels. If the annual minimum is not achieved, we record revenues using a reduced percentage of net sales based upon our level of achievement of the predetermined calendar year net sales target levels. Amounts receivable from Allergan in excess of recorded co-promotion revenue are recorded as deferred revenue. Calendar year 2009 is the last year in which there is a minimum annual net sales target level for Elestat under the co-promotion agreement. As of September 30, 2009, we had deferred revenue associated with sales of Elestat of $1.2 million.

Collaborative Research and Development Revenues

We recognize revenue under our collaborative research and development agreements when we have performed services under such agreements or when we or our collaborative partner have met a contractual milestone triggering a payment to us. We recognize revenue from our research and development service agreements ratably over the estimated service period as related research and development costs are incurred and the services are substantially performed. Upfront non-refundable fees and milestone payments received at the initiation of collaborative agreements for which we have an ongoing research and development commitment are deferred and recognized ratably over the period in which the services are substantially performed. This period, if not defined in the collaborative agreement, is based on estimates by management and the progress towards agreed upon development events as set forth in our collaborative agreements. These estimates are subject to revision as our development efforts progress and we gain knowledge regarding required additional development. Revisions in the commitment period are made in the period that the facts related to the change first become known. If the estimated service period is subsequently modified, the period over which the upfront fee or revenue related to ongoing research and development services is modified on a prospective basis. We are also entitled to receive milestone payments under our collaborative research and development agreements based upon the achievement of agreed upon development events that are substantively at-risk by our collaborative partners or us. This collaborative research and development revenue is recognized upon the achievement and acknowledgement of our collaborative partner of a development event, which is generally at the date payment is received from the collaborative partner or is reasonably assured. Accordingly, our revenue recognized under our collaborative research and development agreements may fluctuate significantly from period to period. No collaborative research and development revenues were recognized in the nine months ended September 30, 2009. For the three months ended June 30, 2008, we recognized $1.25 million of collaborative research and development revenue from Santen upon the completion of its Phase 3 clinical testing relating to its formulation of diquafosol tetrasodium.

Inventories

Our inventories are related to AzaSite and are valued at the lower of cost or market using the first-in, first-out (i.e., FIFO) method. Cost includes materials, labor, overhead, shipping and handling costs. Our inventories are subject to expiration dating. We regularly evaluate the carrying value of our inventories and provide valuation reserves for any estimated obsolete, short-dated or unmarketable inventories. Our determination that a valuation reserve might be required, in addition to the quantification of such reserve, requires us to utilize significant judgment. We base our analysis, in part, on the level of inventories on hand in relation to our estimated forecast of product demand, production requirements for forecasted product demand, expected market conditions and the expiration dates or remaining shelf life of inventories. As of September 30, 2009, we had net reserves of $10,000 for potential overstocking.

Taxes

We account for uncertain tax positions in accordance with FASB authoritative guidance regarding the accounting for taxes. Significant management judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against net deferred tax assets. We have recorded a valuation allowance against all potential tax assets due to uncertainties in our ability to utilize deferred tax assets, primarily consisting of certain net operating losses carried forward, before they expire. The valuation allowance is based on estimates of taxable income in each of the jurisdictions in which we operate and the period over which our deferred tax assets will be recoverable.

Liabilities

We generally enter into contractual agreements with third-party vendors to provide research and development, manufacturing, and other services in the ordinary course of business. Many of these contracts are subject to milestone-based invoicing and services are completed over an extended period of time. We record liabilities under these contractual commitments when we determine an obligation has been incurred, regardless of the timing of the invoice. We monitor all significant research and development, manufacturing, sales and marketing and other service activities and the progression of work related to these activities. We estimate the underlying obligation for each activity based upon our estimate of the amount of work performed and compare the estimated obligation against the amount that has been invoiced. Because of the nature of certain contracts and related delay in the contract’s invoicing, the obligation to these vendors may be based upon management’s estimate of the underlying obligation. We record the larger of our estimated obligation or invoiced amounts for completed service. In all cases, actual results may differ from our estimate.

Stock-Based Compensation Expense

We recognize stock-based compensation expense in accordance with FASB authoritative guidance regarding the accounting for share-based payments, which requires us to measure compensation cost for share-based payment awards at fair value and recognize compensation expense over the service period for awards expected to vest. We utilize the Black-Scholes option-pricing model to value our awards and recognize compensation expense on a straight-line basis over the vesting periods of our awards. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Our expected volatility is determined based on our own historical volatility. The estimation of share-based payment awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. Significant management judgment is also required in determining estimates of future stock price volatility, forfeitures and expected life to be used in the valuation of the options. Actual results, and future changes in estimates, may differ substantially from our current estimates.

Impact of Inflation

We do not believe that our operating results have been materially impacted by inflation during the periods covered in this report. However, we cannot assure that our operating results will not be adversely affected by inflation in the future. We will continually seek to mitigate the adverse effects of inflation on the costs of goods and services that we use through improved operating efficiencies and cost containment and periodic price increases for our product.

Impact of Recently Issued Accounting Pronouncements

In October 2009, the FASB issued authoritative guidance regarding revenue arrangements with multiple deliverables. The guidance requires entities to allocate revenue in an arrangement using estimated selling prices of the delivered goods and services based on a selling price hierarchy. The guidance further eliminates the residual method of revenue allocation and requires revenue to be allocated using the relative selling price method. The new guidance should be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted. We are currently assessing the impact of adopting this new guidance.

In August 2009, the FASB issued authoritative guidance regarding measuring liabilities at fair value. The authoritative guidance sets forth the types of valuation techniques to be used to value a liability when a quoted price in an active market for the identical liability is not available. It also clarifies transfer restrictions on the fair value of a liability and the ability to use the fair value of a liability that is traded as an asset as an input to the valuation of the underlying liability. The authoritative guidance is effective for interim and annual periods beginning after August 26, 2009. We have assessed the impact of this new guidance and expect no material impact to our financial statements upon adoption.

In April 2009, the FASB issued authoritative guidance to aid in determining fair value when the volume and level of activity for the assets or liabilities have significantly decreased and when identifying transactions are not orderly, such as a forced liquidation or distressed sale. The authoritative guidance became effective for us on April 1, 2009 and the adoption of the guidance did not have a material impact on our consolidated financial statements.

In April 2009, the FASB issued authoritative guidance on the recognition and presentation of other-than-temporary impairments. The authoritative guidance incorporates impairment guidance for debt securities from various sources of authoritative literature and clarifies the interaction of the factors that should be considered when determining whether a debt security is other than temporarily impaired. The authoritative guidance became effective for us on April 1, 2009 and the adoption of the guidance did not have a material impact on our consolidated financial statements.

In April 2009, the FASB issued authoritative guidance to require disclosures about fair value of financial instruments in interim financial statements as well as in annual financial statements. The authoritative guidance is effective for interim periods ending after June 15, 2009, and we have adopted the guidance and have provided the additional disclosures as required.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Risk

We are subject to interest rate risk on our investment portfolio and borrowings under our term loan facility.

We invest in marketable securities in accordance with our investment policy. The primary objectives of our investment policy are to preserve capital, maintain proper liquidity to meet operating needs and maximize yields. Our investment policy specifies credit quality standards for our investments and limits the amount of credit exposure to any single issue, issuer or type of investment. Our investment portfolio may consist of a variety of securities, including United States government and government agency obligations, money market and mutual fund investments, municipal and corporate notes and bonds and asset or mortgage-backed securities. As of September 30, 2009, cash equivalents consisted of $3.6 million in a money market account and $77.0 million in money market funds. Our investment portfolio as of September 30, 2009 consisted of corporate notes and bonds, commercial paper and U.S. Government and agency securities and had an average maturity of less than 12 months, using the stated maturity. All of our cash, cash equivalents and investments are maintained at two banking institutions.

Our investment exposure to market risk for changes in interest rates relates to the increase or decrease in the amount of interest income we can earn on our portfolio, changes in the market value due to changes in interest rates and other market factors as well as the increase or decrease in any realized gains and losses. Our investment portfolio includes only marketable securities and instruments with active secondary or resale markets to help ensure portfolio liquidity and we have implemented guidelines limiting the duration of investments. At September 30, 2009, our portfolio of available-for-sale investments consisted of approximately $31.7 million of investments maturing within one year and approximately $23.4 million of investments maturing after one year but within 36 months. In general, securities with longer maturities are subject to greater interest-rate risk than those with shorter maturities. A hypothetical 100 basis point drop in interest rates along the entire interest rate yield curve would not significantly affect the fair value of our interest sensitive financial instruments. We generally have the ability to hold our fixed-income investments to maturity and therefore do not expect that our operating results, financial position or cash flows will be materially impacted due to a sudden change in interest rates. However, our future investment income may fall short of expectations due to changes in interest rates, or we may suffer losses in principal if forced to sell securities which have declined in market value due to changes in interest rates or other factors, such as changes in credit risk related to the securities’ issuers.

We do not use interest rate derivative instruments to manage exposure to interest rate changes. We ensure the safety and preservation of invested principal funds by limiting default risk, market risk and reinvestment risk. We reduce default risk by investing in investment grade securities.

Our risk associated with fluctuating interest expense is limited to future capital leases and other short-term debt obligations we may incur in our normal operations. The interest rates on our long-term debt borrowings under the term loan facility are fixed and as a result, interest due on borrowings are not impacted by changes in market-based interest rates.

Investment Risk

In addition to our normal investment portfolio, we have an investment in Parion Sciences, Inc. of $200,000 as of September 30, 2009. This investment is in the form of unregistered common stock and is subject to higher investment risk than our normal investment portfolio due to the lack of an active resale market for the Parion Sciences, Inc. securities.

