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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2011

or

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

For the transition period from              to             

Commission File Number: 001-34973

Anacor Pharmaceuticals, Inc.

(Exact Name of Registrant as Specified in Its Charter)

1020 East Meadow Circle

Palo Alto, California 94303-4230

(Address of Principal Executive Offices) (Zip Code)

(650) 543-7500

(Registrant’s Telephone Number, Including Area Code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x    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.

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

As of October 31, 2011, there were 28,192,158 shares of the registrant’s common stock outstanding.

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Anacor Pharmaceuticals, Inc.

Form 10-Q

Index

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Anacor Pharmaceuticals, Inc.

Condensed Balance Sheets

(In Thousands)

(1) Derived from the audited financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

See accompanying notes.

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Anacor Pharmaceuticals, Inc.

Condensed Statements of Operations

(In Thousands, Except Share and Per Share Data)

(1) See Note 2 for a discussion of the weighted-average number of common shares and net income (loss) per common share for the three and nine months ended September 30, 2011 and 2010.

See accompanying notes.

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Anacor Pharmaceuticals, Inc.

Condensed Statements of Cash Flows

(In Thousands)

See accompanying notes.

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Anacor Pharmaceuticals, Inc.

Notes to Condensed Financial Statements

(unaudited)

1. The Company

Nature of Operation

Anacor Pharmaceuticals, Inc. (the Company) is a biopharmaceutical company focused on discovering, developing and commercializing novel small-molecule therapeutics derived from its boron chemistry platform. The Company has discovered, synthesized and developed five molecules that are currently in clinical development. Its three lead programs are tavaborole, formerly known as AN2690, a topical antifungal for the treatment of onychomycosis; AN2728, a topical anti-inflammatory for the treatment of psoriasis and atopic dermatitis; and GSK2251052 (GSK ‘052), a systemic antibiotic for the treatment of infections caused by Gram-negative bacteria. In addition to its three lead programs, the Company has two other clinical product candidates, AN2718, its second topical antifungal product candidate, and AN2898, its second topical anti-inflammatory product candidate. The Company also has a pipeline of internally discovered topical and systemic boron-based compounds in development.

2. Summary of Significant Accounting Policies

Interim Financial Information

The accompanying condensed financial statements as of September 30, 2011 and for the three and nine months ended September 30, 2011 and 2010 are unaudited. The unaudited interim condensed financial statements have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to state fairly the Company’s financial position as of September 30, 2011 and the results of its operations for the three and nine months ended September 30, 2011 and 2010 and cash flows for the nine months ended September 30, 2011 and 2010. The December 31, 2010 balance sheet is derived from the audited financial statements for the year ended December 31, 2010 but does not include all the disclosures necessary for audited financial statements. The financial data and other information disclosed in these notes to the condensed financial statements related to the three and nine month periods are unaudited. The results for the three and nine months ended September 30, 2011 are not necessarily indicative of results to be expected for the year ending December 31, 2011 or for any other interim period or for any future year.

The condensed financial statements follow the requirements of the Securities and Exchange Commission (SEC) for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by U.S. generally accepted accounting principles (GAAP) for annual periods can be condensed or omitted. For more complete financial information, these condensed financial statements, and the notes hereto, should be read in conjunction with the audited financial statements for the year ended December 31, 2010 included in the Company’s Annual Report on Form 10-K filed with the SEC on March 29, 2011.

Use of Estimates

The preparation of the condensed financial statements in accordance with U.S. GAAP requires the Company to make estimates and judgments in certain circumstances that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. In preparing these condensed financial statements, management has made its best estimates and judgments of certain amounts included in the condensed financial statements, giving due consideration to materiality. On an ongoing basis, the Company evaluates its estimates, including those related to revenue recognition, fair values of financial instruments in which it invests, notes payable, income taxes, preclinical study and clinical trial accruals and other contingencies. Management bases its estimates on historical experience or on various other assumptions that it believes to be reasonable under the circumstances. Actual results could differ from these estimates.

Cash, Cash Equivalents and Short-Term Investments

The Company considers all highly liquid investments with a maturity of three months or less at the time of purchase to be cash and cash equivalents. Investments with a maturity date of more than three months, but less than twelve months, from the date of purchase are considered short-term investments and are classified as current assets. The Company’s short-term investments in marketable securities are classified as available for sale (see Note 4). Securities available for sale are carried at estimated fair value, with unrealized gains and losses reported as part of accumulated other comprehensive income or loss, a separate component of stockholders’ equity. The Company has estimated the fair value amounts by using available market information. The cost of available-for-sale securities sold is based on the specific-identification method.

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Fair Value of Financial Instruments

The carrying amounts of certain of the Company’s financial instruments, including cash and cash equivalents, short-term investments, restricted investments, contract receivables and accounts payable, approximate their fair value due to their short maturities. Based on the borrowing rates available to the Company for loans with similar terms and average maturities, the carrying value of the Company’s long-term notes payable approximate their fair values at September 30, 2011 and December 31, 2010.

