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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For The Quarterly Period Ended June 30, 2010

OR

o         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 001-33523

COMBIMATRIX CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s telephone number, including area code:  (949) 753-0624

6500 Harbour Heights Parkway, Suite 303

Mukilteo, WA 98275

(Former name, former address and former fiscal year, if changed since last report.)

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 filing requirements for the past 90 days.      Yes x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, 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 o No o

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 Act).   Yes o No x

As of August 10, 2010, 7,620,398 shares of CombiMatrix Corporation common stock were issued and outstanding.

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COMBIMATRIX CORPORATION

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COMBIMATRIX CORPORATION

CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

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

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COMBIMATRIX CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except share and per share information)

(Unaudited)

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

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COMBIMATRIX CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.    OVERVIEW AND BACKGROUND

CombiMatrix Corporation (the “Company,” “we,” “us” and “our”) was originally incorporated in October 1995 as a California corporation and later reincorporated as a Delaware corporation in September 2000.  In December 2002, we merged with and became a wholly owned subsidiary of Acacia Research Corporation (“Acacia”).  In December 2006, we filed a registration statement with the U.S. Securities and Exchange Commission (“SEC”) in order to register our common stock as part of a plan to split-off from Acacia (the “Split-Off”).  On August 15, 2007 (the “Split-Off Date”), the Split-Off was effected and our common stock became publicly traded on the Nasdaq Global Market (symbol: “CBMX”).  As of the Split-Off Date, we ceased to be a subsidiary of, or affiliated with, Acacia.

Description of the Company

We are a diversified biotechnology business that primarily operates in the field of genetic analysis and molecular diagnostics through our wholly owned subsidiary, CombiMatrix Molecular Diagnostics, Inc. (“CMDX”). CMDX operates as a diagnostics reference laboratory that provides genetic and other diagnostics services to physicians, hospitals and clinics.

Leuchemix Inc. (“Leuchemix”), a minority-owned subsidiary, is developing a series of compounds to address a number of oncology-related diseases.  Leuchemix’s first compound has entered initial clinical trials in the United Kingdom.

On April 19, 2010, we announced a strategic and operational restructuring plan (the “Restructuring Plan”) to significantly reduce operating costs, increase the focus on the Company’s diagnostic services business and transition senior management.  As part of the Restructuring Plan, we have closed our Mukilteo, Washington facility, which had been focused primarily on research, development and commercialization of the Company’s oligonucleotide microarray technologies, also known as our “CustomArray” business.  We have also relocated our corporate headquarters from Mukilteo to CMDX’s Irvine, California location.  After the restructuring, we will be focused primarily on our diagnostics services business, including increasing the utilization of our existing tests, expanding the test menu, increasing the number of customers and partners, and improving reimbursement for our testing services.  As a component of this plan, we initiated a search for a new President and Chief Executive Officer, which was completed on August 11, 2010 (see Note 9).  On June 30, 2010, Dr. Amit Kumar stepped down from his role as President and Chief Executive Officer and Mr. Mark McGowan, our Chairman of our Board of Directors, assumed this role on an interim basis.

Basis of Presentation

The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 8-03 of Regulation S-X.  Accordingly, certain information and footnotes required by generally accepted accounting principles in annual financial statements have been omitted or condensed in accordance with quarterly reporting requirements of the SEC.  These interim consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2009, as reported by us in our Annual Report on Form 10-K filed on March 18, 2010.  The year-end consolidated balance sheet data was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States of America.  The consolidated financial statements include all adjustments of a normal recurring nature which, in the opinion of management, are necessary for a fair statement of our financial position as of June 30, 2010, and results of operations and cash flows for the interim periods presented.  The results of operations for the three and six months ended June 30, 2010 are not necessarily indicative of the results to be expected for the entire year.

As a result of executing the Restructuring Plan, the financial results of our CustomArray business have been classified as discontinued operations in the consolidated statements of operations for all periods presented.  See Note 3 for additional information regarding discontinued operations.  Unless otherwise noted, amounts and disclosures throughout the notes to our consolidated financial statements relate to our continuing operations.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

Liquidity and Risks

We have a history of incurring net losses and net operating cash flow deficits.  We are also deploying new and unproven technologies and continue to develop commercial tests and products.

At June 30, 2010, we had cash and cash equivalents of $10.2 million.  As a result, we anticipate that our cash and cash equivalent balances, anticipated cash flows from operations, operating cash savings from our Restructuring Plan and other sources of funding from the capital markets will be sufficient to meet our cash requirements beyond the next twelve months.  In order for us to continue as a going concern beyond this point, we may be required to obtain capital from external sources. However, there can be no assurances that additional sources of financing, including the issuance of debt and/or equity securities, will be available at times and at terms acceptable to us.