Foreign Currency Exchange Risk

The majority of our transactions occur in U.S. dollars and we do not have subsidiaries or investments in foreign countries. Therefore, we are not subject to significant foreign currency exchange risk. We do, however, have

foreign currency exposure with regard to the purchase of active pharmaceutical ingredients as they relate to AzaSite, which is manufactured by a foreign-based company, future milestone payments due under the technology license agreement with Yamasa Corporation, as well as development activities currently ongoing in Europe. We have established policies and procedures for assessing market and foreign exchange risk. As of September 30, 2009, we did not have any material foreign currency hedges.

Item 4. Controls and Procedures

Our management is responsible for establishing and maintaining an adequate system of internal control over our financial reporting. The design, monitoring and revision of the system of internal accounting controls involves, among other items, management’s judgments with respect to the relative cost and expected benefits of specific control measures. The effectiveness of the control system is supported by the selection, retention and training of qualified personnel and an organizational structure that provides an appropriate division of responsibility and formalized procedures. The system of internal accounting controls is periodically reviewed and modified in response to changing conditions. Internal audit consultants regularly monitor the adequacy and effectiveness of internal accounting controls. In addition to the system of internal accounting controls, management maintains corporate policy guidelines that help monitor proper overall business conduct, possible conflicts of interest, compliance with laws and confidentiality of proprietary information. Our Chief Executive Officer and Chief Financial Officer have reviewed and evaluated the effectiveness of our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that our current disclosure controls and procedures are effective. There were no changes in our internal control over financial reporting during such period that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II: OTHER INFORMATION

Item 1A. Risk Factors.

RISK FACTORS

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

Risks Related to Product Commercialization

Failure to adequately market and commercialize AzaSite will negatively impact our revenues.

The commercial success of AzaSite will depend on a number of factors, including:

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Acceptance by patients and physicians;

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Effectiveness of our sales and marketing efforts;

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Ability to differentiate AzaSite relative to our competitors’ products;

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Ability to further develop clinical information to support AzaSite;

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Market satisfaction with existing alternative therapies;

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Perceived efficacy relative to other available therapies;

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Disease prevalence;

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Cost of treatment;

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Pricing and availability of alternative products, including generic or over-the-counter products;

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Marketing and sales activities of competitors;

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Shifts in the medical community to new treatment paradigms or standards of care;

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Relative convenience and ease of administration;

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The manufacturer’s successful sustaining of manufacturing capability; and

•

Our ability to enter into managed care and governmental agreements on favorable terms.

We are responsible for all aspects of the commercialization of this product, including the determination of formularies upon which AzaSite is listed, manufacturing, distribution, marketing and sales. The determination of formularies upon which AzaSite is listed, the discounts and pricing under such formularies, as well as the amount of time it takes for us to obtain favorable formulary status under various plans will impact our commercialization efforts. Additionally, inclusion on certain formularies will require significant price concessions through rebate programs that impact the level of revenue that we receive. The need to give price concessions can be particularly acute where competing products are listed on the same formulary, such as the area of bacterial conjunctivitis. If AzaSite is not successfully commercialized, our revenues will be limited.

Under our agreement with InSite Vision, we are obligated to make pre-determined minimum annual royalty payments to InSite Vision. To the extent annual royalty payments actually paid to InSite Vision on our sales of AzaSite are less than the minimum annual royalty amounts established under our agreement with InSite Vision, we are obligated to pay the difference. In the event we are required to make annual minimum royalty payments, our profits with respect to AzaSite, if any, will be decreased or any losses with respect to the product will be increased. Such circumstances may result in us ceasing our commercialization of AzaSite and terminating our agreement with InSite Vision.

If Restasis is not successfully commercialized by Allergan, our revenues will be negatively impacted.

Allergan is responsible for commercializing Restasis. Accordingly, our revenues on the net sales of Restasis are dependent on the actions and success of Allergan, over whom we have no control.

Following the expiration of a use patent in August 2009, the manufacture and sale of Restasis is protected in the United States by a formulation patent that expires in May 2014. While a formulation patent may afford certain limited protection, a competitor may attempt to gain FDA approval for a cyclosporine product using a different formulation. Furthermore, following the expiration of the formulation patent in 2014, a generic form of Restasis could be introduced into the market. If and when Restasis experiences competition from a cyclosporine product, including generics, our revenues attributable to Restasis may be significantly impacted.

Other factors that could affect the commercialization of Restasis include:

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Extent and effectiveness of Allergan’s sales and marketing efforts;

•

Satisfaction with existing alternative therapies, including generic or over-the-counter products;

•

Perceived efficacy relative to other available therapies;

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Changes in, or the levels of, third-party reimbursement of product costs;

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Coverage and reimbursement under Medicare Part D, state government sponsored plans and commercial plans;

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Cost of treatment;

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Development and FDA approval of competing dry eye products; and

•

Shifts in the medical community to new treatment paradigms or standards of care.

When a generic form of Elestat or an over-the-counter form of epinastine ophthalmic solution is introduced into the market, our agreement with Allergan to co-promote Elestat will no longer be in effect, and our revenues from sales of Elestat will be minimal.

Our Elestat co-promotion agreement with Allergan provides that unless earlier terminated, the term of such agreement will be in effect until the earlier of (i) the approval and launch of the first generic epinastine product after expiration of the FDA exclusivity period covering Elestat in the United States, or (ii) the approval and launch of the first over-the-counter epinastine product after expiration of the listing of Elestat in the FDA publication Approved Drug Products with Therapeutic Equivalence (commonly called the “Orange Book”). Following the termination of the co-promotion agreement, we will no longer have rights to co-promote Elestat. We will be entitled to receive post-termination payments from Allergan, based on any remaining net sales of Elestat for a period of 36 months. During the initial 12-month period immediately following the termination of the agreement, Allergan will be obligated to pay to us 20% of any net sales of Elestat in the United States. Allergan will be obligated to pay us 15% of any net sales in the United States in the second 12-month period following termination and 10% of any net sales in the United States in the third, and final, 12-month period following termination of the agreement.

We have been notified that Boehringer Ingelheim and Allergan received notices of Paragraph IV certifications from Apotex, Inc., Cypress Pharmaceutical, Inc., Paddock Laboratories, Inc. and Sandoz Inc. advising that each company filed an ANDA for a generic version of Elestat. Each ANDA notice alleges that the method of treatment patent related to Elestat is invalid, unenforceable and/or will not be infringed by the respective ANDA applicant’s manufacture, use, sale, or offer for sale of the drug for which the ANDA was submitted. The date of submission of the first filing to the FDA Office of Generic Drugs was October 14, 2008, according to the FDA’s website (www.fda.gov). Furthermore, we have been notified by Allergan that Boehringer Ingelheim has decided not to file infringement lawsuits

against the ANDA filers. Boehringer Ingelheim is the owner of a method of treatment patent related to Elestat, and we do not have a license to this patent.

The FDA’s review of an ANDA is a confidential process between the FDA and the applicable ANDA filer. We do not expect to be informed by the FDA, any ANDA filer or any other party regarding the status or timing of the review relating to any of the ANDA filings pertaining to a generic form of Elestat. The FDA may complete its review of the filed ANDAs at any time. As a result, we expect to be required to stop the co-promotion of Elestat with little, if any, advance notice. Loss of our co-promotion revenue from Elestat will significantly impact our results of operations and cash flows.

If we do not successfully market and promote Elestat, our revenues will be negatively impacted.

Notwithstanding the expected termination of the Elestat agreement upon the launch of a generic form of Elestat, our present revenues depend, in part, upon the continued acceptance of Elestat by eye care professionals, allergists and patients. Other factors that could affect the commercialization of Elestat include:

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Satisfaction with existing alternative therapies, including therapies requiring only one dose per day;

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Decreases in the size of the market for topical allergic conjunctivitis products;

•

Extent and effectiveness of our sales and marketing efforts;

•

Changes in, or the levels of, third-party reimbursement of product costs;

•

Coverage and reimbursement under Medicare Part D, state government sponsored plans and commercial plans;

•

Pricing and availability of alternative products, including generic or over-the-counter products; and

•

Marketing and sales activities of competitors.

Under our agreement with Allergan related to our co-promotion of Elestat, we are obligated to meet predetermined minimum calendar year net sales target levels through fiscal 2009. To the extent net sales of Elestat do not meet the minimum annual net sales requirements, the percentage of net sales of Elestat payable to us will be reduced.

We rely on third parties to distribute and sell our products and those third parties may not perform.

We are dependent on third parties to perform or assist us in the distribution or sale of AzaSite, and are dependent on third parties, primarily Allergan, to perform or assist us in the distribution and sale of Elestat. We rely on the services of a single source, third-party distributor to deliver AzaSite to our customers. In addition to the physical storage and distribution of AzaSite, this third-party distributor maintains and provides us with information and data with regard to our inventory, AzaSite orders, billings and receivables, chargebacks and returns, among others, on which our accounting estimates are based. If third parties do not successfully carry out their contractual duties in maximizing the commercial potential of our products, we may be required to hire or expand our own staff and sales force to compete successfully, which may not be possible. If third parties or Allergan do not perform, or assist us in performing these functions, or if there is a delay or interruption in the distribution of our products, it could have an adverse effect on product revenue, accounting estimates and our overall operations.

We depend on three pharmaceutical wholesalers for the vast majority of our AzaSite sales in the United States, and the loss of any of these wholesalers would negatively impact our revenues.

