UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

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

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

Commission File Number: 000-51665

Somaxon Pharmaceuticals, Inc.

(Exact name of registrant as specified in its charter)

Delaware (State or other jurisdiction of incorporation or organization)		20-0161599 (I.R.S. Employer Identification No.)
3570 Carmel Mountain Road, Suite 100, San Diego CA (Address of principal executive offices)		92130 (Zip Code)

(858) 876-6500
(Registrant’s telephone number, including area code)

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

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

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

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer o (Do not check if a smaller reporting company)		Smaller reporting company o

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

The number of outstanding shares of the registrant’s common stock, par value $0.0001 per share, as of July 15, 2011 was 47,198,093.

 

 

SOMAXON PHARMACEUTICALS, INC.

QUARTERLY REPORT ON FORM 10-Q

For the Quarter Ended June 30, 2011

TABLE OF CONTENTS

		Page
PART I — FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Condensed Balance Sheets			F-1
Condensed Statements of Operations			F-2
Condensed Statements of Cash Flows			F-3
Condensed Statements of Stockholders’ Equity and Comprehensive Loss			F-4
Notes to Condensed Financial Statements			F-5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			1
Item 3. Quantitative and Qualitative Disclosures about Market Risk			12
Item 4. Controls and Procedures			13
PART II — OTHER INFORMATION
Item 1. Legal Proceedings			13
Item 1A. Risk Factors			14
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			23
Item 3. Defaults Upon Senior Securities			23
Item 4. (Removed and Reserved)			23
Item 5. Other Information			23
Item 6. Exhibits			24
SIGNATURES			25
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1
Exhibit 32.2
EX-101 INSTANCE DOCUMENT
EX-101 SCHEMA DOCUMENT
EX-101 CALCULATION LINKBASE DOCUMENT
EX-101 LABELS LINKBASE DOCUMENT
EX-101 PRESENTATION LINKBASE DOCUMENT
EX-101 DEFINITION LINKBASE DOCUMENT

PART I — FINANCIAL INFORMATION

Item 1.		Financial Statements

CONDENSED BALANCE SHEETS
(Unaudited)
(In thousands, except par value)

		June 30,				December 31,
		2011				2010
ASSETS
Current assets
Cash and cash equivalents		$	28,395			$	21,008
Short-term investments			2,458				33,809
Accounts receivable, net			1,953				5,584
Inventory			980				991
Other current assets			3,167				1,882
Total current assets			36,953				63,274
Property and equipment, net			956				755
Intangibles, net			1,190				1,102
Total assets		$	39,099			$	65,131
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable		$	1,674			$	1,709
Accrued liabilities			7,094				5,699
Deferred revenue, current portion			—				3,459
Total current liabilities			8,768				10,867
Deferred revenue, non-current portion			464				—
Commitments and contingencies (see Note 6)
Stockholders’ equity
Preferred stock, $0.0001 par value; 10,000 shares authorized, none issued and outstanding			—				—
Common stock, $0.0001 par value; 100,000 shares authorized; 47,198 and 45,004 shares outstanding at June 30, 2011 and December 31, 2010, respectively			5				5
Additional paid-in capital			278,701				271,112
Accumulated deficit			(248,839	)			(216,852	)
Accumulated other comprehensive income (loss)			—				(1	)
Total stockholders’ equity			29,867				54,264
Total liabilities and stockholders’ equity		$	39,099			$	65,131

The Accompanying Notes are an Integral Part of these Unaudited Condensed Financial Statements

SOMAXON PHARMACEUTICALS, INC.

CONDENSED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except per share amounts)

		Three months ended								Six months ended
		June 30,								June 30,
		2011				2010				2011				2010
Revenue
Net product sales		$	6,242			$	—			$	8,564			$	—
Operating costs and expenses
Cost of sales		$	661			$	—			$	1,024			$	—
Selling, general and administrative			20,073				4,902				38,666				7,954
Research and development			457				814				876				1,927
Total operating costs and expenses			21,191				5,716				40,566				9,881
Loss from operations			(14,949	)			(5,716	)			(32,002	)			(9,881	)
Other income and expense			—				(5	)			15				(5	)
Net loss		$	(14,949	)		$	(5,721	)		$	(31,987	)		$	(9,886	)
Basic and diluted net loss per share		$	(0.33	)		$	(0.16	)		$	(0.71	)		$	(0.33	)
Shares used to calculate net loss per share			45,492				34,890				45,250				30,268

The Accompanying Notes are an Integral Part of these Unaudited Condensed Financial Statements

SOMAXON PHARMACEUTICALS, INC.

CONDENSED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)

		Six Months Ended June 30,
		2011				2010
Cash flows from operating activities
Net loss		$	(31,987	)		$	(9,886	)
Adjustments to reconcile net loss to net cash used in operating activities:
Share-based compensation expense			2,588				3,525
Depreciation			116				99
Amortization			74				—
Amortization of investment discount			145				—
Realized gain on sale of short-term investments			1				—
Loss on disposal of equipment			—				13
Changes in operating assets and liabilities:
Accounts receivable			3,631				—
Inventory			(108	)			(531	)
Other current and non-current assets			(1,230	)			(344	)
Accounts payable			(34	)			1,514
Accrued liabilities			1,362				(40	)
Deferred revenue			(2,962	)			—
Net cash used in operating activities			(28,404	)			(5,650	)
Cash flows from investing activities
Purchases of property and equipment			(318	)			(110	)
Payments for intangible assets			(161	)			(1,000	)
Purchases of marketable securities			(3,508	)			—
Sales and maturities of marketable securities			34,777				—
Net cash provided by (used in) investing activities			30,790				(1,110	)
Cash flows from financing activities
Issuance of common stock, net of costs			5,000				52,745
Exercise of warrants			—				1,474
Exercise of stock options			1				1,884
Purchase of treasury stock			—				(44	)
Net cash provided by financing activities			5,001				56,059
Increase in cash and cash equivalents			7,387				49,299
Cash and cash equivalents at beginning of the period			21,008				5,165
Cash and cash equivalents at end of the period		$	28,395			$	54,464
Non-cash investing and financing activities
Common stock issued to settle severance obligation		$	—			$	860

The Accompanying Notes are an Integral Part of these Unaudited Condensed Financial Statements

SOMAXON PHARMACEUTICALS, INC.

CONDENSED STATEMENT OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE LOSS
(Unaudited)
(In thousands, except per share amounts)

																		Accumulated
										Additional								Other
		Common Stock								Paid-in				Accumulated				Comprehensive
		Shares				Amount				Capital				Deficit				Income (Loss)				Total
Balance at December 31, 2010			45,004			$	5			$	271,112			$	(216,852	)		$	(1	)		$	54,264
Net loss			—				—				—				(31,987	)			—				(31,987	)
Unrealized gains in short-term investments			—				—				—				—				1				1
Comprehensive loss			—				—				—				—				—				(31,986	)
Issuance of common stock			2,185				—				5,000				—				—				5,000
Issuance of common stock pursuant to vesting of restricted stock units			8				—				—				—				—				—
Exercise of stock options			1				—				1				—				—				1
Share-based compensation expense			—				—				2,588				—				—				2,588
Balance at June 30, 2011			47,198			$	5			$	278,701			$	(248,839	)		$	—			$	29,867

The Accompanying Notes are an Integral Part of these Unaudited Condensed Financial Statements

Note 1. Organization

Business

Somaxon Pharmaceuticals, Inc. (“Somaxon”, “the Company”, “we”, “us” or “our”), is a specialty pharmaceutical company focused on the in-licensing, development and commercialization of proprietary branded products and late-stage product candidates to treat important medical conditions where there is an unmet medical need and/or high-level of patient dissatisfaction, currently in the central nervous system therapeutic area. In March 2010, the U.S. Food and Drug Administration (“FDA”), approved our New Drug Application (“NDA”) for Silenor^® 3 mg and 6 mg tablets for the treatment of insomnia characterized by difficulty with sleep maintenance. Silenor was made commercially available by prescription in the United States in September 2010. We operate in one reportable segment, which is the development and commercialization of pharmaceutical products.

Basis of Presentation

The accompanying condensed balance sheet as of December 31, 2010, which has been derived from our audited financial statements, and the unaudited interim condensed financial statements have been prepared in accordance with U.S. generally accepted accounting principles and the rules and regulations of the Securities and Exchange Commission (“SEC”) related to a quarterly report on Form 10-Q. Certain information and note disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to those rules and regulations, although we believe that the disclosures made are adequate to make the information presented not misleading. The unaudited interim condensed financial statements reflect all adjustments which, in the opinion of our management, are necessary for a fair statement of the results for the periods presented. All such adjustments are of a normal and recurring nature. These unaudited condensed financial statements should be read in conjunction with the financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2010. The operating results presented in these unaudited condensed financial statements are not necessarily indicative of the results that may be expected for any future periods.

Capital Resources

Since inception, our operations have been financed primarily through the sale of equity securities and the proceeds from the exercise of warrants and stock options. We have incurred losses from operations and negative cash flows since the inception of the Company, and we expect to continue to incur substantial losses for the foreseeable future as we continue our commercial activities for Silenor, commercialize any other products to which we obtain rights and potentially pursue the development of other product candidates.

We believe we have sufficient financial resources to fund our operations for at least the next twelve months. We have received $14.9 million in net proceeds pursuant to a loan and security agreement with Silicon Valley Bank (“SVB”) and Oxford Finance LLC (together with SVB, the “Lenders”). We may need to obtain additional funds to finance our operations, particularly if we are unable to access adequate or timely funds under our at-the-market equity sales agreement with Citadel Securities LLC, (“Citadel”). Until we can generate significant cash from our operations, we intend to obtain any additional funding we require through strategic relationships, public or private equity or debt financings, assigning receivables or royalty rights, or other arrangements and we cannot assure such funding will be available on reasonable terms, or at all. Additional equity financing will be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants.

If our efforts in raising additional funds when needed are unsuccessful, we may be required to delay, scale-back or eliminate plans or programs relating to our business, relinquish some or all rights to Silenor or renegotiate less favorable terms with respect to such rights than we would otherwise choose or cease operating as a going concern. In addition, if we do not meet our payment obligations to third parties as they come due, we may be subject to litigation claims. Even if we were successful in defending against these claims, litigation could result in substantial costs and be a distraction to management, and may result in unfavorable results that could further adversely impact our financial condition.

If we are unable to continue as a going concern, we may have to liquidate our assets and may receive less than the value at which those assets are carried on our financial statements, and it is likely that investors will lose all or a part of their investments. These financial statements do not include any adjustments that might result from the outcome of this uncertainty.

Note 2. Summary of Significant Accounting Policies

Use of Estimates

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

Cash and Cash Equivalents

All highly liquid investments with maturities of three months or less at the time of purchase are considered to be cash equivalents. Investments with maturities at the date of purchase greater than three months are classified as marketable securities. At June 30, 2011, our cash and cash equivalents consisted primarily of money market funds and other available-for-sale securities that have an original maturity date of three months or less. All of our cash equivalents have liquid markets and high credit ratings.

Marketable Securities

Our investments in marketable securities are classified as available-for-sale securities. Available-for-sale securities are carried at fair market value, with unrealized gains and losses reported as a component of stockholders’ equity in accumulated other comprehensive income/loss. Interest and dividend income is recorded when earned and included in interest income. Premiums and discounts on marketable securities are amortized and accreted, respectively, to maturity and included in interest income. Marketable securities with a maturity date of less than one year as of the balance sheet date are classified as short-term investments. Marketable securities with a maturity of more than one year as of the balance sheet date are classified as long-term investments. We assess the risk of impairment related to securities held in our investment portfolio on a regular basis and noted no impairment during the three and six months ended June 30, 2011.

Concentration of Credit Risk, Significant Customers and Sources of Supply

Financial instruments that potentially subject us to concentrations of credit risk consist primarily of cash and cash equivalents, short-term investments, and accounts receivable. We maintain accounts in federally insured financial institutions in excess of federally insured limits. We also maintain investments in money market funds and similar short-term investments that are not federally insured. However, management believes we are not exposed to significant credit risk due to the financial positions of the depository institutions in which these deposits are held and of the money market funds and other entities in which these investments are made. Additionally, we have established guidelines regarding the diversification of our investments and their maturities that are designed to maintain safety and liquidity.

We sell our product primarily to established wholesale distributors in the pharmaceutical industry. The following table sets forth customers who represented 10% or more of our product sales for the three and six months ended June 30, 2011:

		Three Months Ended				Six Months Ended
		June 30, 2011				June 30, 2011
Cardinal Health			42	%			45	%
McKesson			41	%			37	%
AmerisourceBergen			11	%			11	%

The majority of our accounts receivable balance as of June 30, 2011 represents amounts due from these three wholesale distributors. Credit is extended based on an evaluation of the customer’s financial condition. Based upon the review of these factors, we did not record an allowance for doubtful accounts at June 30, 2011.

We rely on third-party manufacturers for the production of Silenor and single source third-party suppliers to manufacture key components of Silenor. If our third-party manufacturers are unable to continue manufacturing Silenor, or if we lost our single source suppliers used in the manufacturing process, we may not be able to meet market demand for our product.

Inventory

Our inventories are valued at the lower of weighted average cost or net realizable value. We analyze our inventory levels quarterly and write down inventory that has become obsolete or has a cost basis in excess of its expected net realizable value, as well as any inventory quantities in excess of expected requirements. We did not record a reserve for potentially obsolete or excess inventory as of June 30, 2011.

Intangible Assets

Our intangible assets consist of the costs incurred to in-license our product and technology development costs relating to our websites. Prior to the FDA approval of our NDA for Silenor, we had expensed all license fees and milestone payments for acquired development and commercialization rights to operations as incurred since the underlying technology associated with these expenditures related to our research and development efforts and had no alternative future use at the time. Costs related to our intellectual property are capitalized once technological feasibility has been established. Capitalized amounts are amortized on a straight line basis over the expected life of the intellectual property. License fees began being amortized upon the first sale of Silenor to our wholesaler in August 2010 and are being amortized over approximately ten years. Costs incurred in the planning stage of a website are expensed, while costs incurred in the development stage are capitalized and will be amortized over the expected life of the product associated with the website once the asset is placed in service. Costs incurred for other intangible assets to be used primarily on our website are capitalized and amortized over the expected useful life, which we estimate to be two years. The carrying values of our intangible assets are periodically reviewed to determine if the facts and circumstances suggest that a potential impairment may have occurred. We had no impairment of our intangible assets for the three and six months ended June 30, 2011.

Revenue Recognition

Product Sales

We sell Silenor to wholesale pharmaceutical distributors. Our returned goods policy generally permits our customers to return products up to six months before and up to twelve months after the expiration date of the product. We authorize returns for expired products in accordance with our returned goods policy and issue credit to our customers for expired returned product. We do not exchange product from inventory for returned product. As of June 30, 2011, the dollar amount of returns received in 2011 has been negligible.

We recognize product revenue from product sales when it is realized or realizable and earned. Revenue is realized or realizable and earned when all of the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) our price to the buyer is fixed or determinable; and (4) collectability is reasonably assured. Revenue from sales transactions where the buyer has the right to return the product is recognized at the time of sale only if (1) our price to the buyer is substantially fixed or determinable at the date of sale, (2) the buyer has paid us, or the buyer is obligated to pay us and the obligation is not contingent on resale of the product, (3) the buyer’s obligation to us would not be changed in the event of theft or physical destruction or damage of the product, (4) the buyer acquiring the product for resale has economic substance apart from that provided by us, (5) we do not have significant obligations for future performance to directly bring about resale of the product by the buyer, and (6) the amount of future returns can be reasonably estimated.