Our business operations are also subject to certain risks and uncertainties, including:

·                  market acceptance of products and services;

·                  technological advances that may make our products and services obsolete or less competitive;

·                  increases in operating costs, including costs for supplies, personnel and equipment;

·                  the availability and cost of capital; and

·                  government regulation that may restrict our business.

Our products and services are concentrated in a highly competitive market that is characterized by rapid technological advances, frequent changes in customer requirements and evolving regulatory requirements and industry standards.  Failure to anticipate or respond adequately to technological advances, changes in customer requirements, changes in regulatory requirements or industry standards, or any significant delays in the development or introduction of planned products or services, could have a material adverse effect on our business and operating results.  The accompanying consolidated financial statements have been prepared assuming that the Company continues as a going concern.  The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the matters discussed herein.

2.    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

References to Authoritative Accounting Literature.  In June 2009, the Financial Accounting Standards Board (“FASB”) issued the Accounting Standards Codification (“ASC”) as the single source of authoritative U.S. generally accepted accounting principles (“GAAP”) recognized by the FASB to be applied by non-governmental entities in preparation of financial statements in conformity with U.S. GAAP, except for additional authoritative rules and interpretative releases issued by the SEC.  While the adoption of the ASC changes how we reference accounting standards, the adoption did not have an impact on our consolidated financial statements.

Discontinued Operations.  We reclassify, from continuing operations to discontinued operations, for all periods presented, the results of operations for any component either held for sale or disposed of.  We define a component as being distinguishable from the rest of our Company because it has its own operations and cash flows.  A component may be a reportable segment, an operating segment, a reporting unit, a subsidiary, or an asset group.  Such reclassifications had no effect on our net loss or shareholders’ equity.

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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

Principles of Consolidation.  The accompanying consolidated financial statements include the accounts of the Company and our wholly owned and majority-owned subsidiaries.  Investments for which we possess the power to direct or cause the direction of the management and policies, either through majority ownership or other means, are accounted for under the consolidation method. Material intercompany transactions and balances have been eliminated in consolidation.  Investments in companies in which we maintain an ownership interest of 20% to 50% or exercise significant influence over operating and financial policies are accounted for under the equity method.  The cost method is used where we maintain ownership interests of less than 20% and do not exercise significant influence over the investee.  In addition, U.S. GAAP generally stipulates that an entity is a variable interest entity, or VIE, if it does not have sufficient equity investment at risk, or if the holders of the entity’s equity instruments lack the essential characteristics of a controlling financial interest.  Further, these standards require that the holder subject to a majority of the risk of loss from a VIE’s activities must consolidate the VIE.  However, if no holder has a majority of the risk of loss, then a holder entitled to receive a majority of the entity’s residual returns would consolidate the entity.

Revenue Recognition. We recognize revenue when (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred or services have been performed, (iii) amounts are fixed or determinable and (iv) collectibility of amounts is reasonably assured.

Service revenues from providing diagnostic tests are recognized when the testing process is complete and test results are reported to the ordering physician or clinic.  These diagnostic services are billed to various payors, including commercial insurance companies, healthcare institutions, individuals and government payors including Medicare and Medicaid.  We report revenues from contracted payors based on a contractual rate, or in the case of Medicare and Medicaid, published fee schedules for our tests.  We report revenues from non-contracted payors based on the amount expected to be collected.  The difference between the amount billed and the amount expected to be collected from non-contracted payors is recorded as a contractual allowance to arrive at net recognized revenues.  The expected revenues from non-contracted payors are based on the historical collection experience of each payor or payor group, as appropriate.  In each reporting period, we review our historical collection experience for non-contracted payors and adjust our expected revenues for current and subsequent periods accordingly.  Because a substantial portion of our revenues is from non-contracted third party payors, it is likely that we will be required to make positive or negative adjustments to accounting estimates with respect to contractual allowances in the future, which may positively or adversely affect our results of operations.

Revenues from the sale of aCGH slides, including shipping and handling fees but excluding statutory taxes collected from customers, as applicable, have been recognized when delivery occurred.  There is no written or implied right to return or exchange the products.

Revenues from multiple element arrangements are based on the relative selling price method, whereby we allocate consideration received to all deliverables of an arrangement at the inception of the arrangement based on the relative selling prices of each element. In order to determine the selling price of a deliverable, we apply the following hierarchy: 1) vendor-specific objective evidence (“VSOE”); 2) third-party evidence if VSOE is not available; and 3) our best estimate of selling price for the deliverable if neither VSOE nor third-party evidence is available.  Several factors are considered when determining the estimated selling price of a deliverable, including, but not limited to, the cost to produce the deliverable, the expected margin on that deliverable, our ongoing pricing strategy and policies and the value-added components of differentiated deliverables, if determinable.  In order for a deliverable to be accounted for as a separate unit of accounting, both of the following criteria must be met: 1) the delivered item or items have value to the customer on a standalone basis; and 2) when a general right of return exists, the delivery or performance of an undelivered item is considered probable and under our control.  Our revenue arrangements do not have a general right of return.  When a deliverable does not meet the criteria to be considered a separate unit of accounting, we group that deliverable with other deliverables that, when combined, meet the criteria, and the appropriate allocation of arrangement consideration and revenue recognition is determined.