The prescription drug wholesaling industry in the United States is highly concentrated, with a vast majority of all sales made by three major full-line companies: Cardinal Health, McKesson Corporation and AmerisourceBergen. Greater than 85% of our AzaSite revenues come from sales to these three companies. The loss of any of these wholesalers could have a negative impact on our commercialization of AzaSite.

It is also possible that these wholesalers, or others, could decide to change their policies and fees in the future. This could result in or cause us to incur higher product distribution costs, lower margins or the need to find alternative methods of distributing our products. Such alternative methods may not be economically or administratively feasible.

Risks Related to Manufacture and Supply

If we are unable to contract with third parties for the manufacture of active pharmaceutical ingredients required for preclinical testing, for the manufacture of drug products for clinical trials, for the large-scale manufacture of any approved products, or for the manufacture of related devices, we may be unable to develop or commercialize our drug products.

The manufacturing of sufficient quantities of new products or product candidates is a time-consuming and complex process. We have no experience or capabilities to conduct the manufacture of any of our product candidates. In order to successfully commercialize AzaSite and continue to develop our product candidates, we need to contract or otherwise arrange for the necessary manufacturing services. There are a limited number of manufacturers that operate under the FDA’s cGMP regulations capable of manufacturing for us or our collaborators. We depend upon third parties for the manufacture of active pharmaceutical ingredients, finished drug products for clinical trials, and for the manufacture of AzaSite. We expect to depend upon third parties for the large-scale manufacture of commercial quantities of any other approved product. This dependence may adversely affect our ability to develop and deliver such products on a timely and competitive basis. Similarly, our dependence on our partners to arrange for their own supplies of finished drug products may adversely affect our operations and revenues. If we, or our partners, are unable to engage or retain third-party manufacturers on a long-term basis or on commercially acceptable terms, our products may not be commercialized as planned, and the development of our product candidates could be delayed.

Under our agreement with the manufacturer of AzaSite, we are required to purchase a minimum number of units of AzaSite annually, regardless of our ability to sell AzaSite. If we are unable to sell the AzaSite that we are required to purchase, our inventory of the product will increase and the shelf life of the inventory will be adversely impacted. In such circumstances, we may be required to make price concessions to sell short-dated product or write-off and dispose of expired product, which may have an adverse affect on our AzaSite profitability.

The manufacturing processes for our product candidates have not been validated at the scale required for commercial sales. Delays in scale-up to commercial quantities and any change at the site of manufacture could delay clinical trials, regulatory submissions and ultimately the commercialization of our products. In addition, manufacturing facilities are subject to an FDA inspection to confirm cGMP compliance prior to a product candidate’s potential NDA approval as well as ongoing post-approval FDA inspections to ensure continued compliance with cGMP regulations, over which we have no control.

We depend upon a third-party vendor to manufacture the nebulizer used with denufosol with whom we have no supply agreement. This vendor is responsible for managing the manufacturing process of the nebulizer in accordance with all applicable regulatory requirements. Any manufacture or regulatory compliance problems related to the manufacture of this device or any failure on the part of the manufacturer to supply the device (including discontinuation of the nebulizer) could delay product development or adversely affect regulatory approvals of denufosol.

Reliance on a single party to manufacture and supply either finished product or the bulk active pharmaceutical ingredients for a product or product candidates could adversely affect us.

Under our agreements with Allergan, Allergan is responsible for the manufacture and supply of Restasis and Elestat. It is our understanding that Allergan relies upon an arrangement with a single third party for the manufacture and supply of active pharmaceutical ingredients, or APIs, for each of Restasis and Elestat. Allergan then completes the manufacturing process to yield finished product.

Under our supply agreement with InSite Vision, InSite Vision is responsible for supplying us with azithromycin, the API used in AzaSite. InSite Vision, in turn, relies upon an arrangement with a single third party for the manufacture and supply of such API. We are responsible for producing the finished product form of AzaSite, which is currently manufactured by a single party. There can be no assurance that such manufacturer will be able to continue to produce sufficient quantities of finished product in a timely manner to support the commercialization of AzaSite.

In the event a third-party manufacturer is unable to supply Allergan or InSite Vision (as the case may be), if such supply is unreasonably delayed, or if Allergan or our finished product contract partner are unable to complete the manufacturing cycle, sales of the applicable product could be adversely impacted, which would result in a reduction in any applicable product revenue. In addition, if Allergan or the third-party manufacturers do not maintain cGMP compliance, the FDA could require corrective actions or take enforcement actions that could affect production and availability of the applicable product, thus adversely affecting sales.

In addition, we rely upon supply agreements with third parties for the manufacture and supply of the bulk APIs for our product candidates for purposes of preclinical testing and clinical trials. We presently depend upon one vendor as the sole manufacturer of our supply of APIs for both Prolacria and denufosol. We have entered into an agreement with such manufacturer to facilitate the transfer of the current denufosol manufacturing technology, including intellectual property, to an additional manufacturer and thus enable a two-supplier strategy for denufosol. However, we have not yet entered into an agreement with a secondary supplier for denufosol. Delays in any aspect of implementing the manufacturing process could cause significant development delays and increased costs.

It would be time consuming and costly to identify and qualify new sources for manufacture of APIs or finished products. If our vendors were to terminate our arrangement or fail to meet our supply needs we might be forced to delay our development programs and/or be unable to supply products to the market, which could delay or reduce revenues and result in loss of market share.

The third-party vendor manufacturing denufosol and the API related to Prolacria and Santen’s DE-089 does not currently have the capacity to manufacture the projected commercial quantities of API for all three products, if approved.

A single party currently manufactures the clinical supplies of denufosol, and the API for Prolacria and Santen’s DE-089. Such manufacturer does not presently have capacity to manufacture projected commercial supplies of API for all three of these product candidates at the same time, if necessary. As a result, we have entered into an agreement to acquire access to its manufacturing know-how and processes related to denufosol and are currently in discussions with such manufacturer to further assess its intent to increase capacity. In addition, we are in discussions with additional third-party manufacturers for the purpose of establishing a secondary source of supply for denufosol.

If a third-party manufacturer is unable to timely produce sufficient commercial quantities of denufosol, or the API for each of DE-089 and Prolacria, the launch of such product candidate following approval (if any) may be significantly delayed. Furthermore, insufficient supply of denufosol, or the API for each of DE-089 and Prolacria, following any product launch would significantly impact the commercial success of such product(s). A failure to achieve sufficient commercial supply would likely result in a loss of sales in the case of denufosol and a reduction of royalty income associated with each of DE-089 and Prolacria.

In May 2008, Santen filed an application for manufacturing and marketing approval of DE-089 with the Japanese Ministry of Health, Labor, and Welfare, which is pending review. Under our agreement with Santen, we are required to supply Santen with all of its API requirements for DE-089 for commercial use. We do not have manufacturing expertise, capabilities or facilities, and rely on third parties for such manufacturing activities. We have an agreement with a third party with respect to the manufacture of clinical supplies of API for DE-089. We are currently in negotiations with a third party with respect to the manufacture of commercial supplies of API for DE-089. Santen has not yet submitted a contractually binding firm order for commercial supplies of DE-089. If we fail to supply Santen with its API requirements for DE-089, Santen may pursue legal or equitable remedies against us.

Risks Related to Product Development

Even if our Trial 03-113 is successful in meeting its primary endpoint, the FDA may not approve our NDA for Prolacria.

We have not received marketing approval for any of our internally developed product candidates. We have recently completed enrollment of a Phase 3 environmental clinical trial (Trial 03-113) to evaluate the efficacy and safety of Prolacria in approximately 450 subjects with dry eye. The FDA indicated, as part of the SPA review process for such trial, that even if the trial is successful, the FDA’s review of Prolacria will also take into account the robustness of the trial results, that a surrogate endpoint was used, the results from previous Prolacria trials and the overall risk/benefit of the product. There can be no guarantee that the FDA would approve Prolacria even if such additional clinical trial is successful in meeting its primary endpoint. If additional Phase 3 clinical trials for Prolacria are required by the FDA, we may decide not to conduct those clinical trials, which would result in the inability to obtain FDA approval for Prolacria.

If the FDA does not conclude that our product candidates meet statutory requirements for safety and efficacy, we will be unable to obtain regulatory approval for marketing in the United States.

We have to conduct significant development activities, non-clinical and clinical tests and obtain regulatory approval before our product candidates can be commercialized. Product candidates that may appear to be promising at early stages of development may not successfully reach the market for a number of reasons. The results of preclinical and clinical testing of our product candidates under development may not necessarily indicate the results that will be obtained from later or more extensive testing. Additionally, companies in the pharmaceutical and biotechnology industries, including us, have suffered significant setbacks in advanced clinical trials, even after obtaining promising results in earlier clinical trials. Our ongoing clinical trials might be delayed or halted for various reasons, including:

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The measure of efficacy of the drug is not statistically significant compared to placebo;

•

Patients experience severe side effects or serious adverse events during treatment;

•

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

•

Patients do not enroll in the clinical trials at the rate we expect;

•

We decide to modify the drug or the clinical trial protocol during testing;

•

Our commercial partners, or future commercial partners, delay, amend or change our development plan or strategy; and

•

We allocate our limited financial and other resources to other clinical and preclinical programs.

Changes in regulatory policy or new regulations as well as clinical investigator misconduct could also result in delays or rejection of our applications for approval of our product candidates. Clinical investigator misconduct that raises questions about the integrity of data in one or more applications (e.g., fraud, bribery, omission of a material fact, gross negligence) could be used by the FDA as grounds to suspend substantive scientific review of all pending marketing applications until the data in question have successfully undergone a validity assessment. Product candidates that fail validity assessments must be withdrawn from FDA review or, if the drug is an approved, marketed product, such product must be removed from the market.