Prior to the second quarter of 2011, we were unable to reasonably estimate returns. We therefore deferred revenue recognition until the right of return no longer existed, which was the earlier of Silenor being dispensed through patient prescriptions or the expiration of the right of return. We estimated patient prescriptions dispensed using an analysis of third-party information. In order to develop a methodology to reliably estimate product returns and provide a basis for recognizing revenue on sales to customers at the time of product shipment, we analyzed many factors, including, without limitation, industry data regarding product return rates, and tracked the Silenor product return history, taking into account product expiration dating at the time of shipment and levels of inventory in the wholesale channel compared to prescription units dispensed and the sell-down of our launch inventory. During the second quarter of 2011, the sell-down of our launch inventory was completed, which we believe demonstrates sufficient market acceptance of

our product for purposes of our revenue recognition analysis. In addition, since product launch, we have sold product to wholesale pharmaceutical distributors at standard commercial terms utilized in the industry. As a result, we believe we can analogize to industry data regarding product return rates. Based on the sell-down of our launch inventory and the industry and internal data gathered, we believe we have the information needed to reasonably estimate product returns. As a result, in the second quarter of 2011, we began recognizing revenue for Silenor sales at the time of delivery of the product to wholesale pharmaceutical distributors and our other customers.

License and Royalty Revenue

In June 2011, we entered into a license agreement with Paladin Labs Inc. (“Paladin”) pursuant to which Paladin will commercialize Silenor in Canada, South America, the Caribbean and Africa subject to the receipt of marketing approval in each such territory. We received an upfront payment of $500,000 in connection with the execution of this agreement. We recorded the upfront payment as deferred revenue and are recognizing the upfront payment as license revenue over the period of our significant involvement under the agreement, which we are estimating to be 15 years. As of June 30, 2011, the deferred revenue balance associated with the license agreement is $497,000. We recognized $3,000 as revenue during each of the three and six months ended June 30, 2011, which is recorded in other income and expense.

Once Silenor is commercialized in the licensed territories, we will be eligible to receive sales-based milestone payments of up to $128.5 million as well as a tiered double-digit percentage of net sales in the licensed territories. Due to the uncertainty surrounding the achievement of these future sales-based milestones and royalties, these potential payments will not be recognized as revenue until they are realized and earned.

Product Sales Discounts and Allowances

We record product sales discounts and allowances at the time of sale and report revenue net of such amounts in the same period that product sales are recorded. In determining the amount of product sales discounts and allowances, we must make significant judgments and estimates. If actual results vary from our estimates, we may need to adjust these estimates, which could have an effect on product revenue in the period of adjustment. Our product sales discounts and allowances and the specific considerations we use in estimating these amounts include:

Prompt Pay Discounts. As an incentive for prompt payment, we offer a 2% cash discount to customers. We expect that all customers will comply with the contractual terms to earn the discount. We record the discount as an allowance against accounts receivable and a corresponding reduction of revenue. At June 30, 2011 and December 31, 2010, the allowance for prompt pay discounts was $40,000 and $114,000, respectively.

Patient Discount Programs. We offer discount programs to patients of Silenor under which the patient receives a discount on his or her prescription. We reimburse pharmacies for these discounts through third-party vendors. We estimate the total amount that will be redeemed based on the dollar amount of the discounts, the timing and quantity of distribution and historical redemption rates. We accrue the discounts and recognize a corresponding reduction of revenue. At June 30, 2011 and December 31, 2010, the accrual for patient discount programs was $376,000 and $182,000, respectively.

Distribution Service Fees. We pay distribution services fees to each wholesaler for distribution and inventory management services. We accrue for these fees based on contractually defined terms with each wholesaler and recognize a corresponding reduction of revenue. At June 30, 2011 and December 31, 2010, the accrual for distribution service fees was $240,000 and $276,000, respectively.

Chargebacks. We provide discounts to federal government qualified entities with whom we have contracted. These federal entities purchase products from the wholesalers at a discounted price, and the wholesalers then charge back to us the difference between the current retail price and the contracted price the federal entity paid for the product. We accrue chargebacks based on contract prices and sell-through sales data obtained from third party information. At June 30, 2011 and December 31, 2010, the accrual for chargebacks was $13,000 and $9,000, respectively.

Rebates. We participate in certain rebate programs, which provide discounted prescriptions to qualified insured patients. Under these rebate programs, we pay a rebate to the third-party administrator of the program. We accrue rebates based on contract prices, estimated percentages of product sold to qualified patients and estimated levels of inventory in the distribution channel. At June 30, 2011 and December 31, 2010, the accrual for rebates was $536,000 and $6,000, respectively.

Product Returns. We estimate future product returns based upon actual returns history, product expiration dating analysis, estimated inventory levels in the distribution channel, and industry data regarding product return rates for similar products. There may be a significant time lag between the date we determine the estimated allowance and when we receive product returns and issue credits to customers. Due to this time lag, we may record adjustments to our estimated allowance over several periods, which would impact our operating results in those periods. At June 30, 2011, the allowance for product returns was $85,000.

Cost of Sales

Cost of sales includes the costs to manufacture, package, and ship Silenor, including personnel costs associated with manufacturing oversight, as well as royalties and amortization of capitalized license fees associated with our license agreement with ProCom One, Inc. (“ProCom”).

Share-Based Compensation Expense

Share-based compensation expense for employees and directors is recognized in the statement of operations based on estimated amounts, including the grant date fair value, the probability of achieving performance conditions and the expected service period for awards with conditional vesting provisions. We estimate the grant date fair value for our stock option awards using the Black-Scholes valuation model which requires the use of multiple subjective inputs including estimated future volatility, expected forfeitures and the expected terms of the stock option awards. Our stock did not have a readily available market prior to our initial public offering in December 2005, creating a relatively short history from which to obtain data to estimate the volatility of our stock price. Consequently, we estimate expected future volatility based on a combination of both comparable companies and our own stock price volatility to the extent such history is available. The expected term for stock options is estimated using guidance provided by the SEC in Staff Accounting Bulletin (“SAB”) No. 107 and SAB 110. This guidance provides a formula-driven approach for determining the expected term. Share-based compensation is based on awards expected to ultimately vest and has been reduced for estimated forfeitures. The estimated forfeiture rates may differ from actual forfeiture rates which would affect the amount of expense recognized during the period. Estimated forfeitures are adjusted to actual amounts as they become known.

We recognize the value of the portion of the awards that are ultimately expected to vest on a straight-line basis over the award’s requisite service period. The requisite service period is generally the time over which our share-based awards vest. Some of our share-based awards vested upon achieving certain performance conditions, generally pertaining to the commercial performance of Silenor or the achievement of other strategic objectives. Share-based compensation expense for awards with performance conditions is recognized over the period from the date the performance condition is determined to be probable of occurring through the time the applicable condition is met. If the performance condition is not considered probable of being achieved, no expense is recognized until such time the meeting of the performance condition is considered probable.

Income Taxes

Our income tax expense consists of current and deferred income tax expense or benefit. Current income tax expense or benefit is the amount of income taxes expected to be payable or refundable for the current year. A deferred income tax asset or liability is recognized for the future tax consequences attributable to tax credits and loss carryforwards and to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. As of December 31, 2010, we have established a valuation allowance to fully reserve our net deferred tax assets. It is expected that the amount of unrecognized tax benefits may change over the course of the year; however, because our deferred tax assets are fully reserved, we do not expect the change to have a significant impact on our results of operations, cash flows or financial position. Tax rate changes are reflected in income during the period such changes are enacted. Changes in ownership may limit the amount of net operating loss carryforwards that can be utilized in the future to offset taxable income.

Net Loss per Share

Basic earnings per share (“EPS”) excludes the effects of common stock equivalents. EPS is calculated by dividing net income or loss applicable to common stockholders by the weighted average number of common shares outstanding for the period, reduced by the weighted average number of unvested common shares outstanding subject to repurchase. Diluted EPS is computed in the same manner as basic EPS, but includes the effects of common stock equivalents to the extent they are dilutive, using the treasury-stock method. For us, basic and diluted net loss per share are equivalent because we have incurred a net loss in all periods presented, causing any potentially dilutive securities to be anti-dilutive.

Net loss per share was determined as follows (in thousands, except per share amounts):

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2011				2010				2011				2010
Numerator:
Net loss		$	(14,949	)		$	(5,721	)		$	(31,987	)		$	(9,886	)
Denominator:
Weighted average common shares outstanding			45,492				34,890				45,250				30,311
Weighted average unvested common shares subject to repurchase			—				—				—				(43	)
Denominator			45,492				34,890				45,250				30,268
Basic and diluted net loss per share		$	(0.33	)		$	(0.16	)		$	(0.71	)		$	(0.33	)
Weighted average anti-dilutive securities not included in diluted net loss per share calculation:
Weighted average stock options outstanding			4,645				3,283				4,207				3,391
Weighted average restricted stock units outstanding			563				716				404				794
Weighted average warrants outstanding			2,418				2,921				2,418				3,544
Weighted average unvested common shares subject to repurchase			—				—				—				44
Total weighted average anti-dilutive securities not included in diluted net loss per share			7,626				6,920				7,029				7,773

Recent Accounting Pronouncements

In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2009-13 “Revenue Recognition,” which provides guidance on recognizing revenue in arrangements with multiple deliverables. This standard impacts the determination of when the individual deliverables included in a multiple element arrangement may be treated as a separate unit of accounting. It also modifies the manner in which the consideration received from the transaction is allocated to the multiple deliverables and no longer permits the use of the residual method of allocating arrangement consideration. This accounting standard is effective for the first year beginning on or after June 15, 2010, with early adoption permitted. The adoption of ASU 2009-13 did not have a material impact on our financial statements.

In December 2010, the FASB issued ASU No. 2010-27 “Other Expenses: Fees Paid to the Federal Government by Pharmaceutical Manufacturers,” which provides guidance concerning the recognition and classification of the new annual fee payable by branded prescription drug manufacturers and importers on branded prescription drugs which was mandated under the health care reform legislation enacted in the United States in March 2010. Under this new authoritative guidance, the annual fee should be estimated and recognized in full as a liability upon the first qualifying commercial sale with a corresponding deferred cost that is amortized to operating expenses using a straight-line method unless another method better allocates the fee over the calendar year in which it is payable. This new guidance is effective for calendar years beginning on or after December 31, 2010, when the fee initially becomes effective. The adoption of ASU 2010-27 did not have a material impact on our financial statements.

In May 2011, the FASB issued ASU No. 2011-04 “Fair Value Measurement: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs”. Some of the amendments clarify the FASB’s intent about the application of existing fair value measurement requirements. Other amendments change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. This guidance is effective for interim and annual periods beginning after December 15, 2011. We are still evaluating the potential future effects of this guidance.

In June 2011, the FASB issued ASU No. 2011-05 “Comprehensive Income: Presentation of Comprehensive Income.” Under the new guidance, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. This guidance is effective for interim and annual periods beginning after December 15, 2011. We have evaluated the potential future effects of this guidance and do not expect the adoption of ASU 2011-05 to have a material impact on our financial statements.

Note 3. Fair Value of Financial Instruments

Cash and investment holdings, accounts receivable, accounts payable and accrued liabilities are presented in the financial statements at their carrying amounts, which are reasonable estimates of fair value due to their short maturities.

The fair value of financial assets and liabilities is measured under a framework that establishes “levels” which are defined as follows: Level 1 fair value is determined from observable, quoted prices in active markets for identical assets or liabilities. Level 2 fair value is determined from quoted prices for similar items in active markets or quoted prices for identical or similar items in markets that are not active. Level 3 fair value is determined using the entity’s own assumptions about the inputs that market participants would use in pricing an asset or liability.

The fair value of our investment holdings at June 30, 2011 and December 31, 2010 is summarized in the following tables (in thousands).

		June 30, 2011
		Total Fair				Fair Value Determined Under:
		Value				(Level 1)				(Level 2)				(Level 3)
Commercial paper		$	600			$	—			$	600			$	—
U.S. government agency securities			4,009				—				4,009				—
Money market funds			25,288				25,288				—				—
Total		$	29,897			$	25,288			$	4,609			$	—

						December 31, 2010
		Total Fair				Fair Value Determined Under:
		Value				(Level 1)				(Level 2)				(Level 3)
Commercial paper		$	18,415			$	—			$	18,415			$	—
U.S. government agency securities			30,628				—				30,628				—
Total		$	49,043			$	—			$	49,043			$	—

Commercial paper and U.S. government agency securities are classified as part of either cash and cash equivalents or short-term investments in the condensed consolidated balance sheets. The carrying value of short-term investments consisted of the following as of June 30, 2011 and December 31, 2010 (in thousands).

		June 30, 2011
		Amortized				Unrealized				Unrealized				Fair Market
		Cost				Gains				Losses				Value
Commercial paper		$	600			$	—			$	—			$	600
U.S. government agency securities			4,009				—				—				4,009
Total		$	4,609			$	—			$	—			$	4,609

		December 31, 2010
		Amortized				Unrealized				Unrealized				Fair Market
		Cost				Gains				Losses				Value
Commercial paper		$	18,415			$	—			$	—			$	18,415
U.S. government agency securities			30,629				2				(3	)			30,628
Total		$	49,044			$	2			$	(3	)		$	49,043

Available-for-sale marketable securities with maturities of three months or less from date of purchase have been classified as cash equivalents, and amounted to $2.2 million and $15.2 million as of June 30, 2011 and December 31, 2010, respectively.

Note 4. Composition of Certain Balance Sheet Items

Accounts Receivable

Accounts receivable, net consisted of the following (in thousands):

		June 30,				December 31,
		2011				2010
Accounts receivable for product sales, gross		$	1,993			$	5,975
Allowances for discounts			(40	)			(391	)
Total accounts receivable		$	1,953			$	5,584

Inventory

Inventory consisted of the following (in thousands):

		June 30,				December 31,
		2011				2010
Work in process		$	441			$	207
Finished goods inventory held by the Company			539				515
Finished goods inventory held by others			—				269
Total inventory		$	980			$	991

Other Current Assets

Other current assets consisted of the following (in thousands):

		June 30,				December 31,
		2011				2010
Deposits and other prepaid expenses		$	1,680			$	641
Prepaid sales and marketing expenses			1,467				529
Interest receivable			20				206
Other current assets			—				506
Total other current assets		$	3,167			$	1,882

Property and Equipment

Property and equipment consisted of the following (in thousands):

		June 30,				December 31,
		2011				2010
Tooling		$	832			$	832
Computer equipment			481				354
Furniture and equipment			256				66
Property and equipment, at cost			1,569				1,252
Less: accumulated depreciation			(613	)			(497	)
Property and equipment, net		$	956			$	755

Intangible Assets

Intangible assets consisted of the following (in thousands):

		June 30,				December 31,
		2011				2010
License fees		$	1,000			$	1,000
Technology development costs relating to websites			147				147
Other intangible assets			161				—
Less: accumulated amortization			(118	)			(45	)
Total intangible assets, net		$	1,190			$	1,102

Accrued Liabilities

Accrued liabilities consisted of the following (in thousands):

		June 30,				December 31,
		2011				2010
Accrued fees and royalties		$	2,070			$	1,566
Other accrued expenses			2,036				1,489
Accrued compensation and benefits			1,285				1,329
Accrued product discounts, allowances and returns			1,250				473
Accrued liability to third party sales organization			453				842
Total accrued liabilities		$	7,094			$	5,699

Note 5. License Agreements

ProCom. In August 2003, we entered into an exclusive worldwide in-license agreement with ProCom to develop and commercialize Silenor for the treatment of insomnia. This agreement was amended and restated in September 2010. The term of the license extends until the last licensed patent expires, which is expected to occur no earlier than 2020. The license agreement is terminable by us at any time with 30 days notice if we believe that the use of the product poses an unacceptable safety risk or if it fails to achieve a satisfactory level of efficacy. Either party may terminate the agreement with 30 days notice if the other party commits a material breach of its obligations and fails to remedy the breach within 90 days, or upon the filing of bankruptcy, reorganization, liquidation, or receivership proceedings. Costs related to the licensed intellectual property made after approval of the Silenor NDA by the FDA in March 2010 have been capitalized and included in intangibles in our balance sheet as of December 31, 2010. Capitalized amounts are amortized on a straight line basis over approximately ten years. Royalty payments due under the terms of the agreement are recorded in accrued liabilities as of June 30, 2011. The royalty payments are recognized as an expense in cost of sales when the related shipments of product are recognized as revenue.