Fair value is considered to be the price at which an asset could be exchanged or a liability transferred (an exit price) in an orderly transaction between knowledgeable, willing parties in the principal or most advantageous market for the asset or liability. Where available, fair value is based on or derived from observable market prices or other observable inputs. Where observable prices or inputs are not available, valuation models are applied. These valuation techniques involve management estimation and judgment, the degree of which is dependent on the price transparency for the instruments or market and the instruments’ complexity.

Concentration of Credit Risk

Financial instruments that potentially subject the Company to a concentration of credit risk consist of cash, cash equivalents, short-term investments and restricted investments. Substantially all the Company’s cash, cash equivalents and restricted investments are held by two financial institutions that management believes are of high credit quality. Such deposits may, at times, exceed federally insured limits. At September 30, 2011 and December 31, 2010, approximately 80% and 62%, respectively, of the cash and cash equivalents were held in a money market fund invested in U.S. Treasuries, securities guaranteed as to principal and interest by the U.S. government and repurchase agreements in respect of such securities. The Company’s short-term investments at September 30, 2011 and December 31, 2010 are held in securities guaranteed as to principal and interest by the U.S. government. The Company has not experienced any losses on its deposits of cash, cash equivalents, short-term investments and restricted investments and management believes that its guidelines for investment of its excess cash maintain safety and liquidity through diversification and investment maturity.

Customer Concentration

The Company’s revenues consist primarily of contract revenue from collaboration agreements with GlaxoSmithKline LLC (GSK) and Eli Lilly and Company (Lilly). Collaborators have accounted for significant revenues in the past and may not provide contract revenues in the future under existing agreements and/or new collaboration agreements, which may have a material effect on the Company’s operating results.

Contract revenue and contract revenue—related party from collaborators that accounted for 10% or more of total revenues were as follows:

*                      less than 10% of total revenue

(1)               Agreement with Schering was terminated in May 2010 (see Note 8)

Contract Receivable

At September 30, 2011 and December 31, 2010, the contract receivable consisted of $0.8 million and $0.8 million, respectively, in research funding due from Lilly (see Note 8), $0.9 million and $0, respectively, due from Medicines for Malaria Venture (MMV) (see Note 8) and $0 and $0.3 million, respectively, due related to other contracts. The contract receivable—related party at September 30, 2011 and December 31, 2010 represents reimbursable patent and research costs of $53,000 and $18,000, respectively, due from GSK (see Note 8).

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Revenue Recognition

The Company’s contract revenues are generated primarily through research and development collaboration agreements, which typically may include non-refundable, non-creditable upfront fees, funding for research and development efforts, payments for achievement of specified development, regulatory and sales goals and royalties on product sales of licensed products.

For multiple element arrangements, the Company evaluates the components of each arrangement as separate elements based on certain criteria. Where multiple deliverables are combined as a single unit of accounting, revenues are recognized based on the performance requirements of the agreements. The Company recognizes revenue when persuasive evidence of an arrangement exists; transfer of technology has been completed, services are performed or products have been delivered; the fee is fixed and determinable; and collection is reasonably assured.

On January 1, 2011, the Company adopted an accounting standard update that amends the guidance on accounting for arrangements with multiple deliverables. This update requires that each deliverable be evaluated to determine whether it qualifies as a separate unit of accounting. This determination is generally based on whether the deliverable has stand-alone value to the customer. This update also establishes a selling price hierarchy for determining how to allocate arrangement consideration to identified units of accounting. The selling price used for each unit of accounting will be based on vendor-specific objective evidence, if available, third-party evidence if vendor-specific objective evidence is not available or estimated selling price if neither vendor-specific nor third-party evidence is available. Management may be required to exercise considerable judgment in determining whether a deliverable is a separate unit of accounting and in estimating the selling prices of identified units of accounting for new agreements. The adoption of the update had a material impact on the revenues recognized by the Company for the three and nine month periods ended September 30, 2011 as a result of the amended guidance being applied to a material modification of the Company’s 2007 collaboration agreement with GSK in September 2011 (see Note 8). The potential future impact of the adoption of this update will depend on the nature of any new arrangements entered into, or material modifications of existing arrangements, in the future.

Upfront payments for licensing the Company’s intellectual property are evaluated to determine if the licensee can obtain stand-alone value from the license separate from the value of the research and development services to be provided by the Company. Typically, the Company has determined that the licenses it has granted to collaborators do not have stand-alone value separate from the value of the research and development services provided. As such, upfront payments are recorded as deferred revenue in the condensed balance sheet and are recognized as contract revenue over the contractual or estimated performance period that is consistent with the term of the research and development obligations contained in the research and development collaboration agreement. When stand-alone value is identified, the related consideration is recorded as revenue in the period in which the license or other intellectual property rights are issued.

Payments resulting from the Company’s efforts under research and development agreements or government grants are recognized as the activities are performed and are presented on a gross basis. Revenue is recorded gross because the Company acts as a principal, with discretion to choose suppliers, bears credit risk and performs part of the services. The costs associated with these activities are reflected as a component of research and development expense in the condensed statements of operations and approximate the amount of revenue recognized.

