NeurogesX Inc - FORM 10-Q

NeurogesX Inc - FORM 10-Q - May 9, 2011

Attached files

Attached files

NeurogesX Inc Reports

file	filename
EX-32.1 - CERTIFICATIONS OF THE PEO AND THE PFO PURSUANT TO SECTION 906 - NeurogesX Inc	dex321.htm
EX-31.1 - CERTIFICATION OF PEO PURSUANT TO SECTION 302 - NeurogesX Inc	dex311.htm
EX-31.2 - CERTIFICATION OF PFO PURSUANT TO SECTION TO 302 - NeurogesX Inc	dex312.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 March 31, 2011

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

Commission file number: 001-33438

NEUROGESX, INC.

(Exact name of registrant as specified in its charter)


Delaware		94-3307935
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

2215 Bridgepointe Parkway, Suite 200 San Mateo, California		94404
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (650) 358-3300

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 (§232.405 of this chapter) 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 definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

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

Number of shares of common stock, $0.001 par value, outstanding as of April 29, 2011: 17,873,878

NEUROGESX, INC.

TABLE OF CONTENTS FOR FORM 10-Q

FOR THE QUARTER ENDED MARCH 31, 2011


	Page
PART I. FINANCIAL INFORMATION		1
Item 1. Financial Statements (unaudited)		1
Condensed Consolidated Balance Sheets as of March 31, 2011 and December 31, 2010		1
Condensed Consolidated Statements of Operations for the three months ended March 31, 2011 and 2010		2
Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2011 and 2010		3
Notes to Condensed Consolidated Financial Statements		4
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		18
Item 3. Quantitative and Qualitative Disclosures About Market Risk		32
Item 4. Controls and Procedures		32

PART II. OTHER INFORMATION		33
Item 1. Legal Proceedings		33
Item 1A. Risk Factors		33
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		54
Item 3. Defaults Upon Senior Securities		54
Item 4. [Removed and Reserved]		54
Item 5. Other Information		54
Item 6. Exhibits		55

SIGNATURES		56

EXHIBIT INDEX		57

PART I. FINANCIAL INFORMATION

ITEM 1.

FINANCIAL STATEMENTS

NeurogesX, Inc.

Condensed Consolidated Balance Sheets

(in thousands)


	March 31, 2011			December 31, 2010
	(unaudited)			(Note 1)
Assets
Current assets:
Cash and cash equivalents	$	4,240		$	8,705
Short-term investments		30,463			38,125
Trade receivable		623			607
Receivable from collaboration partner		98			65
Inventories		768			786
Prepaid expenses and other current assets		1,770			1,082
Restricted cash		290			290

Total current assets		38,252			49,660

Property and equipment, net		774			809
Other assets		253			261
Restricted cash		120			120

Total assets	$	39,399		$	50,850

Liabilities and Stockholders’ Deficit
Current liabilities:
Accounts payable	$	1,674		$	1,544
Accrued compensation		1,506			1,867
Accrued research and development		821			582
Other accrued expenses		4,173			3,011
Deferred product revenue, net		563			577
Deferred collaboration revenue		7,261			7,242
Long term obligations-current portion		2,605			2,222

Total current liabilities		18,603			17,045

Non-current liabilities:
Deferred collaboration revenue		30,554			32,359
Deferred rent		67			115
Long term obligations		44,230			42,622

Total non-current liabilities		74,851			75,096
Commitments and contingencies
Stockholders’ deficit:
Common stock		18			18
Additional paid-in capital		215,806			215,220
Accumulated other comprehensive gain (loss)		11			(2	)
Accumulated deficit		(269,890	)		(256,527	)

Total stockholders’ deficit		(54,055	)		(41,291	)

	$	39,399		$	50,850

See accompanying notes.

NeurogesX, Inc.

Condensed Consolidated Statements of Operations

(in thousands, except share and per share data)

(unaudited)


	Three Months Ended March 31,
	2011			2010
Net product revenue	$	575		$	—
Collaboration revenue		2,595			1,786

Total revenues		3,170			1,786

Operating expenses:
Cost of goods sold		108			—
Research and Development		3,957			2,123
Selling, general and administrative		10,282			8,806

Total operating expenses		14,347			10,929

Loss from operations		(11,177	)		(9,143	)
Interest income		27			8
Interest expense		(2,200	)		(4	)
Other income (expense), net		(13	)		(24	)

Net loss	$	(13,363	)	$	(9,163	)

Basic and diluted net loss per share	$	(0.75	)	$	(0.52	)

Shares used to compute basic and diluted net loss per share		17,870,347			17,726,153

See accompanying notes.

NeurogesX, Inc.

Condensed Consolidated Statements of Cash Flows

(in thousands)

(unaudited)


	Three Months Ended March 31,
	2011			2010
Operating activities
Net loss	$	(13,363	)	$	(9,163	)
Adjustments to reconcile net loss to cash (used in) provided by operating activities:

Depreciation		89			77
Amortization of debt issuance costs and accretion of debt discount		20			4
Amortization of investment premiums		257			104
Stock-based compensation		578			574
Changes in operating assets and liabilities:
Trade receivables		(17	)		—
Receivable from collaboration partner		(33	)		165
Prepaid expenses and other current assets		(687	)		(501	)
Inventories		19			(589	)
Accounts payable		130			774
Accrued compensation		(362	)		(991	)
Accrued research and development		239			(385	)
Accrued license fees		—			(1,213	)
Accrued interest payable on long term obligations		1,979			—
Deferred product revenue, net		(14	)		—
Deferred collaboration revenue		(1,786	)		(1,786	)
Deferred rent		(41	)		(26	)
Other accrued expenses		1,154			3,055

Net cash (used in) provided by operating activities		(11,838	)		(9,901	)

Investing activities
Purchases of short-term investments		(3,582	)		(6,028	)
Proceeds from maturities of short-term investments		11,000			10,504
Purchases of property and equipment		(53	)		(267	)

Net cash (used in) provided by investing activities		7,365			4,209

Financing activities
Repayment of notes payable		—			(191	)
Proceeds from issuance of common stock		8			8

Net cash provided by (used in) financing activities		8			(183	)


Net (decrease) increase in cash and cash equivalents		(4,465	)		(5,875	)
Cash and cash equivalents, beginning of period		8,705			29,695

Cash and cash equivalents, end of period	$	4,240		$	23,820

Supplemental cash flow information
Cash paid for interest	$	200		$	—

See accompanying notes.

NEUROGESX, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Note 1. The Company

Nature of Operations

NeurogesX, Inc. (the “Company”) is a biopharmaceutical company focused on developing and commercializing novel pain management therapies. The Company is assembling a portfolio of pain management product candidates based on known chemical entities to develop innovative new therapies which the Company believes may offer substantial advantages over currently available treatment options. The Company’s initial focus is on the management of chronic peripheral neuropathic pain conditions.

The Company’s first commercial product, Qutenza ^®, became commercially available in United States and in certain European countries in the first half of 2010. Qutenza, the first prescription strength capsaicin product, is a dermal delivery system designed to treat certain neuropathic pain conditions and was approved by the United States Food and Drug Administration (“FDA”) in November 2009 for the management of postherpetic neuralgia (“PHN”).

In May 2009, Qutenza received a marketing authorization (“MA”) in the European Union for the treatment of peripheral neuropathic pain in non-diabetic adults, either alone or in combination with other medicinal products for pain. In June 2009, the Company entered into a Distribution, Marketing and License Agreement (the “Astellas Agreement”) with Astellas Pharma Europe Ltd. (“Astellas” or “Collaboration Partner”), under which Astellas was granted an exclusive license to commercialize Qutenza in the European Economic Area, which includes the 27 countries of the European Union, Iceland, Norway, and Liechtenstein as well as Switzerland, certain countries in Eastern Europe, the Middle East and Africa (“Licensed Territory”). Qutenza was made available on a country by country basis commencing in April 2010 and by March 31, 2011 was available in nineteen European countries.

The Company was incorporated in California as Advanced Analgesics, Inc. on May 28, 1998 and changed its name to NeurogesX, Inc. in September 2000. In February 2007, the Company reincorporated into Delaware. The Company is located in San Mateo, California.

Principles of Consolidation

The accompanying financial statements include the accounts of the Company and its wholly-owned subsidiary, NeurogesX UK Limited, which was incorporated as of June 1, 2004. NeurogesX UK Limited was established for the purposes of conducting clinical trials in the UK and marketing approval submission. The subsidiary has no assets other than the initial formation capital totaling one Pound Sterling.

Basis of Presentation

The accompanying unaudited condensed consolidated interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information on the same basis as the annual consolidated financial statements and in accordance with instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The unaudited condensed consolidated interim financial statements include all adjustments (consisting only of normal recurring adjustments) that management believes are necessary for the fair statement of the balances and results for the periods presented. These unaudited condensed consolidated interim financial statement results are not necessarily indicative of results to be expected for the full fiscal year or any future interim period.

The balance sheet at December 31, 2010 has been derived from the audited consolidated financial statements at that date. The unaudited condensed consolidated interim financial statements and related disclosures have been prepared with the presumption that users of such information have read or have access to the audited consolidated financial statements for the preceding fiscal year. Accordingly, these financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto for the year ended December 31, 2010 contained in the Company’s 2010 Form 10-K.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Note 2. Summary of Significant Accounting Policies

Product revenue

In April 2010, the Company made Qutenza commercially available in the United States to its specialty distributor and specialty pharmacy customers. Under the Company’s agreements with its customers, the customers take title to the product upon shipment and only have the right to return damaged product, product shipped in error and expired or short-dated product. As Qutenza is new to the marketplace, the Company is currently assessing the flow of product through its distribution channel, and cannot currently reasonably estimate returns. Until such time as an estimate of returns can be made the Company is recognizing Qutenza product revenues, and related product costs, at the later of:

•

the time the product is shipped by the customer to healthcare professionals, and

•

the date of cash collection.

Healthcare professionals are generally ordering Qutenza in small quantities only after they have identified a patient for treatment. The Company believes that revenue recognition upon the later of customer shipment to the end user and the date of cash collection is appropriate until the Company has sufficient data on the cash collection and return patterns of its customers. The Company is performing additional procedures to further analyze shipments made by the Company’s customers by utilizing shipping data provided by the Company’s customers to determine when product is shipped by customers to healthcare professionals and are evaluating ending inventories at the Company’s customers each quarter to assess the risk of product returns.

The Company has established terms pursuant to distribution agreements with its customers providing for payment within 120 days of the date of shipment to its specialty distributor customers and 30 days of the date of shipment to its specialty pharmacy customers. Such distribution agreements generally have a term of three years.

The Company had gross shipments of $603,000 for the quarter ended March 31, 2011. The application of the Company’s revenue recognition policy resulted in the recognition of net revenue of $575,000 for the quarter ended March 31, 2011. The Company’s gross shipments are reduced for chargebacks, certain fees paid to distributors and product sales allowances including rebates to qualifying federal and state government programs. At March 31, 2011, net deferred product revenues totaled $563,000.

Revenue from the Astellas Agreement

In June 2009, NeurogesX entered into the Astellas Agreement which provides for an exclusive license by the Company to Astellas for the promotion, distribution and marketing of Qutenza in the Licensed Territory, an option to license NGX-1998, a product candidate that is a non-patch liquid formulation of capsaicin, in the Licensed Territory, participation on a joint steering committee and, through a related supply agreement entered into with Astellas (the “Supply Agreement”), supply of product until direct supply arrangements between Astellas and third party manufacturers are established. The Company anticipates certain of the direct supply arrangements will be established in mid-2011. Revenue under this arrangement includes upfront non-refundable fees and may also include additional option payments for the development of and license to NGX-1998, milestone payments upon achievement of certain product sales levels and royalties on product sales.

The Company analyzed the multiple element arrangements within the Astellas Agreement, to determine whether the various performance obligations, or elements, can be separated or whether they must be accounted for as a single unit of accounting. Accounting rules for multiple element arrangements changed for the Company effective January 1, 2011, however, the new rules apply to new arrangements or the Astellas Agreement if the Company was to significantly modify the agreement subsequent to January 1, 2011.

Pursuant to the multiple-element arrangement guidance in effect at the time of the Astellas Arrangement, the Company made the determination of whether an element can be separated or accounted for as a single unit of accounting based on the availability of evidence with regard to standalone value of each delivered element. If the fair value of all undelivered performance obligations can be determined, then all obligations would then be accounted for separately as performed. If any delivered element is considered to either: 1) not have standalone value or 2) have standalone value but the fair value of any of the undelivered performance obligations are not determinable, then any delivered elements of the arrangement would be accounted for as a single unit of accounting and the multiple elements would be grouped and recognized as revenue over the longest estimated performance obligation period.

Significant management judgment is required in determining the level of effort required under an arrangement and the period over which the performance obligations are estimated to be completed. In addition, if the Company is involved in a joint steering committee as part of a multiple element arrangement that is accounted for as a single unit of accounting, an assessment is made as to whether the involvement in the steering committee constitutes a performance obligation or a right to participate.

Revenue recognition of non-refundable upfront license fees commences when there is a contractual right to receive such payment, the contract price is fixed or determinable, the collection of the resulting receivable is reasonably assured and there are no further performance obligations under the license agreement.

The Company views the Astellas Agreement and related agreements, as a multiple element arrangement with the key deliverables consisting of an exclusive license to Qutenza in the Licensed Territory, an obligation to conduct certain development activities associated with NGX-1998, participation on a joint steering committee and supply of Qutenza components to Astellas until such time that Astellas can establish a direct supply relationship with product vendors. Because not all of these elements have both standalone value and objective and reliable evidence of fair value, the Company is accounting for such elements as a single unit of accounting. Further, the agreement provides for the Company’s mandatory participation in a joint steering committee, which the Company believes represents a substantive performance obligation and also the estimated last delivered element under the Astellas Agreement and related agreements. Therefore, the Company is recognizing revenue associated with upfront payments and license fees ratably over the term of the joint steering committee performance obligation. The Company estimates this performance obligation will be delivered ratably through June 2016.

At the inception of the Astellas Agreement, the upfront license fees were subject to a refund right, which expired upon transfer of the Company’s MA for Qutenza in the European Union to Astellas. In September 2009, the transfer of the MA to Astellas was completed and, therefore, the upfront license fees became non-refundable and revenue recognition of the upfront license fees commenced.

In the accompanying financial statements, Collaboration revenue represents revenue associated with the Astellas Agreement and related agreements. Deferred collaboration revenue arises from the excess of cash received or receivable over cumulative revenue recognized for the period.

Under the terms of the Astellas Agreement, the Company earns royalties based on each sale of Qutenza into the Licensed Territory. The royalty rate is tiered based on the level of sales achieved. These royalties are considered contingent consideration as there is no remaining contract performance obligation of the Company and, therefore, the royalties are excluded from the single unit of accounting treatment discussed above. The Company reports royalty revenue based upon Astellas’ reported net sales of Qutenza in the Licensed Territory. The Company recognizes royalty revenue from Astellas on a quarter lag basis due to the timing of Astellas reporting such royalties to the Company.

Additionally, the Company can earn milestone payments from Astellas if Astellas achieves certain sales levels as outlined in the Astellas Agreement. As these payments are contingent on Astellas’ performance, they are excluded from the single unit of accounting treatment discussed above. The milestones will be recorded as revenue when earned as there is no remaining contractual performance obligation of the Company.

The Company recognizes the revenue net of related costs for collaboration supplies sold to Astellas upon product being delivered to Astellas. The revenue and related costs of the product supplied to Astellas are included in Collaboration revenue. Prior to delivery to Astellas, the costs accumulated for the manufacturing of the collaboration supplies are included as Prepaid expenses on the Company’s balance sheet.

Cost of Goods Sold

Cost of goods sold includes costs to procure, manufacture and distribute Qutenza including certain shipping and handling costs incurred in the distribution channel as well as royalties payable to The Regents of the University of California, or UC, and Lohmann Therapie-Systeme AG or LTS. Costs associated with the manufacture of Qutenza prior to FDA approval were previously expensed as research and development in the period incurred. Cost of goods sold associated with deferred product revenue will be deferred and recognized in the same period as the associated product revenue. At March 31, 2011, the Company had deferred Cost of goods sold of $55,000.

Trade Receivables

Trade accounts receivable are recorded net of allowances for customer chargebacks related to government rebate programs, doubtful accounts and sales returns. Estimates for customer chargebacks for government rebates and sales returns are based on contractual terms, historical trends and the Company’s expectations regarding the utilization rates for these programs. The estimate for the Company’s allowance for doubtful accounts is determined based on existing contractual payment terms, historical payment patterns of the Company’s customers and individual customer circumstances. To date, the Company has not determined that an allowance for uncollectible accounts receivable has been required.

Inventories

Inventories are determined at the lower of cost or market value with cost determined under the specific identification method. Inventories consist of raw materials, work in process and finished goods. Raw materials include certain starting materials used in the production of the active pharmaceutical ingredient of Qutenza. Work in process includes the bulk inventory of the active pharmaceutical ingredient, patches and

cleansing gel of Qutenza that are in the process of being manufactured or have completed manufacture and are awaiting final packaging, including related internal labor and overhead costs. Finished goods include the final packaged kits that contain the Qutenza patch and cleansing gel and that are ready for commercial sale. Qutenza received FDA approval for sale in the United States during the fourth quarter of 2009; costs incurred prior to FDA approval had been recorded as research and development expense on the Company’s condensed consolidated statement of operations. On a quarterly basis, the Company analyzes its inventory levels against forecasted sales volumes, which are subject to change, and writes down inventory that has become obsolete, inventory that has a cost basis in excess of the expected net realizable value and inventory that is in excess of expected requirements based upon anticipated product revenues.