Cash and Cash Equivalents.  We consider all highly liquid, short-term investments with original maturities of three months or less when purchased to be cash equivalents.

Fair Value Measurements.  We measure fair value as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.  As such, fair value is a market-based measurement that is determined based on assumptions that market participants would use in pricing an asset or liability.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

We utilize a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows:

Accounts Receivable and Allowances for Doubtful Accounts.  Accounts receivable are stated at principal amounts and are primarily comprised of amounts contractually due from customers for products and services.  An allowance for doubtful accounts is recorded for estimated uncollectible amounts due from various payor groups such as commercial insurance companies, healthcare institutions, government payors and individuals.  The process for estimating the allowance for doubtful accounts involves significant assumptions and judgments.  Specifically, the allowance for doubtful accounts is adjusted periodically and is principally based upon specific identification of past due or disputed accounts.  We also review the age of receivables by payor class to assess our allowance at each period end.  The payment realization cycle for certain governmental and commercial insurance payors can be lengthy, involving denial, appeal and adjudication processes, and is subject to periodic adjustments that may be significant.  Accounts receivable are periodically written off when identified as uncollectible and deducted from the allowance for doubtful accounts after appropriate collection efforts have been exhausted. Additions to the allowance for doubtful accounts are charged to bad debt expense as a component of marketing, general and administrative expenses in the consolidated statements of operations.  Collection of governmental, private health insurer, and client receivables are generally a function of providing complete and correct billing information to the insurers and clients within the filing deadlines required by each payor.  Collection of receivables due from patients and clients is generally subject to increased credit risk due to credit worthiness or inability to pay.

Impairment of Long-Lived Assets and Goodwill.  Long-lived assets and intangible assets are reviewed for potential impairment when events or changes in circumstances indicate the carrying amount of an asset may not be recoverable.  In the event the sum of the expected undiscounted future cash flows resulting from the use of the asset is less than the carrying amount of the asset, an impairment loss equal to the excess of the asset’s carrying value over its fair value is recorded.  If an asset is determined to be impaired, the loss is measured based on quoted market prices in active markets, if available.  If quoted market prices are not available, the estimate of fair value is based on various valuation techniques, including a discounted value of estimated future cash flows.  Due to the Restructuring Plan, management determined that our patent intangible assets were impaired — see Note 3 below.

Goodwill is evaluated annually for impairment at the reporting unit level, or earlier if an event occurs or circumstances change that would more likely than not indicate that the fair value of a reporting unit is below its carrying amount.  A reporting unit can be an operating segment or a business if discrete financial information is prepared and reviewed by management.  Under the impairment test, if a reporting unit’s carrying amount exceeds its estimated fair value, goodwill impairment is recognized to the extent that the reporting unit’s carrying amount of goodwill exceeds the implied fair value of the goodwill.  We performed our annual impairment test during the fourth quarter of 2009 and determined that goodwill was not impaired.  During the second quarter of 2010, the Company’s fair value (as determined by the trading of our common stock on Nasdaq) fell below our carrying value, triggering an impairment analysis — see Note 5 below.

Derivatives Embedded in Certain Debt Securities.  We evaluate financial instruments for freestanding or embedded derivatives. Derivative instruments that have been separated from the host contract and do not qualify for hedge accounting are recorded at fair value with changes in value recognized as other non-operating income (expense) in the consolidated statements of operations in the period of change.

Stock-Based Compensation.  The compensation cost for all stock-based awards is measured at the grant date, based on the fair value of the award, and is recognized as an expense, on a straight-line basis, over the employee’s requisite service period (generally the vesting period of the equity award) which is generally three years.  The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model.  Stock-based compensation expense is recognized only for those awards that are expected to vest using an estimated forfeiture rate.  We estimate pre-vesting option forfeitures at the time of grant and reflect the impact of estimated pre-vesting option forfeitures in compensation expense recognized. 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

Stock-based compensation expense for all periods presented attributable to our functional expense categories were as follows (in thousands; unaudited):

Net Loss Per Share.  Basic and diluted net loss per share has been computed by dividing the net loss by the weighted average number of common shares issued and outstanding during the periods presented.  Options and warrants to purchase CombiMatrix stock are anti-dilutive and therefore are not included in the determination of the diluted net loss per share.  The following table presents a reconciliation of basic and diluted loss per share from continuing operations for all periods presented (in thousands, except share and per-share data; unaudited):

Recent and Adopted Accounting Pronouncements.  In March 2010, the FASB issued new authoritative guidance regarding revenue recognition to define a milestone and clarify that the milestone method of revenue recognition is a valid application of the proportional performance model when applied to research or development arrangements.  Accordingly, a company can make an accounting policy election to recognize a payment that is contingent upon the achievement of a substantive milestone in its entirety in the period in which the milestone is achieved.  This guidance begins phasing in during the third quarter of 2010.  We do not expect the implementation of this guidance to have a material impact on our consolidated financial statements.