Additionally, the introduction of our products in foreign markets will subject us to foreign regulatory clearances, the receipt of which may be unpredictable, uncertain and may impose substantial additional costs and burdens which we or our partners in such foreign markets may be unwilling or unable to fund. As with the FDA, foreign regulatory authorities must be satisfied that adequate evidence of safety and efficacy of the product has been presented before marketing authorization is granted. The foreign regulatory approval process includes all of the risks associated with obtaining FDA marketing approval. Approval by the FDA does not ensure approval by other regulatory authorities, nor does approval by any foreign regulatory authority ensure approval by the FDA.

Since some of our clinical candidates utilize new or different mechanisms of action and in some cases there may be no regulatory precedents, conducting clinical trials and obtaining regulatory approval may be difficult, expensive and prolonged, which would delay any commercialization of our products.

To complete successful clinical trials, our product candidates must demonstrate safety and provide substantial evidence of efficacy. The FDA generally evaluates efficacy based on the statistical significance of a product candidate meeting predetermined clinical endpoints. The design of clinical trials to establish meaningful endpoints is done in collaboration with the FDA prior to the commencement of clinical trials. We establish these endpoints based on guidance from the FDA, including FDA guidance documents applicable to establishing the efficacy, safety and tolerability measures required for approval of products. However, since some of our product candidates utilize new or different mechanisms of action, the FDA may not have established guidelines for the design of our clinical trials and may take longer than average to consider our product candidates for approval. The FDA could change its view on clinical trial design and establishment of appropriate standards for efficacy, safety and tolerability and require a change in clinical trial design, additional data or even further clinical trials before granting approval of our product candidates. We could encounter delays and increased expenses in our clinical trials if the FDA concludes that the endpoints established for a clinical trial do not adequately predict a clinical benefit.

The FDA has not published guidelines on the approval of a product for the treatment of dry eye disease. It will be necessary to undertake at least one additional Phase 3 clinical trial in support of our NDA for Prolacria and there can be no guarantee that any such additional clinical trial would be successful or that the FDA would approve Prolacria even if such additional clinical trial was successful.

We are developing denufosol as an inhaled product candidate for the treatment of cystic fibrosis. Denufosol tetrasodium is a first-in-class receptor-mediated chloride channel activator that addresses the underlying ion transport defect in the lungs of patients with cystic fibrosis. The FDA has not published guidance on the drug approval process associated with such a product candidate. Furthermore, we are not aware of any FDA-approved product that addresses the underlying ion transport defect in the lungs of patients with cystic fibrosis. We cannot predict or guarantee the outcome or timing of our Phase 3 program for denufosol for cystic fibrosis. A significant amount of work will be required to advance denufosol through clinical testing, including satisfactory completion of additional clinical trials, toxicology and carcinogenicity studies. We may later decide to change the focus or timing of our Phase 3 program. Our TIGER-2 clinical trial for denufosol for cystic fibrosis may not be successful or unexpected safety concerns may emerge that would negatively change the risk/benefit profile for this product candidate.

We have initiated a Phase 2 development program to evaluate the use of AzaSite for the treatment of blepharitis. The FDA has not published guidelines on the approval of a product for the treatment of blepharitis. Furthermore, to date, no prescription product has been approved by the FDA for the treatment of blepharitis. Even if the results of the ongoing Phase 2 clinical trials demonstrate statistical significance for the trial endpoints, we would need to meet with the FDA to design appropriate pivotal Phase 3 clinical trials. The FDA may require that we evaluate the product in relation to different primary and/or secondary clinical endpoints than those being used presently. This may require us to undertake additional Phase 2 clinical trials, which could lead to increased costs and program delays.

We may need to develop alternate dosing regimens for our product candidates.

In order to achieve broad market acceptance of our product candidates, we may need to develop, alone or with others, alternate dosing regimens and methods for administering our products. For example, we intend that Prolacria will be applied from a vial containing a single day’s dosage of non-preserved medication. Patients may prefer to purchase preserved medication for multiple doses. Neither we nor Allergan have established a plan to develop a multi-dose formulation.

In addition, in our current clinical trials, denufosol for the treatment of cystic fibrosis is administered by a standard nebulizer three times per day, but clinical data from our TIGER-1 clinical trial indicated that patients in that study administered the drug only 2.7 times per day, on average. Patients may prefer a smaller, more portable device or less frequent dose administration. Similar challenges may exist in identifying and developing appropriate and

convenient dosing and methods of administration for our other product candidates. If the number of doses, or the method of dosing, is not convenient, patients may not use our product. Furthermore, if patients use our products at a dosing level that is less than the dosing level tested in our clinical trials, the drug may not be efficacious or may be less efficacious. In such cases, the patient may look for alternative therapies.

Estimated development costs are difficult to project and may change frequently prior to regulatory approval.

The number and type of studies that may be required by the FDA, or other regulatory authorities, for a particular compound are based on the compound’s clinical profile compared to existing therapies for the targeted patient population. While all new compounds require standard regulated phases of testing, the actual type and scope of testing can vary significantly among different product candidates and as a result, creates additional complexity when estimating program costs. Factors that affect the costs of a clinical trial include:

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The number of patients required to participate in clinical trials to demonstrate statistical significance for a drug’s safety and efficacy and the number and geographical location of clinical trial sites necessary to enroll such patients;

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The time required to enroll the targeted number of patients in clinical trials, which may vary depending on the size and availability of the targeted patient population and the perceived benefit to the clinical trial participants; and

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The number and type of required laboratory tests supporting clinical trials.

Additionally, ongoing development programs and associated costs are subject to frequent, significant and unpredictable changes due to a number of factors, including:

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Data collected in preclinical or clinical trials may prompt significant changes, delays or enhancements to an ongoing development program;

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Commercial partners and the underlying contractual agreements may require additional or more involved clinical or preclinical activities;

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The FDA or other regulatory authorities may direct the sponsor to change or enhance its ongoing development program based on developments in the testing of similar compounds or related compounds;

•

Unexpected regulatory requirements, changes in regulatory policy or review standards, or interim reviews by regulatory agencies may cause delays or changes to development programs; and

•

Anticipated manufacturing costs may change significantly due to necessary changes in manufacturing processes, variances from anticipated manufacturing process yields or changes in the cost and/or availability of starting materials, and other costs to ensure the manufacturing facility is in compliance with cGMP requirements and is capable of consistently producing the product candidate in accordance with established specifications submitted to the FDA.

The occurrence of any of these factors may result in significant disparities in total costs required to complete the respective development programs.

Clinical trials may take longer to complete and cost more than we expect, which would adversely affect our ability to commercialize product candidates and achieve profitability.

Clinical trials are expensive and are often lengthy. They require appropriate identification of optimal treatment regimens and relevant patient population, adequate supplies of drug product, and sufficient patient enrollment. Patient enrollment is a function of many factors, including:

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The size and availability of the relevant patient population;

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The nature of the protocol;

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The proximity of patients to clinical sites;

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The eligibility criteria for the clinical trial; and

•

The perceived benefit of participating in a clinical trial.

Delays in patient enrollment can result in increased costs and longer development times. The timing of our Phase 3 program for denufosol for the treatment of cystic fibrosis will be impacted by a number of variables, including clinical development decisions regarding identifying the optimal treatment regimens, patient population, competition for clinical trial participants, approval of other products during our clinical trials, number and length of clinical trials, regulatory requirements of the FDA and/or foreign regulatory authorities, the exclusion criteria for the clinical trials and use of therapies such as hypertonic saline. Our cystic fibrosis clinical trials will present some unique challenges due to the early-intervention approach we are taking with regard to the clinical trials. This approach will require studying mild patients, which are usually younger patients who do not typically participate in clinical trials since new products are generally focused on the sicker patient population and we may have difficulty recruiting such patients for our clinical trials. Even if we successfully complete clinical trials, we may not receive regulatory approval for the product candidate. In addition, if the FDA or foreign regulatory authorities require additional clinical trials, we could face increased costs and significant development delays.

We are conducting portions of our TIGER-2 clinical trial in Canada, Australia and New Zealand and are therefore subject to the risks and uncertainties of doing business internationally. Disruptions in communication and transportation, changes in governmental policies, and currency exchange rates, among other factors, may affect the time and costs required to complete these clinical trials.

If we fail to reach milestones or to make annual minimum payments or otherwise breach our obligations under our license agreements, our licensors may terminate our agreements with them.

If we fail to meet payment obligations, performance milestones relating to the timing of regulatory filings, development and commercial diligence obligations, fail to make milestone payments in accordance with applicable provisions, or fail to pay the minimum annual payments under our respective licenses, our licensors may terminate the applicable license. As a result, our development of the respective product candidate or commercialization of the product would cease.

Risks Related to Governmental Regulation

Failure to comply with all applicable regulations, including those that require us to obtain and maintain governmental approvals for our product candidates, may result in fines, corrective actions, administrative sanctions and restrictions, including the withdrawal of a product from the market.

Pharmaceutical companies are subject to significant regulation by a number of local, state, and federal governmental agencies, including the FDA. Such regulations and their authorizing statutes are amended from time to time. There are laws and regulations that govern areas including financial controls, clinical trials, testing, manufacturing, labeling, safety, packaging, shipping, distribution, marketing and promotion of pharmaceuticals, including those governing interactions with prescribers and health care professionals in a position to prescribe, recommend, or arrange for the provision of our products. Failure to comply with applicable regulatory requirements could, among other things, result in warning letters, fines, corrective actions, administrative sanctions, suspensions or delays of product manufacture or distribution or both, product recalls, delays in marketing activities and sales, withdrawal of marketing approvals, and civil or criminal sanctions including seizure of product, court-ordered injunction, and possible exclusion from eligibility for federal government contracts payment of our products by Medicare, Medicaid, and other third-party payors.