Also on January 1, 2011, the Company adopted an accounting standard update that provides guidance on revenue recognition using the milestone method. This update established the milestone method as an acceptable method of revenue recognition for certain contingent payments under research or development arrangements. Under the milestone method, a payment that is contingent upon the achievement of a substantive milestone is recognized in its entirety in the period in which the milestone is achieved. A milestone is an event (i) that can be achieved based in whole or in part on either the Company’s performance or on the occurrence of a specific outcome resulting from the Company’s performance, (ii) for which there is substantive uncertainty at the date the arrangement is entered into that the event will be achieved and (iii) that would result in additional payments being due to the Company. The determination that a milestone is substantive is judgmental and is made at the inception of the arrangement. Milestones are considered substantive when the consideration earned from the achievement of the milestone is (i) commensurate with either the Company’s performance to achieve the milestone or the enhancement of value of the item delivered as a result of a specific outcome resulting from the Company’s performance to achieve the milestone, (ii) relates solely to past performance and (iii) is reasonable relative to all deliverables and payment terms in the arrangement. The Company has historically applied a milestone method approach to its research and development arrangements, so the prospective adoption of this update did not have a material impact on its results of operations, cash flows or financial position.

Other contingent payments received for which payment is either contingent solely upon the passage of time or the results of a collaborative partner’s performance (bonus payments) are not accounted for using the milestone method. Such bonus payments will be recognized as revenue when earned and when collectibility is reasonably assured.

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Royalties based on reported sales of licensed products will be recognized based on contract terms when reported sales are reliably measurable and collectibility is reasonably assured. To date, none of the Company’s products have been approved and therefore the Company has not earned any royalty revenue from product sales.

Preclinical Study and Clinical Trial Accruals and Deferred Advance Payments

The Company estimates preclinical study and clinical trial expenses based on the services performed pursuant to contracts with research institutions and clinical research organizations that conduct these activities on its behalf. In recording service fees, the Company estimates the time period over which the related services will be performed and compares the level of effort expended through the end of each period to the cumulative expenses recorded and payments made for such services and, as appropriate, accrues additional service fees or defers any non-refundable advance payments until the related services are performed. If the actual timing of the performance of services or the level of effort varies from the estimate, the Company will adjust its accrual or deferred advance payment accordingly. If the Company later determines that it no longer expects the services associated with a deferred non-refundable advance payment to be rendered, the deferred advance payment will be charged to expense in the period that such determination is made.

Stock-Based Compensation

Employee stock-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as an expense over the employee’s requisite service period (generally the vesting period). Stock option awards granted to the Company’s nonemployee Directors for their Board-related services are included in employee stock-based compensation in accordance with current accounting standards. The Company uses the Black-Scholes option-pricing model to estimate the fair value of its stock-based awards and uses the straight-line (single-option) method for expense attribution. The Company estimates forfeitures and recognizes expense only for those shares expected to vest.

The Company accounts for equity instruments issued to nonemployees based on their fair values on the measurement dates using the Black-Scholes option-pricing model. The fair values of the options granted to nonemployees are remeasured as they vest. As a result, the noncash charge to operations for nonemployee options with vesting is affected each reporting period by changes in the fair value of the Company’s common stock.

Net Income (Loss) per Common Share

Basic net income (loss) per common share is calculated by dividing the net income (loss) by the weighted-average number of common shares outstanding during the period, without consideration for common stock equivalents. Diluted net income (loss) per share is computed by dividing the net income (loss) by the weighted-average number of common share equivalents outstanding for the period determined using the treasury-stock method. For purposes of this calculation, potentially dilutive securities consisting of convertible preferred stock, stock options and warrants are considered to be common stock equivalents and are excluded in the calculation of diluted net loss per share because their effect would be antidilutive.

The weighted-average number of common shares used in calculating net income per common share—basic for the three months ended September 30, 2010 and net loss per common share—basic and diluted for the nine months ended September 30, 2010 excludes convertible preferred stock shares outstanding from January 1 through September 30, 2010, which converted into 11,120,725 shares of common stock as of the November 30, 2010 closing of the Company’s initial public offering (IPO). For the three and nine months ended September 30, 2011, the weighted-average number of common shares used in calculating net loss per common share—basic and diluted includes 12,000,000 shares of common stock sold in the Company’s IPO, 2,000,000 shares sold in the concurrent private placement and 1,382,651 shares of common stock sold pursuant to an over-allotment option granted to the underwriters of the Company’s IPO.

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The following table presents the calculation of basic and diluted net income (loss) per share of common stock (in thousands, except share and per share data):

(1) In periods of a net loss, all common stock equivalents are excluded in the calculation of diluted net loss per share because their effect would be antidilutive.

Recent Accounting Pronouncements

In May 2011, an amendment to an accounting standard was issued that amends the fair value measurement guidance and includes some enhanced disclosure requirements. The most significant change is the disclosure information required for Level 3 (see Note 4) measurements based on unobservable inputs. This standard will become effective for the Company on January 1, 2012 and is not expected to have a material impact on the Company’s financial statements.