In January 2010, the FASB issued new authoritative guidance regarding the disclosure of fair value measurements, which clarifies certain existing disclosure requirements as well as requiring new disclosures related to significant transfers between each fair value level as well as requiring additional information about Level 3 activity.  This guidance begins phasing in during the first fiscal period after December 15, 2009.  We do not expect the implementation of this guidance to have a material impact on our consolidated financial statements.

In October 2009, the FASB issued new authoritative guidance to require companies to allocate revenue in multiple-element arrangements based on an element’s estimated selling price if vendor-specific or other third-party evidence of value is not available. The new guidance is effective for revenue transactions entered into during fiscal years beginning on or after June 15, 2010, with earlier application permitted.  We do not believe the adoption of this guidance will have a material impact on our consolidated financial statements.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

3.     RESTRUCTURING

On April 19, 2010, we announced a Restructuring Plan that will focus our Company on our diagnostic services business while shutting down our CustomArray business.  Related charges incurred as of June 30, 2010 are as follows (in thousands):

Of the $1.7 million in restructuring charges listed above, $465,000 were non-cash write-downs, $826,000 were paid out in cash as of June 30, 2010, and $362,000 were accrued as short-term payables and are expected to be paid out during the third quarter of 2010. Remaining costs that are primarily associated with facilities clean-up and relocation are not expected to be significant.  Net of proceeds received from the sales of surplus property, equipment and inventory, we recognized a loss from restructuring of $1.4 million, which is included as a component of loss from discontinued operations in the three and six months ended June 30, 2010 statements of operations.

As a result of the Restructuring Plan, management performed an impairment analysis of its intangible patent assets and determined that these assets were fully impaired.  As a result, these assets were written down by $3.4 million during the second quarter of 2010.  The write-down is included as a component of loss from discontinued operations in the accompanying consolidated statements of operations for the three and six months ended June 30, 2010.

The following table summarizes results of our CustomArray business classified as discontinued operations in the accompanying consolidated statements of operations for the three and six months ended June 30, 2010 and 2009 (in thousands):

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

4.     FAIR VALUE MEASUREMENTS

The following table summarizes, for each major category of financial assets measured on a recurring basis, the respective fair value at June 30, 2010 and the classification by level of input within the fair value hierarchy defined above (in thousands; unaudited):

The following table is a reconciliation of financial liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the six months ended June 30, 2010 (in thousands; unaudited):

(1)          Included in “other liabilities” in the accompanying December 31, 2009 consolidated balance sheet.

5.     GOODWILL IMPAIRMENT

The decline in our market capitalization during the second quarter of 2010 (as indicated by the trading of our common stock on Nasdaq) was considered by management to be a potential goodwill impairment triggering event.  As a result, we performed a business valuation using a market based approach and determined that all of our $16.9 million in goodwill was impaired.  The related charge was recognized as “goodwill impairment” in our 2010 consolidated statements of operations.  The change in the carrying amount of goodwill and impairment losses for the period ended June 30, 2010 is as follows (in thousands):

6.     SECURED CONVERTIBLE DEBENTURE

Description

On July 10, 2008 (the “Closing Date”), we issued to YA Global Investments, L.P. (“YA”): (i) a secured convertible debenture (the “Debenture”) with an aggregate principal amount of $10 million, which was convertible into shares of our common stock at a fixed conversion price of $11.87 per share (and was reduced during 2009 to $7.50 per share); and (ii) warrants (the “YA Warrants”) to purchase up to 336,984 shares of our common stock.  The Debenture was originally due on the earlier of July 10, 2010 (the “Term”) or within four months after receipt of payment of judgment or settlement proceeds from National Union Fire Insurance Company of Pittsburg, PA (“National Union”) in accordance with the $35.7 million judgment (the “Judgment”) issued by the U.S. District Court for the Central District of California (the “District Court”).  In February 2010, we received $25 million in settlement proceeds from National Union, $8.6 million of which was used to fully retire the remaining principal balance of the Debenture, plus accrued interest, on March 2, 2010 (the “Retirement Date”).