After initial regulatory approval, the manufacturing and marketing of drugs, including our products, are subject to continuing FDA and foreign regulatory review. Additionally, the FDA encourages health professionals to report significant adverse events associated with products. The FDA may require additional clinical studies, known as Phase 4 studies, to evaluate product safety effects. In addition to studies required by the FDA after approval, we may conduct our own Phase 4 studies to explore the use of the approved drug product for treatment of new indications or to

broaden our knowledge of the product. The subsequent discovery of previously unknown problems with a product’s safety or efficacy as a result of these studies or as reported in their prescribed use may result in restrictions through labeling changes or withdrawal of the product from the market.

The FDA periodically inspects drug manufacturing facilities to ensure compliance with applicable cGMP regulations. Failure to comply with statutory and regulatory requirements subjects the manufacturer to possible legal or regulatory action, such as warning letters, suspension of manufacturing, seizure of product, court-ordered injunction, or voluntary recall of a product.

Additional authority to take post-approval actions was given to the FDA under the FDA Amendments Act of 2007. The FDA is authorized to revisit and change its prior determinations if new information raises questions about our product’s safety profile. The FDA is authorized to impose additional post-marketing requirements which could result in actions such as requiring additional studies, corrective actions, fines or withdrawal of marketing approval.

In its regulation of advertising, the FDA may issue correspondence to pharmaceutical companies alleging that its advertising or promotional materials are false or misleading. The FDA has the power to impose a wide array of sanctions on companies for such advertising practices, and, if we were to receive correspondence from the FDA alleging these practices, it may be necessary for us to:

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Incur substantial expenses, including fines, penalties, legal fees and costs to conform to the FDA’s limits on such promotion;

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Change our methods of marketing, promoting and selling products;

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Take corrective action, which could include placing advertisements or sending letters to physicians correcting statements made in previous advertisements or promotions; or

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Disrupt the distribution of products and stop sales until we are in compliance with the FDA’s interpretation of applicable laws and regulations.

Medicare prescription drug coverage legislation and future legislative or regulatory reform of the health care system may affect our or our partners’ ability to sell products profitably.

In both the United States and some foreign jurisdictions, there have been a number of legislative and regulatory changes to the health care system that could affect our ability to sell our products profitably. In the United States, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 established a voluntary outpatient prescription drug benefit under Part D of the Social Security Act. The program, which went into effect January 1, 2006, is administered by the Centers for Medicare & Medicaid Services within the Department of Health and Human Services and is implemented and operated by private sector Part D plan sponsors. The federal government can be expected to continue to issue guidance and regulations regarding the obligations of Part D sponsors and their subcontractors. Allergan is responsible for the implementation of the Medicare Part D program as it relates to Restasis and Elestat and has contracted with Part D plan sponsors to cover such drugs under the Part D benefit. We are responsible for contracting with Part D plan sponsors with respect to AzaSite.

Each participating drug plan is permitted by regulation to develop and establish its own unique drug formulary that may exclude certain drugs from coverage, impose prior authorization and other coverage restrictions, and negotiate payment levels for drugs which may be lower than reimbursement levels available through private health plans or other payers. Moreover, beneficiary co-insurance requirements could influence which products are recommended by physicians and selected by patients. There is no assurance that any drug that we co-promote or sell will be covered by drug plans participating under the Medicare Part D program or, if covered, what the terms of any such coverage will be, or that the drugs will be reimbursed at amounts that reflect current or historical payment levels. Our results of operations could be materially adversely affected by the reimbursement changes emerging from Medicare prescription drug coverage legislation or from changes in the formularies or price negotiations with Part D drug plans. To the extent that private insurers or managed care programs follow Medicare coverage and payment developments, the adverse effects of lower Medicare payment may be magnified by private insurers adopting similar lower payment. Our products

also can be impacted by state and federal legislative and regulatory changes in Medicaid reimbursement policy and in mandated levels of Medicaid drug rebates. Congress is considering proposals as part of health reform that would increase the drug rebate level paid by pharmaceutical manufacturers to Medicaid for brand-name drugs and make other changes that could result in larger pharmaceutical manufacturer rebate obligations. There can be no assurances that new federal or state policies will not increase our rebate obligation or lower Medicaid reimbursement levels for our products.

New federal or state drug payment changes or health care reforms in the United States and in foreign countries may be enacted or adopted in the future that could further lower payment for our products. Congress also has enacted the American Recovery and Reinvestment Act, which included a major expansion of federal efforts to compare the effectiveness of different medical treatments, including pharmaceuticals, which eventually could impact Medicare and private payer coverage and payment policies. Also, various legislative proposals have been offered in Congress and in some state legislatures that include major changes in the health care system. These proposals have included price or patient reimbursement constraints on medicines and restrictions on access to certain products. We cannot predict the outcome of such initiatives, and it is difficult to predict the future impact of the broad and expanding legislative and regulatory requirements affecting us.

We are subject to “fraud and abuse” and similar government laws and regulations, and a failure to comply with such laws and regulations, or an investigation into our compliance with such laws and regulations, or a failure to prevail in any litigation related to noncompliance, could harm our business.

We are subject to multiple state and federal laws pertaining to health care fraud and abuse. Pharmaceutical pricing, sales, and marketing programs and arrangements, and related business practices in the health care industry generally are under increasing scrutiny from federal and state regulatory, investigative, prosecutorial, and administrative entities. Many health care laws, including the federal and state anti-kickback laws and federal and state statutory and common law false claims laws, have been construed broadly by the courts and permit government entities to exercise considerable discretion. In the event that any of these government entities believed that wrongdoing had occurred, one or more of them could institute civil, administrative, or criminal proceedings which, if instituted and resolved unfavorably, could subject us to substantial fines, penalties, and injunctive and administrative remedies, including exclusion from government reimbursement programs. We cannot predict whether investigations or enforcement actions would affect our marketing or sales practices. Any such result could have a material adverse impact on our results of operations, cash flows, financial condition, and our business. Such investigations and enforcement actions could be costly, divert management’s attention from our business, and result in damage to our reputation. We cannot guarantee that measures that we have taken to prevent violations, including our corporate compliance program, will protect us from future violations, lawsuits or investigations by governmental entities or private whistleblowers. If any such actions are instituted against us, and we are not successful in defending ourselves or asserting our rights, those actions could have a significant negative impact on our business, including the imposition of significant fines or other sanctions.

Failure to adequately ensure compliance with applicable laws and regulations may subject us to whistleblower and government actions.

In recent years, pharmaceutical companies have been the targets of extensive whistleblower actions in which the person bringing the action alleges violations of the federal civil False Claims Act or its state equivalent, including allegations that manufacturers aided and abetted in the submission of false claims. These actions have focused on such areas as pricing practices, off-label product promotion, sales and marketing practices, and improper relationships with physicians and other health care professionals, among others. If our relationships with health care professionals and/or our promotional or other activities fail to comply with applicable laws, regulations or guidelines, we may be subject to warnings from, or enforcement action by, regulatory and other federal or state governmental authorities. The potential ramifications are far-reaching if there are areas identified as out of compliance by regulatory agencies and governmental authorities including, but not limited to, significant financial penalties, manufacturing and clinical trial consent decrees, commercialization restrictions, exclusion from government programs, product recalls or seizures, the imposition of corporate integrity agreements and deferred prosecution agreements, or other restrictions and litigation.

Furthermore, there can be no assurance that we will not be subject to a whistleblower or other state or federal investigative or enforcement action at some time in the future.

Risks Associated with Our Business and Industry

If we do not receive timely regulatory approvals of our product candidates and successfully launch such products, we may need substantial additional funds to support our expanding capital requirements.

We have used substantial amounts of cash to fund our research and development and commercial activities. Our operating expenses were approximately $98.0 million for the nine months ended September 30, 2009 and $120.2 million for the year ended December 31, 2008. Our cash, cash equivalents and investments totaled approximately $140.3 million on September 30, 2009. Based on current operating plans, we expect our cash and investments to provide liquidity beyond 2010.

We expect that our capital and operating expenditures will continue to exceed our revenue over the next several years as we conduct our research and development and commercial activities. Many factors will influence our future capital requirements, including:

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The number, breadth and progress of our research and development programs;

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The level of activities relating to commercialization of our products;

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The ability to attract collaborators for our products and establish and maintain those relationships;

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Achievement of milestones under our existing or future collaborations and licensing agreements;

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Progress by our collaborators with respect to the development of product candidates;

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Competing technological and market developments;

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The timing and terms of any business development activities;

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The timing and amount of debt repayment requirements;

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The costs involved in defending any litigation claims against us;

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The costs involved in responding to government, the Financial Industry Regulatory Authority, Inc., or other applicable investigations against us; and

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The costs involved in enforcing patent claims and other intellectual property rights.

In addition, our capital requirements will depend upon:

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The level of sales generated for AzaSite, Restasis and Elestat;

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The receipt of revenue from Allergan on net sales of Restasis and Elestat;

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The receipt of revenue from wholesalers and other customers on net sales of AzaSite;

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The receipt or payment of milestone payments under our current collaborative agreements and any future collaborations;

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The ability to obtain approval from the FDA for our product candidates; and

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Payments from existing and future collaborators.