In June 2011, a new accounting standard was issued that eliminates the current option to report other comprehensive income and its components in the statement of stockholders’ equity. Instead, an entity will be required to present items of net income and other comprehensive income in one continuous statement or in two separate, but consecutive, statements. This standard will become effective retrospectively for the Company on January 1, 2012. As this accounting standard relates only to the presentation of other comprehensive income, the adoption of the standard is not expected to significantly impact the Company’s financial statements.

3. Comprehensive Income (Loss)

Comprehensive income (loss) for the three and nine months ended September 30, 2011 and 2010 is as follows (in thousands):

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4. Marketable Securities and Fair Value Measurements

At September 30, 2011, the amortized cost and fair value of marketable securities, with gross unrealized gains and losses, were as follows (in thousands and unaudited):

At December 31, 2010, the amortized cost and fair value of marketable securities, with gross unrealized gains and losses, were as follows (in thousands):

All marketable securities held at September 30, 2011 and December 31, 2010 had original maturities at the date of purchase of less than one year. There were no realized gains or losses recognized from the sale of marketable securities for the three or nine months ended September 30, 2011 and 2010.

In measuring fair value, the Company evaluates valuation techniques such as the market approach, the income approach and the cost approach. A three-level valuation hierarchy that prioritizes the inputs to valuation techniques is used to measure fair value based upon whether such inputs are observable or unobservable.

Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect market assumptions made by the reporting entity. The three-level hierarchy for the inputs to valuation techniques is briefly summarized as follows:

·                  Level 1—Observable inputs such as quoted prices (unadjusted) for identical instruments in active markets;

·                  Level 2—Observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, or model-derived valuations whose significant inputs are observable; and

·                  Level 3—Unobservable inputs that reflect the reporting entity’s own assumptions.

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The Company’s financial assets and financial liabilities subject to fair value measurements on a recurring basis and the levels of the inputs used in such measurements are as follows (in thousands):

The fair values of the money market fund were derived from quoted market prices in an active market. Federal agency securities are valued using third-party pricing sources that apply applicable inputs and other relevant data into their models to estimate fair value.

5. Accrued Liabilities

Accrued liabilities consist of the following (in thousands):

6. Notes Payable

On March 18, 2011, the Company entered into a loan and security agreement with Oxford Finance Corporation and Horizon Technology Finance Corporation (the Lenders) to provide up to $30.0 million available in three tranches of $10.0 million each. The first $10.0 million tranche was drawn at the closing of the transaction, at which time the Company repaid $6.6 million of the remaining obligations under its previous loan. The second and third tranches of $10.0 million each are available upon the achievement of either the full enrollment of the Phase 3 trials for tavaborole or the initiation of a Phase 3 trial for AN2728. Upon achievement of either of these development events, the second tranche of $10.0 million is available for drawdown through March 31, 2012 and the third tranche of $10.0 million is available for drawdown through September 30, 2012. The interest rate for each tranche will be fixed upon drawdown at a rate equal to the greater of 9.4% or 9.1% plus the 3-month U.S. LIBOR rate. Beginning April 1, 2011, payments under the loan agreement are interest only until April 30, 2012 followed by equal monthly payments of interest and principal through April 1, 2015. In addition, a final payment equal to 5.5% of the amounts drawn ($550,000 for the first tranche) will be due on the earlier of April 1, 2015, or such earlier date specified in the loan agreement. The Company paid the Lenders financing fees of $0.3 million and incurred legal fees of $0.1 million in connection with the loan. These fees are being accounted for as a debt discount and deferred debt issuance costs, respectively.

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The loan agreement includes standard affirmative and restrictive covenants, but does not include any covenants to attain or maintain any specific financial metrics, and also includes standard events of default, including payment defaults, breaches of covenants following any applicable cure period, a material impairment in the perfection or priority of the Lenders’ security interest or in the value of the collateral and a material impairment of the prospect of repayment of the loans. Upon the occurrence of an event of default and following any applicable cure periods, a default interest rate of an additional 5% may be applied to the outstanding loan balances, and the Lenders may declare all outstanding obligations immediately due and payable and take such other actions as set forth in the loan agreement.

The loan is secured by all assets of the Company except intellectual property. Under the loan agreement, the Company also agreed to certain restrictions regarding the pledging or encumbrance of its intellectual property.

In connection with the loan agreement and the first tranche drawdown of $10.0 million, the Company issued initial warrants to the Lenders to purchase 80,527 shares of its common stock (with an aggregate exercise price equal to 5.5% of the amount drawn) at an exercise price of $6.83 per share. The warrants are immediately exercisable, may be exercised on a cashless basis and will expire on March 18, 2018. The fair value of the warrants issued was approximately $0.4 million and was calculated using a Black-Scholes valuation model with the following assumptions: risk-free interest rate of 2.8% percent based upon observed risk-free interest rates appropriate for the expected term of the warrants; expected volatility of 73% based on the average historical volatilities of a peer group of publicly-traded companies within the Company’s industry; expected term of 7 years, which is the contractual life of the warrants; and a dividend yield of 0%. The Company recorded a debt discount of $0.4 million to additional paid-in capital associated with the issuance of the warrants. The number of shares subject to the warrants will increase by an amount equal to 5.5% of the amount drawn at each subsequent tranche, divided by the exercise price per share for that tranche (the lower of the 10-day average share price prior to the drawdown or the price per share on the day prior to the drawdown), up to a maximum aggregate exercise price of $1.65 million.