Comprehensive Loss

The Company reports comprehensive loss and its components as part of total stockholders’ deficit. Comprehensive loss is comprised of net loss and unrealized gains (losses) on available-for-sale investments. For the three months ended March 31, 2011 and 2010, comprehensive loss was as follows:


	Three Months Ended March 31,
	2011			2010
Net loss	$	(13,363	)	$	(9,163	)
Changes in unrealized gains		13			7

Total comprehensive loss	$	(13,350	)	$	(9,156	)

The fluctuation in accumulated other comprehensive income represents the net change in fair value for invested assets as a result of changes in interest rates and other factors affecting fair value and as a result of unrealized gains. The cumulative effect of these periodic fluctuations is reflected as accumulated other comprehensive gain (loss) on the accompanying condensed consolidated balance sheets.

Net Loss Per Share

Basic net loss per share is calculated by dividing net loss by the weighted-average number of common shares outstanding during the period less the weighted average unvested common shares subject to repurchase and without consideration of common stock equivalents. Diluted net loss per share is computed by dividing the net loss by the weighted-average number of common shares outstanding and common stock equivalents outstanding for the period, less the weighted average unvested common shares subject to repurchase. For purposes of this calculation, warrants and options to purchase common stock are considered to be common stock equivalents but have been excluded from the calculation of diluted net loss per share as their effect is anti-dilutive. The following table is a reconciliation of the numerator and denominator used in the calculation of basic and diluted net loss per share:


	Three Months Ended March 31,
	2011			2010
	(in thousands except share and per share data)
Numerator:
Net loss	$	(13,363	)	$	(9,163	)

Denominator:
Weighted-average common shares outstanding for basic and diluted net loss per share		17,870,347			17,726,153

Basic and diluted net loss per share	$	(0.75	)	$	(0.52	)


	March 31,
	2011			2010
Common stock equivalents not included in diluted net loss per share because their effect will be anti-dilutive:
Options to purchase common stock		3,958,649			2,791,906
Warrants outstanding		1,265,846			1,265,846

		4,644,495			4,057,752

Recently Issued and Adoption of New Accounting Standards

Not Yet Adopted

None.

Adopted in 2011

In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2009-13, Revenue Recognition (ASC Topic 605) – Multiple-Deliverable Revenue Arrangements . This guidance modifies previous guidance for multiple element arrangements by allowing the use of the “best estimate of selling price” in the absence of vendor-specific objective evidence (“VSOE”) or third party evidence (“TPE”) of selling price for determining the selling price of a deliverable. A vendor is now required to use its best estimate of the selling price when VSOE or TPE of the selling price is not available. In addition, the residual method of allocating arrangement consideration is no longer permitted. This ASU is effective for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 and early adoption was permitted. The Company adopted this ASU on January 1, 2011 and the adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements. The Company currently only has one revenue agreement with multiple elements, the Astellas Agreement. If the Company was to enter into new multiple element arrangements or make a material modification to the Astellas Agreement after January 1, 2011, the contract would be accounted for under the provisions of ASU No. 2009-13.

In April 2010, the FASB issued ASU No. 2010-17, Revenue Recognition—Milestone Method (ASC Topic 605): Milestone Method of Revenue Recognition (“ASU No. 2010-17”). This ASU codifies the consensus reached in EITF Issue No. 08-9, “Milestone Method of Revenue Recognition.” The amendments to the

Codification provide guidance on defining a milestone and determining when it may be appropriate to apply the milestone method of revenue recognition for research or development transactions. Consideration that is contingent on achievement of a milestone in its entirety may be recognized as revenue in the period in which the milestone is achieved only if the milestone is judged to meet certain criteria to be considered substantive. Milestones should be considered substantive in their entirety and may not be bifurcated. An arrangement may contain both substantive and non-substantive milestones, and each milestone should be evaluated individually to determine if it is substantive. ASU No. 2010-17 is effective for fiscal years, and interim periods within those years, beginning on or after June 15, 2010, and may be applied prospectively to milestones achieved after the adoption date or retrospectively for all periods presented. On January 1, 2011, the Company prospectively adopted and elected the Milestone Method of Revenue Recognition as its accounting policy for substantive milestones achieved after the adoption date. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

Note 3. License Agreements

COLLABORATION AGREEMENT - ASTELLAS

In June 2009, NeurogesX entered into the Astellas Agreement granting Astellas an exclusive license to commercialize Qutenza in the Licensed Territory. The Astellas Agreement provided for an upfront payment for past development and the commercialization rights granted, of 30,000,000 Euro, or $41,817,000. In addition, the agreement provided for an upfront payment of 5,000,000 Euro, or $6,970,000, for future development expenses and an option to license NGX-1998, a product candidate in Phase 1 development at that time. Other elements of the Astellas Agreement include future milestone payments of up to 65,000,000 Euro if certain predefined sales thresholds of the products licensed under the agreement are met and royalties, as a percentage of net sales made by Astellas of products under the agreement, with such royalties starting in the high teens and escalating into the mid twenties as revenues increase. The Company is participating on a joint steering committee with Astellas to oversee the development and commercialization activities related to Qutenza and NGX-1998 during the term of the agreement, not to exceed ten years. On the seventh anniversary of the Astellas Agreement, the Company has the unilateral right to opt-out of participation on the joint steering committee. The Astellas Agreement further provides that upon delivery of certain data related to NGX-1998, Astellas may pay two additional NGX-1998 option payments totaling 5,000,000 Euro. Subsequent to Astellas’ exercise of the option to exclusively license NGX-1998 in the Territory, both companies would cooperate on Phase III clinical trials and will share such costs equally.

The Company commenced recognizing revenue related to the upfront and option payments upon transfer of the MA for Qutenza to Astellas, which occurred in September 2009. The Company recognized $1,786,000 as Collaboration revenue related to the upfront and option payments for both of the three month periods ended March 31, 2011 and 2010. As of March 31, 2011, the Company had deferred revenue totaling $37,815,000 of which $7,261,000 is reflected as current. The Astellas upfront license fee and option payments are accounted for as a single unit of accounting, and accordingly, such payments will be recognized ratably through June 2016, which is the Company’s estimate of its substantive performance obligation period related to the joint steering committee. Subsequent option exercise payments received, if any, are expected to be recognized ratably over the remaining estimated period of performance.

The Astellas Agreement will remain effective on a country-by-country and product-by-product basis until the later of ten years after the first commercial sale, expiration or abandonment of the last valid patent claim or expiration of all applicable periods of regulatory exclusivity. Astellas may terminate the agreement for any reason without penalty, consequence or compensation on a country-by-country and product-by-product basis upon written notice to the Company.

Pursuant to the Supply Agreement, the Company has agreed to provide Astellas with a sufficient supply of Qutenza to support their commercialization efforts until Astellas can establish a direct supply relationship with product vendors. These products will be charged to Astellas at contractually agreed upon costs per unit which are intended to reflect the Company’s direct cost of goods and related internal labor and overhead costs without mark-up for profit. The Company reported amounts received from product transactions net of direct costs incurred as a component of Collaboration revenue.

For the three months ended March 31, 2011, the Company included in Collaboration revenue $609,000 from product supply transactions, net of direct costs incurred as a component of Collaboration revenue. The Company did not recognize any collaboration revenue for product transactions in the three months ended March 31, 2010 and does not anticipate reporting significant revenues from supply transactions in the future.

For the three months ended March 31, 2011, the Company recognized $200,000 in royalty revenue related to the Astellas Agreement. The Company recognizes royalty revenue from Astellas on a quarter lag basis , thus these royalties relate to Astellas sales of Qutenza in the fourth quarter of 2010.

UNIVERSITY OF CALIFORNIA

In October 2000 and as amended, the Company licensed certain patents, including a method patent, from the University of California (“UC”) for prescription strength capsaicin for neuropathic pain. Under the terms of the agreement, the Company is required to pay royalties on net sales of the licensed product up to a maximum of $1.0 million per annum as well as a percentage of upfront and milestone payments received by the Company from sublicensing the Company’s rights under the agreement (“Sublicense Fee”). The Company recognized $3,000 in royalty expense due to UC for the three months ended March 31, 2011 related to Qutenza product sales in the United States.

Two of the three inventors named in the method patent did not assign their patent rights to UC. These non-assigning inventors have made various claims related to inventorship and other matters. In 2010, the Company entered into negotiations with these non-assigning inventors to settle any and all claims and to have them assign their rights related to the method patent and any other related patent rights that may exist at the time the Company enters into a final binding settlement agreement. The Company anticipates that a final settlement may include the Company issuing stock or stock options to the two non-assigning inventors and making current and future cash payments. The current cash and estimated fair value of the stock or stock options to be issued as part of a potential settlement is currently estimated to be approximately $1.0 million. The Company anticipates that approximately 50% of the cash settlement amount will be recovered over time, through a reduction in amounts due to the University of California under the Company’s license agreement with them. During the year ended December 31, 2010, the Company recorded a $1.0 million charge within selling, general and administrative expense representing its estimate of the potential settlement.

LTS LOHMANN THERAPIE-SYSTEME AG

In January 2007, the Company entered into a Commercial Supply and License Agreement (“LTS Agreement”) with LTS Lohmann Therapie-Systeme AG (“LTS”) to manufacture commercial and clinical supply of Qutenza. Under the terms of the agreement, the Company is required to pay a transfer price for product purchased as well as a royalty on net sales of product purchased under the LTS Agreement. The Company recognized $10,000 in royalty expense due to LTS Lohmann Therapie-Systeme AG for the three months ended March 31, 2011 related to Qutenza product sales in the United States.

The Company’s March 31, 2011 balance sheet includes a liability for royalties due UC and LTS totaling $13,000 related to gross product shipments in the three months ended March 31, 2011.

Note 4. Cash and Cash Equivalents and Short-Term Investments

The following are summaries of cash, cash equivalents and short-term investments (in thousands):


	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
As of March 31, 2011:
Cash and money market funds	$	4,240	$	—	$	—		$	4,240
Commercial paper		3,567		1		—			3,568
U.S. Treasury securities		26,885		10		—			26,895

	$	34,692	$	11	$	—		$	34,703

Reported as:
Cash and cash equivalents								$	4,240
Short-term investments									30,463

								$	34,703

As of December 31, 2010:
Cash and money market funds	$	6,705	$	—	$	—		$	6,705
Commercial paper		2,000		—		—			2,000
U.S. Treasury securities		38,127		1		(3	)		38,125

	$	46,832	$	1	$	(3	)	$	46,830

Reported as:
Cash and cash equivalents								$	8,705
Short-term investments									38,125

								$	46,830

At March 31, 2011 and December 31, 2010, the contractual maturities of investments held were less than one year. The Company did not sell any of its investments prior to maturity during the three months ended March 31, 2011 or March 31, 2010.

Note 5. Inventories

The components of inventories are as follows (in thousands):


	March 31, 2011		December 31, 2010
Raw Materials	$	7	$	7
Work in process		556		581
Finished Goods		205		198

Total inventories	$	768	$	786

Note 6. Fair Value Measurements

The Company discloses its cash, cash equivalents and short term investments under a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value, which are the following:

Level 1 - Quoted prices in active markets for identical assets or liabilities.

Level 2 - Inputs other than quoted prices included within Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

In accordance with Codification Topic 820, the following table represents the Company’s financial assets (cash equivalents and short-term investments) measured at fair value on a recurring basis and their level within the fair value hierarchy as of March 31, 2011 and December 31, 2010 (in thousands):


	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Fair Value Measurements at March 31, 2011:
Components of cash equivalents and short-term investments measured at fair value:
Money market funds	$	3,852	$	—	$	—	$	3,852
Commercial paper		3,569		—		—		3,569
U.S. Treasury securities		26,895		—		—		26,895

Total financial assets measured at fair value	$	34,316	$		$	—	$	34,316

Operating cash								387

Total cash and cash equivalents and short-term investments							$	34,703

Fair Value Measurements at December 31, 2010:
Components of cash equivalents and short-term investments measured at fair value:
Money market funds	$	6,370	$	—	$	—	$	6,370
Commercial paper		2,000		—		—		2,000
U.S. Treasury securities		38,125		—		—		38,125

Total financial assets measured at fair value	$	46,495	$	—	$	—	$	46,495

Operating cash								335

Total cash and cash equivalents and short-term investments							$	46,830

Note 7. Stockholders’ Equity

2007 Stock Plan

During the three months ended March 31, 2011, the Company granted options to purchase a total of 452,700 shares of the Company’s common stock to employees and officers with a fair value of $1.3 million, which is expected to be amortized through 2015. Employees were granted options to purchase 350,200 shares of the Company’s common stock with a fair value of $980,000, and officers were granted options to purchase 102,500 shares of the Company’s common stock with a fair value of $317,000.

Additionally, in February 2011, the Company granted options to purchase a total of 580,000 shares of the Company’s common stock in the form of market-based stock options with vesting tied to stock price targets to employees and officers. The fair value of these options is $2.1 million and is estimated at the grant date using a Monte Carlo valuation methodology. The fair value of these options is expected to be amortized through 2015. Employees were granted 90,000 market-based stock options with a fair value of $328,000, and officers were granted 490,000 market-based stock options with a fair value of $1.8 million. For the three months ended March 31, 2011 the Company recognized $102,000 of stock-based compensation expense related to these market-based options.

Stock-Based Compensation Expense

The Company recognizes stock-based compensation cost for all share-based payments. Stock-based compensation cost for awards made to employees and directors is measured at the date of grant, based on the fair value of the award, and is recognized as expense on a straight-line basis over the requisite service period. The Company has elected to use the Black-Scholes option valuation model to estimate the fair value of stock options for all options granted except for the market-based stock options granted in February 2011. The Company used the Monte Carlo valuation method to estimate the fair value of market-based stock options.

The following tables show the assumptions used to compute stock-based compensation expense for stock options granted to employees and members of the board of directors, excluding market-based stock option grants, and the assumptions used to compute stock-based compensation expense for the Company’s Employee Stock Purchase Plan (“ESPP”) for the three-month periods ended March 31, 2011 and 2010 using the Black-Scholes valuation model:


	Three Months Ended March 31,
	2011			2010
Stock Options
Expected dividend yield		0	%		0	%
Expected volatility		66	%		72	%
Expected life (in years)		6.0			6.0
Risk-free interest rate		2.5	%		2.8	%

ESPP
Expected dividend yield		0	%		0	%
Expected volatility		55 – 58	%		46 – 89	%
Expected life (in years)		0.5 – 1.0			0.5 – 1.0
Risk-free interest rate		0.2 – 0.4	%		0.1 – 1.0	%

The following table shows the assumptions used to compute stock-based compensation expense for market-based stock options granted to employees during the three-month period ended March 31, 2011 using the Monte Carlo valuation model:


Stock Options
Expected dividend yield			0%
Expected volatility			70%
Expected life (in years)			3.5 – 4.25
Risk free interest rate			3.5%

Non cash stock based compensation expenses included in the operating expenses for the three months ended March 31, 2011 and March 31, 2010 were as follows (in thousands):


	Three Months Ended March 31,
	2011		2010
Research and development expenses	$	203	$	152
Selling, general and administrative expenses		375		422

Total	$	578	$	574

Note 8. Long Term Obligation

On April 30, 2010, the Company entered into a Financing Agreement (the “Financing Agreement”) with Cowen Healthcare Royalty Partners, L.P., a limited partnership organized under the laws of the State of Delaware (“Cowen Royalty”). Under the terms of the Financing Agreement, the Company borrowed $40 million from Cowen Royalty (the “Borrowed Amount”) and the Company agreed to repay such Borrowed Amount together with a return to Cowen Royalty, as described below, out of royalty, milestone, option and certain other payments (collectively, “Revenue Interest”) that the Company may receive under the Astellas Agreement or a replacement licensee, as a result of commercializing the Company’s product, Qutenza, in the Licensed Territory, including payments that Astellas may make to the Company to maintain its option to commercialize NGX-1998 in the Licensed Territory.

Under the Financing Agreement, the Company is obligated to pay to Cowen Royalty:

•

All of the Revenue Interest payments due to the Company under the Astellas Agreement, until Cowen Royalty has received $90 million of Revenue Interest payments; and

•

5% of the Revenue Interest payments due to the Company under the Astellas Agreement for Revenue Interests received by Cowen Royalty over $90 million and until Cowen Royalty has received $106 million of Revenue Interest payments.

The Company also has the option to pay a prepayment amount to terminate the Financing Agreement at the Company’s election at any time or in connection with a change of control of the Company. Such amount is set at a base amount of $76 million (or $68 million if it is being exercised in connection with a change of control), or, if higher, an amount that generates a specified internal rate of return, as noted below, on the Borrowed Amount as of the date of prepayment, in each case reduced by the Revenue Interest payments received by Cowen Royalty up to the date of prepayment.

The obligation of the Company to pay Revenue Interests during the term of the Financing Agreement is secured by rights that the Company has to Revenue Interests under the Astellas Agreement, and by intellectual property and other rights of the Company to the extent necessary or used to commercialize products covered by the Astellas Agreement in the Licensed Territory.

Unless terminated earlier pursuant to a prepayment, the Financing Agreement also terminates on the earlier of:

•

The time when Cowen Royalty has received at least $106 million of Revenue Interest payments; or

•

The maturity date, which is the latest to occur of 10 years following the first commercial sale of Qutenza in the Licensed Territory or the last to expire of any patents or regulatory exclusivity covering the products commercialized under the Astellas Agreement in the Licensed Territory.

If Cowen Royalty has not received Revenue Interest payments totaling at least $40,000,000 by the maturity date, the Company will be obligated to pay to Cowen Royalty the difference between such amount and the Revenue Interests paid to Cowen Royalty under the Financing Agreement up to such date.

In addition, in the event of the Company’s default under the Financing Agreement, the Company is obligated to pay to Cowen the borrowed amount together with interest accrued thereon from the effective date of the Financing Agreement, to the date of repayment at an internal rate of return equal to the lesser of the 19% rate of interest or the maximum rate permitted by law, less any Revenue Interest payments received by Cowen Royalty. Under the Financing Agreement, an event of default includes standard insolvency and bankruptcy terms, including a failure to maintain liquid assets equal to at least the Company’s liabilities due and payable during the following three months.