In the event that we do not receive timely regulatory approvals, we may need substantial additional funds to fully develop, manufacture, market and sell all of our other potential products and support our on-going product commercialization and co-promotion efforts. We may seek such additional funding through public or private equity offerings and debt financings. Additional financing may not be available when needed. If available, such financing may not be on terms favorable to us or our stockholders. Our stockholders’ ownership will be diluted if we raise additional capital by issuing equity securities. If we are required to raise funds through future collaborations and licensing arrangements, we may have to give up rights to our technologies or product candidates or grant licenses on unfavorable terms. If adequate funds are not available, we would have to scale back or terminate research programs and product development and we may not be able to successfully commercialize any product candidate.

Our co-promotion and royalty revenues are based, in part, upon Allergan’s revenue recognition policy and other accounting policies over which we have limited or no control.

We recognize co-promotion revenue based on Allergan’s net sales of Elestat and royalty revenue based on Allergan’s net sales of Restasis, as defined in the co-promotion agreements and as reported to us by Allergan. Accordingly, our co-promotion and royalty revenues are based upon Allergan’s revenue recognition policy and other accounting policies over which we have limited or no control and the underlying terms of our co-promotion agreements. Allergan’s filings with the SEC indicate that Allergan maintains disclosure controls and procedures in accordance with applicable laws, which are designed to provide reasonable assurance that the information required to be reported by Allergan in its Exchange Act filings is reported timely and in accordance with applicable laws, rules and regulations. We are not entitled to review Allergan’s disclosure controls and procedures. All of our co-promotion and royalty revenues are currently derived from Allergan’s net sales of Restasis and Elestat as reported to us by Allergan. We are unable to provide complete assurance that Allergan will not revise reported revenue amounts in the future. If Allergan’s reported revenue amounts were inaccurate, it could have a material impact on our financial statements, including financial statements for previous periods.

Revenues in future periods could vary significantly and may not cover our operating expenses.

Our revenues may fluctuate from period to period due in part to:

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The timing of the introduction of a generic form of Elestat;

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Fluctuations in future sales of AzaSite, Restasis and Elestat due to competition, the intensity of an allergy season, disease prevalence, manufacturing difficulties, reimbursement and pricing under commercial or government plans, seasonality, or other factors that affect the sales of a product;

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Deductions from gross sales relating to estimates of sales returns, credits and allowances, normal trade and cash discounts, managed care sales rebates and other allocated costs;

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The duration of market exclusivity of AzaSite and Restasis;

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The timing of approvals, if any, for other possible future products;

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The progress toward and the achievement of developmental milestones by us or our partners;

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The initiation of new contractual arrangements with other companies; and

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The failure or refusal of a collaborative partner to pay royalties or milestone payments.

Inventory levels of AzaSite held by wholesalers can also cause our operating results to fluctuate unexpectedly. Although we attempt to monitor wholesaler inventory of our products, we rely upon information provided by third parties to quantify the inventory levels maintained by wholesalers. In addition, we and the wholesalers may not be effective in matching inventory levels to end-user demand. Significant differences between actual and estimated inventory levels and product demand may result in inadequate or excessive (1) inventory production, (2) product supply in distribution channels, (3) product availability at the retail level, and (4) unexpected increases or decreases in orders from our major customers. Any of these events may cause our revenues to fluctuate significantly from quarter to quarter, and in some cases may cause our operating results for a particular quarter to be below expectations.

If we are unable to make the scheduled principal and interest payments on our term loan facility or maintain minimum liquidity levels or compliance with other debt covenants as defined in the loan and security agreement, we may default on our debt.

Our $60.0 million term loan facility is secured by substantially all of our assets, except for our intellectual property, but including all accounts, license and royalty fees and other revenues and proceeds arising from our intellectual property. Under the agreement, we are required to maintain minimum liquidity levels based on the balance of the outstanding advances. The agreement also includes a subjective acceleration clause that provides our lenders with the ability to accelerate repayment, even if we are in compliance with all conditions of the agreement, upon a

material adverse change to our business, properties, assets, financial condition or results of operations. The agreement may affect our operations in several ways, including the following:

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A portion of our cash flow from operations will be dedicated to the payment of the principal and interest on our indebtedness;

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Our future cash flow may be insufficient to meet our required principal and interest payments;

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We may need to raise additional capital in order to remain in compliance with the loan covenants;

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Our ability to enter into certain transactions (including incurrences of indebtedness) may be limited; and

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We may need to delay or reduce planned expenditures for clinical trials as well as other development and commercial activities if our current operations are not sufficient enough to service our debt.

Events of default under the loan and security agreement are not limited to, but include the following:

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Payment default;

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Covenant default;

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A material adverse change in our business operations;

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Breach of our agreements with Allegan; and

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Judgments against us over a specified dollar amount.

In case of an uncured default, the following actions may be taken against us by the lending institutions:

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All outstanding obligations associated with the term loan facility would be immediately due and payable;

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Any of our balances and deposits held by the lending institutions would be applied to the obligation;

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Balances and accounts at other financial institutions could be “held” or exclusive control could be transferred to the lending institutions; and

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All collateral, as defined in the agreement, could be seized and disposed of.

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

We have experienced significant losses since inception. We incurred net operating losses of approximately $35.5 million for the nine months ended September 30, 2009 and $51.6 million for the year ended December 31, 2008. As of September 30, 2009, our accumulated deficit was approximately $397.9 million. We currently expect to incur operating losses over the next several years. We expect that losses will fluctuate from quarter to quarter and that such fluctuations may be substantial. Such fluctuations will be affected by the timing and level of the following:

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Commercialization activities to support AzaSite and Elestat;

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Revenues from Restasis;

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Regulatory approvals of our product candidates;

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Patient demand for our products and any licensed products;

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Payments to and from licensors and corporate partners;

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Research and development activities;

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Investments in new technologies and product candidates; and

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The costs involved in defending any litigation claims against, or government investigations of, us.

To achieve and sustain profitable operations, we must, alone or with others, develop successfully, obtain regulatory approval for, manufacture, introduce, market and sell our products. The time frame necessary to achieve market success is long and uncertain. We may not generate sufficient product revenues to become profitable or to

sustain profitability. If the time required to achieve profitability is longer than we anticipate, we may not be able to continue our operations.

The current stock market and credit market conditions are extremely volatile and unpredictable. It is difficult to predict whether these conditions will continue or worsen, and, if so, whether the conditions would impact us and whether such impact could be material.

We have exposure to many different industries and counterparties, including commercial banks, investment banks and customers (which include wholesalers, managed care organizations and governments) that may be unstable or may become unstable in the current economic environment. Any such instability may impact these parties’ ability to fulfill contractual obligations to us or they might limit or place burdensome conditions upon future transactions with us. Customers may also reduce spending during times of economic uncertainty. Also, it is possible that suppliers may be negatively impacted. If such events were to occur, there could be a resulting material and adverse impact on our operations and results of operations.

We may decide to access the equity or debt markets to meet capital or liquidity needs. However, the constriction and volatility in these markets may restrict our future flexibility to do so when such needs arise. Further, recent economic conditions have resulted in severe downward pressure on the stock and credit markets, which could reduce the return available on invested corporate cash, which if severe and sustained could have a material and adverse impact on our results of operations and cash flows.

Our dependence on collaborative relationships may lead to delays in product development, lost revenues and disputes over rights to technology.

Our business strategy depends to some extent upon the formation of research collaborations, licensing and/or marketing arrangements. We currently have collaboration agreements with several collaborators, including Allergan, InSite Vision and Santen. The termination of any collaboration will result in the loss of any unmet development or commercial milestone payments, may lead to delays in product development and disputes over technology rights, and may reduce our ability to enter into collaborations with other potential partners. In the event we breach an agreement with a collaborator, the collaborator is entitled to terminate our agreement with them in the event we do not cure the breach within a specified period of time, which is typically 60 or 90 days from the notice date. With respect to the Allergan collaboration, in the event we become an affiliate of a third party that manufactures, markets or sells any then currently promoted prescription ophthalmic product, Allergan will have the right to terminate our Elestat co-promotion agreement, which right must be exercised within 3 months of the occurrence of such event. If we do not maintain our current collaborations, or establish additional research and development collaborations or licensing arrangements, it will be difficult to develop and commercialize potential products. Any future collaborations or licensing arrangements may not be on terms favorable to us.

Our current or any future collaborations or licensing arrangements ultimately may not be successful. Under our current strategy, and for the foreseeable future, we do not expect to develop or market products outside North America without a collaborative partner or outside our therapeutic areas of focus. We are currently pursuing the out-licensing of certain rights related to our cystic fibrosis program. We may be unsuccessful in out-licensing this program or we may be forced to out-license this program on terms that are not favorable to us.

It may be necessary in the future for us to obtain additional licenses to avoid infringement of third-party patents. Additionally, we may enter into license arrangements with other third parties as we build our product portfolio. We do not know the terms on which such licenses may be available, if at all.

We will continue to depend on collaborators and contractors for the preclinical study and clinical development of therapeutic products and for manufacturing and marketing of potential products. Our agreements with collaborators typically allow them some discretion in electing whether to pursue such activities. If any collaborator were to breach or terminate its agreement with us or otherwise fail to conduct collaborative activities in a timely and successful manner, the clinical development or commercialization of product candidates or research programs would be delayed or

terminated. Any delay or termination in clinical development or commercialization would delay or eliminate potential product revenues relating to our product candidates.

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

Failure to hire and retain key personnel may hinder our product development programs and our business efforts.