Paladin. In June 2011, we entered into a license agreement, a supply agreement and a stock purchase agreement with Paladin. Under the license agreement, Paladin will commercialize Silenor in Canada, South America, the Caribbean and Africa, subject to the receipt of marketing approval in each such territory. We received $500,000 in connection with the execution of the agreements, and Paladin purchased 2,184,769 shares of our common stock for an aggregate purchase price of $5.0 million. Once Silenor is commercialized in the licensed territories, we will also be eligible to receive sales-based milestone payments of up to $128.5 million as well as a tiered double-digit percentage of net sales in the licensed territories. Paladin will be responsible for regulatory submissions for Silenor in the licensed territories and will have the exclusive right to commercialize Silenor in the licensed territories. Governance of the collaboration will occur through a joint committee. We have also granted to Paladin a right of first negotiation with respect to additional doxepin products we may develop in the licensed territories and, subject to the rights we have previously granted to Procter & Gamble (“P&G”), a right of first negotiation relating to rights to develop and market Silenor as an over-the-counter medication in the licensed territories.

The term of the license agreement runs through the longer of the last date on which Silenor is sold by Paladin in the licensed territories or 15 years from the first commercial sale of Silenor in the licensed territories. We may terminate the license agreement on a country-by-country basis in specified key countries upon 60 days’ prior written notice if the first commercial sale has not occurred in such country within 12 months of the date on which marketing approval was obtained in such country. We may also terminate the license agreement upon 60 days’ prior written notice if marketing approval in Canada has not been received by December 7, 2013. Either party may terminate the license agreement upon an uncured material breach by the other party, upon the bankruptcy or insolvency of the other party, or a force majeure event that lasts for at least 120 days. We may also terminate the license agreement upon 60 days’ prior written notice and payment of a termination fee if we are unable to license rights to a third party’s intellectual property and such failure would reasonably be expected to result in a claim from such third party alleging intellectual property infringement or misappropriation. Pursuant to the license agreement, we also entered into the supply agreement, under which we will supply Paladin all of its requirements for Silenor during the term of the license agreement or until Paladin procures its own supply of Silenor. Paladin may terminate the supply agreement upon 10 business days notice if we are materially unable to supply Silenor to Paladin’s requirements as defined in the supply agreement, and at any time if Paladin enters into a direct contractual relationship with our manufacturer of Silenor. We may terminate the supply agreement upon 180 days prior written notice if there is a regulatory change or safety consideration that would have a material adverse effect on the global supply chain and at any time on six months’ prior notice after April 30, 2013.

Other Agreement. In October 2006, we entered into a supply agreement pertaining to a certain ingredient used in the formulation for Silenor. In August 2008, this supply agreement was amended to provide us with the exclusive right to use this ingredient in combination with doxepin. Pursuant to the amendment, we are obligated to pay a royalty on worldwide net sales of Silenor beginning as of the expiration of the statutory exclusivity period for Silenor in each country in which Silenor is marketed. Such royalty is only payable if one or more patents under the license agreement continue to be valid in each such country and a patent relating to our formulation for Silenor has not issued in such country.

Note 6. Commitments and Contingencies

Commitments

Publicis Touchpoint Solutions, Inc. (“Publicis”). In July 2010, we entered into a professional detailing services agreement with Publicis under which Publicis agreed to provide sales support to promote Silenor in the U.S. through 110 full-time sales representatives, together with management coordination personnel, all of whom will be employees of Publicis. On February 7, 2011 we entered into an amended and restated agreement with Publicis under which Publicis deployed for us an additional 35 sales representatives that are exclusively promoting Silenor, together with management coordination personnel. We recognize the revenue from Silenor product sales generated by the promotional efforts of the sales organization. Under the terms of the agreement, we were required to pay a one-time start up fee, and we are required to pay a fixed monthly fee, which is subject to certain quarterly adjustments based on actual staffing and spending levels. During the term of the agreement, a portion of Publicis’ management fee will be subject to payment by us only to the extent that specified performance targets are achieved. The performance targets relate to initial scale-up activities, turnover and vacancy rates, call attainment and specified sales goals. In addition, we are obligated to reimburse the sales organization for approved pass-through costs, which primarily include bonuses, meeting and travel costs and certain administrative expenses. The agreement has an initial two-year term, and may be extended by us by providing Publicis with written notification no later than 90 days prior to the expiration of the initial term, subject to agreement on compensation terms with Publicis. We have the right to terminate the services agreement upon 90 days written notice. We may also terminate the services agreement by hiring a specified number of sales representatives. In addition, either party may terminate the services agreement upon an uncured material breach by the other party, upon the bankruptcy or insolvency of the other party or if a change in law renders the performance of a material obligation of the services agreement unlawful. If termination occurs during the initial two-year term, we assume financial responsibility for the remaining lease payments for the sales representatives’ vehicles which have a two-year lease term.

Procter & Gamble. In August 2010, we entered into a co-promotion agreement with P&G under which P&G provides sales support to promote Silenor in the U.S. through its team of full-time sales representatives. We recognize the revenue from Silenor product sales generated by the promotional efforts of P&G. Under the terms of the agreement, we are required to pay P&G a fixed fee and a royalty fee as a percentage of U.S. net sales, in each case on a quarterly basis during the term of the agreement. The fees are recognized as a sales, general, and administrative expense and are recorded in accrued liabilities as of June 30, 2011. The agreement also provides for financial penalties in the event that either party fails to deliver specified minimum detailing requirements under certain circumstances. Each party will be responsible for the costs of training, maintaining and operating its own sales force, and we are responsible for all other costs pertaining to the commercialization of Silenor. The term of the agreement is from August 2010 through December 2012, and we will pay P&G a reduced royalty fee based on U.S. net sales of Silenor for one year after the expiration of the agreement or its earlier termination under certain circumstances. Beginning as of June 30, 2012, the parties will discuss in good faith the continuation of the collaboration upon mutually-agreed terms and conditions. We have the right to terminate the agreement upon 90 days written notice if P&G fails to provide at least 75% of its minimum detailing obligations. Beginning October 1, 2011, P&G may cure such shortfall for a calendar quarter one time each calendar year during the calendar quarter immediately following such shortfall. Either party may terminate the agreement upon 90 days written notice to the other party, although no such termination may be effective prior to December 31, 2011. P&G may terminate the agreement if Silenor is withdrawn from the market for longer than three months as the result of a legal requirement or 30 days after the end of a calendar quarter in which the market share for Silenor is less than 75% of the Silenor market share immediately prior to the loss of Silenor’s market exclusivity in the U.S. In addition, either party may terminate the agreement upon a large scale recall or withdrawal of Silenor from the U.S. resulting from a significant safety risk that is not due to tampering, a remediable manufacturing problem or other defect that can be cured after such risk is discovered. Either party may also terminate the agreement upon an uncured material breach by the other party, upon the bankruptcy or insolvency of the other party or a force majeure event that lasts for at least six months.

Comerica Bank (“Comerica”). On February 7, 2011, we entered into a loan agreement with Comerica, pursuant to which we may request advances in an aggregate outstanding amount not to exceed $15.0 million. The revolving loan bears interest at a variable rate of interest, per annum, at our option of either LIBOR plus 3.00% or Comerica’s prime rate plus 0.50%. Interest payments on advances made under the loan agreement are due and payable in arrears on the first business day of each month during the term of the loan agreement. Amounts borrowed under the loan agreement may be repaid and re-borrowed at any time prior to February 7, 2013, subject to certain conditions. Once we have two consecutive quarters of profitability, the amounts we borrow are limited to a percentage of our accounts receivable. There is a non-refundable unused commitment fee equal to 0.25% per annum on the difference between the amount of the revolving line and the average daily balance outstanding thereunder during the term of the loan agreement, payable quarterly in arrears. The loan agreement will remain in full force and effect for so long as any obligations remain outstanding or Comerica has any obligation to make credit extensions under the loan agreement. Amounts borrowed under the loan agreement are secured by substantially all of our personal property, excluding intellectual property. Under the loan agreement, we are subject to certain affirmative and negative covenants, including limitations on our ability to: undergo certain change of control events; convey, sell, lease, license, transfer or otherwise dispose of assets, other than in certain specified circumstances; create, incur, assume, guarantee or be liable with respect to certain indebtedness; grant liens; pay dividends and make certain other restricted payments; and make certain investments. In addition, under the loan agreement, we are required to maintain a cash balance with Comerica in an amount of not less than $5.0 million and to maintain 50% of any other cash balances with Comerica and any other cash or investments must be covered by a control agreement for the benefit of Comerica. We are also subject to specified financial covenants with respect to a minimum liquidity ratio and, once we have two consecutive quarters of profitability, minimum EBITDA requirements. We met all of our obligations under the loan agreement. This agreement was terminated on July 28, 2011 in connection with our new loan and security agreement with the Lenders as discussed below in “Note 9. Subsequent Events.”

Other Commitments. We have contracted with various consultants, drug manufacturers, wholesalers, and other vendors to assist in clinical trial work, data analysis, and commercialization activities for Silenor. The contracts are terminable at any time, but obligate us to reimburse the providers for any time or costs incurred through the date of termination. We have employment agreements with certain of our current employees that provide for severance payments and accelerated vesting for certain share-based awards if their employment is terminated under specified circumstances.

Lease

In May 2011, we entered into a new lease arrangement to rent approximately 12,100 square feet of office space, which we plan to use as our new corporate headquarters. The lease will commence on the date that the premises are delivered to us after tenant improvements have been completed, which has not occurred as of June 30, 2011. The lease will expire 64 months after the date that the lease term commences, and we will have the option to extend the term for an additional five years at the then-current fair market rental rate (as defined in the lease).

We have paid the first month’s rent of approximately $30,000 and the monthly rent following lease commencement will be approximately $30,000. However, the second through thirteenth month’s rent will be abated by one-half, provided that we are not in default of the lease. After the first year, the monthly rent will increase by 3.5% per year. We also have a $200,000 letter of credit in favor of our landlord to secure our obligations under the lease.

Litigation

We have received notices from each of Actavis Elizabeth LLC and Actavis Inc. (collectively, “Actavis”), Mylan Pharmaceuticals Inc. and Mylan, Inc. (collectively, “Mylan”), Par Pharmaceutical, Inc. and Par Pharmaceutical Companies, Inc. (collectively, “Par”), and Zydus Pharmaceuticals USA, Inc. and Cadila Healthcare Limited (d/b/a Zydus Cadila) (collectively, “Zydus”) that each has filed with the FDA an Abbreviated New Drug Application (“ANDA”) for a generic version of Silenor 3 mg and 6 mg tablets. The notices included “paragraph IV certifications” with respect to eight of the nine patents listed in the FDA’s Approved Drug Products with Therapeutic Equivalence Evaluations, commonly known as the Orange Book, for Silenor. A paragraph IV certification is a certification by a generic applicant that in the opinion of that applicant, the patent(s) listed in the Orange Book for a branded product are invalid, unenforceable, and/or will not be infringed by the manufacture, use or sale of the generic product.

We, together with ProCom, have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus. The lawsuits allege that each of Actavis, Mylan, Par and Zydus have infringed U.S. Patent No. 6,211,229 (the “’229 patent”) by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

In addition, we have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that such parties have infringed U.S. Patent No. 7,915,307 (the “’307 patent”) by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

Pursuant to the provisions of the Hatch-Waxman Act, FDA final approval of the Actavis and Mylan ANDAs can occur no earlier than May 3, 2013, FDA final approval of the Par ANDA can occur no earlier than June 23, 2013 and FDA final approval of the Zydus ANDA can occur no earlier than November 13, 2013, unless in each case there is an earlier court decision that the ’229 patent and the ’307 patent are not infringed and/or invalid or unless any party to the action is found to have failed to cooperate reasonably to expedite the infringement action.

At this time, the other patents included in Orange Book have not been asserted against these parties.

We intend to vigorously enforce our intellectual property rights relating to Silenor, but cannot predict the outcome of these matters.

Note 7. Share-based Compensation and Equity

Share-based Compensation Expense

Somaxon has restricted stock units (“RSUs”) and stock options outstanding under its equity incentive award plans. Share-based expense for employees and directors is based on the grant-date fair value of the award. The following table summarizes non-cash share-based compensation expense (in thousands).

		Three Months Ended								Six Months Ended
		June 30,								June 30,
Composition of share-based compensation expense:		2011				2010				2011				2010
Included in research and development expense		$	148			$	209			$	294			$	760
Included in selling, general and administrative expense			1,245				1,136				2,294				2,765
Total share-based compensation expense		$	1,393			$	1,345			$	2,588			$	3,525

Certain of our share-based awards will vest upon the achievement of performance conditions. Compensation expense for share-based awards granted to employees and directors is recognized based on the grant date fair value for the portion of the awards for which performance conditions are considered probable of being achieved. Such expense is recorded over the period the performance condition is expected to be performed. No expense is recognized for awards with performance conditions that are considered improbable of being achieved. On March 18, 2010, the FDA notified us that it approved our NDA for Silenor 3 mg and 6 mg tablets. FDA approval of the Silenor NDA caused 105,000 shares of restricted stock to vest, 129,000 RSUs to vest, and 275,000 stock options to vest. The Company recognized an aggregate of $1,384,000 of share-based compensation expense during the first quarter of 2010 from the vesting of these awards.

Included in these tables for 2010 is the effect of a modification of the option agreements with certain terminated employees as a result of an extension of the term of their post-employment consulting agreements. We recognized $233,000 of share-based compensation expense during 2010 as a result of this modification.

Equity

In June 2011, we entered into agreements with Paladin pursuant to which Paladin purchased 2,184,769 shares of our common stock for an aggregate purchase price of $5.0 million (see Note 5, “License Agreements”) in a private placement pursuant to Rule 506 of the Securities Act of 1933, as amended.

Note 8. Related Party Transaction

We have in-licensed certain intellectual property from ProCom (see Note 5, “License Agreements”). In March 2010, we paid $1.0 million to ProCom pursuant to the terms of this agreement. During 2011, we recognized in costs of sales $470,000 of ProCom royalty payments in connection with this arrangement. At June 30, 2011, $196,000 is recorded in accrued liabilities for ProCom royalty payments. As part of the in-license agreement, ProCom has the right to designate one nominee for election to our board of directors (Terrell Cobb, a principal of ProCom).