The upfront cash receipt of $40,000,000 less a discount of $494,000 in cost reimbursements paid to Cowen Royalty was recorded as a Long term obligation at issuance. The carrying value of the non-current portion of the Long term obligation at March 31, 2011, including accrued interest of $4,680,000, is $44,230,000 and the estimated fair market value is $40,920,000. The carrying value of the non-current portion of the Long term obligation at December 31, 2010, including accrued interest of $3,083,000, was $42,622,000 and the estimated fair market value was $40,870,000. The Company received $200,000 of royalty payments from Astellas in the three months ended March 31, 2011, and consistent with the provisions of the arrangement, the Company paid that amount to Cowen as a reduction of the obligation. The best estimate of future payments, the timing of which determines the short and long term classification of the obligation under the Financing Agreement, was based upon returning to Cowen Royalty an internal rate of return of 19% through Revenue Interest payments. Under this methodology, the Company recorded interest expense of approximately $2,200,000 during the three months ended March 31, 2011. The accrued interest on the Long term debt obligation is presented on the condensed consolidated balance sheets as of March 31, 2011 in two components, the Long term obligation-current portion, which totals $2,605,000 and the remaining $4,680,000 included in Long term obligation. At December 31, 2010, the Long term obligation-current portion was $2,222,000 and the remaining $3,083,000 was included in Long term obligation.

The Company capitalized $313,000 of debt issuance costs related to the agreement which are being amortized over the term. At March 31, 2011 and December 31, 2010, the unamortized debt issuance costs were $284,000 and $292,000, respectively, and are included in “Prepaid expenses and other current assets” and “Other assets” on the Company’s consolidated balance sheet. The Company is accreting the discount of $494,000 to interest expense over the term of the related debt.

The estimated fair market value of the Long term obligation was calculated using the income method of valuation. The key assumptions required for the calculation were an estimate of the future royalty revenues to be received from Astellas and an estimated cost of capital. Management’s estimate of the future royalty revenues to be received from Astellas is subject to significant variability due to the recent product launch, regulatory process still to be conducted for significant portions of the Astellas territory and the extended time period associated with the Cowen Financing Agreement, and thus are subject to significant uncertainty.

Note 9. Commitments and Contingencies

The Company has issued non-cancellable purchase orders to third party manufacturers of Qutenza and NGX-1998 for manufacturing, stability and related services including reimbursable amounts from Astellas for the supply of Qutenza based on the Astellas Agreement. These purchase orders totaled $2.1 million as of March 31, 2011 and included approximately $1.0 million for stability and related services, $0.6 million related to product manufacturing costs for the U.S. market, $0.3 million of commitments related to supply of Qutenza to Astellas, and $0.1 million for the Phase 2 clinical study for NGX-1998. The Company will record these amounts in its financial statements when title to the applicable materials has transferred to the Company.

Note 10. Subsequent event

On April 29, 2011, the Company announced the planned retirement of Anthony DiTonno, the Company’s President and Chief Executive Officer, by December 31, 2011. In connection with Mr. DiTonno’s retirement, the Company’s Board of Directors approved accelerating the vesting of options to purchase the Company’s common stock held by Mr. DiTonno by 12 months upon termination of his employment or consulting services, if any.

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This discussion and analysis should be read in conjunction with our financial statements and accompanying notes included elsewhere in this report. Operating results are not necessarily indicative of results that may occur in future periods.

This report contains forward-looking statements that are based upon current expectations within the meaning of the Private Securities Reform Act of 1995. We intend that such statements be protected by the safe harbor created thereby. Forward-looking statements involve risks and uncertainties and our actual results and the timing of events may differ significantly from the results discussed in the forward-looking statements. Examples of such forward-looking statements include, but are not limited to, statements about or relating to:

•

Our plans with regard to our sales efforts for Qutenza^® in the United States and the plans of Astellas Pharma Europe Ltd., or Astellas, for commercialization of Qutenza pursuant to the terms of the Distribution, Marketing Agreement and License Agreement or the Astellas Agreement;

•

the sufficiency of existing resources to fund our operations beyond December 31, 2011;

•

efforts to expand the scope of indications in which our capsaicin-based product candidates are approved and may be marketed;

•

the scope and size of research and development efforts and programs, including with respect to development of additional product candidates;

•

our proposed distribution and sales strategies including our plans for sales, marketing and manufacturing;

•

anticipated development of NGX-1998 and other potential product candidates;

•

the potential benefits of, and markets for, our product candidates;

•

losses, costs, expenses, expenditures, cash flows and cash usage;

•

gross margin expectations;

•

potential competitors and competitive products;

•

patents and our and others’ intellectual property; and

•

expected future sources of revenue and capital.

We undertake no obligation to, and expressly disclaim any obligation to, revise or update the forward-looking statements made herein or the risk factors whether as a result of new information, future events or otherwise. Forward-looking statements involve risks and uncertainties, which are more fully described in the section of this quarterly report entitled “Risk Factors”, including, but not limited to, those risks and uncertainties relating to:

•

our ability to build and manage an effective sales force and supporting infrastructure to successfully commercialize Qutenza

•

physician or patient reluctance to use Qutenza or payer coverage for Qutenza and for the procedure to administer it, which may impact physician utilization of Qutenza;

•

our ability to obtain additional financing if necessary;

•

our ability to obtain adequate pricing and sufficient insurance coverage and reimbursement;

•

changing standards of care and the introduction of products by competitors or alternative therapies for the treatment of indications we target;

•

difficulties or delays in development, testing, obtaining regulatory approval for, and undertaking production and marketing of our drug candidates;

•

Astellas’ ability and efforts to effectively commercialize Qutenza in the territory covered by the Astellas Agreement;

•

the uncertainty of protection for our intellectual property, through patents, trade secrets or otherwise; and

•

potential infringement of the intellectual property rights or trade secrets of third parties.

When used in this quarterly report, unless otherwise indicated, “NeurogesX,” “the Company,” “we,” “our” and “us” refers to NeurogesX, Inc. and its subsidiaries.

Qutenza^® and Neurogesx^® are registered trademarks in the United States. We have also applied for these trademarks in several other countries. Other service marks, trademarks and trade names referred to in this quarterly report are the property of their respective owners.

The following discussion should be read in conjunction with the section of this quarterly report entitled “Risk Factors.”

Overview

We are a biopharmaceutical company focused on developing and commercializing novel pain management therapies. We are assembling a portfolio of pain management product candidates based on known chemical entities to develop innovative new therapies that we believe may offer substantial advantages over currently available treatment options. Our initial focus is on the management of chronic peripheral neuropathic pain conditions.

Our first commercial product is a dermal delivery system designed to treat certain neuropathic pain conditions that was approved by the United States Food and Drug Administration, or FDA in November 2009 for the management of neuropathic pain associated with postherpetic neuralgia, or PHN. Qutenza, the first prescription strength capsaicin product approved in the United States, became commercially available in the first half of 2010 in the United States, through a specialty distribution and specialty pharmacy network supported by our own sales force, and in certain European countries through our collaborator Astellas Pharma Europe Ltd., or Astellas.

In May 2009, Qutenza received a marketing authorization, or MA, in the European Union for the treatment of peripheral neuropathic pain in non-diabetic adults, either alone or in combination with other medicinal products for pain. In June 2009, we entered into a Distribution, Marketing and License Agreement, or the Astellas Agreement, under which we granted Astellas an exclusive license to commercialize Qutenza in the European Economic Area, which includes the 27 countries of the European Union, Iceland, Norway, and Liechtenstein as well as Switzerland, certain countries in Eastern Europe, the Middle East and Africa, which we refer to as the Licensed Territory. Qutenza was made available on a country by country basis commencing in April 2010, and by March 31, 2011 was available in nineteen European countries. We believe that Astellas plans to introduce Qutenza in additional European Union countries as well as non-European Union countries within its territory during the remainder of 2011. We recognize royalty revenue based upon Astellas’ reported net sales of Qutenza in the Licensed Territory. We recognize royalty revenue from Astellas on a quarter lag basis due to timing of Astellas reporting such royalties to us.

We plan to submit a supplemental new drug application, or sNDA, in 2011 in pursuit of a label expansion for Qutenza in the United States. The label expansion would include patients with HIV-associated neuropathy, or HIV-AN, also known as HIV-distal sensory polyneuropathy, or HIV-DSP. The submission is expected to utilize data from two completed Phase 3 studies in patients with HIV-AN, one of which did not meet its primary endpoint. Our plans for continued Qutenza development efforts with respect to PDN are being evaluated in light of Astellas’ plans for market support studies and satisfaction of the European Medicines Agency, or EMA, post-approval regulatory commitments.

In November 2010, we treated the first patient in a Phase 2 clinical study of NGX-1998, a liquid formulation of high-concentration capsaicin, in patients with PHN. The Phase 2, adaptive-design, clinical study is being conducted in two stages. The objective of the study is to select the appropriate pretreatment and concentration of NGX-1998 for further evaluation in a Phase 3 clinical program. The first stage is designed to determine the shortest tolerable anesthetic pretreatment regimen and was completed in the quarter ended March 31, 2011. The second stage has begun and is designed to evaluate two NGX- 1998 dose concentrations using the pretreatment regimens determined during stage 1. Based on the results from the first stage, the second stage of the study is being conducted without the use of a topical anesthetic pretreatment regimen. The Astellas Agreement provides Astellas an option to exclusively license NGX-1998 in the Licensed Territory. If Astellas exercised such option, it is obligated under the Astellas Agreement to perform certain tasks, as are we, on the Phase 3 clinical trials and it would be responsible for 50% of the costs incurred for Phase 3 clinical development.

In April 2011, we announced that we received a Notice of Allowance from the U.S. Patent and Trademark Office for its patent entitled, “Methods and Compositions for Administration of TRPV1 Agonists.” The allowed claims include method of use, formulation and system claims. The patent, scheduled to issue from this application, is expected to expire in 2024, with an expected extension of the patent term in excess of two years due to patent term adjustment.

We also have a series of compounds which represent an early stage pipeline of potential product candidates which include various prodrugs of acetaminophen for potential use in acute pain, including traumatic pain, post-surgical pain and fever and various prodrugs of opioids for potential use in chronic pain indications. These other product candidates are in the pre-clinical stage of development and may or may not be the subject of further development in 2011 or beyond. We are currently seeking development partners for our acetaminophen prodrug programs.

To date we have not generated any significant product revenues and have funded our operations primarily by selling equity securities, establishing debt facilities and through the Astellas Agreement. Our net loss for the quarter ended March 31, 2011 was $13.4 million and as of March 31, 2011 we had an accumulated deficit of $269.9 million. We had cash, cash equivalents and short-term investments totaling $34.7 million at March 31, 2011 and during the quarter ended March 31, 2011, we used cash of $11.8 million in operating activities. We expect to continue to incur annual operating losses for the foreseeable future, and expect that our operating loss for the year ending December 31, 2011 will be consistent with our operating loss for the year ended December 31, 2010, as we continue our sales and marketing efforts relating to Qutenza in the United States, conduct the Phase 2 clinical study and other development activities of NGX-1998 and pursue a label expansion for Qutenza in the U.S.

In April 2010, we borrowed $40.0 million from Cowen Healthcare Royalty Partners, L.P., or Cowen Royalty, pursuant to a Financing Agreement, referred to as the Financing Agreement, and under the terms of such agreement we agreed to repay Cowen Royalty up to $106 million by assigning Cowen Royalty one hundred percent of royalty, milestone, option and other payments that we may receive under the Astellas Agreement until our repayment obligation is satisfied in full.

We anticipate that our existing cash and investments will be sufficient to meet our projected operating requirements beyond December 31, 2011.

On April 29, 2011, we announced the planned retirement of Anthony DiTonno, the Company’s President and Chief Executive Officer, by December 31, 2011 and initiated a formal executive search for a Chief Executive Officer.

Critical Accounting Policies and Significant Judgments and Estimates

Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, expenses and related disclosures. Actual results could differ from those estimates.

While our significant accounting policies are described in more detail in Note 2 of Notes to Condensed Consolidated Financial Statements included elsewhere in this report, we believe the following accounting policies to be critical to the judgments and estimates used in the preparation of our financial statements.

Product revenue

In April 2010, we made Qutenza commercially available in the United States to our specialty distributor and specialty pharmacy customers. Under the agreements with our customers, the customers take title to the product upon shipment and only have the right to return damaged product, product shipped in error and expired or short-dated product. As Qutenza is new to the marketplace, we are currently assessing the flow of product through our distribution channel, and cannot currently reasonably estimate returns. Until such time as an estimate of returns can be made we are recognizing Qutenza product revenues, and related product costs, at the later of:

•

the time the product is shipped by the customer to healthcare professionals, and

•

the date of cash collection.

Healthcare professionals are generally ordering Qutenza in small quantities only after they have identified a patient for treatment. We believe that revenue recognition upon the later of customer shipment to the end user and the date of cash collection is appropriate until we have sufficient data on cash collection and return patterns of our customers. We are performing additional procedures to further analyze shipments made by our customers by utilizing shipping data provided by our customers to determine when product is shipped by the customers to healthcare professionals and are evaluating ending inventory levels at our customers each month to assess the risk of product returns.

We have established terms pursuant to distribution agreements with our specialty distributor customers providing for payment within 120 days of the date of shipment to our specialty distributor customers and 30 days of the date of shipment to our specialty pharmacy customers. Such distribution agreements generally have a term of one year.

We had gross shipments of $603,000 for the quarter ended March 31, 2011. The application of the above revenue recognition policy resulted in the recognition of net revenue of $575,000 for the quarter ended March 31, 2011. Our gross shipments are reduced for chargebacks, certain fees paid to distributors and product sales allowances including rebates to qualifying federal and state government programs. At March 31, 2011, net deferred product revenues totaled $563,000.

Revenue from the Astellas Agreement

In June 2009, we entered into the Astellas Agreement which provides for an exclusive license by us to Astellas for the promotion, distribution and marketing of Qutenza in the Licensed Territory, an option to license NGX-1998, a product candidate that is a non-patch liquid formulation of capsaicin, in the Licensed Territory, participation on a joint steering committee and, through a related supply agreement entered into with Astellas, or Supply Agreement, supply of product until direct supply arrangements between Astellas and third party manufacturers are established, some of which we anticipate to occur in mid-2011. Revenue under this arrangement includes upfront non-refundable fees and may also include additional option payments for the development of and license to NGX-1998, milestone payments upon achievement of certain product sales levels and royalties on product sales.

We analyzed the multiple element arrangements within the Astellas Agreement, to determine whether the various performance obligations, or elements, can be separated or whether they must be accounted for as a single unit of accounting utilizing the accounting guidance in effect when the agreement is signed or materially changed. Accounting rules for multiple element arrangements changed for us effective January 1, 2011, however, the new rules apply to new arrangements or the Astellas Agreement if we were to significantly modify the agreement subsequent to January 1, 2011. Pursuant to the multiple-element arrangement guidance in effect at the time of the Astellas Arrangement, the Company made the determination of whether an element can be separated or accounted for as a single unit of accounting based on the availability of evidence with regard to standalone value of each delivered element. If the fair value of all undelivered performance obligations could be determined, then all obligations would then be accounted for separately as performed. If any delivered element was considered to either: not have standalone value or have standalone value but the fair value of any of the undelivered performance obligations are not determinable, then any delivered elements of the arrangement would be accounted for as a single unit of accounting and the multiple elements would be grouped and recognized as revenue over the longest estimated performance obligation period.

Significant management judgment is required in determining the level of effort required under an arrangement and the period over which the performance obligations are estimated to be completed. In addition, if we are involved in a joint steering committee as part of a multiple element arrangement that is accounted for as a single unit of accounting, an assessment is made as to whether the involvement in the steering committee constitutes a performance obligation or a right to participate.

We view the Astellas Agreement and related agreements, as a multiple element arrangement with the key deliverables consisting of an exclusive license to Qutenza in the Licensed Territory, an obligation to conduct certain development activities associated with NGX-1998, participation on a joint steering committee and supply of Qutenza components to Astellas until such time that Astellas can establish a direct supply relationship with product vendors. Because not all of these elements have both standalone value and objective and reliable evidence of fair value, we are accounting for such elements as a single unit of accounting. Further, the agreement provides for our mandatory participation in a joint steering committee, which we believe represents a substantive performance obligation and also the estimated last delivered element under the Astellas Agreement and related agreements. Therefore, we are recognizing revenue associated with upfront payments and license fees ratably over the term of the joint steering committee performance obligation. We estimate this performance obligation will be delivered ratably through June 2016.

At the inception of the Astellas Agreement, the upfront license fees were subject to a refund right, which expired upon transfer of our MA for Qutenza in the European Union to Astellas. In September 2009, the transfer of the MA to Astellas was completed and, therefore, the upfront license fees became non-refundable and revenue recognition of the upfront license fees commenced.

Under the terms of the Astellas Agreement, we earn royalties based on each sale of Qutenza into the Licensed Territory. The royalty rate is tiered based on the level of sales achieved. These royalties are considered contingent consideration as we have no remaining contract performance obligation and, therefore, the royalties are excluded from the single unit of accounting discussed above. We report royalty revenue based upon Astellas’ reported net sales of Qutenza in the Licensed Territory. We recognize royalty revenue from Astellas on a quarter lag basis due to the timing of Astellas reporting such royalties to us.

Additionally, we can earn milestone payments from Astellas if Astellas achieves certain sales levels as outlined in the Astellas Agreement. As these payments are contingent on Astellas’ performance, they are excluded from the single unit of accounting discussed above. The milestones will be recorded as revenue when earned as we have no remaining contractual performance obligation.