We depend on the principal members of management and scientific staff, including Christy L. Shaffer, Ph.D., our President and Chief Executive Officer and a director, and Thomas R. Staab, II, our Chief Financial Officer and Treasurer. If these people leave us, we may have difficulty conducting our operations. Dr. Shaffer has informed our Board of Directors that she intends to step down as our President and Chief Executive Officer once a successor is in place. There can be no assurance regarding the timing of succession of the President and Chief Executive Officer or the status of the external search process undertaken by our Board of Directors. Furthermore, there can be no assurance that our Board of Directors will be able to identify and hire an appropriately skilled and experienced executive to serve as our next President and Chief Executive Officer or that any person hired will have strong commercial biopharmaceutical experience. There can be no assurance that Dr. Shaffer will remain in place during the hiring of her successor, that a smooth and orderly transition process will occur or that Dr. Shaffer will be available to serve in an advisory role after a successor has been identified and hired. We have not entered into agreements with any officers or any other members of our management and scientific staff that bind them to a specific period of employment. Our future success will depend in part on our ability to attract, hire or appoint, and retain additional personnel skilled or experienced in the pharmaceutical industry. There is significant competition for such qualified personnel and we may not be able to attract and retain such personnel.

We may not be able to successfully compete with other biotechnology companies and established pharmaceutical companies.

The biotechnology and pharmaceutical industries are intensely competitive and subject to rapid and significant technological change. There are many companies seeking to develop products for the same indications that we are working on. Our competitors in the United States and elsewhere are numerous and include, among others, major multinational pharmaceutical and chemical companies and specialized biotechnology firms.

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

Our competitors may also develop technologies and drugs that are safer, more effective, or less costly than any we are developing or which would render our technology and future drugs obsolete and non-competitive. In addition, alternative approaches, such as gene therapy, in treating diseases that we have targeted, such as cystic fibrosis, may make our product candidates obsolete.

In May 2009, Pharmaxis Ltd. announced that its first Phase 3 trial of Bronchitol™ in patients with cystic fibrosis achieved its primary and a secondary endpoint. A second Phase 3 trial of Bronchitol has completed enrollment of 319 patients and Pharmaxis expects the results in the first half of 2010. Pharmaxis filed a marketing authorization

(i.e. new drug application) with the European Medicines Agency, or EMEA, in October 2009 and expects to know the outcome of the review in the second half of 2010. If both denufosol and Bronchitol are approved by a regulatory agency, we expect that the products could compete.

If our intellectual property protection is inadequate, the development and any possible sales of our product candidates could suffer or competitors could force our products completely out of the market.

Our business and competitive position depends on our ability to continue to develop and protect our products and processes, proprietary methods and technology and to prevent others from infringing on our patents, trademarks and other intellectual property rights. Upon the expiration or loss of patent protection for a product, we or our applicable collaborative partners may lose a significant portion of sales of that product in a short period of time as other companies manufacture generic forms of the previously protected product or manufacture similar products at lower cost, without having had to incur significant research and development costs in formulating the product. Therefore, our future financial success may depend in part on our and our partners obtaining patent protection for technologies incorporated into our products. We cannot assure that such patents will be issued, or that any existing or future patents will be of commercial benefit. In addition, it is impossible to anticipate the breadth or degree of protection that any such patents will afford, and we cannot assure that any such patents will not be successfully challenged in the future. If we are unsuccessful in obtaining or preserving patent protection, or if any of our products rely on unpatented proprietary technology, we cannot assure that others will not commercialize products substantially identical to those products. We also believe that the protection of our trademarks is an important factor in product recognition and in our ability to maintain or increase market share. If we do not adequately protect our rights in our various trademarks from infringement, their value to us could be lost or diminished, seriously impairing our competitive position. Moreover, the laws of certain foreign countries do not protect our intellectual property rights to the same extent as the laws of the United States.

Certain of our patents are use patents containing claims covering methods of treating disorders and diseases by administering therapeutic chemical compounds. Use patents may provide limited protection for commercial efforts in the United States, but may afford a lesser degree of protection, if any, in other countries due to their patent laws. Besides our use patents, we have patents and patent applications covering compositions (new chemical compounds), pharmaceutical formulations and processes for manufacturing our new chemical compounds. Many of the chemical compounds included in the claims of our use patents and process applications were known in the scientific community prior to our patent applications. None of our composition patents or patent applications covers these previously known chemical compounds, which are in the public domain. As a result, competitors may be able to commercialize products that use the same previously known chemical compounds used by us for the treatment of disorders and diseases not covered by our use patents. Such competitors’ activities may reduce our revenues.

Third parties may challenge, invalidate or circumvent our patents and patent applications relating to our products, product candidates or technologies at any time. If we must defend a patent suit, or if we choose to initiate a suit to have a third-party patent declared invalid, we may need to make considerable expenditures of money and management time in litigation. We believe that there is significant litigation in the pharmaceutical and biotechnology industry regarding patent and other intellectual property rights. A patent does not provide the patent holder with freedom to operate in a way that infringes the patent rights of others. We may be accused of patent infringement at any time. A judgment against us in a patent infringement action could cause us to pay monetary damages, require us to obtain licenses, or prevent us from manufacturing or marketing the affected products. In addition, we may need to initiate litigation to enforce our proprietary rights against others. Initiation of litigation may result in considerable expenditures of money and management time and may result in our patents being declared invalid. Further, we may need to participate in interference proceedings in the U.S. Patent and Trademark Office, or USPTO, to determine the priority of invention of any of our technologies.

Our ability to develop sufficient patent rights in our pharmaceutical, biopharmaceutical and biotechnology products to support commercialization efforts is uncertain and involves complex legal and factual questions. For instance, the USPTO examiners may not allow our claims in examining our patent applications. If we have to appeal a decision to the USPTO’s Appeals Board for a final determination of patentability, we could incur significant legal fees.

Use of our products may result in product liability claims for which we may not have adequate insurance coverage.

Manufacturing, marketing and sale of our products or conducting clinical trials of our product candidates may expose us to liability claims from the use of those products and product candidates. Product liability claims could result in the imposition of substantial liability on us, a recall of products, or a change in the indications for which they may be used. Although we carry product liability insurance and clinical trial liability insurance, we, or our collaborators, may not maintain sufficient insurance to cover these potential claims. We do not have the financial resources to self-insure and it is unlikely that we will have these financial resources in the foreseeable future. If we are unable to protect against potential product liability claims adequately, we may find it difficult or impossible to continue to commercialize our products or the product candidates we develop. If claims or losses exceed our liability insurance coverage, we may go out of business.

Insurance coverage is increasingly more costly and difficult to obtain or maintain.

While we currently have insurance for our business, property, directors and officers, and our products, insurance is increasingly more costly and narrower in scope, and we may be required to assume more risk in the future. If we are subject to claims or suffer a loss or damage in excess of our insurance coverage, we will be required to share that risk in excess of our insurance limits. If we are subject to claims or suffer a loss or damage that is outside of our insurance coverage, we may incur significant uninsured costs associated with loss or damage that could have an adverse effect on our operations and financial position. Furthermore, any claims made on our insurance policies may impact our ability to obtain or maintain insurance coverage at reasonable costs or at all.

Risks Related to Our Stock

Our common stock price has been volatile and your investment in our stock may decline in value.

The market price of our common stock has been volatile. These fluctuations create a greater risk of capital losses for our stockholders as compared to less volatile stocks. Factors that have caused volatility and could cause additional volatility in the market price of our common stock include among others:

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Announcements made by us concerning results of clinical trials with our product candidates;

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Announcements regarding the commercialization of AzaSite;

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Announcements regarding FDA approval of Prolacria, denufosol or any of our product candidates;

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Market acceptance and market share of AzaSite, Restasis and Elestat;

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The timing of the introduction of a generic form of Elestat;

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Duration of market exclusivity of AzaSite and Restasis;

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Volatility in other securities including pharmaceutical and biotechnology securities;

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Changes in government regulations;

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Regulatory actions and/or investigations;

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Changes in the development priorities of our collaborators that result in changes to, or termination of, our agreements with such collaborators;

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

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Variations in our operating results;

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FDA approval of other treatments for the same indication as any one of our product candidates;

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Business development activities; and

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Litigation.

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

Warburg is able to exercise substantial control over our business.

Warburg Pincus Private Equity IX, L.P., or Warburg, holds 22,907,488 shares of our common stock, which represented approximately 28% of our outstanding common stock as of September 30, 2009. Warburg and its affiliates may acquire the lesser of: (x) 32.5% of our voting securities on a fully diluted basis and (y) 34.9% of our then outstanding voting securities, without triggering the provisions of our stockholder rights plan. Warburg has the right to designate one person for election to our Board of Directors for so long as Warburg owns a significant percentage of our securities. Pursuant to this right, Jonathan S. Leff serves as a Class C member of the Board of Directors. Pursuant to a Securities Purchase Agreement, dated July 17, 2007, for so long as Warburg owns at least 10% of the shares of common stock issued upon the exchange of Exchangeable Preferred Stock it acquired in July 2007, it will have subscription rights to acquire a pro rata amount of future issuances of equity securities by us, subject to certain exceptions. As a result of the foregoing, Warburg is able to exercise substantial influence over our business, policies and practices.

Our existing principal stockholders hold a substantial amount of our common stock and may be able to influence significant corporate decisions, which may conflict with the interest of other stockholders.

As of September 30, 2009, our current 5% and greater stockholders (which includes Warburg) and their affiliates beneficially owned approximately 43% of our outstanding common stock. These stockholders, if they act together, may be able to influence the outcome of matters requiring approval of the stockholders, including the election of our directors and other corporate actions such as:

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a merger or corporate combination with or into another company;

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a sale of substantially all of our assets; and

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amendments to our certificate of incorporation.