The Debenture bore interest at an annual rate of 10%, with interest payments due quarterly in either cash or our common stock. As a result of a registered direct offering of our common stock that occurred in May 2009, the fixed conversion price of the Debenture was reduced from $11.87 per share to $7.50 per share pursuant to anti-dilution provisions of the Debenture.  The YA Warrants, which remain outstanding, and have a five-year term and allow YA to purchase: (i) 168,492 shares of common stock at an exercise price of $11.87; and (ii) 168,492 shares of common stock at an exercise price of $13.65.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

As a result of separating the YA Warrants and embedded derivative features of the Debenture, an aggregate contra-liability totaling $2.9 million was recognized as of the Closing Date and was netted against the Debenture as a debt discount, which was being accreted to the face amount due YA over the Term using the effective interest method, with the corresponding charges recorded as interest expense.  For the three and six months ended June 30, 2010 and 2009, interest and amortization charges were $0, $348,000, $506,000 and $1.0 million, respectively.  As of the Retirement Date, the remaining unamortized debt discount of $572,000 was written off as a non-operating loss from early extinguishment of debt in the six-month ended June 30, 2010 consolidated statement of operations.

Since the Closing Date, YA had converted $1.6 million of the Debenture into common stock, leaving an outstanding principal balance plus accrued interest due of $8.6 million prior to being retired as of the Retirement Date.  The embedded derivative liabilities were marked to fair value of zero as of the Retirement Date and $1.8 million as of June 30, 2009, resulting in net non-operating derivative gains (charges) of $0, $605,000, $137,000 and $(1.4 million) for the three and six months ended June 30, 2010 and 2009, respectively.

7.     SHAREHOLDERS’ EQUITY

Equity Financings

On May 1, 2009, we closed a registered direct offering (the “Offering”) of our common stock and warrants for gross proceeds of $8.25 million.  Under the terms of the Offering, we sold 1.1 million units for $7.50 per unit to certain investors.  Each unit consisted of one share of our common stock and one warrant, each warrant to purchase one share of our common stock at an exercise price of $9.00 per share.  The warrants were not exercisable until six months after the Offering and have a term of five years.  The warrants are also callable if our common stock trades at or above $22.50 per share during any 20 trading days during a period of 30 consecutive trading days, with a minimum daily trading volume of 50,000 shares each day during that 30 trading day period.  Subsequent to the date of the Offering, we listed the warrants on the Nasdaq Global Market under the symbol “CBMXW”.  Net proceeds from the Offering, net of placement agent fees and expenses, were approximately $7.6 million.  As a result of the Offering, the fixed conversion price of the Debenture was reduced to $7.50 per share, effective May 1, 2009.

Warrants

Outstanding warrants to purchase CombiMatrix stock are as follows:

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

8.    COMMITMENTS AND CONTINGENCIES

Human Resources

We provide certain severance benefits such that if an executive of CombiMatrix who is a vice president or higher is terminated for other than cause, death or disability, the executive will receive payments equal to three months’ base salary plus medical and dental benefits.

In addition, we have implemented an Executive Change of Control Severance Plan (the “Severance Plan”) that affects certain of our senior management-level employees of CombiMatrix Corporation.  Pursuant to the Severance Plan, if a participating employee is involuntarily terminated (other than for death, disability or for cause) or resigns for “good reason” (as defined in the Severance Plan) during the two-year period following a “change of control” (as defined in the Severance Plan) of the Company, then, subject to execution of a release of claims against the Company, the employee will be entitled to receive: (i) a cash severance payment equal to one times annual base salary, in the case of our Chief Executive Officer; or one-half times annual base salary, in the case of other participating employees; (ii) immediate vesting of outstanding compensatory equity awards; and (iii) payment of COBRA premiums for the participating employee and eligible dependants for a pre-determined period of time.  Payment of benefits under the Severance Plan will be limited by provisions contained in Section 409A of the U.S. Internal Revenue Code.  The Severance Plan is administered by a plan administrator, which initially is the Compensation Committee of the Board of Directors.  In order to participate in the Severance Plan, an eligible employee must waive any prior retention or severance agreements. The Severance Plan was modified on August 10, 2010 (see Note 9 below).

Litigation

On September 30, 2002, we entered into a settlement agreement with Nanogen, Inc. (“Nanogen”) to settle all pending litigation between the parties.  Pursuant to the terms of the settlement agreement, we agreed to make quarterly payments to Nanogen equal to 12.5% of total sales of products developed by us and our affiliates based on the patents that had been in dispute in the litigation, up to an annual maximum amount of $1.5 million.  The minimum quarterly payments under the settlement agreement are $25,000 per quarter until the patents expire in 2018.  Royalty expenses recognized under the agreement were $25,000, $50,000, $25,000, and $50,000, for the three and six months ended June 30, 2010 and 2009, respectively, and are included in patent amortization and royalties in the accompanying consolidated statements of operations.