We recognize revenue net of related costs for collaboration supplies sold to Astellas upon the product being delivered to Astellas. The revenue and related costs of the product supplied to Astellas are included in Collaboration revenue. Prior to delivery to Astellas, the costs accumulated for the manufacturing of the collaboration supplies are included as Prepaid expenses on our balance sheet.

Stock-Based Compensation

We account for our stock-based compensation in accordance with the fair value recognition provisions of current authoritative guidance. Under the authoritative guidance, stock-based awards, including stock options, are recorded at fair value as of the grant date and recognized to expense over the employee’s requisite service period (generally the vesting period), which we have elected to amortize on a straight-line basis. Because non-cash stock compensation expense is based on awards ultimately expected to vest, it has been reduced by an estimate for future forfeitures. We estimate forfeitures at the time of grant and revise, if necessary, in subsequent periods.

We estimate the fair value of options granted using either the Black-Scholes option valuation model or a Monte Carlo valuation model and the assumptions used in such estimate are shown in Note 7 to the Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q. The Monte Carlo valuation model was utilized to value the market based options granted to our officers and certain employees in February 2011. Significant judgment is required on the part of management in determining the proper assumptions used in these models. The assumptions used in the Black-Scholes option valuation model include the risk free interest rate, expected term, expected volatility and expected dividend yield. The assumptions used in the Monte Carlo valuation model include the risk free interest rate, expected term, expected volatility and expected dividend yield. We base our assumptions on historical data where available or when not available, on a peer group of companies. These assumptions consist of estimates of future market conditions, which are inherently uncertain, and therefore subject to management’s judgment.

Clinical Trials

We accrue and expense costs for clinical trial activities performed by third parties, including clinical research organizations and clinical investigators, based upon estimates made, as of the reporting date, of the work completed through the reporting date as a percentage of the total work contracted for under our agreements with such third parties. We make our estimates at the end of each reporting period after discussion with internal personnel and outside service providers and thorough evaluation as to progress or stage of completion of trials or services. On a periodic basis we adjust our estimated clinical trial costs to reflect actual expenses incurred to date. Due to the nature of the estimation of clinical trial costs, we may be required to make changes to our estimates in the future as we become aware of additional information about the status or conduct of clinical trials.

Long Term Obligation

On April 30, 2010, we entered into the Financing Agreement (with Cowen Royalty. Under the terms of the Financing Agreement, we borrowed $40 million from Cowen Royalty, or the Borrowed Amount, and we agreed to repay such amount together with a return to Cowen Royalty, out of royalty, milestone, option and certain other payments, collectively referred to as the Revenue Interest, that we may receive under the Astellas Agreement.

The accounting for the Financing Arrangement requires us to make certain estimates and assumptions, including the timing and extent of royalty, milestone, option and other payments to be received from Astellas and an internal rate of return we are to pay to Cowen. Changes in the estimated Revenue Interest payments can result in changes in our classification of the current and long term portions of the amounts payable pursuant to the Financing Agreement, as well as the internal rate of return paid to Cowen.

We are also required to make assumptions for the calculation of the estimated fair market value of the Long term obligation disclosed in the footnotes to our financial statements. The key assumptions required for the estimated fair market value calculation are estimates of the amounts and timing of the future royalty revenues and other payments to be received from Astellas, the amount and timing of payments to Cowen Royalty to repay the Borrowed Amount and an estimated cost of capital

The estimate of the future royalty revenues and other payments to be received from Astellas is subject to significant variability due to the recent product launch, regulatory processes still to be conducted for significant portions of the Astellas territory and the extended time period associated with the Financing Agreement, and thus are subject to significant uncertainty. For further discussion of this long term obligation, see the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources.”

Results of Operations

In November 2009, we received marketing approval from the FDA for Qutenza for the management of neuropathic pain associated with PHN. In April 2010, we launched Qutenza in the United States. We are marketing and selling Qutenza in the United States through a team of approximately 40 sales professionals. We have established a distribution network to allow healthcare providers to access Qutenza through specialty distributors and specialty pharmacies. We are marketing Qutenza to high volume prescribing physicians who treat PHN patients in private practices, hospitals, military treatment facilities and veterans associations. Our approach requires considerable time and effort to educate and train physicians and their staff prior to their initial Qutenza treatments.

We commenced recording collaboration revenue for the upfront payments from Astellas in 2009, when the upfront payment of $48.8 million received from Astellas became nonrefundable as a result of our transfer of the Qutenza MA to Astellas. We recognized $1.8 million of the upfront payment as revenue in each of the first quarters of 2011 and 2010. As of March 31, 2011, we have $37.8 million remaining in deferred collaboration revenue which will be recognized on a straight line basis over the remaining service period of

the joint steering committee, which we estimate will expire in June 2016. Under our Supply Agreement with Astellas, we are obligated to supply product, at a contractual price which approximates our cost, until such time as Astellas establishes its own supply relationship.

As of March 31, 2011, Astellas has made Qutenza commercially available in nineteen European countries and Astellas has informed us that it is continuing its focus on intensive site training on a country by country basis. In the first quarter of 2011, Qutenza sales were initiated in Poland and the Czech Republic. We believe that Astellas plans to expand Qutenza availability in the European Union and seek regulatory approvals in certain countries in the remainder of the Licensed Territory in 2011.

Cost of goods sold includes the cost of products sold, costs associated with services provided by our third-party logistics partner for managing the shipping, billing and other administrative functions associated with the distribution channel and also includes royalty obligations due to our intellectual property licensors, the University of California, or UC, and LTS Lohmann Therapie-Systeme AG, or LTS. We recognize costs associated with our third party logistics provider in the period in which those costs are incurred, however, costs to manufacture product and royalty obligations due to third parties are deferred and recognized in the period in which the associated revenue is recognized. Costs associated with the manufacture of Qutenza prior to regulatory approval were previously expensed in the period in which those costs were incurred. We believe that the effect on cost of goods sold of previously expensed materials prior to approval is immaterial as compared to what cost of goods sold would have been if such costs were expensed in the period that the product was sold.

Our research and development expenses consist of internal and external costs. Our internal costs are primarily employee salaries and benefits, contract employee expense, non-cash stock compensation expense, allocated facility and other overhead costs. Our external costs are primarily expenses related to the development of product candidates including formulation development, manufacturing process development, non-clinical studies, clinical trial costs, such as the cost of clinical research organizations and clinical investigators, milestone payments to our licensors in connection with the use of certain intellectual property, and costs associated with preparation and filing of regulatory submissions. Additionally, external and internal costs related to manufacturing and quality assurance activities for production batches of our active pharmaceutical ingredient, patches and cleansing gel, which are destined for commercial sale in the United States, were recorded to research and development expense if purchase of such components occurred prior to FDA approval.

We commence tracking the separate, external costs of a project when we determine that a project has a reasonable chance of entering clinical development. Senior management discusses the possibility of entering clinical development, along with the possibility of meeting other regulatory milestones, throughout the development cycle. These discussions include consideration of the costs and time required to bring the project to market and potential market acceptance for a product from the project, if one receives marketing approval. We do not maintain and evaluate research and development costs by specific therapeutic indications within a program due to the difficulties in allocating such costs to specific indications. We use our internal research and development resources across several projects and many resources may not be attributable to specific projects or indications. Thus, we do not allocate the internal resources to specific development programs.

In the three months ended March 31, 2011 and 2010, our research and development costs totaled $4.0 million and $2.1 million, respectively. The following table reflects the distribution of our research and development costs by development program:

Three months ended March 31;

(in thousands)

Qutenza

NGX-
1998

Acetaminophen
Prodrug and
Opioid Prodrug

Internal costs

Total

2011

577

1,320

2,040

3,957

2010

209

158

1,755

2,123

The process of conducting preclinical testing and clinical trials necessary to obtain marketing approvals in the United States and other regions is costly and time consuming. The probability of success for each product candidate and clinical trial may be affected by a variety of factors, including, among others, patient enrollment, manufacturing capabilities, successful clinical results, our funding, and competitive and commercial viability. As a result of these and other factors, we are unable to determine the duration and completion costs of current or future clinical stages of our product candidates or when or to what extent we will generate revenues from commercialization and sale of any of our unapproved product candidates. In November 2010, we treated the first patient in a Phase 2 clinical study of NGX-1998. NGX-1998 is our most advanced product candidate and costs to complete development of NGX-1998 could be significant. Pursuant to the Astellas Agreement, we might receive future option payments related to this program at Astellas’ election; however, we are obligated to pay any such amounts to Cowen Royalty under the terms of the Financing Agreement. Further, if Astellas exercises its option to license NGX-1998, the Astellas Agreement provides for Astellas to be responsible for 50% of the costs incurred for Phase 3 clinical development. If we do not obtain regulatory approval for NGX-1998 or our other product candidates, or for other indications for Qutenza, our ability to achieve additional revenue, our operating results, and our financial position will be adversely affected. We expect that our annual 2011 research and development costs will increase as compared to 2010 as we expand development activities for NGX-1998 including the on-going Phase 2 clinical study and work to file an sNDA for Qutenza’s label expansion to cover patients with HIV-AN.

Our selling, general and administrative expenses consist primarily of salaries and benefits, including those of our sales, marketing, commercial operations and administrative functions such as finance, human resources, legal, medical affairs and information technology. Additionally, selling, general and administrative expenses include marketing expenses, commercialization costs, pharmacovigilance costs and costs associated with our status as a public company and patent costs. In addition, general and administrative expenses include allocated facility, basic operational and support costs and insurance costs. We anticipate that our selling, general and administrative expenses may increase over the next several years as a result of our commercialization of Qutenza. These increases are likely to be attributable to increasing marketing activities, costs to maintain and potentially grow our U.S. sales force and infrastructure costs to support commercial operations, and may include adding additional personnel in certain of the key functional areas that support growth of our general operations, including accounting and finance, legal and human resources.

Comparison of the Three Months Ended March 31, 2011 and 2010


	Three Months Ended March 31,				$ Increase		% Increase
(in thousands)	2011		2010		(Decrease)		(Decrease)
Product revenue	$	575	$	—	$	575		100	%
Collaboration revenue		2,595		1,786		809		45	%
Cost of goods sold		108		—		108		100	%
Research and development expenses		3,957		2,123		1,834		86	%
Selling, general and administrative expenses		10,282		8,806		1,476		17	%
Interest income		27		8		19		238	%
Interest expense and other		2,213		28		2,185		7803	%

Product Revenue. Due to limited history of product returns and cash collections from our customers, (specialty distributors and specialty pharmacies), we recognize revenue for Qutenza at the later of the time our customers ship product to healthcare professionals and cash collections received by us from our customers. We recorded gross shipments of Qutenza to our customers totaling $603,000 in the first quarter of 2011. Based on our revenue recognition methodology, we recognized $575,000 as Qutenza revenue for the first quarter 2011. We have deferred product revenue of $563,000 at March 31, 2011 which is reported net of associated cost of goods sold of $55,000 in our condensed consolidated balance sheet as of March 31, 2011.

Collaboration Revenue. Collaboration revenue of $2.6 million recorded in the three months ended March 31, 2011 consisted of $1.8 million of the amortization of upfront payments received pursuant to the Astellas Agreement, $0.6 million of Collaboration revenue under our Supply Agreement with Astellas and $0.2 million in royalty income. Collaboration revenue of $1.8 million was recorded in the three months ended March 31, 2010 for the amortization of upfront payments received under the Astellas Agreement.

Under our Supply Agreement with Astellas, we are obligated to supply product, at a contractually agreed upon cost for materials and our related labor and overhead, until such time as Astellas establishes its own supply relationship with suppliers. The majority of this revenue results from our having expensed certain product costs in periods prior to receiving regulatory approval and subsequently, selling that product to Astellas during this quarter. Going forward, we do not expect to make a significant net profit or loss on sales of product to Astellas.

Cost of goods sold. Cost of goods sold totaled $108,000 for the three months ended March 31, 2011. Cost of goods sold includes the cost of products sold, fixed costs associated with services provided by our third-party logistics partner for managing the shipping, billing and other administrative functions associated with the distribution channel and also includes royalty obligations due to our intellectual property licensors, UC and LTS. During the three month period ended March 31, 2011, the cost of finished goods sold includes fixed costs of $57,000. As our product revenues increase over time, we expect that our gross margin will improve to approximately 90%.

Research and Development expenses. Research and development expenses increased $1.9 million, or 86%, to $4.0 million for the three months ended March 31, 2011, from $2.1 million for the same period in 2010. This increase is primarily due to $1.0 million higher costs related to our Phase 2 clinical study and non-clinical development costs for NGX-1998. In addition, we incurred $0.3 million of higher costs in 2011 associated with our pursuit of a label expansion for Qutenza to cover the HIV-AN indication in the United States. We also incurred higher expense of $0.1 million in each employee and temporary help expense versus the prior year period.

Selling, General and Administrative expenses. Selling, general and administrative expenses increased $1.5 million, or 17%, to $10.3 million for the three months ended March 31, 2011, from $8.8 million for the same period in 2010. We incurred $1.8 million higher salary, benefit, support and travel costs in the three months ended March 31, 2011 related to the sales force versus the prior year period as we hired most of our sales force on March 1, 2010, just prior to the launch of Qutenza in the United States, and thus they were in place for only a portion of the prior year quarter. In addition, we incurred higher costs of $0.9 million in the 2011 period for marketing events and professional services costs of $0.4 million. These higher costs were partially offset by lower marketing materials costs of $1.2 million and training costs of $0.3 million as we incurred significant Qutenza launch related costs in the three months ended March 31, 2010.

Interest expense. Interest expense was $2.2 million for the three months ended March 31, 2011 as compared to $4,000 for the same period in 2010. This increase was primarily due to interest on the $40.0 million Long term obligation related to the Financing Agreement entered into with Cowen Royalty, in April 2010.

Liquidity and Capital Resources

Since our inception through March 31, 2011, we have funded our operations primarily by selling equity securities, establishing debt facilities and through a collaboration agreement with Astellas. In May 2007, we completed an initial public offering of our common stock which resulted in net cash proceeds, after deducting total expenses including underwriting discounts and commissions and other-offering related expenses, of $38.1 million. In December 2007, we completed the first closing of a private placement of our common stock and warrants resulting in net cash proceeds of $21.5 million and in January 2008, we completed the second and final closing of this private placement of our common stock and warrants resulting in net cash proceeds of $2.3 million. In April 2010, we borrowed $40.0 million under a Financing Agreement with Cowen Royalty.

As of March 31, 2011, we had approximately $34.7 million in cash, cash equivalents and short-term investments. We also had working capital, adjusted to exclude the current portion of non-cash deferred revenue of approximately $7.8 million, of $27.4 million. Our cash and investment balances are generally held in money market funds and obligations of U.S. government agencies. Cash in excess of immediate operational requirements is invested in accordance with our investment policy primarily with a view to capital preservation and liquidity. Further, to reduce portfolio risk, our investment policy specifies a concentration limit of 10% in any one issuer or group of issuers of corporate bonds or commercial paper at the time of purchase. Our investment holdings at March 31, 2011 consist of $26.9 million in U.S. Treasury, $4.2 million in cash and money market funds and $3.6 million in commercial paper.

Net cash used in operating activities was $11.8 million and $9.9 million in the first quarter of 2011and 2010, respectively. The increase in cash used in operating activities in 2011 as compared to 2010 resulted primarily from funding the sales force for an entire quarter and our Phase 2 clinical trial for NGX-1998 which commenced in November 2010. Included in net cash used in operating activities are net changes in assets and liabilities affecting cash. We anticipate that cash used in operating activities will remain at similar quarterly levels as the first quarter of 2011 over the remainder of 2011.

Net cash provided by investing activities was $7.4 million and $4.2 million in the quarters ended March 31, 2011 and 2010, respectively. Investing activities consisted primarily of the purchase, sale and maturity of marketable securities and to a lesser extent, the purchase of capital equipment.

Fluctuations in our investing activities have primarily been driven by the timing and receipt of proceeds from financing activities. We expect that property and equipment expenditures in for the remainder of 2011 will remain at historical levels.

Net cash provided by financing activities in the quarter ended March 31, 2011 was $8,000 due to employees exercising stock options. Net cash used in financing activities in the quarter ended March 31, 2010 was $0.2 million and represents the final payment on our venture loan financing.

Our future capital expenditures and requirements depend on numerous forward-looking factors. These factors include but are not limited to the following:

•

the success of the commercialization of our products;

•

the costs of establishing and maintaining sales and marketing infrastructure, distribution capabilities and a sales force;

•

the scope and cost of commercial activities including, but not limited to, costs associated with pharmacovigilance and medical affairs activities;

•

the conduct of manufacturing activities;

•

the costs of carrying out our obligations under our commercial arrangement with Astellas;

•

our ability to establish and maintain strategic collaborations, including licensing and other arrangements that we have or may establish;

•

the costs and timing of seeking regulatory approvals;

•

the progress of our development programs including the number, size and scope of clinical trials and non-clinical development;

•

the costs involved in enforcing or defending patent claims or other intellectual property rights; and

•

the extent to which we acquire or invest in other products, technologies and businesses.

At March 31, 2011, we had $34.7 million in cash, cash equivalents and short-term investments. We anticipate that our operating expenses may slightly increase from recent levels for the remainder of 2011. We anticipate that cash used in operating activities for the entire year may increase in 2011 as compared to 2010 as a result of our efforts to increase sales of Qutenza in the United States while conducting the Phase 2 clinical study of NGX-1998 and pursing a label expansion for Qutenza in the United States. We anticipate that our existing cash and investments will be sufficient to meet our projected operating requirements beyond December 31, 2011.

If we were to default under the Financing Agreement with Cowen Royalty, we are obligated to pay to Cowen Royalty the borrowed amount together with interest accrued thereon from the effective date of the Financing Agreement, to the date of repayment at an internal rate of return equal to the lesser of the 19% rate of interest or the maximum rate permitted by law, less any Revenue Interest payments received by Cowen Royalty. Under the Financing Agreement, an event of default includes standard insolvency and bankruptcy terms, including a failure to maintain liquid assets equal to at least our liabilities due and payable during the following three months.