The Company granted certain piggyback registration rights pursuant to which, under certain conditions, the Company will register its shares of common stock issuable upon exercise of the warrants held by the Lenders.

The interest on the loan was calculated using the interest method with the debt issuance costs paid directly to the Lenders (financing fees) and the fair value of the warrants issued to the Lenders treated as a discount on the debt. The debt issuance costs for legal fees are included in prepaid expenses and other current assets and in other assets in the accompanying condensed balance sheet. The amortization of the debt discount is recorded as a noncash interest expense and the amortization of the debt issuance costs is recorded as other income (expense) in the condensed statements of operations.

In March 2011, the Company recorded a loss of $0.3 million on the early extinguishment of its previous debt, which consisted of the write-off of the unamortized portions of the debt discount and the deferred issuance costs of approximately $0.2 million, the unaccrued portion of the final payment of $0.1 million and a prepayment penalty of $50,000. The loss on the early extinguishment of debt is included in the condensed statements of operations.

Future payments at September 30, 2011 are as follows (in thousands):

The Company recorded interest expense related to all borrowings of $0.4 million and $0.5 million for the three months ended September 30, 2011 and 2010, respectively, and $1.0 million and $1.6 million for the nine months ended September 30, 2011 and 2010, respectively. The annual effective interest rate on the new note payable, including the amortization of the debt discounts and accretion of the final payments, is 14.94%.

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7. Commitments and Contingencies

Operating Leases

In October 2011, the Company amended one of its existing leases for its office and laboratory space in Palo Alto, California to extend the lease term to December 31, 2013. In addition, the Company has two (2) one-year options to extend the lease through each of December 31, 2014 and 2015. The lease is cancelable with four months’ notice. The amendment provides for a $0.1 million allowance from the landlord for tenant improvements. The Company continues to provide a $0.1 million standing letter of credit as a security deposit under its lease agreement. Future minimum cash payments under this amended lease at September 30, 2011 are as follows: $0.1 million for the remainder of 2011; $0.3 million for 2012; and $0.3 million for 2013.

Indemnifications

The Company, as permitted under Delaware law and in accordance with its bylaws, indemnifies its officers and directors for certain events or occurrences, subject to certain limits, while the officer or director is or was serving at the Company’s request in such capacity. The term of the indemnification period is equal to the officer’s or director’s lifetime.

The maximum amount of potential future indemnification is unlimited; however, the Company currently holds director and officer liability insurance. This insurance limits the Company’s exposure and may enable it to recover a portion of any future amounts paid. The Company believes that the fair value of these indemnification obligations is minimal. Accordingly, the Company has not recognized any liabilities relating to these obligations for any period presented.

The Company has certain agreements with contract research organizations with which it does business that contain indemnification provisions pursuant to which the Company typically agrees to indemnify the party against certain types of third-party claims. The Company accrues for known indemnification issues when a loss is probable and can be reasonably estimated. The Company would also accrue for estimated incurred but unidentified indemnification issues based on historical activity. There were no accruals for or expenses related to indemnification issues for any period presented.

8. License, Research, Development and Commercialization Agreements

GSK

In September 2011, the Company amended and expanded its research and development collaboration with GSK (Master Amendment) to, among other things, give effect to certain rights in GSK ‘052 that would be acquired by the U.S. government in connection with GSK’s contract for government funding to support GSK’s further development of GSK ‘052, provide GSK the option to extend its rights around the bacterial enzyme target leucyl-tRNA synthetase (LeuRS), as well as to add new programs for tuberculosis (TB) and malaria using the Company’s boron chemistry platform. As a result of the Master Amendment, the Company received a $5.0 million upfront payment in September 2011(the Amendment Fee) and may receive additional milestone payments, bonus payments and research funding as described below, all of which, when earned, will be non-refundable and non-creditable. The Company is also eligible to receive royalties on future sales of resulting products.

The original research and development collaboration with GSK was entered into in October 2007 for the discovery, development and worldwide commercialization of boron-based systemic anti-infectives against four discovery targets. The Master Amendment terminated three of the four target-based research projects under the original agreement. All rights to the compounds developed under these three projects, except for compounds with a specified activity level against LeuRS, will revert to the Company. In addition, the Master Amendment terminated all previous activities within the fourth target-based project under the original agreement, except GSK’s activities related to GSK ‘052, which was licensed by GSK in July 2010 under the original agreement. GSK retained sole responsibility for the further development and commercialization of GSK ‘052 and will continue to be obligated to make bonus payments to the Company if certain development, regulatory and commercial events occur and based on sales of this drug and to pay the Company royalties on annual net sales of GSK ‘052. Any future payment obligations of GSK with respect to the three terminated projects or with respect to previous activities within the fourth project, other than those related to GSK ‘052, were also terminated. The Master Amendment also terminated any research and development obligations that the Company had with respect to the original agreement.