The decisions of these individual stockholders may conflict with our interests or those of our other stockholders.

Future sales and issuances of securities may dilute the ownership interests of our current stockholders and cause our stock price to decline.

Future sales of our common stock by current stockholders into the public market could cause the market price of our stock to fall. As of September 30, 2009, there were 82,300,128 shares of our common stock outstanding. In addition, after deducting the $115 million of common stock sold in August 2009, we retain the ability to issue and may in the future issue, up to an additional $15 million of securities, including common stock, preferred stock, debt securities, depositary shares and securities warrants, from time to time at prices and on terms to be determined at the time of sale remaining under an active shelf registration statement, which we filed with the SEC on March 9, 2007. Furthermore, we may from time to time issue securities in relation to a license arrangement, collaboration, merger or acquisition.

Up to 15,178,571 shares of our common stock are issuable upon the release of restricted stock units and/or exercise of stock options that have been, or stock options, stock appreciation rights, stock awards and restricted stock units that may be, issued pursuant to our Amended and Restated 1995 Stock Plan and our Amended and Restated 2005 Equity Compensation Plan. The shares underlying existing stock options and restricted stock units and possible future stock options, stock appreciation rights and stock awards have been registered pursuant to registration statements on Form S-8.

If some or all of such shares are sold or otherwise issue into the public market over a short period of time, our current stockholders’ ownership interests may be diluted and the value of all publicly traded shares is likely to decline,

as the market may not be able to absorb those shares at then-current market prices. Additionally, such sales and issuances may make it more difficult for us to sell equity securities or equity-related securities in the future at a time and price that our management deems acceptable, or at all.

Our Rights Agreement, the provisions of our Change in Control Severance Benefit Plans, the anti-takeover provisions in our Amended and Restated Certificate of Incorporation, as amended, and Amended and Restated Bylaws, standstill agreements, and our right to issue preferred stock, may discourage a third party from making a take-over offer that could be beneficial to us and our stockholders and may make it difficult for stockholders to replace our Board of Directors and effect a change in our management if they desire to do so.

In October 2002, we entered into a Rights Agreement with Computershare Trust Company. The Rights Agreement could discourage, delay or prevent a person or group from acquiring 15% or more of our common stock. The Rights Agreement provides that if a person acquires 15% or more of our common stock without the approval of our Board of Directors, all other stockholders will have the right to purchase securities from us at a price that is less than its fair market value, which would substantially reduce the value of our common stock owned by the acquiring person. As a result, our Board of Directors has significant discretion to approve or disapprove a person’s efforts to acquire 15% or more of our common stock. In connection with the transaction with Warburg, we and Computershare entered into a First Amendment to Rights Agreement which provides that Warburg and its affiliates will be exempt from the definition of an “Acquiring Person” under the Rights Agreement, unless Warburg or certain of its affiliates becomes the beneficial owner of the lesser of: (x) 32.5% of our voting securities on a fully diluted basis and (y) 34.9% of our then outstanding voting securities. In addition to Warburg’s ability to exercise substantial control over our business, the First Amendment to Rights Agreement could further discourage, delay or prevent a person or group from acquiring 15% or more of our common stock. As part of the same transaction with Warburg, we entered into a standstill agreement, dated July 20, 2007, pursuant to which Warburg and certain of its affiliates agreed for three years not to increase their holdings of our common stock beyond the levels described above in the First Amendment to Rights Agreement. On August 4, 2009, we amended the standstill agreement to extend its term until August 4, 2012.

Our employees are covered under Change in Control Severance Benefit Plans which provide severance benefits in the event of a change of control that occurs prior to July 8, 2010, and in the event they are terminated after a change in control occurring on or after July 8, 2010. The plans would increase the acquisition costs to a purchasing company that triggers the change in control provisions and as a result, may discourage, delay or prevent a change in control.

Our Amended and Restated Certificate of Incorporation, as amended, and Amended and Restated Bylaws contain provisions which could discourage, delay or prevent a third party from acquiring shares of our common stock or replacing members of our Board of Directors. Our Amended and Restated Certificate of Incorporation, as amended, allows our Board of Directors to issue shares of preferred stock. Our Board of Directors can determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. As a result, our Board of Directors could make it difficult for a third party to acquire a majority of our outstanding voting stock. Since management is appointed by the Board of Directors, any inability to effect a change in the Board of Directors may result in the entrenchment of management.

Our Amended and Restated Certificate of Incorporation, as amended, also provides that the members of the Board will be divided into three classes. Each year, the terms of approximately one-third of the directors will expire. Our Amended and Restated Bylaws include director nomination procedures and do not permit our stockholders to call a special meeting of stockholders. The staggering of directors’ terms of office, the director nomination procedures and the inability of stockholders to call a special meeting may make it difficult for stockholders to remove or replace the Board of Directors should they desire to do so. The director nomination requirements include a provision that requires stockholders give advance notice to our Secretary of any nominations for director or other business to be brought by stockholders at any stockholders’ meeting. Our directors may be removed from our Board of Directors only for cause. These provisions may discourage, delay or prevent changes of control or management, either by third parties or by stockholders seeking to change control or management.

In the ordinary course of our business, from time to time we discuss possible collaborations, licenses and other transactions with various third parties, including pharmaceutical companies and biotechnology companies. When we deem it appropriate, we enter into standstill agreements with such third parties in relation to the discussions. These standstill agreements, several of which are currently in force, typically prohibit such parties from acquiring our securities for a period of time.

We are also subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law. Under these provisions, if anyone becomes an “interested stockholder,” we may not enter a “business combination” with that person for three years without special approval, which could discourage a third party from making a take-over offer and could delay or prevent a change of control. For purposes of Section 203, “interested stockholder” means, generally, someone owning 15% or more of our outstanding voting stock or an affiliate of ours that owned 15% or more of our outstanding voting stock during the past three years, subject to certain exceptions as described in Section 203. In connection with our prior sale of stock to Warburg, we agreed to waive Warburg’s acquisition of securities from the provisions of Section 203 of the Delaware General Corporation Law.

Item 6. Exhibits


Exhibit No.		Description of Exhibit

1.1		Underwriting Agreement, dated August 5, 2009, between Inspire Pharmaceuticals, Inc. and Deutsche Bank Securities Inc. (Incorporated by reference to Exhibit 1.1 to the Company’s Current Report on Form 8-K filed on August 10, 2009).

3.1		Amended and Restated Certificate of Incorporation (Incorporated by reference to Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q filed on August 8, 2006).

3.2		Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on December 18, 2007).

3.3		Certificate of Designations of Series H Preferred Stock of Inspire Pharmaceuticals, Inc. (Incorporated by reference to Exhibit 3.3 to the Company’s Annual Report on Form 10-K filed March 7, 2003).

3.4		Certificate of Amendment to Certificate of Designations of Series H Preferred Stock of Inspire Pharmaceuticals, Inc. (Incorporated by reference to Exhibit 4.4 to the Company’s Current Report on Form 8-K filed on July 23, 2007).

10.1		Amendment No. 1 to Standstill Agreement, dated August 4, 2009, between Inspire Pharmaceuticals, Inc. and Warburg Pincus Private Equity IX, L.P. (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on August 10, 2009).

10.2		Technology License Agreement For the Manufacture of Denufosol, dated as of October 2, 2009, between Inspire Pharmaceuticals, Inc. and Yamasa Corporation, with an effective date of September 25, 2009.

31.1		Certification of the President & Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934.

31.2		Certification of the Chief Financial Officer & Treasurer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934.

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

32.2		Certification of the Chief Financial Officer & Treasurer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

SIGNATURES

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


	Inspire Pharmaceuticals, Inc.

Date: November 6, 2009	By:	/S/ CHRISTY L. SHAFFER
		Christy L. Shaffer
		President & Chief Executive Officer
		(principal executive officer)

Date: November 6, 2009	By:	/S/ THOMAS R. STAAB, II
		Thomas R. Staab, II
		Chief Financial Officer & Treasurer
		(principal financial and chief accounting officer)

EXHIBIT INDEX


Exhibit No.		Description of Exhibit

1.1		Underwriting Agreement, dated August 5, 2009, between Inspire Pharmaceuticals, Inc. and Deutsche Bank Securities Inc. (Incorporated by reference to Exhibit 1.1 to the Company’s Current Report on Form 8-K filed on August 10, 2009).

3.1		Amended and Restated Certificate of Incorporation (Incorporated by reference to Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q filed on August 8, 2006).

3.2		Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on December 18, 2007).

3.3		Certificate of Designations of Series H Preferred Stock of Inspire Pharmaceuticals, Inc. (Incorporated by reference to Exhibit 3.3 to the Company’s Annual Report on Form 10-K filed March 7, 2003).

3.4		Certificate of Amendment to Certificate of Designations of Series H Preferred Stock of Inspire Pharmaceuticals, Inc. (Incorporated by reference to Exhibit 4.4 to the Company’s Current Report on Form 8-K filed on July 23, 2007).

10.1		Amendment No. 1 to Standstill Agreement, dated August 4, 2009, between Inspire Pharmaceuticals, Inc. and Warburg Pincus Private Equity IX, L.P. (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on August 10, 2009).

10.2		Technology License Agreement For the Manufacture of Denufosol, dated as of October 2, 2009, between Inspire Pharmaceuticals, Inc. and Yamasa Corporation, with an effective date of September 25, 2009.

31.1		Certification of the President & Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934.

31.2		Certification of the Chief Financial Officer & Treasurer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934.

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

32.2		Certification of the Chief Financial Officer & Treasurer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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