Note 9. Subsequent Events

On August 1, 2011, we entered into an at-the-market equity sales agreement with Citadel (the “Sales Agreement”) pursuant to which we may sell, at our option, up to an aggregate of $30.0 million in shares of our common stock through Citadel, as sales agent. Sales of the common stock made pursuant to the Sales Agreement, if any, will be made on the NASDAQ Stock Market under our currently-effective Registration Statements on Form S-3 by means of ordinary brokers’ transactions at then-prevailing market prices. Additionally, under the terms of the Sales Agreement, we may also sell shares of our common stock through Citadel, on the NASDAQ Stock Market or otherwise, at negotiated prices or at prices related to the prevailing market price. Under the terms of the Sales Agreement, we may also sell shares to Citadel as principal for Citadel’s own account at a price agreed upon at the time of sale pursuant to a separate terms agreement to be entered into with Citadel at such time. We will pay Citadel a commission equal to 3% of the gross proceeds from the sale of shares of our common stock under the Sales Agreement. The offering of common stock pursuant to the Sales Agreement will terminate upon the earlier of (a) the sale of all of the common stock subject to the Sales Agreement or (b) the termination of the Sales Agreement by us or Citadel. Either party may terminate the Sales Agreement in its sole discretion at any time upon written notice to the other party.

On July 28, 2011, we terminated our existing loan agreement with Comerica Bank and on August 2, 2011, we entered into a new loan and security agreement (the “Loan Agreement”) with the Lenders pursuant to which the Lenders made to us a term loan in the principal amount of $15.0 million. The term loan bears interest at 7.5% per annum. We are obligated to pay interest on the loan through December 31, 2011, and to thereafter pay the principal balance of the loan and interest in 24 equal monthly installments through December 31, 2013. At our option, we may prepay all or any part of the outstanding principal balance, subject to a pre-payment fee of $150,000. We will be required to repay the entire outstanding principal balance if a generic version of Silenor enters the market while the loan is outstanding. We paid to the Lenders an initial fee of $150,000 upon the closing of the term loan. In the event of the final payment of the loan, either through repayment of the loan in full at maturity or upon any pre-payment, we are required to pay a final payment fee of $637,500. In connection with the Loan Agreement, we granted the Lenders a security interest in substantially all of our personal property now owned or hereafter acquired, excluding intellectual property. Under the Loan Agreement, we are subject to certain affirmative and negative covenants, including limitations on our ability to: undergo certain change of control events; convey, sell, lease, license, transfer or otherwise dispose of assets, other than in certain specified circumstances; create, incur, assume, guarantee or be liable with respect to certain indebtedness; grant liens; pay dividends and make certain other restricted payments; and make certain investments. In addition, under the Loan Agreement, subject to certain exceptions, we are required to maintain with SVB our primary cash and investment accounts, which accounts are also covered by control agreements for the benefit of the Lenders. We have currently met all of our obligations under the loan agreement. We are also required to maintain the Sales Agreement unless we raise at least $30 million in equity proceeds.

As part of the financing, the Lenders received warrants to purchase up to an aggregate of 583,152 fully paid and non-assessable shares of our common stock at an exercise price equal to $1.5433 per share. The warrants will expire ten years from the date of the grant.

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

The interim financial statements and this Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the financial statements and notes thereto for the year ended December 31, 2010, and the related Management’s Discussion and Analysis of Financial Condition and Results of Operations, both of which are contained in our Annual Report on Form 10-K for the year ended December 31, 2010. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties, and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including but not limited to those set forth under the caption “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2010 and the caption “Risk Factors” in this Quarterly Report on Form 10-Q for the quarter ended June 30, 2011.

Overview

Background

We are a specialty pharmaceutical company focused on the in-licensing, development and commercialization of proprietary branded products and late-stage product candidates to treat important medical conditions where there is an unmet medical need and/or high-level of patient dissatisfaction, currently in the central nervous system therapeutic area. In March 2010, the U.S. Food and Drug Administration, or FDA, approved our New Drug Application, or NDA, for Silenor 3 mg and 6 mg tablets for the treatment of insomnia characterized by difficulty with sleep maintenance. Silenor was made commercially available by prescription in the United States in September 2010.

Our principal focus is on commercial activities relating to Silenor. We have increased our headcount from 5 employees as of March 2010 to 44 employees as of July 15, 2011. We commercially launched Silenor in September 2010 with 110 sales representatives provided to us on an exclusive basis under our contract sales agreement with Publicis Touchpoint Solutions, Inc., or Publicis, and an additional 105 sales representatives provided to us under our co-promotion agreement with Procter and Gamble, or P&G. In February 2011, we engaged Publicis to provide us with an additional 35 sales representatives that were fully deployed as of early April 2011. We have also established the manufacturing and distribution channel for Silenor through agreements with third-party suppliers and service providers, and we have established reimbursement coverage for Silenor with numerous private and government payors. In June 2011, we entered into agreements with Paladin Labs Inc., or Paladin, under which Paladin will commercialize Silenor in Canada, South America, the Caribbean and Africa.

Critical Accounting Policies and Estimates

Management’s discussion and analysis of our financial condition and results of operations is based on our condensed financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed 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. We believe the following accounting policies to be critical to the judgments and estimates used in the preparation of our condensed financial statements.

Revenue Recognition

Product Sales

We sell Silenor to wholesale pharmaceutical distributors. Our returned goods policy generally permits our customers to return products up to six months before and up to twelve months after the expiration date of the product. We authorize returns for expired products in accordance with our returned goods policy and issue credit to our customers for expired returned product. We do not exchange product from inventory for returned product. As of June 30, 2011, the dollar amount of returns received in 2011 has been negligible.

We recognize product revenue from product sales when it is realized or realizable and earned. Revenue is realized or realizable and earned when all of the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) our price to the buyer is fixed or determinable; and (4) collectability is reasonably assured. Revenue from sales transactions where the buyer has the right to return the product is recognized at the time of sale only if (1) our price to the buyer is substantially fixed or determinable at the date of sale, (2) the buyer has paid us, or the buyer is obligated to pay us and the obligation is not contingent on resale of the product, (3) the buyer’s obligation to us would not be changed in the event of theft or physical destruction or damage of the product, (4) the buyer acquiring the product for resale has economic substance apart from that provided by us, (5) we do not have significant obligations for future performance to directly bring about resale of the product by the buyer, and (6) the amount of future returns can be reasonably estimated.

Prior to the second quarter of 2011, we were unable to reasonably estimate returns. We therefore deferred revenue recognition until the right of return no longer existed, which was the earlier of Silenor being dispensed through patient prescriptions or the expiration of the right of return. We estimated patient prescriptions dispensed using an analysis of third-party information. In order to develop a methodology to reliably estimate product returns and provide a basis for recognizing revenue on sales to customers at the time of product shipment, we analyzed many factors, including, without limitation, industry data regarding product return rates, and tracked the Silenor product return history, taking into account product expiration dating at the time of shipment and levels of inventory in the wholesale channel compared to prescription units dispensed and the sell-down of our launch inventory. During the second quarter of 2011, the sell-down of our launch inventory was completed, which we believe demonstrates sufficient market acceptance of our product for purposes of our revenue recognition analysis. In addition, since product launch, we have sold product to wholesale pharmaceutical distributors at standard commercial terms utilized in the industry. As a result, we believe we can analogize to industry data regarding product return rates. Based on the sell-down of our launch inventory and the industry and internal data gathered, we believe we have the information needed to reasonably estimate product returns. As a result, in the second quarter of 2011, we began recognizing revenue for Silenor sales at the time of delivery of the product to wholesale pharmaceutical distributors and our other customers.

License and Royalty Revenue

In June 2011, we entered into a license agreement with Paladin. Under the license agreement, Paladin will commercialize Silenor in Canada, South America, the Caribbean and Africa. We received an upfront payment of $500,000 in connection with the execution of this agreement. We recorded the upfront payment as deferred revenue and are recognizing the upfront payment as license revenue over the period of our significant involvement under the agreement, which we are estimating to be 15 years. As of June 30, 2011, the deferred revenue balance associated with the license agreement is $497,000. We recognized $3,000 as revenue during each of the three and six months ended June 30, 2011 which is recorded in other income and expense.

Once Silenor is commercialized in the licensed territories, we will be eligible to receive sales-based milestone payments of up to $128.5 million as well as a tiered double-digit percentage of net sales in the licensed territories. Due to the uncertainty surrounding the achievement of these future sales-based milestones and royalties, these potential payments will not be recognized as revenue until they are realized and earned.

Product Sales Discounts and Allowances

We record product sales discounts and allowances at the time of sale and report revenue net of such amounts in the same period that product sales are recorded. In determining the amount of product sales discounts and allowances, we must make significant judgments and estimates. If actual results vary from our estimates, we may need to adjust these estimates, which could have an effect on product revenue in the period of adjustment. Our product sales discounts and allowances and the specific considerations we use in estimating these amounts include:

Prompt Pay Discounts. As an incentive for prompt payment, we offer a 2% cash discount to customers. We expect that all customers will comply with the contractual terms to earn the discount. We record the discount as an allowance against accounts receivable and a corresponding reduction of revenue. At June 30, 2011 and December 31, 2010, the allowance for prompt pay discounts was $40,000 and $114,000, respectively.

Patient Discount Programs. We offer discount programs to patients of Silenor under which the patient receives a discount on his or her prescription. We reimburse pharmacies for these discounts through third-party vendors. We estimate the total amount that will be redeemed based on the dollar amount of the discounts, the timing and quantity of distribution and historical redemption rates. We accrue the discounts and recognize a corresponding reduction of revenue. At June 30, 2011 and December 31, 2010, the accrual for patient discount programs was $376,000 and $182,000, respectively.

Distribution Service Fees. We pay distribution services fees to each wholesaler for distribution and inventory management services. We accrue for these fees based on contractually defined terms with each wholesaler and recognize a corresponding reduction of revenue. At June 30, 2011 and December 31, 2010, the accrual for distribution service fees was $240,000 and $276,000, respectively.

Chargebacks. We provide discounts to federal government qualified entities with whom we have contracted. These federal entities purchase products from the wholesalers at a discounted price, and the wholesalers then charge back to us the difference between the current retail price and the contracted price the federal entity paid for the product. We accrue chargebacks based on contract prices and sell-through sales data obtained from third party information. At June 30, 2011 and December 31, 2010, the accrual for chargebacks was $13,000 and $9,000, respectively.

Rebates. We participate in certain rebate programs, which provide discounted prescriptions to qualified insured patients. Under these rebate programs, we pay a rebate to the third-party administrator of the program. We accrue rebates based on contract prices, estimated percentages of product sold to qualified patients and estimated levels of inventory in the distribution channel. At June 30, 2011 and December 31, 2010, the accrual for rebates was $536,000 and $6,000, respectively.

Product Returns. We estimate future product returns based upon actual returns history, analysis of product expiration dating, estimated inventory levels in the distribution channel, and industry data regarding product return rates for similar products. There may be a significant time lag between the date we determine the estimated allowance and when we receive product returns and issue credits to customers. Due to this time lag, we may record adjustments to our estimated allowance over several periods, which would impact our operating results in those periods. At June 30, 2011, the allowance for product returns was $85,000.

As we expand our managed care rebate programs and discount programs to offset patients’ out of pocket costs, we expect product sales discounts and allowances to increase.

The following table summarizes the activity for the six months ended June 30, 2011 associated with product sales discounts and allowances, with amounts shown in thousands. From the initial launch of Silenor through September 30, 2010, we offered additional discounts to wholesale distributors for product purchased. At June 30, 2011 and December 31, 2010, the allowance for product launch discounts was $0 and $277,000, respectively.

																						Total
																						Accrued
																						Sales
		Prompt				Patient								Charge-								Discounts
		Pay				Discount				Distribution				backs and				Product				and
		Discounts				Fees				Service Fees				Rebates				Returns				Allowances
Balance at January 1, 2011		$	114			$	182			$	276			$	15			$	—			$	587
Provision made for sales during period			137				435				448				627				85				1,732
Payments			(211	)			(241	)			(484	)			(93	)			—				(1,029	)
Balance at June 30, 2011		$	40			$	376			$	240			$	549			$	85			$	1,290

Cost of Sales

Cost of sales includes the costs to manufacture, package, and ship Silenor, including personnel costs associated with manufacturing oversight, as well as royalties and amortization of capitalized license fees associated with our license agreement with ProCom One, Inc., or ProCom.

Inventory

Our inventories are valued at the lower of weighted average cost or net realizable value. We analyze our inventory levels quarterly and write down inventory that has become obsolete, or has a cost basis in excess of its expected net realizable value, as well as any inventory quantities in excess of expected requirements. Expired inventory is disposed of and the related costs are written off.

Capitalized License Fees

License fees related to our intellectual property are capitalized once technological feasibility has been established. Determining when technological feasibility has been achieved, and determining the related amortization period for capitalized intellectual property, requires the use of estimates and subjective judgment. Costs incurred to in-license our product candidates subsequent to FDA approval of our NDA for Silenor have been capitalized and recorded as an intangible asset. Capitalized amounts are amortized on a straight line basis over approximately ten years.

Share-based Compensation

Share-based compensation expense for employees and directors is recognized in the statement of operations based on estimated amounts, including the grant date fair value, the probability of achieving performance conditions and the expected service period for awards with conditional vesting provisions. For stock options, we estimate the grant date fair value using the Black-Scholes valuation model which requires the use of multiple subjective inputs including an estimate of future volatility, expected forfeitures and the expected terms of the awards. Our stock did not have a readily available market prior to our initial public offering in December 2005, creating a relatively short history from which to obtain data to estimate volatility for our stock price. Consequently, we estimate our expected future volatility based on a combination of both comparable companies and our own stock price volatility to the extent such history is available. Our future volatility may differ from our estimated volatility at the grant date. We estimate the expected term of our options using guidance provided by the Securities and Exchange Commission, or SEC, in Staff Accounting Bulletin, or SAB, No. 107 and SAB No. 110. This guidance provides a formula-driven approach for determining the expected term. Share-based compensation recorded in our statement of operations is based on awards expected to ultimately vest and has been reduced for estimated forfeitures. Our estimated forfeiture rates may differ from actual forfeiture rates which would affect the amount of expense recognized during the period. Estimated forfeitures are adjusted to actual amounts as they become known.

We recognize the value of the portion of the awards that are expected to vest on a straight-line basis over the awards’ requisite service periods. The requisite service period is generally the time over which our share-based awards vest. Some of our share-based awards vested upon achieving certain performance conditions, generally pertaining to the commercial performance of Silenor or the achievement of other strategic objectives. Share-based compensation expense for awards with performance conditions is recognized over the period from the date the performance condition is determined to be probable of occurring through the time the applicable condition is met. If the performance condition is not considered probable of being achieved, then no expense is recognized until such time the performance condition is considered probable of being met. At that time, expense is recognized over the period during which the performance condition is likely to be achieved. Determining the likelihood and timing of achieving performance conditions is a subjective judgment made by management which may affect the amount and timing of expense related to these share-based awards. Share-based compensation is adjusted to reflect the value of options which ultimately vest as such amounts become known in future periods. As a result of these subjective and forward-looking estimates, the actual value of our stock options realized upon exercise could differ significantly from those amounts recorded in our financial statements.

Results of Operations

Comparisons of the Three Months Ended June 30, 2011 and 2010

Product Sales. Product sales represent sales of Silenor for which we have recognized revenue. Net product sales for 2011 and 2010 are summarized in the following table (in thousands, except percentages).