The Master Amendment added a new program for TB, under which GSK will fund the Company’s TB research activities through to candidate selection, including paying the Company for the services of its employees and for any third-party vendor costs it incurs in connection with the agreed TB research plan. Once TB compounds meet specified candidate selection criteria, GSK will have the option to license such compounds and, upon exercise of this option, would become responsible for all further development and commercialization of such compounds. The Company would be eligible for bonus payments, if certain development, regulatory and commercial events occur, and royalties on sales of resulting products.

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In addition, the Master Amendment provided an option for GSK to expand its rights around LeuRS in return for a bonus payment, the amount of which will depend upon the timing of GSK’s exercise of this option. The Master Amendment also allowed GSK to initiate an additional collaborative research program directed toward LeuRS (New Research Program) and, provided such initiation occurs before October 5, 2013, the term of the collaboration agreement would be extended for a minimum of two years from the date of such initiation. The Company and GSK would conduct collaborative research under any such New Research Program to pursue additional drug candidates to candidate selection and any such future work would be funded by GSK, including paying the Company for the services of its employees and for any third-party vendor costs it incurs in connection with an agreed research plan for such a program. Upon candidate selection, GSK would make a milestone payment to the Company and would have the right to undertake further development and commercialization at its sole expense, in which case the Company would become eligible for additional milestone payments, bonus payments and royalties on sales of resulting products.

At its sole discretion, and without any penalty or liability, GSK may terminate the TB program, any New Research Program or the development or commercialization of any compounds that result from such programs. If such termination occurs, rights to the compounds affected by the termination will revert to the Company, subject to certain restrictions on the further development of certain of these compounds. If GSK terminates one of these programs entirely, the Company will have no further obligations with respect to research services under the canceled program and GSK shall pay the Company for all such research services performed by the Company prior to the date of termination.

The Master Amendment also includes the option for GSK to acquire rights to certain compounds from the Company’s malaria program, which is currently being conducted through a collaboration with MMV. GSK will have the option to license certain compounds from the program on an exclusive worldwide basis upon completion of a specified clinical trial. Upon exercise of this option, GSK would assume sole responsibility for the further development and commercialization of any such compounds, the Company would receive an option exercise payment from GSK and, pursuant to a related September 2011 amendment to the Company’s development agreement with MMV, the Company would be obligated to pay MMV one-third of the option exercise payment. The Company would also be eligible for bonus payments, if certain regulatory and commercial events occur, and royalties on sales of resulting products and would be obligated to pay MMV one-third of any such bonus payments up to a maximum amount equal to the total amount paid by MMV to the Company pursuant to the research and development agreements between these two parties. The current lead candidate under the MMV collaboration has recently been discontinued and MMV and the Company are discussing next steps.

In 2007, pursuant to the original agreement, GSK paid the Company a $12.0 million non-refundable, non-creditable upfront fee, which was being recognized over the six-year research collaboration term on a straight-line basis in accordance with the revenue recognition guidance for multiple element arrangements. As of the effective date of the Master Amendment, $4.2 million of the 2007 upfront fee was included in deferred revenue. The Company evaluated the terms of the Master Amendment relative to the entire arrangement and determined the Master Amendment to be a material modification to the original agreement for financial reporting purposes. As a result, the Company evaluated the entire arrangement under the guidance of ASU 2009-13, which it had adopted in January 2011, and identified all undelivered elements under the agreement, as modified. Because the Master Amendment terminated all previously active programs under the original agreement except the GSK ‘052 program, for which GSK had become solely responsible when it exercised its option to license GSK ‘052 in 2010, the Company determined that there were no undelivered elements remaining from the original agreement as of the effective date of the Master Amendment. The Company also determined that the only undelivered element resulting from the Master Amendment, other than contingent deliverables, was the research services it is obligated to provide under the new TB program. The Company then determined the best estimate selling price (BESP) for the TB program research services based on factors such as estimated direct expenses and other costs involved in providing these services, the contractually agreed reimbursement rates for the services and estimated margins the Company has realized under its other contracts involving the provision of and reimbursement for research services. Based on these same factors, the Company also concluded that the contractually agreed reimbursement rates for the services approximate the fair value of such services. The Company then allocated arrangement consideration equal to the BESP for the undelivered TB program research services and determined that the estimated consideration still to be received from GSK for these services would be sufficient to ensure the BESP amount is available for future revenue recognition using the proportional performance method. This amount was then deducted from the sum of the consideration currently committed to be received in the future under the Master Amendment plus any deferred revenue from the original agreement, with the remainder recognized as revenue on the modification date. This process resulted in excess deferred revenue at the date of the material modification of $9.2 million, composed of the remaining deferred revenue balance from the 2007 upfront fee of $4.2 million and the $5.0 million Amendment Fee from the Master Amendment. This $9.2 million was recognized as revenue in September 2011, upon the material modification of the original agreement. The Company determined that the amount of revenue recognized for the

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three and nine months ended September 30, 2011 would have been $0.7 million and $1.7 million, respectively, if the GSK agreement, as modified by the Master Amendment, were subject to the revenue recognition standards for multiple element arrangements that were in effect prior to January 1, 2011. As of September 30, 2011, the Company has no remaining deferred revenue associated with the GSK agreement.