In April 2005, Acacia and CombiMatrix filed a complaint against our insurance carrier, National Union (collectively, the “Parties”), seeking reimbursement of litigation and settlement costs for a prior lawsuit pursuant to our directors and officers insurance policy with National Union.  A trial was held and concluded during the fourth quarter of 2007.  In March 2008, the District Court issued its Judgment in favor of Acacia and us, and awarded approximately $32.1 million in monetary damages to be paid by National Union.  In May 2008, the District Court awarded us an additional $3.6 million in attorneys’ fees and litigation costs, thereby increasing the overall award to $35.7 million.  National Union appealed the Judgment to the U.S. Ninth Circuit Court of Appeals, which we vigorously opposed.  On January 27, 2010, the Parties entered into a settlement agreement whereby National Union agreed to pay $25 million to us in order to settle the dispute.  These proceeds, net of attorneys’ fees and costs of $5.6 million, were paid to us on February 3, 2010 and a dismissal of the action was entered by the District Court on February 11, 2010.

We are subject to other claims and legal actions that arise in the ordinary course of business.  We believe that the ultimate liability with respect to these claims and legal actions, if any, will not have a material effect on our financial position, results of operations or cash flows.  Based on a distribution agreement executed between us and Acacia, it is expected that such claims, legal actions, etc. attributable to CombiMatrix Corporation prior to the Split-Off Date will remain with us subsequent to the Split-Off Date.  As of the date of this report and prior to such date, we are not aware of the existence of any such claims or legal actions.

9.     SUBSEQUENT EVENTS

On August 10, 2010, our Board of Directors approved a restatement of the Severance Plan, that affects certain of our senior management-level employees of CombiMatrix Corporation.  As restated, any cash severance payment payable under the Severance Plan will be equal to one-half times annual base salary for all senior management-level employees of the Company, including our Chief Executive Officer.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

On August 11, 2010, R. Judd Jessup accepted our offer to become the Company’s new President and Chief Executive Officer, and his employment with us will commence on August 23, 2010.  Mr. Jessup was also elected to serve as a member of our Board of Directors, effective August 23, 2010.  Mr. Jessup replaces Mark McGowan who had served as our interim President and Chief Executive Officer.  Mr. McGowan will continue to serve as Chairman of the Board.  Mr. Jessup will be paid a base salary of $420,000 per year and, subject to Board approval, an annual performance bonus.  We also granted Mr. Jessup a stock option to purchase 400,000 shares of our common stock at an exercise price of $2.74 per share.  The stock option vests over four years.  Mr. Jessup is entitled to standard company benefits and may be entitled to certain severance benefits under the Company’s Severance Plan. Pursuant to the Severance Plan, if Mr. Jessup is involuntarily terminated (other than for death, disability or for cause) or resigns for “good reason” (as defined in the Severance Plan) during the two-year period following a “change of control” (as defined in the Severance Plan) of the Company, then, subject to execution of a release of claims against the Company, the Mr. Jessup will be entitled to receive: (i) a cash severance payment equal to one-half times his annual base salary; (ii) immediate vesting of outstanding compensatory equity awards; and (iii) payment of COBRA premiums for Mr. Jessup and eligible dependants for a pre-determined period of time.

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

Cautionary Statement

You should read the following discussion and analysis in conjunction with the consolidated financial statements and related notes thereto contained in Part I, Item 1 of this report.  The information contained in this Quarterly Report on Form 10-Q is not a complete description of our businesses or the risks associated with an investment in our common stock.  We urge you to carefully review and consider the various disclosures made by us in this report and in our other reports filed with the U.S. Securities and Exchange Commission, or “SEC,” including our Annual Report on Form 10-K, filed on March 18, 2010.

This report contains forward-looking statements within the meaning of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Reference is made in particular to the description of our plans and objectives for future operations, assumptions underlying such plans and objectives, and other forward-looking statements included in this report. Such statements may be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “believe,” “estimate,” “anticipate,” “intend,” “continue,” or similar terms, variations of such terms or the negative of such terms.  Such statements are based on management’s current expectations and are subject to a number of factors and uncertainties, which could cause actual results to differ materially from those described in the forward-looking statements.  Such statements address future events and conditions concerning product development, capital expenditures, earnings, litigation, regulatory matters, markets for products and services, liquidity and capital resources and accounting matters.  Actual results in each case could differ materially from those anticipated in such statements by reason of factors such as future economic conditions, changes in consumer demand, legislative, regulatory and competitive developments in markets in which we and our subsidiaries operate, results of litigation and other circumstances affecting anticipated revenues and costs.  We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.  Additional factors that could cause such results to differ materially from those described in the forward-looking statements are set forth in connection with the forward-looking statements and in the “Risk Factors” described in our Annual Report on Form 10-K filed on March 18, 2010.

General

We are a diversified biotechnology business that primarily operates in the field of genetic analysis and molecular diagnostics through our wholly owned subsidiary, CombiMatrix Molecular Diagnostics, Inc. (“CMDX”). CMDX operates as a diagnostics reference laboratory that provides genetic and other diagnostics services to physicians, hospitals and clinics.