		Three Months Ended
		June 30,								Change
		2011				2010				Dollar				Percent
Gross product sales		$	8,234			$	—			$	8,234				N/A
Discounts and allowances			(1,992	)			—				(1,992	)			N/A
Total net product sales		$	6,242			$	—			$	6,242				N/A

We recognized net product sales of $6.2 million for the three months ended June 30, 2011 and had no product sales for the comparable period in 2010 as sales of Silenor commenced in the third quarter of 2010. Reductions from gross to net product sales, which include allowances for discounts, patient discount programs, distribution service fees, chargebacks, rebates and returns, totaled $2.0 million for the three months ended June 30, 2011, compared to $0 in the same period in 2010. As a percentage of gross sales, the reductions were 24.2% for the three months ended June 30, 2011. As a result of recognizing revenue upon delivery to our wholesale customers, we recognized additional net product sales of Silenor of $3.2 million.

Cost of Sales. Cost of sales includes the costs to manufacture, package, and ship Silenor, including personnel costs associated with manufacturing oversight, as well as royalties and amortization of capitalized license fees associated with our license agreement. Cost of sales for 2011 and 2010 are summarized in the following table (in thousands, except percentages).

		Three Months Ended
		June 30,								Change
		2011				2010				Dollar				Percent
Cost of sales		$	661			$	—			$	661				N/A

We recognized cost of sales of $0.7 million for the three months ended June 30, 2011 relating to product with respect to which revenue was recognized. We had no cost of sales for the comparable period in 2010 as sales of Silenor commenced in the third quarter of 2010. Gross profit was $5.6 million for the three months ended June 30, 2011. Expressed as a percentage of net product sales, gross margin was 89.4% for the three months ended June 30, 2011.

Selling, General and Administrative Expense. Our selling, general and administrative expenses consist primarily of salaries, benefits, share-based compensation expense, advertising and market research costs, insurance and facility costs, and professional fees related to our marketing, administrative, finance, human resources, legal and internal systems support functions. Selling, general and administrative expense for 2011 and 2010 are summarized in the following tables (in thousands, except percentages).

		Three Months Ended
		June 30,								Change
		2011				2010				Dollar				Percent
Sales and marketing		$	14,849			$	2,196			$	12,653				576	%
General and administrative			5,224				2,706				2,518				93	%
Total selling, general and administrative expense		$	20,073			$	4,902			$	15,171				309	%

Selling and marketing expenses totaled $14.8 million and $2.2 million for the three months ended June 30, 2011 and 2010, respectively. Of this, share-based compensation expense totaled $0.4 million and $0.2 million for the three months ended June 30, 2011 and the comparable period in 2010, respectively. The net increase of $12.6 million was due to the costs associated with the commercial activities of Silenor. These costs included the costs of our sales representatives, royalties paid to our co-promotion partner, personnel costs and other promotional spending and consulting costs.

General and administrative expenses totaled $5.2 million and $2.7 million for the three months ended June 30, 2011 and 2010, respectively. Of this, share-based compensation expense totaled $0.8 million and $0.9 million for the three months ended June 30, 2011 and 2010, respectively. The net increase of $2.5 million was primarily due to an increase in salary and benefits expense resulting from an increase in overall headcount during the three months ended June 30, 2011 compared to the comparable period in 2010.

Research and Development Expense. Our most significant research and development costs during the three months ended June 30, 2011 were salaries, benefits and share-based compensation expense related to our research and development personnel. Research and development expense for 2011 and 2010 are summarized in the following table (in thousands, except percentages).

		Three Months Ended
		June 30,								Change
		2011				2010				Dollar				Percent
Personnel and other costs		$	309			$	605			$	(296	)			(49	)%
Share-based compensation expense			148				209				(61	)			(29	)%
Total research and development expense		$	457			$	814			$	(357	)			(44	)%

Research and development expense decreased $0.4 million for the three months ended June 30, 2011 compared to the same period in 2010 primarily due to lower personnel and other costs. Personnel and other costs attributable to research and development personnel decreased due to the commercial launch of Silenor in September 2010.

Comparisons of the Six Months Ended June 30, 2011 and 2010

Product Sales. Product sales represent sales of Silenor for which we have recognized revenue. Net product sales for 2011 and 2010 are summarized in the following table (in thousands, except percentages).

		Six Months Ended
		June 30,								Change
		2011				2010				Dollar				Percent
Gross product sales		$	11,112			$	—			$	11,112				N/A
Discounts and allowances			(2,548	)			—				(2,548	)			N/A
Total net product sales		$	8,564			$	—			$	8,564				N/A

We recognized net product sales of $8.6 million for the six months ended June 30, 2011 and had no product sales for the comparable period in 2010 as sales of Silenor commenced in the third quarter of 2010. Reductions from gross to net product sales, which include allowances for discounts, patient discount programs, distribution service fees, chargebacks, rebates and returns, totaled $2.5 million for the six months ended June 30, 2011, compared to $0 in the same period in 2010. As a percentage of gross sales, the reductions were 22.9% for the six months ended June 30, 2011. As a result of recognizing revenue upon delivery to our wholesale customers, in the second quarter of 2011 we recognized additional net product sales of Silenor of $3.2 million.

Cost of Sales. Cost of sales includes the costs to manufacture, package, and ship Silenor, including personnel costs associated with manufacturing oversight, as well as royalties and amortization of capitalized license fees associated with our license agreement. Cost of sales for 2011 and 2010 are summarized in the following table (in thousands, except percentages).

		Six Months Ended
		June 30,								Change
		2011				2010				Dollar				Percent
Cost of sales		$	1,024			$	—			$	1,024				N/A

We recognized cost of sales of $1.0 million for the six months ended June 30, 2011 relating to product with respect to which revenue was recognized. We had no cost of sales for the comparable period in 2010 as sales of Silenor commenced in the third quarter of 2010. Gross profit was $7.5 million for the six months ended June 30, 2011. Expressed as a percentage of net product sales, gross margin was 88.0% for the six months ended June 30, 2011.

Selling, General and Administrative Expense. Our selling, general and administrative expenses consist primarily of salaries, benefits, share-based compensation expense, advertising and market research costs, insurance and facility costs, and professional fees related to our marketing, administrative, finance, human resources, legal and internal systems support functions. Selling, general and administrative expense for 2011 and 2010 are summarized in the following tables (in thousands, except percentages).

		Six Months Ended
		June 30,								Change
		2011				2010				Dollar				Percent
Sales and marketing		$	28,358			$	2,982			$	25,376				851	%
General and administrative			10,308				4,972				5,336				107	%
Total selling, general and administrative expense		$	38,666			$	7,954			$	30,712				386	%

Selling and marketing expenses totaled $28.4 million and $3.0 million for the six months ended June 30, 2011 and 2010, respectively. Of this, share-based compensation expense totaled $0.7 million and $0.6 million for the six months ended June 30, 2011 and the comparable period in 2010, respectively. The net increase of $25.4 million was due to the costs associated with the commercial activities of Silenor. These costs included the costs of our sales representatives, royalties paid to our co-promotion partner, personnel costs and other promotional spending and consulting costs.

General and administrative expenses totaled $10.3 million and $5.0 million for the six months ended June 30, 2011 and 2010, respectively. Of this, share-based compensation expense totaled $1.6 million and $2.2 million for the six months ended June 30, 2011 and 2010, respectively. The net increase of $5.3 million was primarily due to an increase in salary and benefits expense resulting from an increase in overall headcount during the six months ended June 30, 2011 compared to the comparable period in 2010. This was offset by a decrease in share-based compensation expense due to higher share-based compensation expense during the six months ended June 30, 2010 as a result of vesting of performance-based equity awards upon FDA approval of the NDA for Silenor.

Research and Development Expense. Our most significant research and development costs during the six months ended June 30, 2011 were salaries, benefits and share-based compensation expense related to our research and development personnel. Research and development expense for 2011 and 2010 are summarized in the following table (in thousands, except percentages).

		Six Months Ended
		June 30,								Change
		2011				2010				Dollar				Percent
Personnel and other costs		$	582			$	1,167			$	(585	)			(50	)%
Share-based compensation expense			294				760				(466	)			(61	)%
Total research and development expense		$	876			$	1,927			$	(1,051	)			(55	)%

Research and development expense decreased $1.1 million for the six months ended June 30, 2011 compared to the same period in 2010 primarily due to lower personnel and other costs and share-based compensation expense. Personnel and other costs attributable to research and development personnel decreased due to the commercial launch of Silenor in September 2010. Share-based compensation expense attributable to research and development personnel decreased due to recognition of compensation costs associated with the vesting of performance-based equity awards upon FDA approval of the NDA for Silenor in the first half of 2010.

Liquidity and Capital Resources

We expect to continue to incur losses and have negative cash flows from operations in the foreseeable future as we continue our commercial activities for Silenor, commercialize any other products to which we obtain rights and potentially pursue the development of other product candidates. As a result, we may need to obtain additional funds to finance our operations in the future. Until we can generate significant cash from our operations, we intend to obtain any additional funding we require through strategic relationships, public or private equity or debt financings, assigning receivables or royalty rights, or other arrangements and we cannot assure such funding will be available on reasonable terms, or at all.

As of June 30, 2011, we had $30.9 million in cash, cash equivalents and short-term investments. We have received $14.9 million in net proceeds pursuant to a loan and security agreement with Silicon Valley Bank, or SVB, and Oxford Finance LLC, or together with SVB, the Lenders. We believe we have sufficient financial resources to fund our operations for at least the next twelve months. We may need to obtain additional funds to finance our operations, particularly if we are unable to access adequate or timely funds under our at-the-market equity sales agreement with Citadel Securities LLC, or Citadel. Actual financial results for the period of time through which our financial resources will be adequate to support our operations could vary based upon many factors, including but not limited to the rate of growth of Silenor sales, the actual cost of commercial activities and any potential litigation expenses we may incur.

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

•

our success in generating cash flows from the commercialization of Silenor, together with our co-promotion partner P&G and our licensee Paladin;

•

the costs of establishing or contracting for commercial programs and resources;

•

the terms and timing of any future collaborative, licensing and other arrangements that we may establish;

•

the costs of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights;

•

the extent to which we acquire or in-license new products, technologies or businesses;

•

the rate of progress and cost of our non-clinical studies, clinical trials and other development activities;

•

the scope, prioritization and number of development programs we pursue; and

•

the effect of competing technological and market developments.

If our efforts in raising additional funds when needed are unsuccessful, we may be required to delay, scale-back or eliminate plans or programs relating to our business, relinquish some or all rights to Silenor or renegotiate less favorable terms with respect to such rights than we would otherwise choose or cease operating as a going concern. In addition, if we do not meet our payment obligations to third parties as they come due, we may be subject to litigation claims. Even if we were successful in defending against these claims, litigation could result in substantial costs and be a distraction to management, and may result in unfavorable results that could further adversely impact our financial condition.

If we are unable to continue as a going concern, we may have to liquidate our assets and may receive less than the value at which those assets are carried on our financial statements, and it is likely that investors will lose all or a part of their investments. These financial statements do not include any adjustments that might result from the outcome of this uncertainty.

We have invested a substantial portion of our available cash in marketable securities and money market funds. The capital markets have recently been highly volatile and there has been a lack of liquidity for certain financial instruments, especially those with exposure to mortgage-backed securities and auction rate securities. All of our investments in marketable securities and money market funds are highly rated, highly liquid securities with readily determinable fair values. As of June 30, 2011, none of our securities are considered to be impaired.

We have two effective shelf registration statements on Form S-3 filed with the SEC under which we may offer from time to time up to an aggregate of approximately $67.1 million in any combination of debt securities, common and preferred stock and warrants. These registration statements could allow us to seek additional financing, subject to the SEC’s rules and regulations relating to eligibility to use Form S-3. Additional equity financing will be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants.

Cash Flows

Net cash used in operating activities was $28.4 million for the six months ended June 30, 2011, compared to $5.7 million for the same period in 2010. The increase in net cash used in operating activities was primarily due to an increase in our net loss in 2011 as compared to the prior year.

Net cash provided by investing activities was $30.8 million for the six months ended June 30, 2011, compared to net cash used in investing activities of $1.1 million for the same period in 2010. Results for 2011 reflect net sales and maturities of marketable securities of $31.3 million and payments for property and equipment of $0.3 million. Results for 2010 reflect a $1.0 million milestone payment to ProCom under our license agreement which became due as a result of the approval by the FDA of our NDA for Silenor.

Net cash provided by financing activities was $5.0 million for the six months ended June 30, 2011, compared to net cash provided by financing activities of $56.1 million for the same period in 2010. Results for 2011 reflect proceeds of $5.0 million received from Paladin from the sale by us of 2.2 million shares of our common stock. Results for 2010 reflect cash proceeds of $52.7 million from our follow-on offering and proceeds of $3.4 million from the exercise of warrants and stock options.

Loan Agreement

On July 28, 2011, we terminated our existing loan agreement with Comerica Bank and we entered into a new loan and security agreement with the Lenders, pursuant to which the Lenders made us a term loan in the principal amount of $15.0 million. The term loan bears interest at 7.5% per annum. We are obligated to pay interest on the loan through December 31, 2011, and to thereafter pay the principal balance of the loan and interest in 24 equal monthly installments starting on January 1, 2012 and continuing through December 31, 2013. At our option, we may prepay all or any part of the outstanding principal balance, subject to a pre-payment fee of $150,000. We will be required to repay the entire outstanding principal balance if a generic version of Silenor enters the market while the loan is outstanding. We paid to the Lenders an initial fee of $150,000 upon the closing of the term loan. In the event of the final payment of the loan, either through repayment of the loan in full at maturity or upon any pre-payment, we are required to pay a final payment fee of $637,500. In connection with the loan agreement, we granted the Lenders a security interest in substantially all of our personal property now owned or hereafter acquired, excluding intellectual property. Under the loan agreement, we are subject to certain affirmative and negative covenants, including limitations on our ability to: undergo certain change of control events; convey, sell, lease, license, transfer or otherwise dispose of assets, other than in certain specified circumstances; create, incur, assume, guarantee or be liable with respect to certain indebtedness; grant liens; pay dividends and make certain other restricted payments; and make certain investments. In addition, under the loan agreement, subject to certain exceptions, we are required to maintain with SVB our primary cash and investment accounts, which accounts are also covered by control agreements for the benefit of the Lenders. We have currently met all of our obligations under the loan agreement. We are also required to maintain the at-the-market equity sales agreement, or the sales agreement, with Citadel unless we raise at least $30 million in equity proceeds.

As part of the financing, the Lenders received warrants to purchase up to an aggregate of 583,152 fully paid and non-assessable shares of our common stock at an exercise price equal to $1.5433 per share. The warrants will expire ten years from the date of the grant.

Equity Sales Agreement

On August 1, 2011, we entered into the sales agreement with Citadel pursuant to which we agreed to sell, at our option, up to an aggregate of $30.0 million in shares of our common stock through Citadel, as sales agent. Sales of the common stock made pursuant to the sales agreement, if any, will be made on the NASDAQ Stock Market under our currently-effective Registration Statements on Form S-3 by means of ordinary brokers’ transactions at market prices. Additionally, under the terms of the sales agreement, we may also sell shares of our common stock through Citadel, on the NASDAQ Stock Market or otherwise, at negotiated prices or at prices related to the prevailing market price. Under the terms of the sales agreement, we may also sell shares to Citadel as principal for Citadel’s own account at a price agreed upon at the time of sale pursuant to a separate terms agreement to be entered into with Citadel at such time. We will pay Citadel a commission equal to 3% of the gross proceeds from the sale of shares of our common stock under the sales agreement. We or Citadel may terminate the sales agreement at any time. The offering of common stock pursuant to the sales agreement will terminate upon the earlier of (a) the sale of all of the common stock subject to the sales agreement or (b) the termination of the sales agreement by us or Citadel. Either party may terminate the agreement in its sole discretion at any time upon written notice to the other party.