Revenues recognized under this agreement were as follows (in thousands):

The Company has evaluated the remaining contingent payments under the agreement with GSK, as amended by the Master Agreement, based on the new authoritative guidance for research and development milestones and determined that certain of these payments meet the definition of a milestone and that all such milestones are substantive milestones because they are related to events (i) that can be achieved based in whole or in part on either the Company’s performance or on the occurrence of a specific outcome resulting from the Company’s performance, (ii) for which there was substantive uncertainty at the date the agreement was entered into that the event would be achieved and (iii) that would result in additional payments being due to the Company. Accordingly, revenue for these achievements will be recognized in its entirety in the period when the milestone is achieved and collectibility is reasonably assured. Other contingent payments under the agreement, as amended by the Master Amendment, for which payment is contingent upon the results of GSK’s performance will not be accounted for using the milestone method. Such payments will be recognized as revenue when earned and collectibility is reasonably assured. For the three and nine months ended September 30, 2011, the Company did not recognize any revenue from milestone payments or bonus payments under its agreement with GSK. GSK is further obligated to pay the Company royalties on annual net sales of licensed products. To date, no products have been approved and therefore no royalty fees have been earned under this agreement.

Lilly

In August 2010, the Company entered into a research agreement with Lilly under which the companies will collaborate to discover products for a variety of animal health applications. Lilly will be responsible for worldwide development and commercialization of compounds advancing from these efforts. The Company received an upfront payment of $3.5 million in September 2010, which is being recognized over a four-year research term on a straight-line basis, and the Company will receive a minimum of $6.0 million in research funding with the potential of up to $12.0 million in research funding, if successful. As of September 30, 2011, the Company has deferred revenue of $2.5 million related to the upfront fee and $0.8 million related to the research funding.

In addition, the Company will be eligible to receive contingent payments if specified development and regulatory events occur. All such contingent payments, when earned, will be non-refundable and non-creditable. The Company has evaluated the remaining contingent payments under the agreement with Lilly based on the new authoritative guidance for research and development milestones and determined that certain of these payments meet the definition of a milestone and that all such milestones are substantive milestones because they are related to events (i) that can be achieved based in whole or in part on either the Company’s performance or on the occurrence of a specific outcome resulting from the Company’s performance, (ii) for which there was substantive uncertainty at the date the agreement was entered into that the event would be achieved and (iii) that would result in additional payments being due to the Company. Accordingly, revenue for these achievements will be recognized in its entirety in the period when the milestone is achieved and collectibility is reasonably assured. Other contingent payments under the agreement for which payment is contingent upon the results of Lilly’s performance will not be accounted for using the milestone method. Such payments will be recognized as revenue when earned and collectibility is reasonably assured. For both the three and nine months ended September 30, 2011, the Company recognized revenues of $1.0 million from milestones or other contingent payments under its agreement with Lilly.

In addition, the Company will be eligible to receive tiered royalties on annual net sales of licensed products, depending in part upon the mix of products sold. Such royalties would continue through the later of expiration of the Company’s patent rights or six years from the first commercial sale on a product-by-product and country-by-country basis.

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Unless earlier terminated, the agreement continues in effect until the termination of royalty payment obligations. The agreement allows for termination by Lilly upon written notice, with certain additional payments to the Company and a notice period that has a duration dependent on whether the notice is delivered prior to the first regulatory approval of a product under the agreement or thereafter. In addition, either party may terminate for the other party’s uncured material breach of the agreement. In the event of termination by the Company for material breach by Lilly or termination upon written notice by Lilly, Lilly would assign to the Company certain trademarks and regulatory materials used in connection with the products under the agreement and grant to the Company an exclusive license under Lilly’s patent rights covering such products, and the Company would pay to Lilly a reasonable royalty on sales of such products should the Company desire an exclusive license. In the event of termination for material breach by the Company, Lilly will be entitled to a return of all research funding payments for expenses the Company has not incurred or irrevocably committed.

Revenues recognized under this August 2010 agreement were as follows (in thousands):

Medicis

In February 2011, the Company entered into a research and development agreement with Medicis Pharmaceutical Corporation (Medicis) to discover and develop boron-based small molecule compounds directed against a target for the potential treatment of acne. The Company will be primarily responsible during a defined research collaboration term for discovering and conducting early development of product candidates that utilize the Company’s proprietary boron chemistry platform. The Company granted Medicis a non-exclusive, non-royalty bearing license to utilize a relevant portion of the Company’s intellectual property, solely as and to the extent necessary, to enable Medicis to perform additional development work under the agreement. Medicis will also have an option to obtain an exclusive license for products resulting from this collaboration. Upon exercise of this option, Medicis will assume sole responsibility for further development and commercialization of the applicable product candidate on a worldwide basis.