To date, we have incurred recurring net losses and negative cash flows from operations, after excluding the upfront cash received from Astellas in 2009. Until we can generate significant cash from our operations, if ever, we expect to continue to fund our operations with existing cash resources generated from the proceeds of offerings of our equity securities and proceeds from one or more collaboration agreements as well as potentially through royalty monetization, debt financing or the sale of other equity securities. However, we may not be successful in obtaining additional collaboration agreements, or in receiving milestone or royalty payments under those agreements. In addition, we cannot be sure that our existing cash and investment resources will be adequate or that additional financing will be available when needed or that, if available, financing will be obtained on terms favorable to us or our stockholders. Having insufficient funds may require us to delay or potentially eliminate some or all of our development programs, relinquish some or even all rights to product candidates at an earlier stage of development or negotiate less favorable terms than we would otherwise choose. Failure to obtain adequate financing also may adversely affect the launch of our product candidates or our ability to continue in business. If we raise additional funds by issuing equity securities, substantial dilution to existing stockholders would likely result. If we raise additional funds by incurring debt financing, the terms of the debt may involve significant cash payment obligations as well as covenants and specific financial ratios that may restrict our ability to operate our business.

Off-balance Sheet Arrangements

Since inception, we have not engaged in any off-balance sheet arrangements, including the use of structured finance, special purpose entities or variable interest entities.

Contractual Obligations

We have issued non-cancellable purchase orders to third party manufacturers of Qutenza and NGX-1998 for manufacturing, stability and related services including reimbursable amounts from Astellas for the supply of Qutenza based on the Astellas Agreement. These purchase orders totaled $1.5 million as of March 31, 2011 and included approximately $1.0 million for stability and related services, $0.3 million of commitments related to supply of Qutenza to Astellas, $0.1 million related to product manufacturing costs for the U.S. market, and $0.1 million for the Phase 2 clinical study for NGX-1998. We plan to record these amounts in our financial statements when title to the applicable materials has transferred to us.

Recently Issued and Adoption of New Accounting Standards

In October 2009, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update, or ASU, No. 2009-13, Revenue Recognition (ASC Topic 605) – Multiple-Deliverable Revenue Arrangements . This guidance modifies previous guidance for multiple element arrangements by allowing the use of the “best estimate of selling price” in the absence of vendor-specific objective evidence, or VSOE, or third party evidence, or TPE, of selling price for determining the selling price of a deliverable. A vendor is now required to use its best estimate of the selling price when VSOE or TPE of the selling price is not available. In addition, the residual method of allocating arrangement consideration is no longer permitted. This ASU is effective for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 and early adoption was permitted. We adopted this ASU on January 1, 2011 and the adoption of the new guidance did not have a material impact on our consolidated financial statements. We currently only has one revenue agreement with multiple elements, the Astellas Agreement. If we were to enter into new multiple element arrangements or make a material modification to the Astellas Agreement after January 1, 2011, the contract would be accounted for under the provisions of ASU No. 2009-13.

In April 2010, the FASB issued ASU No. 2010-17, Revenue Recognition-Milestone Method (ASC Topic 605): Milestone Method of Revenue Recognition. This ASU codifies the consensus reached in Emerging Issues Task Force Issue No. 08-9, “Milestone Method of Revenue Recognition.” The amendments to the FASB Accounting Standards Codification provide guidance on defining a milestone and determining when it may be appropriate to apply the milestone method of revenue recognition for research or development transactions. Consideration that is contingent on achievement of a milestone in its entirety may be recognized as revenue in the period in which the milestone is achieved only if the milestone is judged to meet certain

criteria to be considered substantive. Milestones should be considered substantive in their entirety and may not be bifurcated. An arrangement may contain both substantive and non-substantive milestones, and each milestone should be evaluated individually to determine if it is substantive. ASU No. 2010-17 is effective for fiscal years, and interim periods within those years, beginning on or after June 15, 2010, and may be applied prospectively to milestones achieved after the adoption date or retrospectively for all periods presented. On January 1, 2011, we prospectively adopted and elected the Milestone Method of Revenue Recognition as its accounting policy for substantive milestones achieved after the adoption date. The adoption of the new guidance did not have a material impact on our consolidated financial statements.

ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We believe there has been no material change in our exposure to market risk from that discussed in our Form 10-K filed for the year ended December 31, 2010.

Foreign Currency Exchange Rate Risk

Our third party manufacturers including the manufacturer of our active pharmaceutical ingredient, trans-capsaicin, the manufacturer of Qutenza and the manufacturer of our cleansing gel, are located in countries outside the United States. As a result, we may experience changes in product supply costs as a result of changes in exchange rates between the U.S. dollar and the local currency where the manufacturing activities occur. In addition, as we oversee scale up to supply Astellas with our product components for commercial sale in the European Union and to supply the U.S. market if regulatory approval is received, our exposure to foreign currency exchange rates, primarily the Euro, will increase.

Amounts paid to us by Astellas under the Astellas Agreement may be based in Euro or other currency which will then be converted to U.S. dollars before payment to us. To the extent that these potential receipts are different than our net payable exposure in Euro to our suppliers mentioned above, and to the extent that the timing of these potential payments and receipts differ, we will have a net receivable or payable exposure in Euro if Qutenza is launched in the European Union and certain other foreign territories.

We currently do not engage in foreign currency hedging activities as the short-term exposure to fluctuations in foreign currency is relatively small.

ITEM 4.

CONTROLS AND PROCEDURES

(a) Evaluation of disclosure controls and procedures

Our management evaluated, with the participation and under the supervision of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded, subject to the limitations described below, that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission, or SEC, rules and forms, and that such information is accumulated and communicated to management as appropriate to allow timely decisions regarding required disclosures.

(b) Changes in internal control over financial reporting

Our management, including our Chief Executive Officer and Chief Financial Officer, has evaluated any changes in our internal control over financial reporting that occurred during the quarter ended March 31, 2011, and has concluded that there was no change during such quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the controls are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues, if any, within a company have been detected. Accordingly, our disclosure controls and procedures are designed to provide reasonable, not absolute, assurance that the objectives of our disclosure control system are met.

PART II. OTHER INFORMATION

ITEM 1.

LEGAL PROCEEDINGS

We are subject to various legal disputes that arise in the normal course of business. These include or may include employment matters, contract disputes, intellectual property matters, product liability actions, and other matters. We do not know whether we would prevail in these matters nor can it be assured that a remedy could be reached on commercially viable terms, if at all. Based on currently available information, we do not believe that any of these disputes will have a material adverse impact on our business, results of operations, liquidity or financial position.

ITEM 1A.

RISK FACTORS

You should consider carefully the risk factors described below, and all other information contained in or incorporated by reference in this quarterly report on Form 10-Q before making an investment decision. If any of the following risks actually occur, they may materially harm our business, financial condition, operating results or cash flows. As a result, the market price of our common stock could decline, and you could lose all or part of your investment. Additional risks and uncertainties that are not yet identified or that we think are immaterial may also materially harm our business, operating results or financial condition and could result in a complete loss of your investment.

Risks Related to our Business

Our success depends on our ability to effectively commercialize our product Qutenza ^® (capsaicin) 8% patch.

Our product Qutenza ^® (capsaicin) 8% patch, was approved by the FDA in November 2009 for the management of neuropathic pain associated with PHN. Our commercial success depends on our ability to successfully launch and commercialize Qutenza in the United States. Prior to receiving FDA marketing approval, our commercialization activities were limited and, as a result, many of our proposed activities to create product awareness or promote market acceptance have only recently been initiated and as such their effect may take some time to be realized, if at all. Although we launched Qutenza in April 2010, we may not know how effective our launch is until six to eight quarters after the launch date, if at all, due to Qutenza’s nature as an office administered product, its expected duration of effect resulting in prolonged periods between product use for a particular patient, and due to our targeted commercialization strategy. Additionally, successful commercialization of Qutenza will depend on a number of factors as further discussed in this Risk Factors section, which include risks related to obtaining adequate reimbursement, continuing to devote sufficient management and financial resources to maintain a qualified sales force, continuing to build infrastructure to support commercial operations and ensuring sufficient product supply. There can be no assurance that we will be able to continue to devote sufficient financial resources to hire, retain and manage the personnel required to maximize the commercial potential of Qutenza or that such commercialization will result in significant product sales of Qutenza. If the commercial launch of Qutenza does not meet our expectations, it would significantly and negatively impact our revenue and results of operations. In addition, we are establishing inventory levels of Qutenza based upon our expectations of future product sales. If actual product sales are significantly lower than our expectations, our inventory levels may be excessive. If Qutenza supplies remain in inventory for significantly longer than anticipated, such supplies may not be suitable for sale due to expiration of their shelf lives, which would require us to write off the cost of such expired product.

Our strategy for launching Qutenza in the United States may result in lower than expected near term revenue and could result in a lower overall revenue potential for Qutenza.

We launched Qutenza with a field sales organization of approximately 40 representatives and managers. We have tasked the sales force with focusing initially on thought leaders in neuropathic pain as well as U.S. pain specialists with a significant practice in treating PHN patients in major markets in the United States. Our

current approach to launching Qutenza contemplates significant interaction with healthcare professionals to facilitate educating staff involved with administering and billing for Qutenza and involves a combination of sales representatives, clinical educators and reimbursement specialists, all of whom we believe are necessary to enable healthcare professionals that use Qutenza to have:

•

access to product information and training concerning the proper use and administration of Qutenza; and

•

support in seeking reimbursement for Qutenza, as well as the services involved in administering Qutenza.

As a result of this approach, we do not expect to initially market Qutenza to a large number of healthcare professionals. While we may expand our sales and marketing efforts if financial and other resources allow, our initial focused strategy may result in reduced market penetration by Qutenza and lower product revenues in the near, and potentially longer term. As a result, our financial results and our stock price could suffer.

If healthcare professionals are not adequately reimbursed for Qutenza or their time and services in administering Qutenza, it is likely that they will not prescribe Qutenza.

Because many people suffering from PHN are elderly, in order for Qutenza to be economically viable in the United States, we will need Medicare coverage for Qutenza to have significant market penetration. We understand that all of the Medicare contractors that process claims for Medicare are covering Qutenza under Part B and consequently, we believe that Medicare Part B coverage for Qutenza is in place nationwide. Although Medicare Part B coverage is in place, Medicare policymakers or local contractors may determine that Qutenza is reasonable and necessary only under limited circumstances. Currently, three contractors have published detailed coverage criteria for Qutenza. If a significant portion of contractors establish restrictive coverage policies for Qutenza, our business would be harmed, not only because Medicare beneficiaries represent a substantial portion of our target market, but also because Medicare’s coverage policies would likely affect the determination of many state Medicaid programs and could influence private payers.

The use of Qutenza is reimbursable under Medicare Part B and the amounts of reimbursement available to the healthcare professionals for the treatment procedure are known in most cases, since 8 of the 11 contractors have instructed healthcare professionals to bill using established evaluation and management codes that have payment rates associated with them. Three contractors have requested that healthcare professionals use a miscellaneous / unlisted code for the Qutenza application procedure. One of these three contractors set a payment rate that we consider inadequate. We are working with local healthcare professionals to advocate for an adjustment to this payment rate that we believe more accurately reflects the resources necessary to administer Qutenza. In the case of another of these contractors, the reimbursement amounts for the Qutenza treatment procedure appear acceptable to local providers. The payment rate has not been confirmed at the final contractor requesting a miscellaneous/unlisted code. We continue to work with local healthcare professionals to determine payment amounts in this contractor’s service area. If the payment rate proves inadequate, such a rate could create a significant barrier to healthcare professionals adoption of Qutenza. Additionally, the timing and process for healthcare professionals to receive reimbursement for use of Qutenza may be a lengthy and uncertain process which can also create a barrier for healthcare professionals adoption of Qutenza. In either case, these factors could serve to seriously limit the market opportunity for Qutenza.

We also will need to obtain favorable coverage and reimbursement decisions for Qutenza from private insurers, including managed care organizations. We expect that private insurers will consider the efficacy, cost-effectiveness and safety of Qutenza in determining whether to provide reimbursement for Qutenza and at what level. At this time, we are aware of two large national plans and ten regional plans, including seven state-based Blue Cross Blue Shield plans that have published coverage criteria for Qutenza. Other private insurers and managed care plans are providing access to Qutenza on a case-by-case basis while they

determine their coverage and reimbursement policies for Qutenza. Obtaining these coverage and reimbursement decisions will be a time consuming process requiring substantial resources and Qutenza patients or providers may not receive adequate reimbursement from private insurers.

We expect to experience pricing pressures in connection with the sale of Qutenza and our potential future products, due to the trend toward programs and legislation aimed at reducing healthcare costs, including the recently passed federal healthcare reform legislation as well as the increasing influence of managed care organizations. In many foreign countries, particularly the countries of the European Union, the pricing of prescription drugs is subject to direct governmental control and is influenced by drug reimbursement programs that employ a variety of price control mechanisms. In these countries, pricing negotiations with governmental authorities or reimbursement programs can take 6 to 12 months or longer after the receipt of regulatory marketing approval for a product. To obtain reimbursement or pricing approval in some countries, we or our collaborators may be required to conduct additional studies, such as a study to evaluate the cost-effectiveness of Qutenza compared to other currently available therapies. If reimbursement for Qutenza is unavailable, delayed or limited in scope or amount, or if pricing is set at unsatisfactory levels, our business would be materially harmed.

Qutenza and our product candidates may never achieve market acceptance.

The commercial success of Qutenza or any other product candidates we develop, if approved, will depend on, among other things, acceptance by healthcare professionals, patients and payers. Market acceptance of, and demand for, any products that we develop and commercialize will depend on many factors, including:

•

the ability to obtain adequate pricing and sufficient insurance and other third party payer coverage and reimbursement;

•

with respect to Qutenza, healthcare professionals and patients willingness and ability to accommodate the time necessary for each Qutenza treatment;

•

patient acceptance of the treatment procedure, efficacy or safety of Qutenza;

•

availability, relative cost and relative efficacy and safety of alternative and competing treatments;

•

the effectiveness of our or our collaborators’ sales, marketing and distribution strategy;

•

publicity concerning our products or competing products and treatments;

•

potential product recalls; and

•

post marketing approval pharmacovigilance or other studies showing safety issues not seen in previous studies.

If Qutenza, or our product candidates if approved, fail to gain market acceptance, we may be unable to earn sufficient revenue to continue our business.

We outsource the manufacturing of Qutenza and our other product candidates and accordingly depend on other parties for our manufacturing operations. If these manufacturers fail to meet our requirements and strict regulatory requirements, Qutenza commercialization efforts and further product development efforts may be negatively affected.

We currently depend on four contract manufacturers as single source suppliers for the components of Qutenza: an intermediate material used in the synthesis of capsaicin, synthetic capsaicin, the dermal delivery system and the associated cleansing gel. We have entered into long-term commercial supply agreements for

these components. In addition we have entered into a long-term agreement for the assembly of the Qutenza treatment kits in the United States. If relationships with any of these manufacturers is terminated, or if any manufacturer is unable to produce required quantities on a timely basis or at all, our operations would be negatively impacted and our business harmed.

Any products we or our contract manufacturers manufacture or distribute under FDA approvals are subject to pervasive and continuing regulation by the FDA, including record-keeping requirements and reporting of adverse experiences with the products. Drug manufacturers and their subcontractors are required to register with the FDA and, where appropriate, state agencies, and are subject to periodic unannounced inspections by the FDA and state agencies for compliance with cGMP, regulations which impose procedural and documentation requirements upon us and each third party manufacturer we utilize. This ongoing regulation and evaluation results in an obligation on us to continually evaluate the manufacturing process, the applicability of our analytical methods and the specifications that are used to release product for sale and evaluate long term stability of our product to ensure they continue to meet their objective of ensuring that such processes and methods enable the consistent manufacture of product that meets regulatory approved specifications. This process often results in identification of matters that can result in changes to specifications, analytical methods and manufacturing processes as part of normal and ongoing process improvement. This process can also identify matters that can have significant implications including the potential for reduction in applicable product shelf life, suspension of product commercialization, or requirement of product recalls, all of which would have a material adverse effect on us. We are undertaking such ongoing process improvement processes with our contract manufacturers and we cannot assure you that the outcome of such initiatives will not have a material effect on our business.

Reliance on contract manufacturers exposes us to additional risks, including:

•

failure of current and future manufacturers to comply with strictly-enforced regulatory requirements;

•

failure to manufacture products that meet our specifications throughout their shelf lives;

•

failure to deliver sufficient quantities in a timely manner;

•

the possibility that we may terminate a contract manufacturer and need to engage a replacement;

•

the possibility that current and future manufacturers may not be able to manufacture our product candidates and products without infringing the intellectual property rights of others;

•

the possibility that current and future manufacturers may not have adequate intellectual property rights to provide for exclusivity and prevent competition; and

•

insufficiency of intellectual property rights to any improvements in the manufacturing processes or new manufacturing processes for our products.

Any of these factors could result in insufficient supply of Qutenza to meet demand which would have a significant impact on our financial results and adversely impact any revenues we may derive from Qutenza. With respect to our product candidates, such factors could result in significant delay or suspension of clinical trials, regulatory submissions, or receipt of required approvals, all of which could significantly harm our business.

Because our third party manufacturers operate outside of the United States, and many of the raw materials and the labor that are used to manufacture Qutenza and our product candidates are based in foreign countries, we may experience currency exchange rate risks, even though, in some instances our contracts are denominated in U.S. dollars. We do not currently engage in forward contracts to hedge this currency risk and as a result, may suffer adverse financial consequences as a result of this currency risk.