Litigation

We have received notices from each of Actavis Elizabeth LLC and Actavis Inc., or collectively, Actavis, Mylan Pharmaceuticals Inc. and Mylan, Inc., or collectively, Mylan, Par Pharmaceutical, Inc. and Par Pharmaceutical Companies, Inc., or collectively, Par, and Zydus Pharmaceuticals USA, Inc. and Cadila Healthcare Limited (d/b/a Zydus Cadila), or collectively, Zydus, that each that each has filed with the FDA an ANDA for a generic version of Silenor 3 mg and 6 mg tablets. The notices included “paragraph IV certifications” with respect to eight of the nine patents listed in the Orange Book for Silenor. A paragraph IV certification is a certification by a generic applicant that in the opinion of that applicant, the patent(s) listed in the Orange Book for a branded product are invalid, unenforceable, and/or will not be infringed by the manufacture, use or sale of the generic product.

We, together with ProCom, have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus. The lawsuits allege that each of Actavis, Mylan, Par and Zydus have infringed U.S. Patent No. 6,211,229, or the ’229 patent, by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

In addition, we have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that such parties have infringed U.S. Patent No. 7,915,307, or the ’307 patent, by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

Pursuant to the provisions of the Hatch-Waxman Act, FDA final approval of the Actavis and Mylan ANDAs can occur no earlier than May 3, 2013, FDA final approval of the Par ANDA can occur no earlier than June 23, 2013 and FDA final approval of the Zydus ANDA can occur no earlier than November 13, 2013, unless in each case there is an earlier court decision that the ’229 patent and the ’307 patent are not infringed and/or invalid or unless any party to the action is found to have failed to cooperate reasonably to expedite the infringement action.

At this time, the other patents included in Orange Book have not been asserted against these parties.

We intend to vigorously enforce our intellectual property rights relating to Silenor, but we cannot predict the outcome of these matters.

The prosecution of the lawsuits against Actavis, Mylan, Par and Zydus will increase our cash expenditures. Any adverse outcome in this litigation could result in one or more generic versions of Silenor being launched before the expiration of the listed patents, which could adversely affect our ability to successfully execute our business strategy to increase sales of Silenor and would negatively impact our financial condition and results of operations, including causing a significant decrease in our revenues and cash flows.

Contractual Obligations

In May 2011, we entered into a new lease arrangement to rent approximately 12,100 square feet of office space, which we plan to use as our new corporate headquarters. The lease will commence on the date that the premises are delivered to us after tenant improvements have been completed. The lease will expire 64 months after the date that the lease term commences, and we will have the option to extend the term for an additional five years at the then-current fair market rental rate (as defined in the lease).

We have paid the first month’s rent of approximately $30,000 and the monthly rent following lease commencement will be approximately $30,000. However, the second through thirteenth month’s rent will be abated by one-half provided that we are not in default of the lease. If the lease has not commenced by September 1, 2011, then we shall receive one day of free rent and the abated rent shall also be extended for an additional day for each day that the commencement of the lease is delayed, other than due to delays by us. After the first year, the monthly rent will increase by 3.5% per year, and we will provide reimbursements for our proportional share of any increases in operating expenses over the first year’s operating expenses (as defined in the lease). We have also have a $200,000 letter of credit in favor of our landlord to secure our obligations under the lease.

A summary of our other minimum contractual obligations related to our major outstanding contractual commitments is included in our Annual Report on Form 10-K for the year ended December 31, 2010.

Off-Balance Sheet Arrangements

We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Recent Accounting Pronouncements

In October 2009, the FASB issued ASU No. 2009-13 “Revenue Recognition,” which provides guidance on recognizing revenue in arrangements with multiple deliverables. This standard impacts the determination of when the individual deliverables included in a multiple element arrangement may be treated as a separate unit of accounting. It also modifies the manner in which the consideration received from the transaction is allocated to the multiple deliverables and no longer permits the use of the residual method of allocating arrangement consideration. This accounting standard is effective for the first reporting period beginning on or after June 15, 2010, with early adoption permitted. The adoption of ASU 2009-13 did not have a material impact on the financial statements.

In December 2010, the FASB issued ASU No. 2010-27 “Other Expenses: Fees Paid to the Federal Government by Pharmaceutical Manufacturers,” which provides guidance concerning the recognition and classification of the new annual fee payable by branded prescription drug manufacturers and importers on branded prescription drugs which was mandated under the health care reform legislation enacted in the United States in March 2010. Under this new authoritative guidance, the annual fee should be estimated and recognized in full as a liability upon the first qualifying commercial sale with a corresponding deferred cost that is amortized to operating expenses using a straight-line method unless another method better allocates the fee over the calendar year in which it is payable. This new guidance is effective for calendar years beginning on or after December 31, 2010, when the fee initially becomes effective. The adoption of ASU 2010-27 did not have a material impact on our financial statements.

In May 2011, the FASB issued ASU No. 2011-04 “Fair Value Measurement: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” Some of the amendments clarify the Board’s intent about the application of existing fair value measurement requirements. Other amendments change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. This guidance is effective for interim and annual periods beginning after December 15, 2011. We are still evaluating the potential future effects of this guidance.

In June 2011, the FASB issued ASU No. 2011-05 “Comprehensive Income: Presentation of Comprehensive Income.” Under the new guidance, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. This guidance is effective for interim and annual periods beginning after December 15, 2011. We have evaluated the potential future effects of this guidance and do not expect the adoption of ASU 2011-05 to have a material impact on our financial statements.

Caution on Forward-Looking Statements

Any statements in this report about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and are forward-looking statements. You can identify these forward-looking statements by the use of words or phrases such as “believe,” “may,” “could,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “seek,” “plan,” “expect,” “should” or “would.” Among the factors that could cause actual results to differ materially from those indicated in the forward-looking statements are risks and uncertainties inherent in our business including, without limitation: our ability to successfully commercialize Silenor; the market potential for insomnia treatments, and our ability to compete within that market; our reliance on our co-promotion partner, P&G, and our contract sales force provider, Publicis, for critical aspects of the commercial sales process for Silenor; the performance of P&G and Publicis and their adherence to the terms of their contracts with us; the ability of our sales management personnel to effectively manage the sales representatives employed by Publicis; our ability to successfully enforce our intellectual property rights and defend our patents, including any developments relating to the recent submission of ANDAs for generic versions of Silenor 3 mg and 6 mg tablets and related patent litigation; the scope, validity and duration of patent protection and other intellectual property rights for Silenor; whether the approved label for Silenor is sufficiently consistent with such patent protection to provide exclusivity for Silenor; the possible introduction of generic competition of Silenor; our ability to ensure adequate and continued supply of Silenor to successfully meet anticipated market demand; our ability to raise sufficient capital to fund our operations, including patent infringement litigation, and the impact of any financing activity on the level of our stock price; the impact of any inability to raise sufficient capital to fund ongoing operations, including any patent infringement litigation; our ability to comply with the covenants under the Loan Agreement with the Lenders; the potential for an event of default under the Loan Agreement, and the corresponding risk of acceleration of repayment and potential foreclosure on the assets pledged to secure the loan; our ability to fully utilize the sales agreement with Citadel as a source of future financings, whether due to market conditions, our ability to satisfy various conditions required to sell shares under the agreement, Citadel’s performance of its obligations under the agreement or otherwise; the impact on the level of our stock price, which may decline, in connection with the implementation of the sales agreement or the occurrence of any sales under the agreement; changes in healthcare regulation and reimbursement policies; our ability to operate our business without infringing the intellectual property rights of others; our reliance on our licensee, Paladin, for critical aspects of the commercial sales process for Silenor outside of the United States; the performance of Paladin and its adherence to the terms of its contracts with us; inadequate therapeutic efficacy or unexpected adverse side effects relating to Silenor that could result in recalls or product liability claims; other difficulties or delays in development, testing, manufacturing and marketing of Silenor; the timing and results of post-approval regulatory requirements for Silenor, and the FDA’s agreement with our interpretation of such results; and other risks detailed in this report under Part II — Item 1A — Risk Factors below and previously disclosed in our Annual Report on Form 10-K.

Although we believe that the expectations reflected in our forward-looking statements are reasonable, we cannot guarantee future results, events, levels of activity, performance or achievement. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless required by law. This caution is made under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995.

Item 3.		Quantitative and Qualitative Disclosures about Market Risk

Our cash and cash equivalents at June 30, 2011 consisted primarily of money market funds and marketable securities. The primary objective of our investment activities is to preserve principal while maximizing the income we receive from our investments without significantly increasing risk. Historically, our primary exposure to market risk is interest rate sensitivity. This means that a change in prevailing interest rates may cause the value of the investment to fluctuate. For example, if we purchase a security that was issued with a fixed interest rate and the prevailing interest rate later rises, the value of our investment will probably decline. Currently, our holdings are in money market funds and marketable securities, and therefore this interest rate risk is minimal. To minimize our interest rate risk going forward, we intend to continue to maintain our portfolio of cash, cash equivalents and marketable securities in a variety of securities consisting of money market funds and United States government debt securities, all with various maturities. In general, money market funds are not subject to market risk because the interest paid on such funds fluctuates with the prevailing interest rate. We also generally time the maturities of our investments to correspond with our expected cash needs, allowing us to avoid realizing any potential losses from having to sell securities prior to their maturities.

Our cash is invested in accordance with a policy approved by our board of directors which specifies the categories, allocations, and ratings of securities we may consider for investment. We do not believe our cash and cash equivalents and short-term investments have significant risk of default or illiquidity. We made this determination based on discussions with our treasury managers and a review of our holdings. While we believe our cash and cash equivalents and short-term investments are well diversified and do not contain excessive risk, we cannot provide absolute assurance that our investments will not be subject to future adverse changes in market value.

Item 4.		Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports made under the Securities Exchange Act of 1934, as amended, or the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by SEC Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level as of June 30, 2011.

Changes in Internal Control Over Financial Reporting

There has been no change in our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

Item 1.		Legal Proceedings

We have received notices from each of Actavis, Mylan, Par, and Zydus that each has filed with the FDA an ANDA for a generic version of Silenor 3 mg and 6 mg tablets. The notices included “paragraph IV certifications” with respect to eight of the nine patents listed in the Orange Book for Silenor.

We, together with ProCom, have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus. The lawsuits allege that each of Actavis, Mylan, Par and Zydus have infringed the ’229 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

In addition, we have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that such parties have the ’307 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

Pursuant to the provisions of the Hatch-Waxman Act, FDA final approval of the Actavis and Mylan ANDAs can occur no earlier than May 3, 2013, FDA final approval of the Par ANDA can occur no earlier than June 23, 2013 and FDA final approval of the Zydus ANDA can occur no earlier than November 13, 2013, unless in each case there is an earlier court decision that the ’229 patent and the ’307 patent are not infringed and/or invalid or unless any party to the action is found to have failed to cooperate reasonably to expedite the infringement action. We do not know when there will be a court decision on the merits in any of these cases.

At this time, the other patents included in Orange Book have not been asserted against these parties.

We intend to vigorously enforce our intellectual property rights relating to Silenor, but we cannot predict the outcome of these matters.

Item 1A.		Risk Factors

Investing in our common stock involves a high degree of risk. Our Annual Report on Form 10-K for the year ended December 31, 2010 includes a detailed discussion of our risk factors under the heading “Part I, Item 1A—Risk Factors.” Set forth below are certain changes from the risk factors previously disclosed in our Annual Report on Form 10-K. You should carefully consider the risk factors discussed in our Annual Report on Form 10-K and in this report, as well as the other information in this report, before deciding whether to invest in shares of our common stock. The occurrence of any of the risks discussed in the Annual Report on Form 10-K or this report could harm our business, financial condition, results of operations or growth prospects. In that case, the trading price of our common stock could decline, and you may lose all or part of your investment. Except with respect to our trademarks, the trademarks, trade names and service marks appearing in this report are the property of their respective owners.

Risks Related to Our Business

We may require substantial additional funding and may be unable to raise capital when needed, which could force us to delay, reduce or eliminate planned activities or result in our inability to continue as a going concern.

We began generating revenues from the commercialization of Silenor late in the third quarter of 2010, and our operations to date have generated substantial needs for cash. We expect our negative cash flows from operations to continue until we are able to generate significant cash flows from the commercialization of Silenor.

In November 2010, we completed a public offering of 8,800,000 shares of our common stock at a public offering for aggregate net proceeds of approximately $24.8 million. In June 2011, we completed a private placement of 2,184,769 shares of our common stock to Paladin Labs Inc. for aggregate net proceeds of approximately $5.0 million in connection with a license of the rights to market Silenor in Canada, South America, Africa and the Caribbean.

At June 30, 2011 we had cash, cash equivalents, and short-term investments totaling $30.9 million. We have received $14.9 million in net loan proceeds pursuant to a loan and security agreement with Silicon Valley Bank, or SVB and Oxford Finance LLC, or together with SVB, the Lenders. We believe we have sufficient financial resources to fund our operations for at least next the twelve months. We may need to obtain additional funds to finance our operations, particularly if we are unable to access adequate or timely funds under our at-the-market equity sales agreement with Citadel Securities LLC, or Citadel. Actual financial results for the period of time through which our financial resources will be adequate to support our operations could vary based upon many factors, including but not limited to the rate of growth of Silenor sales, the actual cost of commercial activities and any potential litigation expenses we may incur.

We are responsible for the costs relating to the commercialization of Silenor in the U.S. As a result, commercial activities relating to Silenor are likely to result in the need for substantial additional funds. Our future capital requirements will depend on, and could increase significantly as a result of, many factors, including:

•

our success in generating cash flows from the commercialization of Silenor, together with our co-promotion partner P&G and our licensee Paladin;

•

the costs of establishing or contracting for commercial programs and resources;

•

the terms and timing of any future collaborative, licensing and other arrangements that we may establish;

•

the costs of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights;

•

the extent to which we acquire or in-license new products, technologies or businesses;

•

the rate of progress and cost of our non-clinical studies, clinical trials and other development activities;

•

the scope, prioritization and number of development programs we pursue; and

•

the effect of competing technological and market developments.

On July 28, 2011, we terminated the existing loan agreement with Comerica Bank and entered into a new loan and security agreement on August 2, 2011 with the Lenders, pursuant to which the Lenders made to us a term loan in the principal amount of $15.0 million. The term loan bears interest at 7.50% per annum. We will make monthly interest-only payments through December 2011, and the principal, together with interest, thereafter will be paid in monthly installments thereafter through December 2013.

In addition, on August 1, 2011, we entered into an at-the-market equity sales agreement, or the sales agreement, with Citadel, pursuant to which we agreed to sell, at our option, up to an aggregate of $30,000,000 in shares of our common stock through Citadel, as sales agent. Sales of the common stock made pursuant to the sales agreement, if any, will be made on the NASDAQ Stock Market under our currently-effective Registration Statements on Form S-3 by means of ordinary brokers’ transactions at market prices. Additionally, under the terms of the sales agreement, we may also sell shares of our common stock through Citadel, on the NASDAQ Stock Market or otherwise, at negotiated prices or at prices related to the prevailing market price.