Under the terms of the agreement, the Company received a $7.0 million upfront payment from Medicis in February 2011. The Company has identified the deliverables within the arrangement as a license on the technology and on-going research and development activities. The Company has concluded that the license is not a separate unit of accounting as it does not have stand-alone value to Medicis. As a result, the Company will recognize revenue from the upfront payment on a straight-line basis over a six-year research term. As of September 30, 2011, the Company has deferred revenue of $6.3 million related to this upfront fee.

The Company will also be eligible to receive contingent payments if specified development and regulatory events occur. All such contingent payments, when earned, will be non-refundable and non-creditable. The Company has evaluated the contingent payments under the agreement with Medicis based on the new authoritative guidance for research and development milestones and determined that certain of these payments meet the definition of a milestone and that all such milestones are substantive milestones because they are related to events (i) that can be achieved based in whole or in part on either the Company’s performance or on the occurrence of a specific outcome resulting from the Company’s performance, (ii) for which there was substantive uncertainty at the date the agreement was entered into that the event would be achieved and (iii) that would result in additional payments being due to the Company. Accordingly, revenue for these achievements will be recognized in its entirety in the period when the milestone is achieved and collectibility is reasonably assured. Other contingent payments under the agreement for which payment is contingent upon the results of Medicis’ performance will not be accounted for using the milestone method. Such payments will be recognized as revenue when earned and collectibility is reasonably assured. For the three and nine months ended September 30, 2011, the Company did not recognize any revenue from milestones or other contingent payments under its agreement with Medicis.

In addition, the Company will be eligible to receive tiered royalties on annual net sales of licensed product sold by Medicis or its sublicensees. To date, no products have been approved and therefore no royalty fees have been earned under this agreement.

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Revenues recognized under this 2011 agreement related to the upfront payment were as follows (in thousands):

MMV

In March 2011, the Company entered into a three-year development agreement with MMV to collaborate on the development of compounds for the treatment of malaria through human proof-of-concept studies. This development agreement was preceded by a 2010 research agreement between the two parties. In August 2011, the Company and MMV amended the development agreement (Amendment 1) to expand, and increase the funding for, the Company’s malaria compound development activities. In addition, pursuant to Amendment 1, any 2011 advance payments in excess of the actual costs for the research and development activities under the agreement are refundable or creditable and will be deducted from any future advance payments. In September 2011, the Company and MMV further amended their research and development agreements (Amendment 2) to allow, among other things, the Company to grant GSK a sublicense to certain malaria compounds. GSK will have the option to license such compounds on an exclusive worldwide basis upon the completion of a specified clinical trial. Upon exercise of this option, GSK would assume sole responsibility for the further development and commercialization of the licensed compounds, the Company would receive an option exercise payment from GSK and the Company would be obligated to pay MMV one-third of the option exercise payment. The Company would also be eligible for bonus payments, if certain development, regulatory and commercial events occur, and royalties on sales of resulting products and would be obligated to pay MMV one-third of any such bonus payments up to a maximum amount equal to the total amount paid by MMV to the Company pursuant to the research and development agreements between these two parties. In November 2011, the current lead candidate under the MMV collaboration was discontinued and the parties are discussing next steps (see Note 8 — GSK).

Under the terms of the March 2011 development agreement, the Company received a $1.7 million advance payment from MMV in April 2011 to fund malaria compound development activities through December 2011. In January 2011, the Company had received an advance payment of $0.6 million to fund ongoing research activities through December 2011 in connection with an extension of its previous research agreement with MMV. Additional funding will be determined on an annual basis at the sole discretion of MMV. At September 30, 2011, the advance payment of $0.9 million due under Amendment 1 is included in contract receivable and deferred revenue. The Company will recognize revenue from the advance payments as the research and development activities are performed. As of September 30, 2011, the Company has deferred revenue of $1.7 million related to advance payments from the research and the development agreements.

Revenues recognized under the MMV research and development agreements were as follows (in thousands):

Schering Corporation

In November 2009, Schering Corporation (Schering) merged with Merck. In May 2010, the Company entered into a mutual termination and release agreement with Merck pursuant to which the 2007 exclusive license, development and commercialization agreement with Schering for the development and worldwide commercialization of tavaborole was terminated. Under the May 2010 agreement, the Company regained the exclusive worldwide rights to tavaborole, Merck provided for the transfer to the Company of all material and information related to tavaborole, Merck paid $5.8 million to the Company, and the parties released each other from any and all claims, liabilities or other types of obligations relating to the 2007 agreement. Merck did not retain any rights to this compound.

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Revenues recognized for the three and nine months ended September 30, 2010 under the agreement with Schering and the related mutual termination and release agreement with Merck were as follows (in thousands):

9. Stock-Based Compensation

The Company recorded stock-based compensation expense for the three and nine months ended September 30, 2011 and 2010 as follows (in thousands):