Leuchemix Inc. (“Leuchemix”), a minority-owned subsidiary, is developing a series of compounds to address a number of oncology-related diseases.  Leuchemix’s first compound has entered initial clinical trials in the United Kingdom.

On April 19, 2010, we announced a strategic and operational restructuring plan (the “Restructuring Plan”) to significantly reduce operating costs, increase the focus on the Company’s diagnostic services business and transition senior management.  As part of the Restructuring Plan, we closed our Mukilteo, Washington facility, which had been focused primarily on research, development and commercialization of the Company’s oligonucleotide microarray technologies, previously referred to as our “CustomArray” business. We also relocated our corporate headquarters to CMDX’s Irvine, California location.  After the restructuring, CombiMatrix will be focused primarily on our diagnostics services business, including increasing the utilization of our existing tests, expanding the test menu, increasing the number of customers and partners, and improving reimbursement for our testing services.  As a component of this plan, we initiated a search for a new President and Chief Executive Officer, which was completed on August 11, 2010 with the hiring of R. Judd Jessup as our permanent President and CEO.  On June 30, 2010, Dr. Amit Kumar stepped down from his role as President and Chief Executive Officer and Mr. Mark McGowan, our Chairman of our Board of Directors, assumed this role on an interim basis.  See Notes 1, 3 and 9 to the consolidated financial statements included elsewhere in this report for additional discussion of these matters.

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Prior Relationship with Acacia Research Corporation

We were originally incorporated in October 1995 as a California corporation and later reincorporated as a Delaware corporation in September 2000.  In December 2002, we merged with and became a wholly owned subsidiary of Acacia Research Corporation (“Acacia”).  In December 2006, we filed a registration statement with the U.S. Securities and Exchange Commission (“SEC”) in order to register our common stock under the Securities Act of 1933 as part of a plan to split-off from Acacia (the “Split-Off”).  On August 15, 2007 (the “Split-Off Date”), the Split-Off was effected and our common stock became publicly traded on the Nasdaq Global Market (symbol: CBMX).  As of the Split-Off Date, we ceased to be a subsidiary of, or affiliated with, Acacia.

Liquidity

At June 30, 2010, we had cash and cash equivalents of $10.2 million.  As a result, we anticipate that our cash and cash equivalent balances, cash flows from operations, operating cash savings from our Restructuring Plan and other sources of funding from the capital markets will be sufficient to meet our cash requirements beyond the next twelve months.  In order for us to continue as a going concern beyond this point and ultimately to achieve profitability, we may be required to obtain capital from external sources, increase revenues and reduce operating costs.  However, there can be no assurance that our operations will become profitable or that external sources of capital will be available at times and at terms acceptable to us.  The issuance of additional equity securities may also cause dilution to our shareholders.  If external financing sources are not available or are inadequate to fund our operations, we will be required to reduce operating costs, including research projects and personnel, of which reduction could jeopardize the future strategic initiatives and business plans of our company.  See the Liquidity and Capital Resources section below as well as Note 1 to the consolidated financial statements included elsewhere in this report for additional discussion of these matters.

Basis Of Presentation Of Financial Statements

The consolidated financial statements included in this Form 10-Q are consistent with our historical financial statements included in our Form 10-K for our fiscal year ended December 31, 2009.

As a result of executing the Restructuring Plan, the financial results of our CustomArray business have been classified as discontinued operations in the consolidated statements of operations for all periods presented.  See Note 3 to the consolidated financial statements for additional information regarding discontinued operations.  Unless otherwise noted, amounts and disclosures throughout the notes to our consolidated financial statements relate to our continuing operations.

Overview of Recent Business Activities

For the three months ended June 30, 2010, our operating activities included the recognition of $916,000 in revenues, including $796,000 in diagnostic lab revenues and $120,000 from the sale of CGH arrays to foreign distributors.  Marketing, general and administrative expenses increased due to increased sales and marketing activities and increased headcount in general and administrative departments.  Due primarily to a decline in our market capitalization during the second quarter, an impairment analysis of our goodwill resulted in an impairment charge of $16.9 million.

Significant business developments that occurred during the second quarter ended June 30, 2010 were:

·                  In April 2010, we announced the Restructuring Plan described above.  Also, see Notes 1 and 3 to the consolidated financial statements included elsewhere in this report for additional discussion of this matter.

·                  In June 2010, we announced that we ceased our M&A activities to focus primarily on the Restructuring Plan, growing our diagnostics business and recruitment of a new President and Chief Executive Officer.  Later in June, we announced that Mr. Tom Akin and Dr. Brooke Anderson would be stepping down from our Board of Directors, and that Mr. Mark McGowan was named Chairman of the Board.  Mr. Rigdon Currie was named Chairman of the Audit Committee.  Finally, on June 30, 2010, Dr. Amit Kumar stepped down as President and CEO of the Company and Mr. Mark McGowan assumed these roles on an interim basis effective July 1, 2010.