Materials used by these entities to manufacture our product candidates originate outside the United States, including certain materials which may be sourced from China and India. The FDA has increased its diligence with regard to foreign-sourced materials and manufacturing processes. Increased FDA scrutiny of foreign manufacturers could result in delays in product availability, which could have a negative impact on our business.

Furthermore, because we are currently required to supply Qutenza to Astellas under the Supply Agreement, the foregoing risks to us related to supply of Qutenza and its components could also harm Astellas’ ability to commercialize Qutenza in the Licensed Territory. Whether we supply Qutenza to Astellas or Astellas enters into direct supply arrangements with our suppliers, Astellas’ ability to generate revenue and in turn our ability to generate royalty and sales-milestone revenue, would be impacted by these foregoing risks relating to manufacturing.

If we are unable to establish, maintain and grow an effective sales, marketing and distribution infrastructure or enter into collaborations with partners to perform these functions, we will not be successful in commercializing Qutenza or our product candidates.

In order to successfully commercialize Qutenza or any of our product candidates, we must devote sufficient resources to develop a capable sales, marketing and distribution infrastructure or enter into collaborations with partners to perform these services for us. We may be unable to devote the resources necessary to develop a suitable sales, marketing and distribution infrastructure. We have entered into the Astellas Agreement to market Qutenza in the Licensed Territory, and we may enter into additional partnering or other distribution arrangements for commercialization outside the United States. While we have a direct sales and marketing organization in the United States for commercializing Qutenza, we may explore the possibilities to enter into collaborations with partners for commercializing Qutenza in the United States. Our establishment of Astellas as our collaboration partner for the Licensed Territory could limit the potential collaboration options we have for the United States and other countries, or could render potential collaborators less inclined to enter into an agreement with us because of such relationship. Similarly, if we enter into an agreement with a collaboration partner in the United States, such agreement may negatively impact our ability to seek additional strategic relationships. Factors that may inhibit our efforts to develop an internal sales, marketing and distribution infrastructure and ability to commercialize our products successfully include:

•

lack of available financial resources;

•

our inability to recruit and retain adequate numbers of effective sales and marketing personnel;

•

the inability of sales personnel to obtain prescriber demand for our products;

•

the lack of complementary products to be offered by sales personnel, which may put us at a competitive disadvantage relative to companies with more extensive product lines; and

•

unforeseen costs and expenses associated with maintaining and expanding a sales and marketing organization.

We also may not be able to enter into collaborations on acceptable terms, if at all, and we may face competition in our search for partners with whom we may collaborate. If we are not able to maintain and expand an effective sales, marketing and distribution infrastructure, or collaborate with a partner to perform these functions, we may be unable to commercialize our product candidates successfully, which would adversely affect our business and financial condition.

Qutenza is distributed through a small network of third-party specialty distributors and specialty pharmacies and we rely on a single third party logistics partner; if any of the distributors are unable or unwilling to distribute Qutenza on commercially favorable terms, or at all, or if the third party logistics partner is unable or unwilling to perform its function, our business could be adversely affected.

We distribute Qutenza through a small network of third party specialty distributors and specialty pharmacies that generally sell, distribute or provide Qutenza to hospitals or healthcare professionals. All of our Qutenza shipments are through these distributors. In addition, we rely on a single third party logistics provider to manage our warehouse, packaging and shipping functions as well as certain customer and account administrative functions. Our business would be harmed if any of these distributors was unable or unwilling to distribute Qutenza or unable or unwilling to purchase Qutenza on commercially favorable terms to us. It is possible that distribution partners could decide to change their policies or fees, or both, in the future. This could result in their refusal to distribute smaller volume products, or cause higher product distribution costs, lower margins or the need to find alternative methods of distributing products. Such alternative methods may not exist or may not be economically viable.

Our success will depend, in part, on the successful efforts of our collaboration partner in the European Union, certain countries in Eastern Europe, the Middle East and Africa.

The success of sales of Qutenza in the Licensed Territory will be dependent on Astellas’ ability to successfully launch and commercialize Qutenza pursuant to the Astellas Agreement. The manner in which Qutenza is launched, including the timing of launch in each country of the European Union and the pricing that will be established in each such country, will have a significant impact on the ultimate success of Qutenza in the European Union, and ultimately the success of the overall commercial arrangement with Astellas. If commercial launch of Qutenza throughout the Licensed Territory is delayed or prevented, our revenues will suffer and our stock price will decline. Further, if sales of Qutenza are less than anticipated, our stock price will decline. The outcome of Astellas’ commercialization efforts could also have an effect on investors’ perception of potential sales of Qutenza in the United States, which could cause a decline in our stock price if such efforts are unsuccessful.

The Astellas Agreement provides for Astellas to be responsible for conducting certain studies for Qutenza in the European Union, both to satisfy post-marketing commitments that were made in conjunction with the Qutenza MA in the European Union and to carry out in support of Astellas’ commercialization plans for Qutenza in the Licensed Territory. The planning and execution of these studies will be primarily the responsibility of Astellas, and may not be carried out in accordance with our indicated preferences, or may yield results that are detrimental to Astellas’ sales of Qutenza in the Licensed Territory or detrimental in our efforts to develop or commercialize Qutenza outside the Licensed Territory, including in the United States. Together with Astellas, we may attempt to design such studies with a view toward having the resulting data be supportive of other regulatory and commercial efforts in both the European Union and the United States, such as potential label expansion studies that may be carried out with respect to use of Qutenza to treat pain associated with PDN. However, such studies may have limited or no utility to support such efforts and may negatively impact our revenues.

Within the Licensed Territory, regulatory approval for Qutenza has been obtained within the European Economic Area and Georgia. Other regulatory jurisdictions in the Licensed Territory may require further clinical and manufacturing activities to gain approval for sales of Qutenza in these countries. There can be no assurance that these activities will be successful and that approval in these countries will be obtained in a timely manner, if at all. Further, there can be no assurance that such clinical or manufacturing activities will not negatively impact the regulatory processes in the European Economic Area, United States or other markets where regulatory approval of Qutenza may have been obtained or may be in the process of being sought.

The Astellas Agreement requires us to expend resources in support of our commercial relationship with Astellas. Although we believe that our contractual arrangement with Astellas provides for reimbursement for many of these activities, the time and financial costs of managing such a relationship can be significant and may occur at a time when we are executing the commercialization of Qutenza in the United States.

The Supply Agreement we entered into in connection with the Astellas Agreement requires us to supply components of Qutenza to Astellas at the same cost we obtain such components from our third-party manufacturers. Because we have never overseen commercial manufacturing processes and quantities of these components, we may incur non-reimbursable costs related to manufacturing scale up, quality assurance and release, which could negatively impact our financial results. Such Supply Agreement also provides for Astellas to enter into direct supply relationships with our current suppliers to replace the need for us to provide Astellas with pass-through supply of Qutenza components. There can be no assurance that the establishment of such separate supply relationships will not negatively impact our ability to obtain our own supply of Qutenza components in support of our commercialization of Qutenza in the United States or other markets outside the Licensed Territory that we seek to commercialize.

The Astellas Agreement grants to Astellas an option to exclusively license our second generation product, NGX-1998. In connection with this option, we are required to execute a development plan for NGX-1998 and achieve certain objectives. After completion of an initial set of objectives, Astellas may make an additional payment to us to retain its option to license NGX-1998 until further agreed upon development of NGX-1998 has been performed by us. Upon completion of these objectives, Astellas may elect to make a final payment to us in order to exercise its option. If Astellas determines not to make one of these payments, the option to license NGX-1998 will expire, Astellas will not be required to provide further funding for NGX-1998, and we would be precluded from marketing NGX-1998 in the Licensed Territory for a period of time. If Astellas fails to exercise its options with respect to NGX-1998, we will be unable to generate revenues from potential sales of NGX-1998 in the Licensed Territory, and our business will be harmed.

Astellas’ commercialization of Qutenza in the Licensed Territory may result in lower levels of income to us than if we marketed Qutenza in the Licensed Territory on our own. Astellas may not fulfill its obligations or commercialize Qutenza as quickly as we would like. We could also become involved in disputes with Astellas, which could lead to delays in or termination of the Astellas Agreement and time-consuming and expensive litigation or arbitration. If Astellas terminates or breaches its agreement with us, or otherwise fails to complete its obligations in a timely manner, the chances of successfully developing or commercializing Qutenza in the Licensed Territory would be materially and adversely affected.

Qutenza will be subject to ongoing regulatory requirements and may face regulatory or enforcement action.

Any product candidate for which regulatory approval is obtained is subject to significant review and ongoing and changing regulation by the FDA, the EMA, and other regulatory agencies. These ongoing regulatory requirements may include, but are not limited to:

•

obtaining additional post-approval clinical study data;

•

regulatory review of advertising, promotional and education activities for the product;

•

establishment and monitoring of pharmacovigilance programs; and

•

periodic regulatory agency inspections and reviews of third-party manufacturing facilities and processes.

Failure to comply with regulatory requirements may subject us or our collaboration partner to administrative and judicially-imposed sanctions. These may include warning letters, adverse publicity, civil and criminal penalties, injunctions, product seizures or detention, product recalls, total or partial suspension of production, and refusal to approve pending product marketing applications.

Even if regulatory approval to market a particular product candidate is obtained, the approval could be conditioned on conducting additional costly post-approval studies or could limit the indicated uses included in such product’s labeling. For example, the Qutenza MA owned by Astellas in the European Union requires the conduct of certain post-authorization follow up measurers including ongoing evaluations of safety of Qutenza’s use in the labeled indications, as well as clinical evaluation in patients with PDN, although the timing of clinical evaluations in PDN has not yet been determined. Astellas did initiate a long term safety study in patients with PHN, HIV-AN and/or other painful peripheral neuropathies (excluding diabetics) in the third quarter of 2010. These studies, which are funded by Astellas pursuant to Astellas Agreement, may prove difficult and expensive to complete and their results may identify safety, efficacy or other issues related to Qutenza’s use that could hinder or prevent commercialization efforts. Moreover, the product may later be found in the course of these studies or through our pharmacovigilance programs to cause adverse effects that limit its use, force us or our partner to withdraw it from the market or impede or delay the ability to obtain regulatory approvals in additional countries.

We are subject to various regulations pertaining to the marketing of our products.

We are subject to various federal and state laws pertaining to healthcare fraud and abuse, including inducing, facilitating or encouraging submission of false claims to government programs and prohibitions on the offer of payment or acceptance of kickbacks or other remuneration for the purchase of Qutenza. Specifically, these anti-kickback laws make it illegal for a prescription drug manufacturer to solicit, offer, or pay any remuneration in exchange for purchasing, leasing or ordering any service or items including the purchase or prescription of a particular drug for which payment may be made under a federal healthcare program. Because of the sweeping language of the federal anti-kickback statute, many potentially beneficial business arrangements would be prohibited if the statute were strictly applied. To avoid this outcome, the U.S. Department of Health and Human Services has published regulations – known as “safe harbors” – that identify exceptions or exemptions to the statute’s prohibitions. Arrangements that do not fit within the safe harbors are not automatically deemed to be illegal, but must be evaluated on a case-by-case basis for compliance with the statute. We seek to comply with anti-kickback statutes and if necessary to fit within one of the defined “safe harbors”; we are unaware of any violations of these laws. However, due to the breadth of the statutory provisions and the absence of uniform guidance in the form of regulations or court decisions, there can be no assurance that our practices will not be challenged under anti-kickback or similar laws. Violations of such restrictions may be punishable by civil or criminal sanctions, including fines and civil monetary penalties, as well as the possibility of exclusion from U.S. federal healthcare programs (including Medicaid and Medicare). Any such violations could have a material adverse effect on our business, financial condition, results of operations and cash flows.

In addition, the FDA has the authority to regulate the claims we make in marketing our prescription drug products to ensure that such claims are true, not misleading, supported by scientific evidence and consistent with the labeled use of the drug. Failure to comply with FDA requirements in this regard could result in, among other things, warning letters, suspensions of approvals, seizures or recalls of products, injunctions against a product’s manufacture, distribution, sales and marketing, operating restrictions, civil penalties and criminal prosecutions. Any of these FDA actions could negatively impact our product sales and profitability.

We face potential product liability exposure, and if successful claims are brought against us, we may incur substantial liability and may have to limit our commercialization efforts for Qutenza or our development efforts with respect to our product candidates.

The use of our product candidates in clinical trials and the sale of Qutenza expose us to the risk of product liability claims. Product liability claims might be brought against us by consumers, health care providers, pharmaceutical companies or others selling our products. If we cannot successfully defend ourselves against these claims, we will incur substantial liabilities. Regardless of merit or eventual outcome, liability claims may result in:

•

decreased demand for our product candidates;

•

impairment of our business reputation;

•

costs of related litigation;

•

substantial monetary awards to patients or other claimants;

•

loss of revenues;

•

the inability to commercialize our product candidates; and

•

withdrawal of clinical trial participants.

Although we currently have product liability insurance coverage with limits that we believe are customary and adequate to provide us with coverage for foreseeable risks associated with our Qutenza commercialization or product candidate development efforts, our insurance coverage may not reimburse us or may be insufficient to reimburse us for the actual expenses or losses we may suffer. Moreover, in the future, we may not be able to maintain insurance coverage at a reasonable cost or in sufficient amounts to protect us against losses due to liability.

Our products are expected to face substantial competition which may result in others discovering, developing or commercializing products before or more successfully than us or our collaborators.

Qutenza competes against more established products marketed by large pharmaceutical companies with far greater name recognition and resources than we or Astellas have. The most directly-competitive currently-marketed products in the United States are Lidoderm, an FDA-approved 5% lidocaine topical patch for the treatment of PHN marketed by Endo Pharmaceuticals, and Lyrica, an oral anti-convulsant, marketed by Pfizer for use in the treatment of PHN. In January 2011, Depomed Inc. received FDA approval for Gralise, a formulation of gabapentin that is a once daily tablet for the treatment of PHN. In addition to these branded drugs, the FDA has approved gabapentin (Neurontin) for use in the treatment of PHN. Gabapentin is marketed by Pfizer and multiple generic manufacturers, and is the most widely-prescribed drug in the United States for treatment of neuropathic pain. Pfizer has also received FDA approval for Lyrica for the treatment of PDN, fibromyalgia, epilepsy and general anxiety disorder. Additionally, a number of products that are approved for other diseases are used by physicians to treat PHN.

Competition may become stronger and more direct and products in development, including products that we are unaware of, may compete with Qutenza. There are many other companies working to develop new drugs and other therapies to treat pain in general and neuropathic pain in particular, including Eli Lilly & Co, Pfizer, UCB Pharma SA, GlaxSmithKline plc, Merz, GW Pharmaceuticals, Novartis AG, Novo Nordisk A/S, Dainippon Pharmaceutical Co Ltd., AVANIR Pharmaceuticals, Xenoport, EpiCept, Newron Pharmaceuticals SpA, WEX Pharmaceuticals, Arcion Therapeutics Inc., Endo Pharmaceuticals, AstraZeneca plc, Bristol-Myers Squibb Co., Bio3 Research Srl, Relevare Pharmaceuticals Ltd., and Ortho-McNeil-Janssen Pharmaceuticals. Many of the compounds in development by such companies are already marketed for other indications, such as anti-depressants, anti-convulsants or opioids. In addition, physicians employ other interventional procedures, such as nerve stimulation or nerve blocks, to treat patients with difficult to treat neuropathic pain conditions.

Furthermore, new developments, including the development of other drug technologies and methods of preventing the incidence of disease, such as vaccines including Zostavax, occur in the biopharmaceutical industry at a rapid pace. Any of these developments may render our products or product candidates obsolete or noncompetitive.

Many of our potential competitors, either alone or together with their partners, have substantially greater financial resources, research and development programs, clinical trial and regulatory experience, expertise in prosecution of intellectual property rights, and manufacturing, distribution and sales and marketing capabilities than we and Astellas do. As a result of these factors, our competitors may:

•

initiate or withstand substantial price competition more successfully;

•

have greater success in recruiting skilled scientific workers from the limited pool of available talent;

•

more effectively negotiate third-party licenses and strategic alliances;

•

take advantage of acquisition or other opportunities more readily than we can; and

•

develop product candidates and market products that are less expensive, safer, more effective or involve more convenient treatment procedures than our current and future products.

The life sciences industry is characterized by rapid technological change. If we fail to stay at the forefront of technological change our products may be unable to compete effectively.

The efforts of government entities and third party payers to contain or reduce the costs of health care may adversely affect our sales and limit the commercial success of our products.

In certain foreign markets, pricing or profitability of pharmaceutical products is subject to various forms of direct and indirect governmental control, including the control over the amount of reimbursements provided to the patient who is prescribed specific pharmaceutical products.

In the United States, there have been, and we expect there will continue to be, various proposals to implement similar controls. For example, the health care reform act passed in March 2010, increased the rebate levels for pharmaceutical products sold to Medicaid patients by eight percent. The commercial success of our products could be limited if federal or state governments adopt any such proposals. In addition, in the United States and elsewhere, sales of pharmaceutical products depend in part on the availability of reimbursement to the consumer from third party payers, such as government and private insurance plans. These third party payers are increasingly utilizing their significant purchasing power to challenge the prices charged for pharmaceutical products and seek to limit reimbursement levels offered to consumers for such products. We expect these third party payers to focus their cost control efforts on our products, especially with respect to prices of and reimbursement levels for products prescribed outside their labeled indications. In these cases, their efforts may negatively impact our product sales and profitability.

We may not be able to maintain orphan drug exclusivity for Qutenza in PHN and HIV-AN or obtain orphan designation in additional indications or product candidates.

We rely, in part, on the market exclusivity afforded orphan drugs for the commercialization of Qutenza in the United States. The FDA has granted us orphan drug status with regard to Qutenza for the management of neuropathic pain in patients with PHN and as a consequence, Qutenza is entitled to orphan exclusivity—

that is, for seven years, the FDA may not approve any other applications to market the same drug for the same indication, except in very limited circumstances. Additionally, the FDA has granted us orphan drug status for HIV-AN, an indication for which we currently do not have an FDA-approved product. We may be unable to obtain orphan drug designations for any additional product candidates or exclusivity for any future product candidates or our potential competitors may obtain orphan drug exclusivity for capsaicin-based products competitive with our product candidates in indications other than PHN before we do, in which case we may be excluded from that market for the exclusivity period. In addition, orphan drug designation previously granted may be withdrawn under certain circumstances. Even if we obtain orphan drug exclusivity for any of our product candidates, we may not be able to maintain it if a competitive product based on the same active compound is shown to be clinically superior to our product. Although obtaining FDA approval to market a product with orphan exclusivity can be advantageous, there can be no assurance that it would provide us with a significant commercial advantage.

The Hatch-Waxman Act data exclusivity and any equivalent regulatory data exclusivity protection in other jurisdictions for Qutenza, may not prevent new competition which may negatively impact our financial results.

The Hatch-Waxman Act provides five years of data exclusivity to the first applicant to gain approval of an NDA under Section 505(b) of the Food, Drug and Cosmetic Act for a new chemical entity. Qutenza has been recognized by the FDA as a new chemical entity and therefore has been granted five year data exclusivity under the Hatch-Waxman Act. Hatch-Waxman provides data exclusivity by prohibiting abbreviated new drug applications, or ANDAs, and 505(b)(2) applications, which are marketing applications where the applicant does not own or have a legal right of reference to all the data required for approval, to be submitted by another company for another version of such drug during the exclusivity period. Protection under Hatch-Waxman will not prevent the filing or approval of a full NDA under Section 505(b)(1) for the same active ingredient, although the applicant would be required to conduct its own adequate and well-controlled clinical trials to demonstrate safety and effectiveness.

Even though Qutenza has been granted five year Hatch-Waxman data exclusivity in the United States and ten-year market exclusivity which may be extended to eleven-year market exclusivity upon meeting certain criteria and eight-year data exclusivity by the EMA, there can be no assurance that the exclusivity granted will effectively prevent competition, either generic or otherwise. Such competition could significantly harm our business.

Our “fast track” designation for development of Qutenza for management of pain associated with HIV-associated neuropathy may not actually lead to a faster development or regulatory review or approval process.

A product intended for the treatment of a serious or life-threatening condition that demonstrates the potential to address unmet medical needs for such a condition may be submitted to the FDA for “fast track” designation. Although we received fast track designation from the FDA for Qutenza for the treatment of HIV-AN, and the indication is eligible for priority review, there is no assurance when we file an sNDA for Qutenza in HIV-AN that we will experience a faster development process, review process or approval, compared to conventional FDA standards, or that the product will be approved for such indication at all. We plan to submit the supplemental NDA in 2011, however, we may find no benefit in the fast track designation afforded the HIV-AN indication.

Our clinical trials may fail to demonstrate adequately the safety and efficacy of our product candidates, which could prevent or delay regulatory approval and commercialization.

Before obtaining regulatory approvals for the commercial sale of our product candidates, we must demonstrate through lengthy, complex and expensive preclinical testing and clinical trials that the product is

both safe and effective for use in each target indication. Clinical trial results from the study of neuropathic pain are inherently difficult to predict. The primary measure of pain is subjective patient feedback, which can be influenced by factors outside of our control, and can vary widely from day to day for a particular patient, and from patient to patient and site to site within a clinical study. The results we have obtained in completed clinical trials may not be predictive of results from our ongoing or future trials. Additionally, we may suffer significant setbacks in advanced clinical trials, even after promising results in earlier studies.

Some of our trial results have been negatively affected by factors that had not been fully anticipated prior to our examination of the trial results. For example, we have from time to time observed a significant “placebo effect” within our control groups—a phenomenon in which a sham treatment or, in the case of our studies, a low-dose capsaicin treatment that we believed would not be effective, results in a beneficial effect. Although we design our clinical study protocols to address known factors that may negatively affect our study results, there can be no assurance that our protocol designs will be adequate or that factors that we may or may not be aware of or anticipate, will not have a negative effect on the results of our clinical trials, which could significantly disrupt our efforts to obtain regulatory approvals and commercialize our product candidates. Furthermore, once a study has commenced, we may voluntarily suspend or terminate our clinical trials if at any time we believe that they present an unacceptable safety risk to patients. However, clinical trials in other indications or in a larger patient population could reveal more frequent, more severe or additional side effects that were not seen or deemed unrelated in earlier studies, any of which could interrupt, delay or halt clinical trials of our product candidates and could result in the FDA or other regulatory authorities stopping further development of or denying approval of our product candidates. Based on results at any stage of clinical trials, we may decide to repeat or redesign a trial, modify our regulatory strategy or even discontinue development of one or more of our product candidates.

A number of companies in the biotechnology and pharmaceutical industries have suffered significant setbacks in advanced clinical trials, even after obtaining promising results in earlier trials. If our product candidates are not shown to be both safe and effective in clinical trials, the resulting delays in developing other compounds and conducting associated preclinical testing and clinical trials, as well as the potential need for additional financing, would have a material adverse effect on our business, financial condition and results of operations.

Even though certain of our clinical trials for Qutenza met their primary endpoints, certain other studies have not met their primary endpoints, and if we or our collaborator decide to conduct clinical trials for indications in which our prior clinical trials did not meet their endpoints the new trials may similarly not succeed, which would adversely impact our long term success.

We have not prepared for or conducted any Qutenza clinical trials for indications other than PHN, HIV-AN and PDN. Generally, two successful Phase 3 clinical trials are required to obtain regulatory approval in the U.S. We have conducted two Phase 3 clinical trials with Qutenza for patients with HIV-AN, one of which met its primary endpoint and one which did not meet its primary endpoint. Based on the regulatory process to date, we believe the data we have from the two Phase 3 clinical trials may be sufficient to gain approval for the HIV-AN indication. However, given that only one HIV-AN controlled study met its primary endpoint and that the pre-specified analysis plan in that study did not allow for examination of the recommended dose, the FDA may not accept the data submitted as sufficient for approval of the HIV-AN indication. If the sNDA is not approved, Qutenza will not be marketable for this indication in the United States and this may harm our ability to generate revenue. We have also conducted one Phase 2 clinical trial that evaluated the use of Qutenza in patients with PDN. PDN represents a much larger market opportunity than either PHN or HIV-AN, and unless required clinical trials are successfully completed and regulatory approvals are obtained for the use of Qutenza for PDN patients, Qutenza will not be marketable for this indication in the United States and the European Union and possibly in other countries. If this occurs, our long-term ability to succeed may be significantly and negatively impacted. We believe that to market Qutenza in the United States for PDN, we

may have to conduct two successful Phase 3 trials and we may be required to perform additional safety studies. We are evaluating development programs for Qutenza in PDN and may decide not to conduct studies in PDN beyond those that may be required by post-marketing requirements associated with the MA. If we do not have a sufficient number of successful studies in or have sufficient data to demonstrate the safety or efficacy in PDN, we may not gain approval for Qutenza in this indication, which will significantly harm our ability to potentially generate revenue.

Results of clinical trials of Qutenza for patients with PHN or HIV-AN do not necessarily predict the results of clinical trials involving other indications. If additional clinical studies are conducted with Qutenza in PDN or other indications, those studies may fail to show desired safety and efficacy for management of pain associated with PDN and other indications, despite results from earlier clinical trials involving PDN, PHN and/or HIV-AN.

Any failure or significant delay in completing clinical trials for Qutenza with PDN and other indications, or in receiving regulatory approval involving such indications, may significantly harm our business.

Delays in the commencement or completion of clinical testing could result in increased costs to us and delay our ability to generate revenues.

We do not know whether future clinical trials will begin on time or be completed on schedule, if at all. The commencement and completion of clinical trials can be disrupted for a variety of reasons, including difficulties in:

•

availability of financial resources;

•

addressing issues that could be raised by the FDA or European or other national health authorities regarding safety, design, scope and objectives of future clinical studies;

•

recruiting and enrolling patients to participate in a clinical trial;

•

obtaining regulatory or Institutional Review Board/Ethics Committee approval to commence a clinical trial;

•

reaching agreement on acceptable terms with prospective clinical research organizations and trial sites;

•

manufacturing sufficient quantities of a product candidate; and

•

obtaining institutional review board approval to conduct a clinical trial at a prospective site.

A clinical trial may also be suspended or terminated by the entity conducting the trial (us or Astellas, as the case may be), the FDA or other regulatory authorities due to a number of factors, including:

•

failure to conduct the clinical trial in accordance with regulatory requirements or in accordance with clinical protocols;

•

inspection of the clinical trial operations or trial site by the FDA or other regulatory authorities resulting in the imposition of a clinical hold;

•

unforeseen safety issues; or

•

inadequate patient enrollment or lack of adequate funding to continue the clinical trial.

In addition, changes in regulatory requirements and guidance may occur and may cause a need to amend clinical trial protocols to reflect these changes, which could impact the cost, timing or successful completion of a clinical trial. If delays are experienced in the commencement or completion of a clinical trial, the commercial prospects for our products or product candidates and our ability to generate product revenues may be harmed. Many of the factors that cause, or lead to, a delay in the commencement or completion of clinical trials may also lead to the denial or revocation of regulatory approval of a product or product candidate.

We rely on third parties to conduct our non-clinical studies and clinical trials. If these third parties do not perform as contractually required or otherwise expected, we may not be able to obtain regulatory approval for our product candidates.

We do not currently conduct non-clinical studies and clinical trials on our own, and instead rely on third parties, such as contract research organizations, medical institutions, clinical investigators and contract laboratories, to assist us with our non-clinical and clinical trials. We are also required to comply with regulations and standards, commonly referred to as good clinical practices and good laboratory practices, for conducting, recording and reporting the results of non-clinical and clinical trials to assure that data and reported results are credible and accurate and that the trial participants are adequately protected. If these third parties do not successfully meet their regulatory obligations, meet expected deadlines, or if the quality or accuracy of the data they obtain is compromised due to the failure to adhere to our clinical protocols or regulatory requirements or for other reasons, our non-clinical development activities or clinical trials may be extended, delayed, suspended, terminated, or potentially may be required to be performed again. Any of these factors may result in significant delay or failure to obtain regulatory approval for our product candidates.

We depend on our key personnel. If we are not able to retain them, our business will suffer.

We are highly dependent on the principal members of our management and scientific staff. The competition for skilled personnel among biopharmaceutical companies in the San Francisco Bay Area is intense and the employment services of our scientific, management and other executive officers are terminable at-will. If we lose one or more of these key employees, our ability to implement and execute our business strategy successfully could be seriously harmed. Replacing key employees may be difficult and may take an extended period of time because of the limited number of individuals in our industry with the breadth of skills and experience required to develop, gain regulatory approval of and commercialize products successfully. For example, on April 29, 2011, we announced the planned retirement of Anthony DiTonno, our President and Chief Executive Officer, by December 31, 2011. We initiated a formal executive search for a Chief Executive Officer, however there can be no assurance that our search will be successful in identifying a proper candidate, that a candidate will accept the position on terms acceptable to us or how long such a search will take to perform. We do not carry key man life insurance on any of our key personnel.

Risks Related to Our Finances and Capital Requirements

We have incurred operating losses in each year since inception and expect to continue to incur substantial and increasing losses for the foreseeable future.

We have incurred operating and net losses each year since our inception in 1998. Our net loss for the quarter ended March 31, 2011 was approximately $13.4 million and as of March 31, 2011 we had an accumulated deficit of approximately $269.9 million. We had cash, cash equivalents and short-term investments totaling $34.7 million at March 31, 2011, and for the quarter ended March 31, 2011, we used cash of approximately $11.8 million in operating activities. We expect to continue to incur losses for several years, as we commercialize Qutenza and continue other research and development activities. If Qutenza does not achieve market acceptance in the United States or the European Union, we will not generate significant product related revenue. We cannot assure you that we will be profitable even if Qutenza is successfully commercialized. If we fail to achieve and maintain profitability, or if we are unable to fund our continuing losses, you could lose all or part of your investment.

If we do not raise additional capital, we may be forced to delay, reduce or eliminate our commercialization efforts or development programs.

Our future capital requirements will depend on, and could increase significantly as a result of many factors, including:

•

the success of the commercialization of our products and the amount of revenue we generate;

•

the costs of establishing, maintaining and expanding sales and marketing infrastructure, distribution capabilities and a sales force and other market support functions such as medical affairs and pharmacovigilance;

•

the conduct of manufacturing activities including the manufacture of commercial product supply and clinical product supply;

•

the costs of carrying out our obligations under our commercial arrangement with Astellas;

•

our ability to establish and maintain strategic collaborations, including licensing, distribution and other arrangements that we have or may establish;

•

our ability to meet our obligation under the Financing Agreement with Cowen Royalty including liquidity maintenance requirements;

•

the progress of our development programs including the number, size and scope of clinical trials and non-clinical development;

•

the costs and timing of additional regulatory approvals;

•

the costs involved in enforcing or defending patent claims or other intellectual property rights; and

•

the extent to which we acquire or invest in other products, technologies and businesses.

We intend to seek additional funding through strategic alliances and/or debt facilities or other financing vehicles which may include the public or private sales of our equity securities. There can be no assurance, however, that additional funding will be available on reasonable terms, if at all. If adequate funds are not available, we may be required to further delay, reduce the scope of, or eliminate one or more of our planned development, commercialization or expansion activities.

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

To the extent that we raise additional capital by issuing equity securities, our existing stockholders’ ownership will be diluted. Royalty monetization structures may require us to give up or assign certain rights to certain current and future assets. Any debt financing we enter into may involve covenants that restrict our operations. These restrictive covenants may include limitations on additional borrowing and specific restrictions on the use of our assets, as well as prohibitions on our ability to create liens, pay dividends, redeem our stock or make investments. In addition, if we raise additional funds through licensing arrangements, it may be necessary to relinquish potentially valuable rights to our potential products or proprietary technologies, or grant licenses on terms that are not favorable to us.

Failure to meet our loan obligation with Cowen Royalty could adversely affect our financial condition.

Under the terms of our Financing Agreement with Cowen Royalty, we are obligated to pay Cowen Royalty, substantially all of the payments that may be due to us under the Astellas Agreement, until Cowen Royalty has received $90 million of such payments; and thereafter 5% of the Astellas Agreement payments until Cowen Royalty has received $106 million of such payments.

Our obligation to pay these payments during the term of the financing Agreement is secured under a security agreement by rights that we have to the revenue interests under the Astellas Agreement, and by intellectual property and our other rights to the extent necessary or used to commercialize products covered by the Astellas Agreement in the Licensed Territory.

Because these obligations will in the near term divert all revenues that we may receive under the Astellas Agreement, our financial position and ability to continue operations would be adversely impacted if we required further capital, even if Astellas was successfully commercializing our products in the Licensed Territory. Furthermore, the arrangement under the Financing Agreement may make us less attractive to potential acquirers, and in the event that we exercised our change of control pay-off option to terminate the Financing Agreement in order to carry out a change of control, the payment of such funds out of our available cash or acquisition proceeds would reduce acquisition proceeds for our stockholders.

In addition, if we were to default under the Financing Agreement with Cowen Royalty we are obligated to immediately pay to Cowen Royalty the borrowed amount together with interest accrued thereon from the effective date of the Financing Agreement to the date of repayment at an internal rate of return equal to the lesser of the 19% rate of interest or the maximum rate permitted by law, less any Revenue Interest payments received by Cowen Royalty. Under the Financing Agreement, an event of default includes standard insolvency and bankruptcy terms, including a failure to maintain liquid assets equal to at least our liabilities due and payable during the following three months. If we were required to pay the amounts due under a default to Cowen Royalty, we would be required to find an alternate source of capital from which to draw funds and there can be no assurances that we would be able to do so.

Risks Related to our Intellectual Property

The commercial success, if any, of Qutenza depends, in part, on the rights we have under certain patents.

The commercial success, if any, of Qutenza depends, in part, on a patent granted in the United States and device patents granted in Canada, Hong Kong and certain countries of Europe concerning the use of a dermal delivery system for prescription strength capsaicin delivery for the treatment of neuropathic pain. We exclusively license these patents from the University of California. We do not currently own, and do not have rights under this license to any issued patents that cover Qutenza outside Europe, Hong Kong, Canada and the United States. Although we have filed for an extension of the term for one of the patents licensed from the University of California, there can be no assurance that such extension will be granted.

In addition to other patents and patent applications which have been licensed under our agreements with third party manufacturers, including the issued patents and pending applications licensed under our commercial supply agreement for Qutenza, we also license a method patent granted in the United States from the University of California concerning the delivery of prescription strength capsaicin for the treatment of neuropathic pain. Two of the three inventors named in the method patent did not assign their patent rights to the University of California. These two inventors asserted a claim of inventorship rights to the device patent. In late 2010, we entered into negotiations with these inventors to settle any and all claims and to have them assign their rights related to the method patent and any other related patent rights that may exist at the time we enter into a final binding settlement agreement. We anticipate that any settlement will include us making a cash payment and us issuing stock or stock options to them. The absence of exclusive rights to utilize such patent exposes us to a greater risk of direct competition and could materially harm our business.

If we are unable to maintain and enforce our proprietary rights, we may not be able to compete effectively or operate profitably.

Our commercial success will depend, in part, on obtaining and maintaining patent protection, trade secret protection and regulatory protection (such as Hatch-Waxman protection or orphan drug designation) of our proprietary technology and information as well as successfully defending against third-party challenges to our proprietary technology and information. We will be able to protect our proprietary technology and information from use by third parties only to the extent that valid and enforceable patents, trade secrets or regulatory protection cover them and we have exclusive rights to utilize them.

Our commercial success will continue to depend in part on the patent rights we own, the patent rights we have licensed, the patent rights of our collaborators and suppliers and the patent rights we may obtain related to future products we may market. Our success also depends on our and our licensors’, collaborators’ and suppliers’ ability to maintain these patent rights against third-party challenges to their validity, scope or enforceability. Further, we do not fully control the patent prosecution of our licensed patent applications. There is a risk that our licensors will not devote the same resources or attention to the prosecution of the licensed patent applications as we would if we controlled the prosecution of the patent applications, and the resulting patent protection, if any, may not be as strong or comprehensive as if we had prosecuted the applications ourselves.

The patent positions of biopharmaceutical companies can be highly uncertain and involve complex legal and factual questions for which important legal principles remain unresolved. No consistent policy regarding the breadth of claims allowed in such companies’ patents has emerged to date in the United States. The patent situation outside the United States is even more uncertain. Changes in either the patent laws or in interpretations of patent laws in the United States or other countries may diminish the value of our intellectual property. Accordingly, we cannot predict the breadth of claims that may be allowed or enforced in our patents or in third-party patents. For example:

•

we or our licensors might not have been the first to make the inventions covered by each of our pending patent applications and issued patents;

•

we or our licensors might not have been the first to file patent applications for these inventions;

•

others may independently develop similar or alternative technologies or duplicate any of our technologies;

•

it is possible that none of our pending patent applications or the pending patent applications of our licensors will result in issued patents;

•

our issued patents and the issued patents of our licensors may not provide a basis for commercially viable products, or may not provide us with any competitive advantages, or may be challenged and invalidated by third parties;

•

we may not develop additional proprietary technologies or product candidates that are patentable; or

•

the patents of others may have an adverse effect on our business.

We also rely on trade secrets to protect our technology, especially where we do not believe patent protection is appropriate or obtainable. However, trade secrets are difficult to protect. While we seek to protect confidential information, in part, by confidentiality agreements with our employees, consultants, contractors, or scientific and other advisors, they may unintentionally or willfully disclose our information to competitors. If we were to enforce a claim that a third party had illegally obtained and was using our trade secrets, it would be expensive and time consuming, and the outcome would be unpredictable. In addition, courts outside the United States are sometimes less willing to protect trade secrets.

If we are not able to defend the patent or trade secret protection position of our technologies and product candidates, then we will not be able to exclude competitors from developing or marketing competing products, and we may not generate enough revenue from product sales to justify the cost of development of our product candidates and to achieve or maintain profitability.

If we are sued for infringing intellectual property rights of other parties, such litigation will be costly and time consuming, and an unfavorable outcome would have a significant adverse effect on our business.

Although we believe that we would have valid defenses to allegations that our current product candidates, production methods and other activities infringe the valid and enforceable intellectual property rights of any third parties of which we are aware, we cannot be certain that a third party will not challenge our position in the future. Other parties may own patent or other intellectual property rights that might be infringed by our products, trademarks or activities. There has been, and we believe that there will continue to be, significant litigation and demands for licenses in our industry regarding patent and other intellectual property rights. Our competitors or other patent or intellectual property holders may assert that our products or trademarks and the methods we employ are covered by their intellectual property rights. For example, in 2009 we received a letter indicating a possible trademark conflict for Qutenza from a company claiming that our trademark was similar to theirs. While we believe that these assertions do not have merit and that we have defenses to them, there can be no assurance that we will be successful in defending our trademark. We intend to continue to use the Qutenza trademark and to vigorously defend our use of such trademark against such assertions. These parties could bring claims against us that would cause us to incur substantial expenses and, if successful against us, could cause us to pay substantial damages or possibly prevent us from commercializing our product candidates using the Qutenza trademark which would have a significant negative effect on the Qutenza launch and global commercialization efforts. Further, if a patent infringement suit were brought against us, we could be forced to stop or delay research, development, manufacturing or sales of the product or product candidate that is the subject of the suit, or if a trademark infringement suit were brought against us or our collaboration partner Astellas, we or Astellas could be forced to cease using the name Qutenza in connection with our product.

As a result of intellectual property infringement claims, or in order to avoid potential claims, we may choose to seek, or be required to seek, a license from the third party and would most likely be required to pay license fees or royalties or both. These licenses may not be available on acceptable terms, or at all. Even if we were able to obtain a license, the rights may be non-exclusive, which would give our competitors access to the same intellectual property. Ultimately, we could be prevented from commercializing a product, or be forced to cease some aspect of our business operations if, as a result of actual or threatened infringement claims, we or our collaborators are unable to enter into licenses on acceptable terms. This could harm our business significantly.

We may incur substantial costs as a result of litigation or other proceedings relating to patent and other intellectual property rights.

The cost to us of any litigation or other proceedings relating to intellectual property rights, even if resolved in our favor, could be substantial. Some of our potential competitors, other patent or intellectual property holders may be better able to sustain the costs of complex patent litigation because they have substantially greater resources. Uncertainties resulting from the initiation and continuation of any litigation could have a material adverse effect on our ability to continue our operations. Should third parties file patent applications, or be issued patents claiming technology also claimed by us in pending applications, we may be required to participate in interference proceedings in the U.S. Patent and Trademark Office to determine priority of invention which could result in substantial costs to us or an adverse decision as to the priority of our inventions. An unfavorable outcome in an interference proceeding could require us to cease using the technology or to license rights from prevailing third parties. There is no guarantee that any prevailing party would offer us a license or that we could acquire any license made available to us on commercially acceptable terms.

If we fail to comply with our obligations in the agreements under which we license development or commercialization rights to products or technology from third parties, we could lose license rights that are important to our business.

We are a party to a number of technology licenses that are important to our business and expect to enter into additional licenses in the future. For example, we hold licenses from The University of California and LTS under patents and patent applications relating to Qutenza. These licenses impose various commercialization, milestone payment, royalty, insurance and other obligations on us. If we fail to comply with these obligations, the licensor may have the right to terminate the license, in which event we would not be able to market products covered by the license, including Qutenza.

We may be subject to damages resulting from claims that our employees or we have wrongfully used or disclosed alleged trade secrets of their former employers.

Many of our employees were previously employed at universities or other biotechnology or pharmaceutical companies, including our competitors or potential competitors. Although no claims against us are currently pending, we may be subject to claims that these employees or we have inadvertently or otherwise used or disclosed trade secrets or other proprietary information of their former employers. Litigation may be necessary to defend against these claims. If we fail in defending such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights or personnel. A loss of key research personnel or their work product could hamper or prevent our ability to commercialize certain potential products, which could severely harm our business. Even if we are successful in defending against these claims, litigation could result in substantial costs and be a distraction to management.

Risks Related to an Investment in our Common Stock

We expect that our stock price will fluctuate significantly, and you may not be able to resell your shares at or above your investment price.

The stock market has experienced significant volatility, particularly with respect to pharmaceutical, biotechnology and other life sciences company stocks. The volatility of pharmaceutical, biotechnology and other life sciences company stocks often does not relate to the operating performance of the companies represented by the stock. Factors that could cause volatility in the market price of our common stock include, but are not limited to:

•

failure to meet market expectations with respect to the launch of Qutenza by us in the United States and by Astellas in the European Union;

•

inability of us and Astellas to successfully commercialize Qutenza in the United States and the Licensed Territory, respectively;

•

potential inability to preserve or raise sufficient capital to maintain our operations;

•

potential negative stock market reaction in the event we raise or attempt to raise additional equity capital;

•

failure to meet revenue estimates and revenue growth rates;

•

actual or anticipated quarterly variations in our results of operations or those of our collaborators or competitors;

•

third-party healthcare reimbursement policies or determinations;

•

product recalls, reported incidents of unanticipated adverse effects with respected to Qutenza, or other negative publicity related to Qutenza;

•

general economic conditions and slow or negative growth of our expected markets;

•

delay in entering, or termination of, strategic partnership relationships;

•

our ability to meet our obligation under the Financing Agreement with Cowen Royalty including liquidity maintenance requirements;

•

failure or delays in entering additional product candidates into clinical trials or in commencing additional clinical trials for current product candidates;

•

results from and any delays related to the clinical trials for our product candidates;

•

our ability to develop and market new and enhanced product candidates on a timely basis;

•

announcements by us or our collaborators or competitors of new commercial products, clinical progress or the lack thereof, significant contracts, commercial relationships or capital commitments;

•

issuance of new or changed securities analysts’ reports or recommendations for our stock or the discontinuation of one or more securities analysts’ research coverage for our stock;

•

inclusion in or removal from stock indices such as the Russell 3000;

•

developments or disputes concerning our intellectual property or other proprietary rights;

•

commencement of, or our involvement in, litigation;

•

changes in governmental statutes or regulations or in the status of our regulatory approvals;

•

market conditions in the life sciences sector; and

•

any major change in our board or management.

If the ownership of our common stock continues to be highly concentrated, it may prevent you and other stockholders from influencing significant corporate decisions and may result in conflicts of interest that could cause our stock price to decline.

Our executive officers, directors and their affiliates and 5% stockholders beneficially own or control approximately 60% of the outstanding shares of our common stock as of March 31, 2011 (after giving effect to the exercise of all of their outstanding vested options and warrants exercisable within 60 days of such date). Accordingly, these executive officers, directors and their affiliates and significant stockholders acting as a group, will have substantial influence over the outcome of corporate actions requiring stockholder approval, including the election of directors, any merger, consolidation or sale of all or substantially all of our assets or any other significant corporate transactions. These stockholders may also delay or prevent a change of control of us, even if such a change of control would benefit our other stockholders. The significant concentration of stock ownership may adversely affect the trading price of our common stock due to investors’ perception that conflicts of interest may exist or arise.

Future sales of shares by existing stockholders could cause our stock price to decline.

The market price of our common stock could decline as a result of sales by our existing stockholders of shares of common stock in the market, or the perception that these sales could occur. In particular, the significant concentration of stock ownership may adversely affect the trading price of our common stock in the event that certain large stockholders elect to sell the shares of our common stock held by them. These sales might also make it more difficult for us to sell equity securities at a time and price that we deem appropriate.

If we fail to meet the requirements for continued listing on the NASDAQ Global Market and do not meet initial listing requirements to transfer to the NASDAQ Capital Market, our common stock could be delisted from trading, which would adversely affect the liquidity of our common stock and our ability to raise additional capital.

Our common stock is currently listed on the NASDAQ Global Market and to maintain our listing, we must meet certain financial requirements in accordance with the rules of the NASDAQ Stock Market LLC, or Nasdaq. Although we have maintained our listing status on the NASDAQ Global Market since our initial listing on May 2, 2007, there can be no assurance that we will maintain our listing on this market in the future.

If we are delisted from the NASDAQ Global Market, we can apply to be listed on the NASDAQ Capital Market or other exchanges, which generally have lower standards for listing. Any potential delisting of our common stock would adversely affect the liquidity of our common stock and our ability to raise additional capital.

We will continue to incur increased costs and demands upon management as a result of complying with the laws and regulations affecting public companies, which could affect our operating results.

As a public company, we will continue to incur significant legal, accounting and other expenses that we did not incur as a private company, including costs associated with public company reporting requirements. We also have incurred and will incur costs associated with corporate governance requirements, including requirements under the Sarbanes-Oxley Act of 2002, the Dodd-Frank Act of 2010, as well as new rules implemented by the Securities and Exchange Commission and the NASDAQ Stock Market LLC. We expect these rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly.

Anti-takeover provisions in our charter documents and under Delaware law could make an acquisition of us, which may be beneficial to our stockholders, more difficult and may prevent attempts by our stockholders to replace or remove our current management.

Provisions in our certificate of incorporation and bylaws may delay or prevent an acquisition of us or a change in our management. These provisions include a classified board of directors, a prohibition on actions by written consent of our stockholders and the ability of our board of directors to issue preferred stock without stockholder approval. In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which prohibits stockholders owning in excess of 15% of our outstanding voting stock from merging or combining with us. Although we believe these provisions collectively provide for an opportunity to receive higher bids by requiring potential acquirers to negotiate with our board of directors, they would apply even if the offer may be considered beneficial by some stockholders. In addition, these provisions may frustrate or prevent any attempts by our stockholders to replace or remove our current management by making it more difficult for stockholders to replace members of our board of directors, which is responsible for appointing the members of our management.

Events in the credit markets have, and will continue to, impact our investment returns.

As a result of events in the credit markets, we maintain an investment portfolio of primarily U.S. Treasury securities. As a result of the credit crisis and our shift in investments, we anticipate that our investment returns will be below our historic rates of return. These lower returns will likely continue for some time and we cannot predict when market conditions will improve and when higher yielding investment options may be available to us.

We have never paid dividends on our capital stock, and we do not anticipate paying any cash dividends in the foreseeable future.

We have paid no cash dividends on any of our classes of capital stock to date, have contractual restrictions against paying cash dividends and currently intend to retain our future earnings to fund the development and growth of our business. As a result, capital appreciation, if any, of our common stock will be an investor’s sole source of gain for the foreseeable future.

ITEM 2.

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

ITEM 3.

DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4.

[REMOVED AND RESERVED]

ITEM 5.

OTHER INFORMATION

None.

ITEM 6.

EXHIBITS


Exhibit Number		Exhibit Title
3.1(1)		Amended and Restated Certificate of Incorporation.

3.2(1)		Amended and Restated Bylaws.

4.1(1)		Specimen Common Stock Certificate.

4.2(1)		Third Amended and Restated Investors’ Rights Agreement by and between NeurogesX, Inc. and certain stockholders, dated as of November 14, 2005.

4.3(2)		Amendment No. 1 to the Third Amended and Restated Investors’ Rights Agreement by and between NeurogesX, Inc. and certain stockholders, dated as of December 28, 2007.

4.4(1)		Warrant to Purchase Series A Preferred Stock by and between NeurogesX, Inc. and Silicon Valley Bank, dated as of December 14, 2000.

4.5(1)		Warrant to Purchase Series B Preferred Stock by and between NeurogesX, Inc. and Silicon Valley Bank, dated as of May 1, 2002.

4.6(1)		Warrant to Purchase Shares of Series C2 Preferred Stock by and between NeurogesX, Inc. and Horizon Technology Funding Company II LLC, dated as of July 7, 2006.

4.7(1)		Warrant to Purchase Shares of Series C2 Preferred Stock by and between NeurogesX, Inc. and Horizon Technology Funding Company III LLC, dated as of July 7, 2006.

4.8(1)		Warrant to Purchase Shares of Series C2 Preferred Stock by and between NeurogesX, Inc. and Oxford Finance Corporation, dated as of July 7, 2006.

4.9(1)		Form of First Warrant to Purchase Series C2 Preferred Stock.

4.10(1)		Form of Second Warrant to Purchase Series C2 Preferred Stock.

4.11(2)		Registration Rights Agreement by and between NeurogesX, Inc. and certain investors, dated as of December 23, 2007.

4.12(2)		Form of Warrant to Purchase Common Stock.

31.1		Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certifications of the Principal Executive Officer and the Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350).

(1)	Incorporated by reference from our registration statement on Form S-1, registration number 333-140501, declared effective by the Securities and Exchange Commission on May 1, 2007.

(2)	Incorporated by reference from our Current Report on Form 8-K, filed with the Securities and Exchange Commission on December 28, 2007.

SIGNATURES

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


Dated: May 9, 2011				NEUROGESX, INC.
				(Registrant)

				/s/ Anthony A. DiTonno
				Anthony A. DiTonno
				President and Chief Executive Officer
				(Principal Executive Officer)

				/s/ Stephen F. Ghiglieri
				Stephen F. Ghiglieri
				Executive Vice President, Chief Operating Officer and Chief Financial Officer
				(Principal Financial and Accounting Officer)

EXHIBIT INDEX


Exhibit Number		Exhibit Title
3.1(1)		Amended and Restated Certificate of Incorporation.

3.2(1)		Amended and Restated Bylaws.

4.1(1)		Specimen Common Stock Certificate.

4.2(1)		Third Amended and Restated Investors’ Rights Agreement by and between NeurogesX, Inc. and certain stockholders, dated as of November 14, 2005.

4.3(2)		Amendment No. 1 to the Third Amended and Restated Investors’ Rights Agreement by and between NeurogesX, Inc. and certain stockholders, dated as of December 28, 2007.

4.4(1)		Warrant to Purchase Series A Preferred Stock by and between NeurogesX, Inc. and Silicon Valley Bank, dated as of December 14, 2000.

4.5(1)		Warrant to Purchase Series B Preferred Stock by and between NeurogesX, Inc. and Silicon Valley Bank, dated as of May 1, 2002.

4.6(1)		Warrant to Purchase Shares of Series C2 Preferred Stock by and between NeurogesX, Inc. and Horizon Technology Funding Company II LLC, dated as of July 7, 2006.

4.7(1)		Warrant to Purchase Shares of Series C2 Preferred Stock by and between NeurogesX, Inc. and Horizon Technology Funding Company III LLC, dated as of July 7, 2006.

4.8(1)		Warrant to Purchase Shares of Series C2 Preferred Stock by and between NeurogesX, Inc. and Oxford Finance Corporation, dated as of July 7, 2006.

4.9(1)		Form of First Warrant to Purchase Series C2 Preferred Stock.

4.10(1)		Form of Second Warrant to Purchase Series C2 Preferred Stock.

4.11(2)		Registration Rights Agreement by and between NeurogesX, Inc. and certain investors, dated as of December 23, 2007.

4.12(2)		Form of Warrant to Purchase Common Stock.

31.1		Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certifications of the Principal Executive Officer and the Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350).

(1)	Incorporated by reference from our registration statement on Form S-1, registration number 333-140501, declared effective by the Securities and Exchange Commission on May 1, 2007.

(2)	Incorporated by reference from our Current Report on Form 8-K, filed with the Securities and Exchange Commission on December 28, 2007.

Large accelerated filer

Accelerated filer

Non-accelerated filer

¨ (Do not check if a smaller reporting company)

Smaller reporting company