In addition to the amounts available under our sales agreement with Citadel, we intend to obtain any additional funding we may require through strategic relationships, public or private equity or debt financings, assigning receivables or royalty rights, or other arrangements and cannot assure that such funding will be available on reasonable terms, or at all. If we are unsuccessful in raising additional required funds, we may be required to delay, scale-back or eliminate plans or programs relating to our business, relinquish some or all rights to Silenor, or renegotiate less favorable terms with respect to such rights than we would otherwise choose or cease operating as a going concern. In addition, if we do not meet our payment obligations to third parties as they come due, we may be subject to litigation claims. Even if we are successful in defending against these claims, litigation could result in substantial costs and distract management, and may result in unfavorable results that could further adversely impact our financial condition.

If we raise additional funds by issuing equity securities, substantial dilution to existing stockholders would 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. If we are unable to continue as a going concern, we may have to liquidate our assets and may receive less than the value at which those assets are carried on our financial statements, and it is likely that investors will lose all or a part of their investments.

We, our co-promotion partner, P&G, and our contract sales force provider, Publicis, will need to retain qualified sales and marketing personnel and collaborate in order to successfully commercialize Silenor.

We have entered into a co-promotion agreement with P&G, under which its sales representatives will provide a minimum number of primary details to certain healthcare professionals and a minimum number of calls to pharmacists promoting Silenor. We have retained Publicis to provide 145 sales representatives to promote Silenor under the terms of a contract sales agreement. These representatives are employees of Publicis but were hired to our specifications and are managed by our team of Somaxon sales management personnel. To the extent we, P&G and Publicis are not successful in retaining qualified sales and marketing personnel, we may not be able to effectively market Silenor.

We and P&G each have the right to terminate the co-promotion agreement at any time following December 31, 2011 by providing at least 90 days prior written notice, as well as other more limited termination rights. While our agreement with P&G requires its field sales representatives to promote our products in a minimum number of primary details to target physicians and a minimum number of pharmacy calls, we cannot be sure that P&G’s efforts will be successful.

Our agreement with Publicis will cause us to incur significant costs, and we cannot be sure that the efforts of the contract sales force, together with any efforts made by P&G to promote our products, will generate sufficient awareness or demand for our products. If we determine that the contract sales force is not successful and we decide to terminate our agreement with Publicis prior to the one-year anniversary of the deployment of the contract sales force, we will incur termination fees.

Any revenues we receive from sales of Silenor will largely depend upon the efforts P&G and Publicis, which in many instances will not be within our control. If we are unable to maintain our co-promotion agreement with P&G, to maintain our contract sales agreement with Publicis or to effectively establish alternative arrangements to market our products, our business could be adversely affected. In addition, despite our arrangements with P&G and Publicis, we still may not be able to cover all of the prescribing physicians for insomnia at the same level of reach and frequency as our competitors, and we ultimately may need to further expand our selling efforts in order to effectively compete.

Restrictions on or challenges to our patent rights relating to our products and limitations on or challenges to our other intellectual property rights may limit our ability to prevent third parties from competing against us.

Our success will depend on our ability to obtain and maintain patent protection for Silenor and any other product candidate we develop or commercialize, preserve our trade secrets, prevent third parties from infringing upon our proprietary rights and operate without infringing upon the proprietary rights of others. The patent rights that we have in-licensed relating to Silenor are limited in ways that may affect our ability to exclude third parties from competing against us. In particular, we do not hold composition of matter patents covering the active pharmaceutical ingredient, or API, of Silenor. Composition of matter patents on APIs are a particularly effective form of intellectual property protection for pharmaceutical products as they apply without regard to any method of use or other type of limitation. As a result, competitors who obtain the requisite regulatory approval can offer products with the same active ingredients as our products so long as the competitors do not infringe any method of use or formulation patents that we may hold.

The principal patent protection that covers, or that we expect will cover, Silenor consists of method of use patents. This type of patent protects the product only when used or sold for the specified method. However, this type of patent does not limit a competitor from making and marketing a product that is identical to our product for an indication that is outside of the patented method. Moreover, physicians may prescribe such a competitive identical product for off-label indications that are covered by the applicable patents. Some physicians are prescribing generic 10 mg doxepin capsules and generic oral solution doxepin for insomnia in this off-label indication. In addition, some managed health care plans are requiring the substitution of these generic doxepin products for Silenor, and some pharmacies are suggesting such substitution. Although such off-label prescriptions may induce or contribute to the infringement of method of use patents, the practice is common and such infringement is difficult to prevent or prosecute.

Because products with active ingredients identical to ours have been on the market for many years, there can be no assurance that these other products were never used off-label or studied in such a manner that such prior usage would not affect the validity of our method of use patents. Due to some prior art that we identified, we initiated a reexamination of one of the patents we have in-licensed covering Silenor, (specifically, U.S. Patent No. 5,502,047, “Treatment for Insomnia”) which claims the treatment of chronic insomnia using doxepin in a daily dosage of 0.5 mg to 20 mg and expires in March 2013. The reexamination proceedings terminated and the U.S. Patent and Trademark Office, or USPTO, issued a reexamination certificate narrowing certain claims, so that the broadest dosage ranges claimed by us are 0.5 mg to 20 mg for otherwise healthy patients with chronic insomnia and for patients with chronic insomnia resulting from depression, and 0.5 mg to 4 mg for all other chronic insomnia patients. We also requested reissue of this same patent to consider some additional prior art and to add intermediate dosage ranges below 10 mg. In two office actions relating to this reissue request, the USPTO raised no prior art objections to 32 of the 34 claims we were seeking and raised a prior art objection to the other two, as well as some technical objections. Each of the claims objected to by the USPTO related to dosages above 10 mg. After further review of the prior art submitted, the USPTO withdrew all of its prior art objections. We then determined that the proposed addition of the intermediate dosage ranges and the resolution of the technical objections no longer warranted continuation of the reissue proceeding. As a result, we elected not to continue that proceeding.

We also have multiple internally developed pending patent applications. No assurance can be given that the USPTO or other applicable regulatory authorities will allow pending applications to result in issued patents with the claims we are seeking, or at all.

Patent applications in the United States are confidential for a period of time until they are published, and publication of discoveries in scientific or patent literature typically lags actual discoveries by several months. As a result, we cannot be certain that the inventors of issued patents to which we hold rights were the first to conceive of inventions covered by pending patent applications or that the inventors were the first to file patent applications for such inventions.

In addition, third parties may challenge issued patents to which we hold rights and any additional patents that we may obtain, which could result in the invalidation or unenforceability of some or all of the relevant patent claims, or could attempt to develop products utilizing the same APIs as our products that do not infringe the claims of our in-licensed patents or patents that we may obtain.

When a third party files an ANDA for a product containing doxepin for the treatment of insomnia at any time during which we have patents listed for Silenor in the FDA’s Orange Book publication, the applicant will be required to certify to the FDA concerning the listed patents. Specifically, the applicant must certify that: (1) the required patent information relating to the listed patent has not been filed in the NDA for the approved product; (2) the listed patent has expired; (3) the listed patent has not expired, but will expire on a particular date and approval is sought after patent expiration; or (4) the listed patent is invalid or will not be infringed by the manufacture, use or sale of the new product. A certification that the new product will not infringe the Orange Book-listed patents for Silenor or that such patents are invalid is called a paragraph IV certification.

We have received notices from each of Actavis, Mylan, Par, and Zydus that each has filed with the FDA an ANDA for a generic version of Silenor 3 mg and 6 mg tablets. The notices included paragraph IV certifications with respect to eight of the nine patents listed in the Orange Book for Silenor.

We, together with ProCom, have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus. The lawsuits allege that each of Actavis, Mylan, Par and Zydus have infringed the ’229 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

In addition, we have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that such parties have infringed the ’307 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent

Pursuant to the provisions of the Hatch-Waxman Act, FDA final approval of the Actavis and Mylan ANDAs can occur no earlier than May 3, 2013, FDA final approval of the Par ANDA can occur no earlier than June 23, 2013 and FDA final approval of the Zydus ANDA can occur no earlier than November 13, 2013, unless in each case there is an earlier court decision that the ’229 patent and the ’307 patent are not infringed and/or invalid or unless any party to the action is found to have failed to cooperate reasonably to expedite the infringement action. We do not know when there will be a court decision on the merits in any of these cases. At this time, the other patents included in Orange Book have not been asserted against these parties.

We intend to vigorously enforce our intellectual property rights relating to Silenor, but we cannot predict the outcome of these matters. Any adverse outcome in this litigation could result in one or more generic versions of Silenor being launched before the expiration of the listed patents, which could adversely affect our ability to successfully execute our business strategy to increase sales of Silenor and would negatively impact our financial condition and results of operations, including causing a significant decrease in our revenues and cash flows.

Certain pharmaceutical companies’ patent settlement agreements with generic pharmaceutical companies have been challenged by the U.S. Federal Trade Commission alleging a violation of Section 5(a) of the Federal Trade Commission Act, and any patent settlement agreement that we may enter into with any generic pharmaceutical company may be subject to similar challenges, which will be both expensive and time consuming and may render such settlement agreements unenforceable. In addition, legislation has been proposed by Congress that, if passed, would subject patent settlement agreements to further restrictions.

We also rely upon unpatented trade secrets and improvements, unpatented know-how and continuing technological innovation to develop and maintain our competitive position, which we seek to protect, in part, by confidentiality agreements with our collaborators, employees and consultants. We also have invention or patent assignment agreements with our employees and certain consultants. There can be no assurance that inventions relevant to us will not be developed by a person not bound by an invention assignment agreement with us. There can be no assurance that binding agreements will not be breached, that we would have adequate remedies for any breach, or that our trade secrets will not otherwise become known or be independently discovered by our competitors.

Litigation or other proceedings to enforce or defend intellectual property rights is often very complex in nature, expensive and time-consuming, may divert our management’s attention from our core business and may result in unfavorable results that could adversely impact our ability to prevent third parties from competing with us.

We expect intense competition in the marketplace for Silenor and any other product to which we acquire rights, and new products may emerge that provide different and/or better therapeutic alternatives for the disorders that our products are intended to treat.

Silenor competes with well established drugs approved for the treatment of insomnia, including the branded and generic versions of Sanofi-Synthélabo, Inc.’s Ambien and Ambien CR, Pfizer Inc.’s Sonata, and Lunesta, marketed by Sunovion Pharmaceuticals Inc., a wholly-owned subsidiary of Dainippon Sumitomo Pharma Co., Ltd., all of which are GABA-receptor agonists, and Takeda Pharmaceuticals North America, Inc.’s Rozerem, a melatonin receptor antagonist.

A number of companies are marketing reformulated versions of previously approved GABA-receptor agonists. For example, Meda AB and Orexo AB launched Edluar, formerly known as Sublinox, a sublingual tablet formulation of zolpidem in the third quarter of 2009. ECR Pharmaceuticals Company, Inc., a wholly owned subsidiary of Hi-Tech Pharmacal Co., Inc., launched NovaDel Pharma, Inc.’s ZolpiMist, an oral mist formulation of zolpidem, in the United States in February 2011.

In addition to the currently approved products for the treatment of insomnia, a number of new products may enter the insomnia market over the next several years. Transcept Pharmaceuticals, Inc. resubmitted an NDA for Intermezzo, a low-dose sublingual tablet formulation of zolpidem in January 2011, and on July 14, 2011, Transcept announced that it received a complete response letter from the FDA relating to such NDA. Transcept is currently evaluating the letter and its plan for future regulatory development of Intermezzo. Transcept and Purdue Pharmaceutical Products L.P. have entered into an exclusive license and collaboration agreement to commercialize Intermezzo in the United States. It has been reported that Neurim Pharmaceuticals Ltd. is seeking FDA approval of Circadin, a prescription form of melatonin that is already approved in the EU and several other countries and Neu-P11, a melatonin and serotonin agonist is in clinical development.

Alexza Pharmaceuticals, Inc. has announced positive results from a Phase 1 clinical trial of an inhaled formulation of zaleplon, the API in Sonata. In July 2010, Alexza announced that it was advancing this product candidate into Phase 2 clinical trials during the first half of 2011 for the treatment of insomnia in patients who have difficulty falling asleep, including those patients who awake in the middle of the night and have difficulty falling back asleep, but has not yet done so. Somnus Therapeutics, Inc. has announced positive results from two Phase 1 clinical trials of a delayed-release formulation of zaleplon and has initiated Phase 2 clinical trials of that product candidate.

Vanda Pharmaceuticals Inc. has completed two Phase 3 clinical trials of tasimelteon, a melatonin receptor agonist. Tasimelteon received orphan drug designation status for non-24 hour sleep/wake disorder in blind individuals with no light perception. Vanda has initiated Phase 3 clinical trials for tasimelteon to treat this disorder and plans to file an NDA with the FDA in the first half of 2013.

Merck & Co., Inc. has suvorexant, an orexin antagonist, in Phase 3 clinical trials for the treatment of insomnia and MK-6096 and MK-3697 in Phase 2 clinical trials for the treatment of insomnia. Merck has announced that it plans to file regulatory applications for suvorexant in 2012.

Several other companies, including Sunovion Pharmaceuticals, are evaluating 5HT2 antagonists as potential hypnotics, and Eli Lilly and Company is evaluating a potential hypnotic that is a dual histamine/5HT2 antagonist. Additionally, several other companies are evaluating new formulations of existing compounds and other compounds for the treatment of insomnia.

Furthermore, generic versions of Ambien, Ambien CR and Sonata have been launched and are priced significantly lower than approved, branded insomnia products. Some managed health care plans require that patients try generic versions of these branded insomnia products before the patient can be reimbursed for Silenor. Sales of all of these drugs may reduce the available market for, and could put downward pressure on, the price we are able to charge for Silenor, which could ultimately limit our ability to generate significant revenues.

The active ingredient of Silenor is doxepin, which has been used at higher doses for over 40 years for the treatment of depression and anxiety. Doxepin is available generically in strengths as low as 10 mg in capsule form, as well as in a concentrated liquid form dispensed by a marked dropper and calibrated for 5 mg. Some physicians are prescribing generic 10 mg doxepin capsules and generic oral solution doxepin for insomnia off-label for insomnia. In addition, some managed health care plans are requiring the substitution of these generic doxepin products for Silenor, and some pharmacies are suggesting such substitution. Such off label uses of generic doxepin may reduce the sales of Silenor and may put a downward pressure on the price we are able to charge for Silenor, which could ultimately limit our ability to generate significant revenues.

Upon the expiration of, or successful challenge to, our patents covering Silenor, generic competitors may introduce a generic version of Silenor at a lower price. Some generic manufacturers have also demonstrated a willingness to launch generic versions of branded products before the final resolution of related patent litigation (known as an “at-risk launch”). A launch of a generic version of Silenor could have a material adverse effect on our business and we could suffer a significant loss of sales and market share in a short period of time.

We have received notices from each of Actavis, Mylan, Par, and Zydus that each has filed with the FDA an ANDA for a generic version of Silenor 3 mg and 6 mg tablets. The notices included paragraph IV certifications with respect to eight of the nine patents listed in the Orange Book for Silenor.

We, together with ProCom, have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus. The lawsuits allege that each of Actavis, Mylan, Par and Zydus have infringed the ’229 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

In addition, we have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that such parties have infringed the ’307 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent

Pursuant to the provisions of the Hatch-Waxman Act, FDA final approval of the Actavis and Mylan ANDAs can occur no earlier than May 3, 2013, FDA final approval of the Par ANDA can occur no earlier than June 23, 2013 and FDA final approval of the Zydus ANDA can occur no earlier than November 13, 2013, unless in each case there is an earlier court decision that the ’229 patent and the ’307 patent are not infringed and/or invalid or unless any party to the action is found to have failed to cooperate reasonably to expedite the infringement action. We do not know when there will be a court decision on the merits in any of these cases. At this time, the other patents included in the Orange Book have not been asserted against these parties.

We intend to vigorously enforce our intellectual property rights relating to Silenor, but we cannot predict the outcome of these matters. Any adverse outcome in this litigation could result in one or more generic versions of Silenor being launched before the expiration of the listed patents, which could adversely affect our ability to successfully execute our business strategy to increase sales of Silenor and would negatively impact our financial condition and results of operations, including causing a significant decrease in our revenues and cash flows.

The biotechnology and pharmaceutical industries are subject to rapid and intense technological change. We face, and will continue to face, competition in the development and marketing of Silenor or any other product candidate to which we acquire rights from academic institutions, government agencies, research institutions and biotechnology and pharmaceutical companies. There can be no assurance that developments by others, including the development of other drug technologies and methods of preventing the incidence of disease, will not render Silenor or any other product candidate that we develop obsolete or noncompetitive.

Compared to us, many of our potential competitors have substantially greater:

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capital resources;

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manufacturing, distribution and sales and marketing resources and experience;

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research and development resources, including personnel and technology;

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regulatory experience;

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experience conducting non-clinical studies and clinical trials, and related resources; and

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expertise in prosecution of intellectual property rights.

As a result of these factors, our competitors may develop drugs that are more effective and less costly than ours and may be more successful than we are in manufacturing, marketing and selling their products. Our competitors may also obtain patent protection or other intellectual property rights or seek to invalidate or otherwise challenge our intellectual property rights, limiting our ability to successfully commercialize products.

In addition, manufacturing efficiency and selling and marketing capabilities are likely to be significant competitive factors. We currently have no commercial manufacturing capability and more limited sales and marketing infrastructure than many of our competitors and potential competitors.

We, Paladin or any other future licensee may never receive approval or commercialize our products outside of the United States, or their activities may not be effective or in compliance with applicable laws.

We have licensed to Paladin the rights to commercialize Silenor in Canada, South America, the Caribbean and Africa. Silenor has not been approved for marketing in any jurisdiction outside of the United States. Paladin will be responsible for regulatory submissions for Silenor in the licensed territories and will have the exclusive right to commercialize Silenor in the licensed territories. We may license rights to Silenor or other future products to others for territories outside the United States in the future. In order to market any products outside of the United States, we or our licensees must establish and comply with numerous and varying regulatory requirements of other countries regarding safety and efficacy. Approval procedures vary among countries and can involve additional product testing and additional administrative review periods. Any additional clinical studies that may be required to be conducted as part of the regulatory approval process may not corroborate the results of the clinical studies we have conducted or may have adverse results or effects on our ability to maintain regulatory approvals in the United States or obtain them in other countries. The time required to obtain approval in other countries might differ from that required to obtain FDA approval. The regulatory approval process in other countries may include all of the risks regarding FDA approval in the U.S. as well as other risks. Regulatory approval in one country does not ensure regulatory approval in another, but a failure or delay in obtaining regulatory approval in one country may have a negative effect on the regulatory process in others. Failure to obtain regulatory approval in other countries or any delay or setback in obtaining such approval could limit the uses of the product candidate and have an adverse effect on potential royalties and product sales. Such approval may be subject to limitations on the indicated uses for which the product may be marketed or require costly, post-marketing follow-up studies. In addition, any revenues we receive from sales of Silenor outside the United States will depend upon the efforts of Paladin or any other future licensees, which in many instances will not be within our control. If we are unable to maintain our ex-U.S. license agreement or to effectively establish alternative arrangements to market our products outside of the United States, or if Paladin or any future licensees do not perform adequately under such agreements or arrangements or comply with applicable laws, our business could be adversely affected and we could be subject to regulatory sanctions.

Risks Related to Our Finances and Capital Requirements

Capital raising activities, such as issuing securities, incurring debt, assigning receivables or royalty rights or entering into collaborations or other strategic transactions, may cause dilution to existing stockholders or a reduction in our stock price, restrict our operations or require us to relinquish proprietary rights and may be limited by applicable laws and regulations.

Based on our recurring losses, negative cash flows from operations and working capital levels, we may need to raise substantial additional funds. If we are unable to maintain sufficient financial resources, including by raising additional funds when needed, our business, financial condition and results of operations will be materially and adversely affected.

Because we may need to raise additional capital to fund our business, among other things, we may conduct substantial equity offerings. For example, in August 2011 we entered into the sales agreement with Citadel pursuant to which we agreed to sell, at our option, up to an aggregate of $30.0 million in shares of our common stock through Citadel, as sales agent. Sales of the common stock made pursuant to the sales agreement, if any, will be made on the NASDAQ Stock Market under our currently-effective Registration Statements on Form S-3 by means of ordinary brokers’ transactions at then-prevailing market prices. Additionally, under the terms of the sales agreement, we may also sell shares of our common stock through Citadel, on the NASDAQ Stock Market or otherwise, at negotiated prices or at prices related to the prevailing market price. We also may offer from time to time up to an aggregate of approximately $37 million in any combination of debt securities, common and preferred stock and warrants under our two effective shelf registration statements on Form S-3 filed with the SEC.

To the extent that we raise any required additional capital by issuing equity securities, our existing stockholders’ ownership will be diluted. Any such dilution of the holdings of our current stockholders may result in downward pressure on the price of our common stock.

Any debt, receivables or royalty financing we enter into may involve covenants that restrict our operations or conditions that require repayment. For example, under our new loan agreement with the Lenders, we will be required to repay the entire outstanding principal balance if a generic version of Silenor enters the market while the loan is outstanding. In addition, we are subject to certain affirmative and negative covenants, including limitations on our ability to: undergo certain change of control events; convey, sell, lease, license, transfer or otherwise dispose of assets, other than in certain specified circumstances; create, incur, assume, guarantee or be liable with respect to certain indebtedness; grant liens; pay dividends and make certain other restricted payments; and make certain investments. We are also required to maintain the sales agreement unless we raise at least $30 million in equity proceeds. In addition, under the loan agreement, we are required to maintain with SVB our primary cash and investment accounts, which accounts are also covered by control agreements for the benefit of the Lenders. To secure our performance of our obligations under the Loan Agreement, we pledged substantially all of our assets other than intellectual property assets to the Lenders and agreed to maintain certain minimum cash and investment balances. We also agreed not to pledge our intellectual property assets to others, subject to specified exceptions. Our failure to comply with the covenants in the loan agreement could result in an event of default that, if not cured or waived, could result in the acceleration of all or a substantial portion of our debt. We believe we have currently met all of our obligations under the loan agreement.

Debt financing, receivables assignments, royalty interest assignments and other types of financing are often coupled with an equity component, such as warrants to purchase stock. For example, in connection with our August 2011 loan agreement with the Lenders, we issued to the Lenders warrants to purchase up to 583,152 shares of our common stock with an exercise price of $1.5433 per share. To the extent that any of these warrants, or any additional warrants that are outstanding or that we may issue in the future, are exercised by their holders, dilution of our existing stockholders’ ownership interests will result.

If we raise additional funds through collaborations or other strategic transactions, 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.

In addition, rules and regulations of the SEC or other regulatory agencies may restrict our ability to conduct certain types of financing activities, or may affect the timing of and the amounts we can raise by undertaking such activities. For example, under current SEC regulations, if the aggregate market value of our common stock held by non-affiliates, or our public float, is less than $75 million, the amount that we can raise through primary public offerings of securities in any twelve-month period using one or more registration statements on Form S-3 may be limited to an aggregate of one-third of our public float.

We may not be able to sell shares of our common stock under our equity sales agreement with Citadel at times, prices or quantities that we desire and if such sales do occur, they may result in dilution to our existing stockholders.

In August 2011, we entered into the sales agreement with Citadel. Under the terms of the sales agreement, Citadel will use its commercially reasonable efforts to sell shares of our common stock designated by us. However, there can be no assurance that Citadel will be successful in consummating such sales based on prevailing market conditions or in the quantities or at the prices that we deem appropriate. In addition, we will not be able to make sales of our common stock pursuant to the sales agreement unless certain conditions are met, which include the accuracy of representations and warranties made to Citadel under the sales agreement; compliance with laws; and the continued listing of our stock on the Nasdaq Capital Market. In addition, Citadel is permitted to terminate the sales agreement at any time. If we are unable to access funds through sales under the sales agreement, or it is terminated by Citadel, we may be unable to access capital on favorable terms or at all.

Should we sell shares pursuant to the sales agreement, it will have a dilutive effective on the holdings of our existing stockholders, and may result in downward pressure on the price of our common stock. If we sell shares under the sales agreement at a time when our share price is decreasing, we will need to issue more shares to raise the same amount than if our stock price was higher. Issuances in the face of a declining share price will have an even greater dilutive effect than if our share price were stable or increasing, and may further decrease our share price.

Our indebtedness under our loan agreement could adversely affect our financial health.

Under our new loan agreement, we have incurred $15.0 million of indebtedness. We are obligated to pay interest on the loan through December 31, 2011, and to thereafter pay the principal balance of the loan and interest in 24 equal monthly installments starting on January 1, 2012 and continuing through December 31, 2013. Such indebtedness could have important consequences to our business. For example, it could:

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impair our ability to obtain additional financing in the future for working capital needs, capital expenditures and general corporate purposes;

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increase our vulnerability to general adverse economic and industry conditions;

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make it more difficult for us to satisfy other debt obligations we may incur in the future;

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require us to dedicate a substantial portion of our cash flows from operations to the payment of principal and interest on our indebtedness, thereby reducing the availability of our cash flows to fund working capital needs, capital expenditures and other general corporate purposes;

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limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; and

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place us at a disadvantage compared to our competitors that have less indebtedness.

Covenants in our new loan agreement may limit our ability to operate our business.

Under the new loan agreement, we are required to maintain with SVB our primary cash and investment accounts, which accounts are also covered by control agreements for the benefit of the Lenders, we are also subject to certain affirmative covenants, including, but not limited to the obligations to maintain good standing, provide various notices to the Lenders, deliver financial statements to the Lenders, maintain adequate insurance, promptly discharge all taxes, protect our intellectual property and protect the collateral. We are also subject to certain negative covenants customary for loans of this type, including but not limited to prohibitions against certain mergers and consolidations, certain management and ownership changes constituting a “change of control,” and the imposition of additional liens on collateral or other of our assets, as well as prohibitions against additional indebtedness, certain dispositions of property, changes in our business, name or location, payment of dividends, prepayment of certain other indebtedness, certain investments or acquisitions, and certain transactions with affiliates, in each case subject to certain customary exceptions, including exceptions that allow us to enter into non-exclusive and/or exclusive licenses and similar agreements providing for the use of our intellectual property in collaboration with third parties provided certain conditions are met. We are also required to maintain the sales agreement unless we raise at least $30 million in equity proceeds.

Although we believe we were in compliance with all of our non-financial and financial covenants as of entering into the loan agreement, our future ability to comply with these covenants may be affected by events beyond our control, including prevailing economic, financial, and industry conditions. If we default under the loan agreement because of a covenant breach or otherwise, any outstanding amounts could become immediately due and payable, which would negatively impact our liquidity and reduce the availability of our cash flows to fund working capital needs, capital expenditures and other general corporate purposes.

We have never been profitable and we may not be able to generate revenues sufficient to achieve profitability.

We only began generating revenues from the commercialization of Silenor late in the third quarter of 2010, we have not been profitable since inception, and it is possible that we will not achieve profitability. We incurred net losses of $32.0 million for the six months ended June 30, 2011, and have accumulated losses totaling $248.8 million since inception. We expect to continue to incur significant operating losses and capital expenditures. As a result, we will need to generate significant revenues to achieve and maintain profitability. We cannot assure you that we will achieve significant revenues, or that we will ever achieve profitability. Even if we do achieve profitability, we cannot assure you that we will be able to sustain or increase profitability on a quarterly or annual basis in the future. If revenues grow more slowly than we anticipate or if operating expenses exceed our expectations or cannot be adjusted accordingly, our business, results of operations and financial condition will be materially and adversely affected. If we are unable to maintain sufficient financial resources, including by raising additional funds when needed, our business, financial condition and results of operations will be materially and adversely affected and we may be unable to continue as a going concern. If we are unable to continue as a going concern, it is likely that investors will lose all or a part of their investment.

Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds

In June 2011, we entered into agreements with Paladin pursuant to which Paladin purchased 2,184,769 shares of our common stock for an aggregate purchase price of $5.0 million in a private placement pursuant to Rule 506 of the Securities Act of 1933, as amended.

Item 3.		Defaults Upon Senior Securities

Not applicable.

Item 4.		(Removed and Reserved)

Item 5.		Other Information

Not applicable.

Item 6.		Exhibits

EXHIBIT INDEX

Exhibit
Number				Description
	3.1	(1)		Amended and Restated Certificate of Incorporation of the Registrant
	3.2	(2)		Amended and Restated Bylaws of the Registrant
	4.1	(3)		Form of the Registrant’s Common Stock Certificate
	4.2	(4)		Amended and Restated Investor Rights Agreement dated June 2, 2005
	4.3	(5)		Warrant dated May 21, 2008 issued to Silicon Valley Bank
	4.4	(5)		Warrant dated May 21, 2008 issued to Oxford Finance Corporation
	4.5	(5)		Warrant dated May 21, 2008 issued to Kingsbridge Capital Limited
	4.6	(6)		Form of Warrant dated July 2, 2009 issued to certain Purchasers under the Securities Purchase Agreement dated July 2, 2009
	10.1	(7) †		License Agreement between the Registrant and Paladin Labs Inc. dated June 7, 2011
	10.2	(7)		Supply Agreement between the Registrant and Paladin Labs Inc. dated June 7, 2011
	10.3	(7)		Purchase Agreement between the Registrant and Paladin Labs Inc. dated June 7, 2011
	10.4	(8)		Lease Agreement between the Registrant and TREA Pacific Plaza, LLC dated May 24, 2011
	31.1			Certification of chief executive officer pursuant to Rule 13a-14 and Rule 15d-14 of the Securities Exchange Act of 1934, as amended
	31.2			Certification of chief financial officer pursuant to Rule 13a-14 and Rule 15d-14 of the Securities Exchange Act of 1934, as amended
	32.1	*		Certification of chief executive officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
	32.2	*		Certification of chief financial officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
		(1)		Filed with Amendment No. 3 to the Registrant’s Registration Statement on Form S-1 on November 30, 2005.
		(2)		Filed with Registrant’s Current Report on Form 8-K on December 6, 2007
		(3)		Filed with Amendment No. 4 to the Registrant’s Registration Statement on Form S-1 on December 13, 2005.
		(4)		Filed with the Registrant’s Registration Statement on Form S-1 on October 7, 2005.
		(5)		Filed with Registrant’s Current Report on Form 8-K on May 22, 2008.
		(6)		Filed with Registrant’s Current Report on Form 8-K on July 8, 2009.
		(7)		Filed with Registrant’s Current Report on Form 8-K on June 13, 2011.
		(8)		Filed with Registrant’s Current Report on Form 8-K on May 25, 2011.

SIGNATURES

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