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·                  On June 15, 2010, we announced that CMDX had received final licensure documentation and approvals in order to begin billing for its suite of array-based diagnostic tests to Medicare.

Critical Accounting Estimates

Our unaudited interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America.  Preparation of these statements requires management to make judgments and estimates.  Some accounting policies have a significant impact on amounts reported in these financial statements.  A summary of significant accounting policies and a description of accounting policies that are considered critical may be found in our Annual Report on Form 10-K, filed on March 18, 2010, in the Notes to the Consolidated Financial Statements and the Critical Accounting Estimates section.  In addition, refer to Note 2 to the consolidated interim financial statements included in Part I, Item 1 of this report.

Comparison of the Results of Operations for the Three and Six Months Ended June 30, 2010 and 2009

Revenues and Cost of Revenues:

Services.  Revenues increased primarily due to test volume increases as well as increases in average revenue recognized per test. Billable test volumes were 773 and 1,400 for the three and six months ended June 30, 2010, respectively, compared to 637 and 1,560 for the comparable periods in 2009.  The decrease in volumes for the six month periods presented was due to the loss of test samples from the State of New York (which we are in the process of applying for licensing in that state).  Moreover, the period ending in June 30, 2009 contained certain one-time clinical trial services that were performed for the University of Texas, Health Science Center at San Antonio.  Average revenue per test was approximately $1,120 in 2010 versus $803 in 2009.  This increase is due primarily to improved reimbursement from non-contracted third-party payors, resulting in higher average recognized revenues per test during 2010 compared with 2009.

Products.  Product revenues from selling bacterial artificial chromosome, or “BAC,” comparative genomic hybridization, or “CGH,” arrays to a customer in Taiwan increased due to higher volumes, which were 660 and 900 arrays sold for the three and six months ended June 30, 2010, versus 120 and 220 in the comparable 2009 periods.  Increased volumes were due mainly to increased demand for array CGH services in Asia from our Taiwanese customer.

Cost of Products and Services.  Cost of services for our diagnostic tests include direct materials and direct laboratory labor costs (wages and benefits).   Costs for the three and six month periods ending June 30, 2009 represent higher material costs per unit that have been reduced in 2010 due to better pricing from our suppliers, based on our increased test volume.

Operating Expenses:

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Research and Development Expenses.  These expenses include labor and laboratory supply costs associated with investigating new tests, but primarily consist of development costs to maintain and improve our existing suite of diagnostic tests offered.  Prior to launching a new test or modifying an existing test, appropriate clinical trials and extensive laboratory validations, consistent with the various regulatory bodies that govern our industry, must be performed.  These costs are classified as research and development for all periods presented.  The increase for the six months ended June 30, 2010 was due primarily to additional labor and supply costs incurred from maintaining and improving our diagnostic test suite as compared to the prior period.  In addition, for the three and six months ended June 30, 2010 and 2009, research and development expenses included $46,000, $94,000, $46,000 and $82,000, respectively, of non-cash stock compensation expense.  This increase was due primarily to increases in the number of stock option awards granted to our employees during the past twelve months.  See Note 2 to our consolidated interim financial statements included elsewhere in this report for a detailed description of the amounts recognized for the periods presented.

Marketing, General and Administrative Expenses.  The increase in marketing, general and administrative expenses for the three and six months ended June 30, 2010 versus the comparable period in 2009 was due primarily to increased sales and marketing activities as well as higher headcount compared to the prior periods.  In addition, the three and six months ended June 30, 2010 general and administrative expenses includes a one time, $180,000 write-down of a cost-basis investment that in management’s view had incurred an other-than-temporary decline in the underlying market value of the investment.  In addition, for the three and six months ended June 30, 2010 and 2009, research and development expenses included $522,000, $1.0 million, $502,000 and $974,000, respectively, of non-cash stock compensation expense.  This increase was due primarily to increases in the number of stock option awards granted to our employees during the past twelve months.  See Note 2 to our consolidated interim financial statements included elsewhere in this report for a detailed description of the amounts recognized for the periods presented.

Goodwill Impairment.  The decline in our market capitalization during the second quarter of 2010 (as indicated by the trading of our common stock on Nasdaq) was considered by management to be a potential goodwill impairment triggering event.  As a result, we performed a business valuation using a market-based approach and determined that all of our $16.9 million in goodwill was impaired.

Equity in Loss of Investee.  For the periods presented in 2009, this expense represents our recognition under the equity method of accounting of our minority interests in the operations of Leuchemix, in which we own a one-third minority interest.  During the third quarter of 2009, our equity investment in Leuchemix reached $0 and as a result, we have not been recognizing any additional expense from their underlying operations.

Other Non-Operating Items: