Adhera Therapeutics, Inc. - Quarter Report: 2008 June (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the Quarter Ended June 30, 2008

Commission File Number 000-13789

MDRNA, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (425) 908-3600

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  þ    No  ¨

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  ¨    No  þ

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

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MDRNA, INC. AND SUBSIDIARIES

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PART I — FINANCIAL INFORMATION

Items 1, 2, 3 and 5 of PART II have not been included as they are not applicable.

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PART I — FINANCIAL INFORMATION

ITEM 1 — FINANCIAL STATEMENTS

MDRNA, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

See notes to condensed consolidated financial statements

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MDRNA, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

See notes to condensed consolidated financial statements

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MDRNA, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE LOSS

For the Six Months Ended June 30, 2008

(Unaudited)

See notes to condensed consolidated financial statements

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MDRNA, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

See notes to condensed consolidated financial statements

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MDRNA, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the six months ended June 30, 2007 and 2008 (Unaudited)

Note 1 — Description of Business and Going Concern

Business — We are a biotechnology company focused on the development and commercialization of therapeutic products based on RNA interference (“RNAi”). Our goal is to improve human health through the development of RNAi-based compounds and drug delivery technologies that together provide superior therapeutic options for patients. Over the past decade, we have developed substantial capabilities in molecular biology, cellular biology, lipid chemistry, peptide chemistry, pharmacology and bioinformatics, which we are applying to a wide range of RNAi technologies and delivery approaches. These capabilities, plus the in-licensing of key RNAi-related intellectual property (“IP”), have rapidly enabled us to become a leading RNAi-based therapeutics company with a pre-clinical pipeline in key therapeutic areas including oncology, metabolic disorders and inflammation. Through our capabilities, expertise and know-how, we are incorporating multiple RNAi technologies as well as peptide- and lipid-based delivery approaches into a single integrated drug discovery platform that will be the engine for our clinical pipeline as well as a versatile platform for establishing broad therapeutic partnerships with biotechnology and pharmaceutical companies. We are also investing in new technologies that we expect to lead to safer and more effective RNAi-based therapeutics while aggressively building upon our broad and extensive IP estate. By combining broad expertise in small interfering (“siRNA”) science with proven delivery platforms and a strong IP position, we are well positioned as a leading RNAi-based drug discovery and development company. Our history has been based on nasal delivery; however, our future plans focus on our RNAi programs, and we have changed our name from Nastech Pharmaceutical Company Inc. to MDRNA, Inc. In addition, we have engaged BMO Capital Markets Corp. as our strategic advisor to assist us in identifying a partner or partners to further develop and commercialize our intranasal programs through either a sale or licensing transaction.

Going Concern — The accompanying unaudited condensed consolidated financial statements have been prepared assuming that we will continue as a going concern, which contemplates realization of assets and the satisfaction of liabilities in the normal course of business for the twelve month period following the date of these financial statements. As of June 30, 2008, we had an accumulated deficit of approximately $225.7 million and expect to incur additional losses in the future as we continue our clinical product development. We also have negative cash flows, and customers representing a majority of our 2007 revenue have terminated their contractual agreements with us. We have funded our losses primarily through the sale of common stock in the public markets and private placements and also through revenue provided by our collaboration partners. The continued development of our RNAi programs will require significant capital. At June 30, 2008, we had cash, cash equivalents and short term investments of approximately $19.7 million, including approximately $2.2 million in restricted cash. These factors, among others, raise substantial doubt about our ability to continue as a going concern. Management is implementing plans to address our liquidity needs, including the sale or licensing of our intranasal programs, further restructuring our operations, reducing our workforce, facilities consolidations, renegotiating existing agreements with vendors and taking other actions to limit our expenditures. We are executing a plan to further reduce operating expenses and align our workforce with our strategic, business and research and development requirements. Under this plan, we intend to terminate 23 employees, primarily from our intranasal programs. All affected employees were notified on August 4, 2008 and the majority will finish employment no later than August 31, 2008. Following this action, we will have approximately 55 full-time employees, including approximately six full-time-equivalents maintaining our manufacturing, quality assurance and quality control operations in support of our current partnerships. We expect to incur approximately $1.9 million in severance and related payroll costs as a result of this action, of which approximately $0.3 million had previously been accrued as an accrual for compensated employee absences. This reduction included three executives from our intranasal programs, including our President, Chief Business Officer and Chief Scientific Officer — Delivery. We believe we have retained and will continue to maintain sufficient resources to complete the sale or licensing of certain intranasal programs.

On January 22, 2008, we filed a universal shelf registration statement with the Securities and Exchange Commission (the “SEC”) pursuant to which we can issue up to $50.0 million of our common stock, preferred stock, debt securities, warrants to purchase any of the foregoing securities and units comprised of any of the foregoing securities. The universal shelf registration statement was declared effective by the SEC on February 4, 2008. However, our ability to raise capital using our effective shelf registration statements may be limited for so long as the public float of our common stock remains below $75 million. On April 25, 2008, we raised net proceeds of approximately $7.3 million in a registered direct offering of 4,590,277 shares of common stock along with warrants to purchase up to 5,967,361 shares of common stock at a negotiated purchase price of $1.728 per share. Warrants to purchase up to 4,590,277 shares of common stock are exercisable during the seven-year period beginning October 25, 2008 at a price of $2.376 per share, and warrants to purchase up to 1,377,084 shares of common stock are exercisable during the 90-day period beginning October 25, 2008 at a price of $2.17 per share. In addition, warrants to purchase up to an additional 229,514 shares of common stock, which are exercisable during the five-year period beginning October 25, 2008 at a price of $2.376 per share, were issued to the placement agent in connection with the transaction. However, we anticipate that in the second half of 2008 we may require additional capital to fund our ongoing operations. Our history of declining market valuation and volatility in our stock price could make it difficult for us to raise capital on favorable terms, or at all. Any financing we obtain may further dilute or otherwise impair the ownership interest of our current stockholders. If we fail to generate positive cash flows or fail to obtain additional capital when required, we could modify, delay or abandon some or all of our programs. The accompanying unaudited condensed consolidated financial statements do not include any adjustments that may result from the outcome of this uncertainty.

Note 2 — Summary of Significant Accounting Policies

Basis of Preparation — The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and note disclosures required by U.S. generally accepted accounting principles for complete financial statements. The accompanying unaudited financial information should be read in conjunction with the audited financial statements, including the notes thereto, as of and for the year ended December 31, 2007, included in our 2007 Annual Report on Form 10-K filed with the SEC. The information furnished in this report reflects all adjustments (consisting of normal recurring adjustments), which are, in the opinion of management, necessary for a fair presentation of our financial position, results of operations and cash flows for each period presented. The results of operations for the interim periods ended June 30, 2008 are not necessarily indicative of the results for the year ending December 31, 2008 or for any future period.

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Principles of Consolidation — The financial statements include the accounts of MDRNA, Inc. and our wholly-owned subsidiaries, Atossa HealthCare, Inc., Nastech Holdings I, LLC, Nastech Holdings II, LLC and MDRNA Research, Inc. (formerly MDRNA, Inc.). All inter-company balances and transactions have been eliminated in consolidation.

Use of Estimates — The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires our management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and reported amounts of revenues and expenses during the reporting periods. Estimates having relatively greater significance include revenue recognition, research and development costs, stock-based compensation, inventory reserves, impairment of long-lived assets and income taxes. Actual results could differ from those estimates.

Impairment of Long-Lived Assets — Long-lived assets, such as property, plant and equipment and inventory, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). Conditions that would necessitate an impairment include a significant decline in the observable market value of an asset, a significant change in the extent or manner in which an asset is used, or any other significant adverse change that would indicate that the carrying amount of an asset or group of assets is not recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. Long-lived assets are considered held for sale when certain criteria are met, including whether management has committed to a plan to sell the asset, whether the asset is available for sale in its immediate condition, and whether the sale is probable within one year of the reporting date.

Recent Accounting Pronouncements — Effective January 1, 2008, we adopted SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), for financial assets and liabilities. This standard defines fair value, provides guidance for measuring fair value and requires certain disclosures. This standard does not require any new fair value measurements, but rather applies to all other accounting pronouncements that require or permit fair value measurements. This standard does not apply measurements related to share-based payments. SFAS 157 discusses valuation techniques, such as the market approach (comparable market prices), the income approach (present value of future income or cash flow), and the cost approach (cost to replace the service capacity of an asset or replacement cost). The statement utilizes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The following is a brief description of those three levels:

Level 1: Observable inputs such as quoted prices (unadjusted) in active markets for identical assets or liabilities.

Level 2: Inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly. These include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active.

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

Our financial assets subject to fair value measurements and the necessary disclosures are as follows (amounts in thousands):

In February 2008, the Financial Accounting Standards Board, or FASB, issued FASB Staff Position No. FAS 157-2, “Effective Date of FASB Statement No. 157”, which provides a one year deferral of the effective date of SFAS 157 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed in the financial statements at fair value at least annually. Therefore, we adopted the provisions of SFAS 157 with respect to our financial assets and liabilities only.

In June 2007, the FASB ratified the consensus reached by the Emerging Issues Task Force on EITF Issue No. 07-03, “Accounting for Nonrefundable Advance Payments for Goods or Services Received for Use in Future Research and Development Activities” (“EITF 07-03”). EITF 07-03 provides that nonrefundable advance payments for goods or services that will be used or provided for future research and development activities should be deferred and capitalized and that such amounts should be recognized as an expense as the related goods are delivered or the related services are performed, and provides guidance with respect to evaluation of the expectation of goods to be received or services to be provided. We adopted the provisions of EITF 07-03 effective January 1, 2008. The adoption of EITF 07-03 did not have a significant impact on our consolidated financial position or results of operations.

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In December 2007, the FASB issued SFAS No. 141(Revised 2007), “Business Combinations” (“SFAS 141R”), which replaces SFAS 141, while retaining the fundamental requirements in SFAS 141 that the acquisition method of accounting be used for all business combinations and that an acquirer be identified for each business combination. SFAS 141R changes how business acquisitions are accounted for and establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any non-controlling interest in the acquiree and the goodwill acquired both on the acquisition date and in subsequent periods, and also establishes disclosure requirements which will enable users to evaluate the nature and financial effects of the business combination. SFAS 141R is effective for fiscal years beginning after December 15, 2008. Early adoption is not permitted. We are in the process of evaluating the impact that SFAS 141R will have on our future consolidated financial statements.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of Accounting Research Bulletin No. 51” (“SFAS 160”). SFAS 160 amends Accounting Research Bulletin No. 51 to establish accounting and reporting standards for the non-controlling ownership interests in a subsidiary and for the deconsolidation of a subsidiary, and changes the way the consolidated statement of operations is presented by requiring consolidated net income (loss) to be reported at amounts that include the amounts attributable to both the parent and the non-controlling interest, as well as disclosure, on the face of the statement of operations of those amounts. SFAS 160 also establishes a single method of accounting for changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation, and requires gain recognition in income when a subsidiary is deconsolidated. SFAS 160 also requires expanded disclosures that clearly identify and distinguish between the interests of the parent and the interests of the non-controlling owners. SFAS 160 is effective for fiscal years beginning after December 15, 2008. We have not yet determined the effect that the application of SFAS 160 will have on our consolidated financial statements.

In December 2007, the FASB ratified the consensuses reached in EITF Issue No. 07-1, “Collaborative Arrangements” (“EITF 07-1”). EITF 07-1 defines collaborative arrangements and establishes reporting requirements for transactions between participants in a collaborative arrangement and between participants in the arrangements and third parties. Under EITF 07-1, payments between participants pursuant to a collaborative arrangement that are within the scope of other authoritative accounting literature on income statement classification should be accounted for using the relevant provisions of that literature. If the payments are not within the scope of other authoritative accounting literature, the income statement classification for the payments should be based on an analogy to authoritative accounting literature or if there is no appropriate analogy, a reasonable, rational, and consistently applied accounting policy election. EITF 07-1 also provides disclosure requirements and is effective for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. The effect of applying EITF 07-1 will be reported as a change in accounting principle through retrospective applications to all prior periods presented for all collaborative arrangements existing as of the effective date, unless it is impracticable. We must adopt EITF 07-1 no later than our first quarter of fiscal 2009. EITF 07-1 will not have an effect on our assets, liabilities, stockholders’ equity, cash flows or net results of operations.

In June 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles”(“SFAS 162”). SFAS 162 identifies the sources of generally accepted accounting principles and provides a framework, or hierarchy, for selecting the principles to be used in preparing U.S. GAAP financial statements for nongovernmental entities, and makes the GAAP hierarchy explicitly and directly applicable to preparers of financial statements. The hierarchy of authoritative accounting guidance is not expected to change current practice but is expected to facilitate the FASB’s plan to designate as authoritative its forthcoming codification of accounting standards. This statement is effective 60 days following the SEC’s approval of the PCAOB’s related amendments to remove the GAAP hierarchy from its auditing standards.

Note 3 — Inventories

Inventories, substantially all of which are raw materials, are stated at the lower of cost or market (first-in, first-out basis). At June 30, 2008, the cost basis of our inventory was approximately $2.7 million, composed of $0.1 million of Nascobal^® active pharmaceutical ingredient (“API”) and materials, and $2.6 million of calcitonin-salmon API and materials for our nasal calcitonin-salmon product which is pending U.S. Food and Drug Administration (“FDA”) approval. Apotex has filed a generic application for its nasal calcitonin-salmon product with a filing date that has priority over our abbreviated new drug approval (“ANDA”) for our generic nasal calcitonin-salmon product. In May 2008, a federal district court dismissed the lawsuit between Novartis and Apotex, due to the parties reaching a settlement in their long-standing litigation. The terms of this settlement were not made public. This has created uncertainty over our ability to launch our nasal calcitonin-salmon product and has caused us to reassess the value of our inventory and at June 30, 2008 we considered the carrying amount of this inventory to likely not be recoverable. Accordingly, we recorded a non-cash impairment charge of approximately $2.6 million to cost of goods sold related to the write-down of inventory in the second quarter of 2008. It is possible that we may receive partial or full reimbursement under the terms of our contractual arrangement with Par Pharmaceutical Companies, Inc. (“Par Pharmaceutical”) should we not be able to use this material in connection with our manufacturing arrangement, but the amount and timing of any such reimbursement are not determinable at this time. For additional discussion of the status of our collaboration with Par Pharmaceutical, see Note 8: Contractual Agreements — Par Pharmaceutical.

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Note 4 — Concentration of Credit Risk and Significant Customers

We operate in an industry that is highly regulated, competitive and rapidly changing and involves numerous risks and uncertainties. Significant technological and/or regulatory changes, the emergence of competitive products and other factors could negatively impact our consolidated financial position or results of operations.

We are dependent on our collaborative agreements with a limited number of third parties for a substantial portion of our revenue, and our development and commercialization activities may be delayed or reduced if we do not maintain successful collaborative arrangements. Our agreement with Procter & Gamble Pharmaceuticals, Inc. (“P&G”) was terminated in November 2007. In addition, on January 16, 2008, Novo Nordisk A/S (“Novo Nordisk”) terminated their feasibility study agreement with us. As of June 30, 2008, our two feasibility studies with undisclosed partners had been completed. We had revenue from certain significant customers, as a percentage of total revenue, as follows:

Note 5 — Net Loss Per Common Share

Basic and diluted net loss per common share is computed by dividing the net loss by the weighted average number of common shares outstanding during the period. Diluted loss per share excludes the effect of common stock equivalents (stock options, unvested restricted stock and warrants) since such inclusion in the computation would be anti-dilutive. The following numbers of shares have been excluded (in thousands):

Note 6 — Stockholders’ equity and comprehensive loss

Common Stock — At our annual meeting of stockholders in June 2008, the stockholders approved an increase in the authorized number of shares of our common stock from 50,000,000 to 90,000,000. There were no changes to the rights, preferences or privileges of our common stock.

Common Stock Offerings —On January 22, 2008, we filed a universal shelf registration statement with the SEC pursuant to which we can issue up to $50.0 million of our common stock, preferred stock, debt securities, warrants to purchase any of the foregoing securities and units comprised of any of the foregoing securities. The universal shelf registration statement was declared effective by the SEC on February 4, 2008.

On April 25, 2008, we raised net proceeds of approximately $7.3 million in a registered direct offering of 4,590,277 shares of common stock along with warrants to purchase up to 5,967,361 shares of common stock at a negotiated purchase price of $1.728 per share. Warrants to purchase up to 4,590,277 shares of common stock are exercisable during the seven-year period beginning October 25, 2008 at a price of $2.376 per share, and warrants to purchase up to 1,377,084 shares of common stock are exercisable during the 90-day period beginning October 25, 2008 at a price of $2.17 per share. In addition, warrants to purchase up to an additional 229,514 shares of common stock, which are exercisable during the five-year period beginning October 25, 2008 at a price of $2.376 per share, were issued to the placement agent in connection with the transaction. The warrants were evaluated under the guidance set forth in EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock”. We considered the provisions of EITF 00-19 with respect to the warrants and concluded that the warrants may be physically or net-share settled at the investor’s option and do not contain any net-cash settlement provisions or any provisions deemed under EITF 00-19 to be equivalent to net-cash settlement provisions and are appropriately classified as equity. As of June 30, 2008, we had approximately $110.4 million remaining on our effective shelf registration statements.

Comprehensive Loss — Comprehensive loss was $12.4 million and $14.4 million for the three months ended June 30, 2007 and 2008. Comprehensive loss was $23.9 million and $30.9 million for the six months ended June 30, 2007 and 2008. The only difference between net loss as reported and comprehensive loss is the change in unrealized gains and losses on available-for-sale securities.

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Stockholder Rights Plan — In February 2000, our board of directors adopted a stockholder rights plan and declared a dividend of one preferred stock purchase right for each outstanding share of common stock. Each right entitles the holder, once the right becomes exercisable, to purchase from us one one-thousandth of a share of our Series A Junior Participating Preferred Stock, par value $.01 per share. We issued these rights in March 2000 to each stockholder of record on such date, and these rights attach to shares of common stock subsequently issued. The rights will cause substantial dilution to a person or group that attempts to acquire us on terms not approved by our board of directors and could, therefore, have the effect of delaying or preventing someone from taking control of us, even if a change of control were in the best interest of our stockholders.

Holders of our preferred share purchase rights are generally entitled to purchase from us one one-thousandth of a share of Series A preferred stock at a price of $50.00, subject to adjustment as provided in the Stockholder Rights Agreement. These preferred share purchase rights will generally be exercisable only if a person or group becomes the beneficial owner of 15 percent or more of our outstanding common stock or announces a tender offer for 15 percent or more of our outstanding common stock. Each holder of a preferred share purchase right, excluding an acquiring entity or any of its affiliates, will have the right to receive, upon exercise, shares of our common stock, or shares of stock of the acquiring entity, having a market value equal to two times the purchase price paid for one one-thousandth of a share of Series A preferred stock. The preferred share purchase rights expire on March 17, 2010, unless we extend the expiration date or in certain limited circumstances, we redeem or exchange such rights prior to such date. Initially, 10,000 Series A Junior Participating Preferred shares were authorized. In January 2007, this was increased to 50,000 shares, and in June 2008 this was again increased to 90,000 shares, so that a sufficient number of Series A Junior Participating Preferred shares would be available to the holders of shares of common stock for issuance in satisfaction of such rights, given increases in the number of shares of common stock outstanding.

Note 7 — Stock-based compensation

The following table summarizes stock-based compensation expense recorded related to stock-based awards (in thousands):

Stock Options — In June 2008, our 2008 Stock Incentive Plan was approved by our stockholders and options were issued to certain non-employee directors and members of our Scientific Advisory Board and employees. An aggregate of 4,500,000 shares of common stock is available for grant pursuant to the 2008 Stock Incentive Plan. Stock options to purchase shares of our common stock are granted under our existing stock-based incentive plans at prices at or above the fair market value on the date of grant. In addition, in June 2008, we granted 1,099,963 options to J. Michael French, our Chief Executive Officer, outside of our stock based incentive plans as an employment inducement grant.

Non-cash compensation expense is recognized on a straight-line basis over the applicable vesting periods of one to five years of the options based on the fair value on the grant date. Certain option and share awards provide for accelerated vesting if there is a change in control (as defined in the Plan and certain employment agreements we have with key officers). The following summarizes stock option activity during the six month period ended June 30, 2008:

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We currently use the Black-Scholes option pricing model to determine the fair value of our stock-based awards. The determination of the fair value of stock-based awards on the date of grant using an option-pricing model is affected by our stock price as well as by assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends. Staff Accounting Bulletin (“SAB”) No. 107, “Share Based Payment” (“SAB 107”) provided for a simplified method for estimating expected term for “plain-vanilla” options. The mid-point between the vesting date and the expiration date is used as the expected term under this method. In December 2007, SAB No. 110, “Year-End Help for Expensing Employee Stock Options” (“SAB 110”) was released, which extended the use of the simplified method if a company met certain criteria. We have concluded that we meet the criteria to continue to use the simplified method as we have had significant structural changes in our business such that our historical exercise data may no longer provide a reasonable basis upon which to estimate expected term. We have elected to follow the guidance of SAB 107 and SAB 110 and have continued to use the simplified method in determining expected term for all of our stock option awards to employees and directors. We estimate volatility of our common stock by using stock price history to forecast stock price volatility. The risk-free interest rates used in the valuation model were based on U.S. Treasury issues with remaining terms similar to the expected term on the options. We do not anticipate paying any dividends in the foreseeable future and, therefore, use an expected dividend yield of zero. Forfeitures are estimated based on historical experience. The fair value of stock-based awards was estimated at the date of grant using the Black-Scholes option valuation model with the following weighted average assumptions for the periods presented as follows:

As of June 30, 2008, we had approximately $5.6 million of total unrecognized employee and non-employee director compensation cost related to unvested stock options granted. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures. We expect to recognize this cost over a weighted average period of approximately 1.9 years.

The intrinsic value of stock options outstanding and exercisable at June 30, 2008 is based on the $1.22 closing market price of our common stock on that date, and is calculated by aggregating the difference between $1.22 and the exercise price of each of the outstanding vested and unvested stock options which have an exercise price less than $1.22. The following summarizes stock option activity during the three and six month periods ended June 30, 2007 and 2008 (in thousands):

At June 30, 2008, options to purchase up to 8,431,933 shares of our common stock were outstanding, unvested restricted stock awards for an aggregate of 360,068 shares of our common stock were outstanding under our 2004 Plan and 549,268 shares were available for future grants or awards under our various stock incentive plans.

On June 10, 2008, in connection with our annual shareholders meeting, five members of our board of directors retired. Our board of directors approved a resolution to extend the amount of time the retiring directors have to exercise their vested options from 90 days to two years. Additional compensation expense recognized as a result of the modification was not material.

We generally issue new shares for option exercises unless treasury shares are available for issuance. We have no treasury shares as of June 30, 2008 and have no plans to purchase any in the next year, however, we may accept the surrender of vested restricted shares from employees to cover tax requirements at our discretion.

Non-Employee Option Grants — In June 2008 we granted stock options to four non-employee members of our Scientific Advisory Board. For stock options granted as consideration for services rendered by non-employees, we recognize compensation expense in accordance with the requirements of SFAS 123(R), Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” and EITF 00-18 “Accounting Recognition for Certain Transactions involving Equity Instruments Granted to Other Than Employees,” as amended. Non-employee option grants are recorded as an expense over the vesting period of the underlying stock options. At the end of each financial reporting period prior to vesting, the value of these options, as calculated using the Black-Scholes option pricing model, will be re-measured using the fair value of our common stock and the non-cash compensation recognized during the period will be adjusted accordingly. Since the fair value of options granted to non-employees is subject to change in the future, the amount of future compensation expense will include fair value re-measurements until the stock options are fully vested. During the three month period ended June 30, 2008, we recognized expense of approximately $38,000 relating to options granted to non-employee members of our Scientific Advisory Board.

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Restricted Stock Awards — Pursuant to restricted stock awards granted under our 2004 Stock Incentive Plan, we have issued shares of restricted stock to certain employees and members of our board of directors. Non-cash compensation expense is recognized on a straight-line basis over the applicable vesting periods of one to four years of the restricted shares based on the fair value of such restricted stock on the grant date. Certain share awards provide for accelerated vesting if there is a change in control (as defined in the Plan and certain employment agreements which we have with key officers). We granted restricted stock awards representing 65,656 shares of common stock with a per share weighted average fair value of $11.77 in the three month period ending June 30, 2007. No restricted stock awards were granted in the three month period ended June 30, 2008. We granted restricted stock awards representing 157,418 and 66,429 shares of common stock with a per share weighted average fair value of $12.58 and $2.28 in the six month periods ending June 30, 2007 and 2008. Additional information on restricted shares is as follows (in thousands, except per share amounts):

The fair value of restricted stock vested during the three month periods ended June 30, 2007 and 2008 was approximately $0.6 million and $0.8 million. The fair value of restricted stock vested during the six month periods ended June 30, 2007 and 2008 was approximately $1.1 million and $1.6 million.

Our total unrecognized compensation cost related to unvested restricted stock awards granted under our 2004 Stock Incentive Plan was approximately $4.6 million at June 30, 2008. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures. We expect to recognize this cost over a weighted average period of approximately 1.7 years.

On June 10, 2008, in connection with our annual shareholders meeting, five members of our board of directors retired. Our board of directors approved a resolution to accelerate the vesting of approximately 21,320 restricted shares which would have vested for the retiring directors over the next one or two years. Additional compensation expense recognized as a result of the modification was not material.

Employee Stock Purchase Plan — In June 2007, our shareholders approved the adoption of our 2007 Employee Stock Purchase Plan (“ESPP”). A total of 300,000 shares of common stock were initially reserved for issuance under our ESPP. Under the terms of the ESPP, a participant may purchase shares of our common stock at a price equal to the lesser of 85% of the fair market value on the date of offering or on the date of purchase. Our initial six-month purchase period started October 1, 2007 and ended on March 31, 2008. On April 1, 2008, 42,432 shares of common stock were purchased under the ESPP at $2.00 (85% of the market value of $2.35 on March 31, 2008). The amount expensed related to our ESPP in the three and six month periods ended June 30, 2008 was $33,000 and $72,000 based on employee contributions and on the following weighted average variables:

Warrants — In connection with offerings of our common stock, we have issued warrants to purchase shares of our common stock. At December 31, 2007, there were warrants outstanding for the purchase of 144,430 shares of our common stock with an exercise price of $11.09 which will expire in September 2008. On April 25, 2008, we raised net proceeds of approximately $7.3 million in a registered direct offering of 4,590,277 shares of common stock along with warrants to purchase up to 5,967,361 shares of

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common stock at a negotiated purchase price of $1.728 per share. Warrants to purchase up to 4,590,277 shares of common stock are exercisable during the seven-year period beginning October 25, 2008 at a price of $2.376 per share, and warrants to purchase up to 1,377,084 shares of common stock are exercisable during the 90-day period beginning October 25, 2008 at a price of $2.17 per share. In addition, warrants to purchase up to an additional 229,514 shares of common stock, which are exercisable during the five-year period beginning October 25, 2008 at a price of $2.376 per share, were issued to the placement agent in connection with the transaction. The warrants were evaluated under the guidance set forth in EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock”. We considered the provisions of EITF 00-19 with respect to the warrants and concluded that the warrants may be physically or net-share settled at the investor’s option and do not contain any net-cash settlement provisions or any provisions deemed under EITF 00-19 to be equivalent to net-cash settlement provisions and are appropriately classified as equity. The following summarizes warrant activity during the six month period ended June 30, 2008 (in thousands).

Note 8 — Contractual Agreements

Procter & Gamble Pharmaceuticals, Inc. — In January 2006, we entered into a Product Development and License Agreement with P&G to develop and commercialize our PTH(1-34) nasal spray for the treatment of osteoporosis and in December 2006, we entered into the First Amendment to the License Agreement. Under our agreements with P&G, we received an initial $10.0 million cash payment, which was recorded as deferred revenue and was being amortized into revenue over the estimated development period, a $7.0 million milestone payment received and recognized in full as revenue in the second quarter of 2006, and $11.9 million and $4.3 million in research and development reimbursements recognized as revenue in 2006 and 2007, respectively. Our agreements with P&G were terminated in November 2007, at which time we reacquired all rights and data associated with the PTH(1-34) program. The unamortized balance of P&G’s $10.0 million initial payment, approximately $5.5 million, was recognized as revenue in the fourth quarter of 2007.

Amylin Pharmaceuticals, Inc. (“Amylin”) — In June 2006, we entered into an agreement with Amylin to develop a nasal spray formulation of exenatide for the treatment of type 2 diabetes. Pre-clinical studies of the formulation have been completed in preparation for initiating studies in human subjects. Amylin began clinical trials in the third quarter of 2006 and has completed a Phase 1 clinical trial. Under terms of the agreement, we will receive milestone payments and royalties on product sales. If the development program is successful and the product continues to move forward, milestone payments could reach up to $89 million in total, based on specific development, regulatory, and commercialization goals. Royalty rates escalate with product success. Under the terms of our agreement with Amylin, we will jointly develop the nasal spray formulation with Amylin utilizing our proprietary nasal delivery technology, and Amylin will reimburse us for any development activities we perform under the agreement. Amylin has overall responsibility for the development program including clinical, non-clinical and regulatory activities, and our efforts will focus on drug delivery and CMC activities. If a supply agreement is reached between the companies, we may supply commercial product to Amylin and their exenatide collaboration partner, Eli Lilly and Company, however, there can be no assurance that such a supply agreement will be executed.

Par Pharmaceutical — In October 2004, we entered into a license and supply agreement with Par Pharmaceutical for the exclusive U.S. distribution and marketing rights to a generic calcitonin-salmon nasal spray for the treatment of osteoporosis. Under the terms of the agreement with Par Pharmaceutical, we will manufacture and supply finished calcitonin-salmon nasal spray product to Par Pharmaceutical, while Par Pharmaceutical will distribute the product in the U.S. The financial terms of the agreement include milestone payments, product transfer payments for manufactured product and a profit sharing following commercialization.

In December 2003, we submitted to the FDA an ANDA for a calcitonin-salmon nasal spray for the treatment of osteoporosis. As part of the ANDA process, we have conducted a clinical trial and laboratory tests, including spray characterization, designed to demonstrate the equivalence of our product to the reference listed drug, Miacalcin^®. In February 2004, the FDA accepted the submission for our ANDA for the product. To date, the FDA has informally communicated to us that it has determined that our nasal calcitonin-salmon product is bioequivalent to Miacalcin^®, and has also completed Pre-Approval Inspections of both of our nasal spray manufacturing facilities.

In September 2005, a citizen’s petition was filed with the FDA requesting that the FDA not approve any ANDA as filed prior to additional studies for safety and bioequivalence. We believe this citizen’s petition is an effort to delay the introduction of a generic product in this field. In addition, Apotex has filed a generic application for its nasal calcitonin-salmon product with a filing date that has priority over our ANDA for our generic calcitonin-salmon nasal spray. In November 2002, Novartis brought a patent infringement action against Apotex claiming that Apotex’s nasal calcitonin-salmon product infringes on Novartis’ patents, seeking damages and requesting injunctive relief.

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In the fourth quarter of 2007, we received informal notification from the FDA that our ANDA review is complete and that the citizen’s petition is actively being addressed by the FDA. We do not know the timeline over which the FDA will review this information, nor can we be sure that our additional information will fully satisfy the FDA’s request. If we are not successful at keeping our application as an ANDA, a 505(b)(2) NDA may be pursued or the application may be withdrawn. At this time, we are not able to determine to what degree the citizen’s petition will delay the FDA’s approval of our ANDA, how the Apotex filing priority will be resolved, or when, if at all, our calcitonin-salmon product will receive marketing approval from the FDA. On May 29, 2008 the federal district court dismissed the lawsuit between Novartis and Apotex, due to the parties reaching a settlement in their long-standing litigation. The terms of this settlement were not made public. This has created uncertainty over our ability to launch our nasal calcitonin-salmon product and has caused us to reassess the value of our inventory. At June 30, 2008 we considered the carrying amount of this inventory to likely not be recoverable. Accordingly, we recorded a non-cash impairment charge of approximately $2.6 million to cost of goods sold related to the write-down of inventory in the second quarter of 2008. It is possible that we may receive partial or full reimbursement under the terms of our contractual arrangement with Par Pharmaceutical should we not be able to use this material in connection with our manufacturing arrangement, but the amount and timing of any such reimbursement are not determinable at this time.

Questcor Pharmaceuticals, Inc. (“Questcor”)/QOL — Under the terms of the Questcor Asset Purchase and Supply Agreement, dated June 2003 (the “Questcor Agreements”) that we entered into with Questcor Pharmaceuticals Inc. (“Questcor”), subject to certain limitations, we are obligated to manufacture and supply, and Questcor is obligated to purchase from us, all of Questcor’s requirements for the Nascobal^® nasal gel and the Nascobal^® nasal spray. In February 2005, Questcor paid us a milestone fee of $2.0 million upon receipt of FDA approval of the new drug application (“NDA”) for Nascobal^® nasal spray.

In October 2005, with our consent, Questcor assigned all of its rights and obligations under the Questcor Agreements to QOL. We received $2.0 million from Questcor in October 2005 as consideration for our consent to the assignment and in connection with our entering into an agreement with QOL that modified certain terms of the Questcor Agreements. The $2.0 million is being recognized ratably over the five-year life of the QOL agreement. QOL also assumed Questcor’s obligation to pay us $2.0 million on the issuance by the U.S. Patent and Trademark Office (“PTO”) of a patent covering any formulation that treats any indication identified in our NDA for Nascobal^® nasal spray. This payment became due and was received and recognized as revenue in the second quarter of 2007. We recognized product revenue relating to the supply agreement of approximately zero and $0.2 million in three months ended June 30, 2007 and 2008, respectively, and approximately $0.2 million and $0.7 million in the six months ended June 30, 2007 and 2008, respectively.

Alnylam Pharmaceuticals, Inc. (“Alnylam”) — In July 2005, we acquired an exclusive InterfeRx^™ license from Alnylam to discover, develop, and commercialize RNAi therapeutics directed against TNF-alpha, a protein associated with inflammatory diseases including rheumatoid arthritis and certain chronic diseases. Under the agreement, Alnylam received an initial license fee from us and would receive annual and milestone fees and royalties on sales of any products covered by the licensing agreement. We expensed the initial license fee as research and development expense in 2005. That agreement specified a three-year discovery period with an option to convert a research program to a development and commercialization program. We previously waived our rights to other open targets under the license from Alnylam. In 2006, we licensed IP from City of Hope for Dicer substrate. Based on this licensed IP as well as results from our own efforts in siRNA chemistries and deliveries, we chose to proceed with a Dicer substrate against TNF-alpha. As a result, we have allowed our agreement with Alnylam to expire.

Government Grants — In September 2006, the NIH awarded us a $1.9 million grant over a five year period to prevent and treat influenza. Revenue recognized under this grant totaled $0.1 million for both the three month periods ended June 30, 2007 and 2008. Revenue recognized under this grant totaled $0.2 million for both the six month periods ended June 30, 2007 and 2008.

Thiakis Limited (“Thiakis”) — In September 2004, we acquired exclusive worldwide rights to the Imperial College Innovations and Oregon Health & Science University PYY patent applications in the field of nasal delivery of PYY and the use of glucagon-like peptide-1 (GLP-1) used in conjunction with PYY for the treatment of obesity, diabetes and other metabolic conditions. Under the agreement, we made an equity investment in and paid an initial license fee to Thiakis. We expensed the equity investment and initial license fee as research and development expense in 2004. Under the agreement, Thiakis is entitled to receive an annual fee, additional milestone fees, patent-based royalties, and additional equity investments based upon future progress of the IP and product development processes.

Cytyc Corporation (“Cytyc”) — In July 2003, we entered into a five-year agreement with Cytyc pursuant to which Cytyc acquired patent rights to our Mammary Aspirate Specimen Cytology Test device. Under the terms of the agreement, we received a license fee from Cytyc in 2003 and reimbursement for the cost of patent maintenance and further patent prosecution if incurred during the term of the agreement. In July 2008, the agreement term lapsed and all rights reverted to us. We intend to evaluate further commercial prospects for this device.

City of Hope — In November 2006, we entered into a license with the Beckman Research Institute/City of Hope for exclusive and non-exclusive licenses to the Dicer-substrate RNAi IP developed there. City of Hope granted non-exclusive rights under the licensed patent applications for the treatment of all human diseases, less certain infectious diseases, as well as exclusive rights to five

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named respiratory viral targets. Our rights under the licenses, including sublicensing, are subject to certain limitations. We believe these limitations will have no impact on our programs. This IP and technology, which we continue to build upon as part of our own IP and technology estate, could provide significant commercial and therapeutic advantages for us in this field, by enabling the use of 25 to 30 base pair RNA duplexes designed to act as substrates for processing by the target cells’ natural ability to modulate protein expression.

Feasibility Agreements — We have entered into various feasibility agreements, which are generally for terms of one year or less, including Novo Nordisk and other undisclosed partners. On January 16, 2008, Novo Nordisk completed their feasibility study agreement with us and decided not to further advance the work. As of June 30, 2008, our two feasibility studies with undisclosed partners had been completed.

Note 9 — Commitments and Contingencies

Leases — We lease space for our manufacturing, research and development and corporate offices in Bothell, Washington under operating leases expiring in 2016 and for manufacturing, warehousing and research and development activities in Hauppauge, New York under operating leases expiring in June 2010. In connection with the terms of the leases of our Bothell, Washington facilities, we provided our landlords with stand-by letters of credit that total approximately $2.2 million.

We have entered into a capital lease agreement with GE Capital Corporation, which allows us to finance certain property and equipment purchases over three-or four-year terms depending on the type of equipment. Under this agreement, we have purchased assets approved by GE Capital Corporation, at which date GE Capital Corporation assumes ownership of the assets and we are reimbursed. The equipment is then leased to us. We borrowed approximately $3.0 million and zero in the six months ended June 30, 2007 and 2008, respectively. Weighted average interest rates on capital lease borrowings were approximately 10.0% and 9.8%, respectively, for the three and six month periods ended June 30, 2007 and 10.7% and 10.6% for the three and six month periods ended June 30, 2008.

Contingencies — We are subject to various legal proceedings and claims that arise in the ordinary course of business. Our management currently believes that resolution of such legal matters will not have a material adverse impact on our consolidated financial position, results of operations or cash flows.

Note 10 — Restructuring and Assets Held for Sale

In November 2007, we implemented a plan to reduce our operating costs and appropriately align our operations with our business priorities following the termination by P&G of its collaboration partnership with us with respect to PTH(1-34) nasal spray for the treatment of osteoporosis. As part of this plan, we terminated 72 employees across all areas of our operations and at all of our principal locations, thus reducing our workforce to approximately 160 full-time employees. In connection with this restructuring, we incurred approximately $0.8 million of employee severance and related costs, of which approximately $0.6 million was paid in the fourth quarter of 2007, and the remainder was paid in the first half of 2008.

In February 2008, we terminated approximately 70 additional employees across all areas of our operations, thus reducing our workforce to approximately 85 employees. In connection with the second reduction in force, we incurred approximately $1.6 million of additional employee severance and related costs, which was paid in the first half of 2008. In addition, we also incurred approximately $0.3 million related to our decision in the first quarter 2008 to place our Phase 2 PTH(1-34) clinical trial on hold until further funding has been obtained. We have engaged BMO Capital Markets Corp. as our strategic advisor to assist us in identifying a partner or partners to further develop and commercialize our intranasal programs through either a sale or licensing transaction.

We are executing a plan to further reduce operating expenses and align our workforce with our strategic, business and research and development requirements. Under this plan, we intend to terminate 23 employees, primarily from our nasal programs. All affected employees were notified on August 4, 2008 and the majority will finish employment no later than August 31, 2008. Following this action, we will have approximately 55 full-time employees, including approximately six full-time-equivalents maintaining our manufacturing, quality assurance and quality control operations in support of our current partnerships. We expect to incur approximately $1.9 million in severance and related payroll costs as a result of this action, of which approximately $0.3 million had previously been recorded as an accrual for compensated employee absences. This reduction included three executives from our intranasal programs, including our President, Chief Business Officer and Chief Scientific Officer — Delivery. We believe we have retained and will continue to maintain sufficient resources to complete the sale or licensing of certain intranasal programs.

Given the triggering event as a result of the layoffs and further restructuring announced in the first quarter of 2008, we have evaluated our long-lived assets for possible impairment under the guidance in SFAS 144. At June 30, 2008, laboratory and manufacturing equipment having a net realizable value of approximately $0.4 million, net of estimated costs to sell, was held for sale. We anticipate completing the sale of these assets in the third quarter of 2008. We are also currently contemplating various options that may result in the consolidation of our Bothell, Washington headquarters into a single facility, and we are evaluating strategic alternatives for certain of our assets. The outcome of these events may cause us to reassess whether our assets are impaired, and the results associated with the finalization of such events could be material to our financial statements.

Note 11 — Net Operating Loss Carryforwards

At December 31, 2007, we had available net operating loss carryforwards for federal and state income tax reporting purposes of approximately $176.5 million and $33.1 million, respectively, and had available tax credits of approximately $7.6 million, which are available to offset future taxable income. A portion of these carryforwards will expire in 2008, and will continue to expire through 2027 if not otherwise utilized. Our ability to use such net operating losses and tax credit carryforwards is subject to an annual limitation due to change of control provisions under Sections 382 and 383 of the Internal Revenue Code. An additional change of control as defined by such provisions may have resulted from our registered direct offering dated April 25, 2008, and, if so, the limitation on the usage of our net operating losses and tax credit carryforwards in the future would be significant.

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ITEM 2 — MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Statements contained herein that are not historical fact may be forward-looking statements within the meaning of Section 27A of the Securities Act, and Section 21E of the Exchange Act, that are subject to a variety of risks and uncertainties. There are a number of important factors that could cause actual results to differ materially from those projected or suggested in any forward-looking statement made by us. These factors include, but are not limited to: (i) the ability of our company or a subsidiary to obtain additional funding; (ii) the ability of our company or a subsidiary to attract and/or maintain manufacturing, research, development and commercialization partners; (iii) the ability of our company, a subsidiary and/or a partner to successfully complete product research and development, including pre-clinical and clinical studies and commercialization; (iv) the ability of our company, a subsidiary and/or a partner to obtain required governmental approvals, including product and patent approvals; and (v) the ability of our company, a subsidiary and/or a partner to develop and commercialize products that can compete favorably with those of competitors. In addition, significant fluctuations in quarterly results may occur as a result of the timing of milestone payments, the recognition of revenue from milestone payments and other sources not related to product sales to third parties, and the timing of costs and expenses related to our research and development programs. Additional factors that would cause actual results to differ materially from those projected or suggested in any forward-looking statements are contained in our filings with the Securities and Exchange Commission, including those factors discussed under the captions “Forward-Looking Information” and “Risk Factors” in our most recent Annual Report on Form 10-K, as may be supplemented or amended by our Quarterly Reports on Form 10-Q, which we urge investors to consider. We undertake no obligation to publicly release revisions in such forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrences of unanticipated events or circumstances, except as otherwise required by securities and other applicable laws.

Overview

We are a biotechnology company focused on the development and commercialization of therapeutic products based on RNA interference (“RNAi”). Our goal is to improve human health through the development of RNAi-based compounds and drug delivery technologies that together provide superior therapeutic options for patients. Over the past decade, we have developed substantial capabilities in molecular biology, cellular biology, lipid chemistry, peptide chemistry, pharmacology and bioinformatics, which we are applying to a wide range of RNAi technologies and delivery approaches. These capabilities, plus the in-licensing of key RNAi-related intellectual property (“IP”), have rapidly enabled us to become a leading RNAi-based therapeutics company with a pre-clinical pipeline in key therapeutic areas including oncology, metabolic disorders and inflammation. Through our capabilities, expertise and know-how, we are incorporating multiple RNAi technologies as well as peptide- and lipid-based delivery approaches into a single integrated drug discovery platform that will be the engine for our clinical pipeline as well as a versatile platform for establishing broad therapeutic partnerships with biotechnology and pharmaceutical companies. We are also investing in new technologies that we expect to lead to safer and more effective RNAi-based therapeutics while aggressively building upon our broad and extensive IP estate. By combining broad expertise in small interfering (“siRNA”) science with proven delivery platforms and a strong IP position, we are well positioned as a leading RNAi-based drug discovery and development company. Our history has been based on nasal delivery; however, our future plans focus on our RNAi programs, and we have changed our name from Nastech Pharmaceutical Company Inc. to MDRNA, Inc. In addition, we have engaged BMO Capital Markets Corp. as our strategic advisor to assist us in identifying a partner or partners to further develop and commercialize our intranasal programs through either a sale or licensing transaction.

In connection with our change in focus, we have recently taken steps to restructure certain aspects of our business, including significantly reducing our workforce and reducing certain operating costs. In November 2007, we terminated 72 employees across all areas of our operations and at all of our principal locations, thus reducing our workforce to approximately 160 full-time employees. In connection with this restructuring, we incurred approximately $0.8 million of employee severance and related costs, of which approximately $0.6 million was paid in the fourth quarter of 2007, and the remainder was paid in the first half of 2008. In February 2008, we terminated approximately 70 additional employees across all areas of our operations, thus reducing our workforce to approximately 85 employees. In connection with the second reduction in force, we incurred approximately $1.6 million of employee severance and related costs, which was paid in the first half of 2008. In addition, we also incurred approximately $0.3 million related to our decision in the first quarter 2008 to place our Phase 2 PTH (1-34) clinical trial on hold until further funding has been obtained.

We are executing a plan to further reduce operating expenses and align our workforce with our strategic, business and research and development requirements. Under this plan, we intend to terminate 23 employees, primarily from our intranasal programs. All affected employees were notified on August 4, 2008 and the majority will finish employment no later than August 31, 2008. Following this action, we will have approximately 55 full-time employees, including approximately six full-time-equivalents maintaining our manufacturing, quality assurance and quality control operations in support of our current partnerships. We expect to incur approximately $1.9 million in severance and related payroll costs as a result of this action, of which approximately $0.3 million had previously been recorded as an accrual for compensated employee absences. This reduction included three executives from our intranasal programs, including our President, Chief Business Officer and Chief Scientific Officer — Delivery. We believe we have retained and will continue to maintain sufficient resources to complete the sale or licensing of certain intranasal programs.

Given the triggering event as a result of the layoffs and further restructuring announced in the first quarter, we have evaluated our long-lived assets for possible impairment under the guidance in Statement of Financial Accounting Standards No. 144, “Accounting for Impairments of Long-Lived Assets” (“SFAS 144”). At June 30, 2008, laboratory and manufacturing equipment having a net realizable value of approximately $0.4 million, net of estimated costs to sell, was held for sale. We anticipate completing the sale of these assets in the third quarter of 2008. In the second quarter of 2008, inventories, the majority of which were raw materials for our nasal calcitonin-salmon product that had been acquired by us in furtherance of satisfying our supply obligations under our agreement with Par Pharmaceutical Companies, Inc. (“Par Pharmaceutical”), were considered by management to be impaired. Accordingly, we recorded a non-cash impairment charge of approximately $2.6 million to cost of goods sold related to the write-down of inventory in the second quarter of 2008. We are also currently contemplating various options that may result in the consolidation of our Bothell, Washington headquarters into a single facility, and we are evaluating strategic alternatives for certain of our assets. The outcome of these events may cause us to reassess whether our assets are impaired, and the results associated with the finalization of such events could be material to our financial statements.

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There can be no assurance that our focus on our RNAi programs will produce acceptable results. If we are not successful in implementing or operating under this new business model, our stock price could suffer. Moreover, any other future changes to our business may not prove successful in the short or long term due to a variety of factors, including competition, success of research efforts or our ability to partner our product candidates, and may have a material impact on our financial results.

In addition, we have in the past and may in the future find it advisable to restructure operations and reduce expenses, including, without limitation, such measures as reductions in the workforce, discretionary spending, and/or capital expenditures, as well as other steps to reduce expenses. We have streamlined operations and reduced expenses as a result of the reductions in workforce. Effecting any restructuring places significant strains on management, our employees and our operational, financial and other resources. Furthermore, restructurings take time to fully implement and involve certain additional costs, including severance payments to terminated employees, and we may also incur liabilities from early termination or assignment of contracts, potential litigation or other effects from such restructuring. There can be no assurance that we will be successful in implementing our restructuring program, or that following the completion of our restructuring program, we will have sufficient cash reserves to allow us to fund our business plan until such time as we achieve profitability. Such effects from our restructuring program could have a material adverse affect on our ability to execute on our business plan.

RNAi

We are applying our technological expertise to the development of novel therapeutics using small interfering RNA (“siRNA”) to down-regulate the expression of certain disease-causing proteins that are over-expressed in inflammation, viral respiratory infections, cancer and other diseases. Therapeutics based on RNA interference (“RNAi”) work through a naturally-occurring process within cells that has the effect of reducing levels of genetic material (messenger RNA) required for the production of proteins. RNAi is not gene therapy, but instead targets compounds downstream of DNA. Nevertheless, RNAi enables the targeting of disease with exquisite specificity. The Nobel Prize-winning discovery of RNAi has resulted in its wide use in the research of biological mechanisms and target validation. It is recognized as having tremendous potential in its own right for use as a pharmaceutical. We have created novel RNAi structures for targeting specific diseases and have a variety of proprietary delivery platforms and technologies to enable a range of development programs spanning multiple therapeutic areas. Our current programs and technologies should permit us to make significant progress in pursuing therapeutic indications in the areas of oncology, infectious diseases, metabolic dysfunction, and inflammation-associated disorders. Our current technologies have demonstrated pre-clinical success and a clear potential for commercial application in systemic and local delivery. We intend to expand on the pre-clinical successes of our current platform and utilize our second-generation technologies to facilitate additional modes of delivery in order to expand our therapeutic opportunities and development pipeline.

As part of our corporate restructuring to focus on development of RNA-based therapeutics, near-term business plans will emphasize, in addition to the appropriate development of new and already-established delivery platforms, the expansion and advancement of a therapeutic pipeline that brings value for shareholders and potential partners, as well as proof of concept for our delivery technologies and capabilities.

Our most advanced siRNA program has demonstrated efficacy in animals against multiple influenza strains, including avian flu strains (H5N1). Since the influenza virus has a demonstrated ability to develop drug resistance to first line therapies, the development of an siRNA therapeutic targeting sequences that are highly conserved across all flu genomes, including avian and others having pandemic potential, may provide a solution to this defense mechanism. We believe our lead candidate represents a viable approach to fighting influenza and is one of the most advanced anti-influenza compounds based on RNAi. Our lead candidate can be administered by inhalation to maximize delivery to the lung tissue and has the potential to be delivered to the nasal cavity to prevent or abate early viral infections. As such, it may also have applications in the treatment of seasonal influenza. The product is being designed for ease of use by patients and for long-term stability, both essential for stockpiling the product for rapid mobilization during a flu epidemic.

We are working on a number of pre-clinical siRNA programs including the following:

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We will continue to focus our research and development efforts on therapeutic siRNAs, and continue to acquire and develop our RNAi technologies and intellectual property (“IP”) estate. We expect to expand our RNAi pipeline to additional therapeutic areas. As part of our formulation development and selection process, we have established and validated an in-house, in vivo model to measure knockdown of Apolipoprotein B (“ApoB”), a protein important in the transport of cholesterol in humans and in mice. Independent of ApoB’s potential as a therapeutic target, we are using knockdown of ApoB in liver and other organs as a proof-of-concept model for the development of our formulations for systemic delivery. We have repeatedly demonstrated significant reduction of ApoB messenger RNA and serum cholesterol in mice using our lead liposome-based formulation. As a result, we have nominated a “lead” delivery formulation for certain therapeutic applications.

As of July 25, 2008, we had, either through ownership of or access to, through exclusive licenses, four issued patents and 316 pending patent applications to protect our RNAi proprietary technologies.

RNAi Collaborations

A major part of our business strategy is to enter into collaborations and strategic partnerships with pharmaceutical companies and biotechnology companies, academic institutions, research foundations and others, as appropriate, to gain access to funding, technical resources and intellectual property to further our development efforts and to generate revenue.

City of Hope. In November 2006, we entered into a license with the Beckman Research Institute/City of Hope for exclusive and non-exclusive licenses to the Dicer-substrate RNAi IP developed there. City of Hope granted non-exclusive rights under the licensed patent applications for the treatment of all human diseases, less certain infectious diseases, as well as exclusive rights to five named respiratory viral targets. Our rights under the licenses, including sub-licensing, are subject to certain limitations. We believe these will have no impact on our programs. This IP and technology could provide significant commercial and therapeutic advantages for us in this field by enabling the use of 25 to 30 base pair RNA duplexes designed to act as substrates for processing by the cells’ natural activities. The slightly larger Dicer substrates provide attachment points for delivery-enabling molecules, thereby potentially enhancing the overall efficacy of an RNAi-based therapeutic product.

Alnylam Pharmaceuticals, Inc. (“Alnylam”) — In July 2005, we acquired an exclusive InterfeRx™ license from Alnylam to discover, develop, and commercialize RNAi therapeutics directed against TNF-alpha, a protein associated with inflammatory diseases including rheumatoid arthritis and certain chronic diseases. Under the agreement, Alnylam received an initial license fee from us and would receive annual and milestone fees and royalties on sales of any products covered by the licensing agreement. We expensed the initial license fee as research and development expense in 2005. That agreement specified a three-year discovery period with an option to convert a research program to a development and commercialization program. We previously waived our rights to other open targets under the Alnylam license. In 2006, we licensed IP from City of Hope for Dicer substrate. Based on this licensed IP as well as results of our own efforts in siRNA chemistries and deliveries, we chose to proceed with a Dicer substrate against TNF-alpha. As a result, we have allowed our agreement with Alnylam to expire.

Government Grants. We have entered into contracts with the National Institute of Allergy and Infectious Diseases, or NIAID, a component of the National Institutes of Health, or NIH, over a five year period to prevent and treat influenza. Revenue recognized under this grant totaled $0.1 million for both the three month periods ended June 30, 2007 and 2008. Revenue recognized under this grant totaled $0.2 million for both the six month periods ended June 30, 2007 and 2008.

Intranasal Programs

As previously discussed, we have engaged BMO Capital Markets Corp. as our strategic advisor to assist us in identifying a partner or partners to further develop and commercialize our intranasal programs through either a sale or licensing transaction.

We believe our nasal drug delivery technology offers advantages over injectable routes of administration for large molecules, such as peptides and proteins. These advantages may include improved safety, clinical efficacy and increased patient compliance, due to the elimination of injection site pain or irritation. In addition, we believe our nasal drug delivery technology can potentially offer advantages over oral administration by providing for faster absorption into the bloodstream, and improved effectiveness by avoiding problems relating to gastrointestinal side effects and first-pass liver metabolism.

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We have engaged in a variety of pre-clinical initiatives, alone and with partners, to explore a range of potential therapeutic applications of our tight junction technology. Certain of these initiatives include funded feasibility studies in which our tight junction drug delivery technology is combined with already-approved therapeutics, or product candidates currently in development, to determine if formal pre-clinical trials are warranted. In 2007, we participated in three external feasibility studies with three different partners, including a multi-compound feasibility study with Novo Nordisk with respect to certain undisclosed Novo Nordisk therapeutic compounds, a Factor IX development program for the treatment of hemophilia with an undisclosed partner and a program with an undisclosed partner to deliver an undisclosed anti-seizure medication. Feasibility studies, typically lasting approximately one year, allow us to efficiently evaluate opportunities in which our tight junction technology may produce a product that has improved therapeutic and commercial promise. On January 16, 2008, Novo Nordisk A/S (“Novo Nordisk”) terminated their feasibility study agreement with us.

Insulin. Through our expertise in tight junction biology, we are developing clinical product candidates in multiple therapeutic areas. Our rapid-acting nasal insulin product recently completed a Phase 2 clinical trial in patients with type 2 diabetes. Results from the trial were presented at the American Diabetes Association meeting in June 2008. These data suggest that our nasal insulin when used at mealtime offers glucose control similar to that of a rapidly-acting injectable insulin analog, and may lower the occurrence of hypoglycemia, or low blood sugar, in the hours after a meal. The nasal route of administration is expected to avoid pulmonary side effects associated with the inhalation of insulin.

PYY. Peptide YY(3-36), or PYY(3-36) is produced naturally by specialized endocrine cells (L-cells) in the gut in proportion to the calorie content of a meal. On July 31, 2008, we announced results from our Phase 2 clinical trial involving 551 obese patients evaluating our nasally delivered version of this naturally occurring human hormone. The data indicate that PYY(3-36) did not meet the primary efficacy endpoint of a dose response of weight loss vs. PYY(3-36) dose, nor did PYY(3-36) meet the secondary efficacy endpoint of greater weight loss than the active control, sibutramine (Meridia^®). We believe that our intranasal delivery technology continues to demonstrate value as a means of safely administering peptides and proteins and believe that PYY(3-36) might still prove effective in combination with other weight loss drugs.

PTH. PTH(1-34) is a fragment of human parathyroid hormone that helps regulate calcium and phosphorus metabolism and may cause bone growth. PTH(1-34) is currently being marketed as an injectable product by Eli Lilly & Company (“Lilly”) under the trade name Forteo^®. During the time that Procter & Gamble Pharmaceuticals, Inc. (“P&G”) was leading clinical development of our PTH(1-34) program, two clinical trials were conducted. The first was a Phase 1 PK study in elderly men and women, and the second was a Phase 2A dose-finding study to identify the equivalent dose of nasal PTH(1-34) compared with Forteo^® . The results of this Phase 2A study demonstrate a dose-dependent response of nasal PTH(1-34) for the biochemical marker of bone formation, P1NP. On the basis of this study, a dose equivalent to Forteo^® can be predicted. Plans to initiate a Phase 2B clinical trial to test the predicted Forteo^®-equivalent nasal dose using the U.S. Food and Drug Administration (“FDA”) -identified endpoint of bone mineral density were placed on hold pending further funding or partnering.

Exenatide. Exenatide, marketed by Amylin Pharmaceuticals, Inc. (“Amylin”) and Lilly as Byetta^®, stimulates insulin secretion in response to elevated plasma glucose levels. In June 2006, we entered into an agreement with Amylin to develop a nasal spray formulation of the product, for the treatment of type 2 diabetes. Pre-clinical studies and a Phase 1 clinical trial have been completed by Amylin and additional clinical trials are being evaluated. Under the terms of the agreement, we will receive both milestone payments and royalties on product sales. If the development program is successful and the development of this product continues to move forward, milestone payments could reach up to $89 million in total, based on specific development, regulatory and commercialization goals. Royalty rates escalate with the success of this product. Under the terms of our agreement with Amylin, we will jointly develop the nasal spray formulation with Amylin utilizing our proprietary nasal delivery technology, and Amylin will reimburse us for any development activities performed under the agreement. Amylin has overall responsibility for the development program, including clinical, non-clinical and regulatory activities and our efforts will focus on drug delivery and chemistry, manufacturing and controls, or CMC, activities. If we enter into a supply agreement with Amylin, we may supply commercial product to Amylin and its exenatide collaboration partner, Lilly. However, there can be no assurance that such a supply agreement will be executed.

Calcitonin. In October 2004, we entered into a license and supply agreement with Par Pharmaceutical for the exclusive U.S. distribution and marketing rights to a generic calcitonin-salmon nasal spray for the treatment of osteoporosis. Under the terms of the agreement with Par Pharmaceutical, we will manufacture and supply finished calcitonin-salmon nasal spray product to Par Pharmaceutical, while Par Pharmaceutical will distribute the product in the U.S. The financial terms of the agreement include milestone payments, product transfer payments for manufactured product and profit sharing following commercialization.

In December 2003, we submitted to the FDA an application for abbreviated new drug approval (“ANDA”) for generic calcitonin-salmon nasal spray for the treatment of osteoporosis. As part of the ANDA process, we have conducted a clinical trial and laboratory tests, including spray characterization, designed to demonstrate the equivalence of our product to the reference listed drug, Miacalcin^®. In February 2004, the FDA accepted the submission of our ANDA for the product. To date, the FDA has informally communicated to us that it has determined that our nasal calcitonin-salmon product is bioequivalent to Miacalcin^®, and has also completed Pre-Approval Inspections of both of our nasal spray manufacturing facilities.

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In September 2005, a citizen’s petition was filed with the FDA requesting that the FDA not approve any ANDA as filed prior to additional studies for safety and bioequivalence. We believe this citizen’s petition is an effort to delay the introduction of a generic product in this field. In addition, Apotex has filed a generic application for its nasal calcitonin-salmon product with a filing date that has priority over our ANDA for our generic calcitonin-salmon nasal spray. In November 2002, Novartis brought a patent infringement action against Apotex claiming that Apotex’s nasal calcitonin-salmon product infringes on Novartis’ patents, seeking damages and requesting injunctive relief.

In the fourth quarter of 2007, we received informal notification from the FDA that our ANDA review is complete and that the citizen’s petition is actively being addressed by the FDA. We do not know the timeline over which the FDA will review this information, nor can we be sure that our additional information will fully satisfy the FDA’s request. If we are not successful at keeping our application as an ANDA, a 505(b)(2) NDA may be pursued or the application may be withdrawn. At this time, we are not able to determine to what degree the citizen’s petition will delay the FDA’s approval of our ANDA, how the Apotex filing priority will be resolved, or when, if at all, our calcitonin-salmon product will receive marketing approval from the FDA. On May 29, 2008 the federal district court dismissed the lawsuit between Novartis and Apotex, due to the parties reaching a settlement in their long-standing litigation. The terms of this settlement were not made public. This has created uncertainty over our ability to launch our nasal calcitonin-salmon product and has caused us to reassess the value of our inventory. At June 30, 2008 we considered the carrying amount of this inventory to likely not be recoverable. Accordingly, we recorded a non-cash impairment charge of approximately $2.6 million to cost of goods sold related to the write-down of inventory in the second quarter of 2008. It is possible that we may receive partial or full reimbursement under the terms of our contractual arrangement with Par Pharmaceutical should we not be able to use this material in connection with our manufacturing arrangement, but the amount and timing of any such reimbursement are not determinable at this time.

Carbetocin. Carbetocin, a long-acting analog of oxytocin, is a naturally produced hormone that may benefit autistic patients. In 2007, two foreign Phase 1 dose-escalation studies were conducted in healthy volunteers to evaluate the pharmacokinetics, bioavailability and safety of our carbetocin nasal spray. This program is on hold pending further funding or partnering.

Other Agreements

Questcor Pharmaceuticals, Inc./QOL Medical LLC. In February 2005, the FDA approved our Nascobal^® nasal spray 505(b)(2) application for vitamin B12 (cyanocobalamin) deficiency in patients with pernicious anemia, Crohn’s Disease, HIV/ AIDS and multiple sclerosis. We developed the Nascobal^® nasal spray as an alternative to Nascobal^® (Cyanocobalamin, USP) gel, an FDA-approved product launched in 1997.

Under the terms of the Questcor Asset Purchase and Supply Agreement, dated June 2003 (the “Questcor Agreements”) that we entered into with Questcor Pharmaceuticals Inc. (“Questcor”), subject to certain limitations, we are obligated to manufacture and supply, and Questcor is obligated to purchase from us, all of Questcor’s requirements for the Nascobal^® nasal gel and the Nascobal^® nasal spray. In February 2005, Questcor paid us a milestone fee of $2.0 million upon receipt of FDA approval of the new drug application (“NDA”) for Nascobal^® nasal spray.

In October 2005, with our consent, Questcor assigned all of its rights and obligations under the Questcor Agreements to QOL Medical, LLC. (“QOL”). We received $2.0 million from Questcor in October 2005 as consideration for our consent to the assignment and in connection with our entering into an agreement with QOL that modified certain terms of the Questcor Agreements. The $2.0 million is being recognized ratably over the five-year life of the QOL agreement. QOL also assumed Questcor’s obligation to pay us $2.0 million on the issuance by the U.S. Patent and Trademark Office (“PTO”) of a patent covering any formulation that treats any indication identified in our NDA for Nascobal^® nasal spray. This payment became due and was received and recognized as revenue in the second quarter of 2007. We recognized product revenue relating to the supply agreement of zero and approximately and $0.2 million in three months ended June 30, 2007 and 2008, respectively, and $0.2 million and $0.7 million in the six months ended June 30, 2007 and 2008, respectively.

Cytyc Corporation. In July 2003, we entered into a five-year agreement with Cytyc Corporation (“Cytyc”) pursuant to which Cytyc acquired patent rights to our Mammary Aspirate Specimen Cytology Test (“MASCT”) device. Under the terms of the agreement, we received a license fee from Cytyc in 2003 and reimbursement for the cost of patent maintenance and further patent prosecution if incurred during the term of the agreement. In July 2008, the agreement term lapsed and all rights reverted to us. We intend to evaluate further commercial prospects for this device.

Cash Position, Going Concern and Recent Financings

As of June 30, 2008, we had approximately $19.7 million in cash, cash equivalents and investments, including approximately $2.2 million in restricted cash. As of June 30, 2008, we had an accumulated deficit of $225.7 million, and we expect additional losses in the future as we continue our research and development activities. Our development efforts and the future revenues from sales of these products are expected to generate contract research revenues, milestone payments, license fees, patent-based royalties and manufactured product sales. As a result of our collaborations and other agreements, we recognized revenue of approximately $4.9 million and $9.9 million in the three and six months ended June 30, 2007 and $0.8 million and $2.0 million in the three and six months ended June 30, 2008. This revenue related primarily to license and research fees received from P&G, Novo Nordisk and QOL in 2007 and from QOL and certain undisclosed feasibility partners in 2008.

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On January 22, 2008, we filed a universal shelf registration statement with the Securities and Exchange Commission (“SEC”) pursuant to which we can issue up to $50.0 million of our common stock, preferred stock, debt securities, warrants to purchase any of the foregoing securities and units comprised of any of the foregoing securities. The universal shelf registration statement was declared effective by the SEC on February 4, 2008. However, our ability to raise capital using our effective shelf registration statements may be limited for so long as the public float of our common stock remains below $75 million.

On April 25, 2008, we raised net proceeds of approximately $7.3 million in a registered direct offering of 4,590,277 shares of common stock along with warrants to purchase up to 5,967,361 shares of common stock at a negotiated purchase price of $1.728 per share. Warrants to purchase up to 4,590,277 shares of common stock are exercisable during the seven-year period beginning October 25, 2008 at a price of $2.376 per share, and warrants to purchase up to 1,377,084 shares of common stock are exercisable during the 90-day period beginning October 25, 2008 at a price of $2.17 per share. In addition, warrants to purchase up to an additional 229,514 shares of common stock, which are exercisable during the five-year period beginning October 25, 2008 at a price of $2.376 per share, were issued to the placement agent in connection with the transaction. However, we anticipate that in the second half of 2008 we may require additional capital to fund our ongoing operations. Our recent history of declining market valuation and continued volatility in our stock price could make it difficult for us to raise capital on favorable terms, or at all. Any financing we obtain may dilute or otherwise impair the ownership interest of our current stockholders. If we fail to generate positive cash flows or fail to obtain additional capital when required, we could modify, delay or abandon some or all of our programs. We received an opinion for the year ended December 31, 2007 from our independent registered accounting firm noting the substantial doubt about our ability to continue as a going concern due to our significant recurring operating losses and negative cash flows.

Critical Accounting Policies and Estimates

We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the U.S. As such, we are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the periods presented. Actual results could differ significantly from those estimates under different assumptions and conditions. We believe that the following discussion addresses our most critical accounting estimates, which are those that we believe are most important to the portrayal of our financial condition and results of operations and which require our most difficult and subjective judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Other key estimates and assumptions that affect reported amounts and disclosures include depreciation and amortization, inventory reserves, asset impairments, requirements for and computation of allowances for doubtful accounts, allowances for product returns and expense accruals. We also have other policies that we consider key accounting policies; however, these policies do not meet the definition of critical accounting estimates because they do not generally require us to make estimates or judgments that are difficult or subjective.

Revenue Recognition

Our revenue recognition policies are based on the requirements of SEC Staff Accounting Bulletin (SAB) No. 104 “Revenue Recognition,” the provisions of Emerging Issues Task Force (“EITF”) Issue 00-21, “Revenue Arrangements with Multiple Deliverables,” and the guidance set forth in EITF Issue 01-14, “Income Statement Characterization of Reimbursements Received for “Out-of-Pocket” Expenses Incurred”. Revenue is recognized when there is persuasive evidence that an arrangement exists, delivery has occurred, collectibility is reasonably assured, and fees are fixed or determinable. Deferred revenue expected to be realized within the next 12 months is classified as current.

Substantially all of our revenues are generated from research and licensing arrangements with partners that may involve multiple deliverables. For multiple-deliverable arrangements, judgment is required to evaluate, using the framework outlined in EITF 00-21, whether (a) an arrangement involving multiple deliverables contains more than one unit of accounting, and (b) how the arrangement consideration should be measured and allocated to the separate units of accounting in the arrangement. Our research and licensing arrangements may include upfront non-refundable payments, development milestone payments, payments for contract research and development services performed, patent-based or product sale royalties, government grants, and product sales. For each separate unit of accounting, we have determined that the delivered item has value to the customer on a stand-alone basis, we have objective and reliable evidence of fair value using available internal evidence for the undelivered item(s) and our arrangements generally do not contain a general right of return relative to the delivered item. In accordance with the guidance in EITF 00-21, we use the residual method to allocate the arrangement consideration when we do not have an objective fair value for a delivered item. Under the residual method, the amount of consideration allocated to the delivered item equals the total arrangement consideration less the aggregate fair value of the undelivered items.

Revenue from research and licensing arrangements is recorded when earned based on the performance requirements of the contract. Nonrefundable upfront technology license fees for product candidates where we are providing continuing services related to

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product development are deferred and recognized as revenue over the development period or as we provide the services required under the agreement. The ability to estimate total development effort and costs can vary significantly for each product candidate due to the inherent complexities and uncertainties of drug development. The timing and amount of revenue that we recognize from upfront fees for licenses of technology is dependent upon our estimates of filing dates or development costs. Our typical estimated development periods run two to six years, with shorter or longer periods possible. The estimated development periods are based upon structured detailed project plans completed by our project managers, who meet with scientists and collaborative counterparts on a regular basis and schedule the key project activities and resources including headcount, facilities and equipment, budgets and clinical studies. The estimated development periods generally end on projected filing dates with the FDA for marketing approval. As product candidates move through the development process, it is necessary to revise these estimates to consider changes to the product development cycle, such as changes in the clinical development plan, regulatory requirements, or various other factors, many of which may be outside of our control. The impact on revenue of changes in our estimates and the timing thereof is recognized prospectively over the remaining estimated product development period.

During 2007, we recognized revenue over the estimated development period for a $10.0 million license fee received in early 2006 from P&G. As noted above, we adjust the period on a prospective basis when changes in circumstances indicate a significant increase or decrease in the estimated development period has occurred. For example, our P&G collaboration agreement was amended in December 2006 and we reviewed the estimated development period at that time. Since additional clinical studies were added to the project plan, the estimated development period was lengthened and the portion of the initial $10.0 million recognized each period as revenue was adjusted on a prospective basis to reflect the longer period.

In the fourth quarter of 2007, our collaboration agreement with P&G was terminated. Accordingly, the estimated development period over which we were recognizing the $10.0 million license fee received in early 2006 ended at that time, and the remaining unrecognized portion, approximately $5.5 million, was fully recognized in the fourth quarter of 2007.

We do not disclose the exact development period for competitive reasons and due to confidentiality clauses in our contracts. As an illustrative example only, a one-year increase in a three-year estimated development period to four years, occurring at the end of year one, for a $10.0 million license fee would reduce the annual revenue recognized from approximately $3.3 million in the first year to approximately $2.2 million in each of the remaining three years. Other factors we consider that could impact the estimated development period include FDA actions, clinical trial delays due to difficulties in patient enrollment, delays in the availability of supplies, personnel or facility constraints or changes in direction from our collaborative partners. It is not possible to predict future changes in these elements.

Milestone payments typically represent nonrefundable payments to be received in conjunction with the achievement of a specific event identified in the contract, such as initiation or completion of specified clinical development activities. We believe a milestone payment represents the culmination of a distinct earnings process when it is not associated with ongoing research, development or other performance on our part and it is substantive in nature. We recognize such milestone payments as revenue when they become due and collection is reasonably assured. When a milestone payment does not represent the culmination of a distinct earnings process, revenue is either recognized when the earnings process is deemed to be complete or in a manner similar to that of an upfront technology license fee.

Revenue from contract research and development services performed is generally received for services performed under collaboration agreements and is recognized as services are performed. Payments received in excess of amounts earned are recorded as deferred revenue. Under the guidance of EITF 01-14, reimbursements received for direct out-of-pocket expenses related to contract research and development costs are recorded as revenue in the consolidated statements of operations rather than as a reduction in expenses. Reimbursements received for direct out-of-pocket expenses related to contract research and development for the three and six months ended June 30, 2007 and 2008 were not material.

Royalty revenue is generally recognized at the time of product sale by the licensee.

Government grant revenue is recognized during the period qualifying expenses are incurred for the research that is performed as set forth under the terms of the grant award agreements, and when there is reasonable assurance that we will comply with the terms of the grant and that the grant will be received.

Product revenue is recognized when the manufactured goods are shipped to the purchaser and title has transferred under our contracts where there is no right of return. Provision for potential product returns has been made on a historical trends basis. To date, we have not experienced any significant returns from our customers.

Research and Development Costs

All research and development (“R&D”) costs are charged to operations as incurred. Our R&D expenses consist of costs incurred for internal and external R&D and include direct and research-related overhead expenses. We recognize clinical trial expenses, which are included in R&D expenses, based on a variety of factors, including actual and estimated labor hours, clinical site initiation activities, patient enrollment rates, estimates of external costs and other activity-based factors. We believe this method best approximates the efforts expended on a clinical trial with the expenses recorded. We adjust our rate of clinical expense recognition if actual results differ from our estimates.

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The ability to estimate total development effort and costs can vary significantly for each product candidate due to the inherent complexities and uncertainties of drug development.

Stock-Based Compensation

We use the Black-Scholes option pricing model as our method of valuation for stock-based awards. Stock-based compensation expense for employees and non-employee directors is based on the value of the portion of the stock-based award that will vest during the period, adjusted for expected forfeitures. Our determination of the fair value of stock-based awards on the date of grant using an option pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the expected life of the award, expected stock price volatility over the term of the award and historical and projected exercise behaviors. The estimation of stock-based awards that will ultimately vest requires judgment, and to the extent actual or updated results differ from our current estimates, such amounts will be recorded in the period estimates are revised. Although the fair value of stock-based awards is determined in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123R (revised 2004) “Share-Based Payment,” (“SFAS 123R”), Staff Accounting Bulletin No. 107, “Share Based Payment” and Staff Accounting Bulletin No. 110, “Year-End Help for Expensing Employee Stock Options” (SAB 110), the Black-Scholes option pricing model requires the input of highly subjective assumptions, and other reasonable assumptions could provide differing results.

For example, during the three month period ended June 30, 2008, approximately 4.4 million options were granted to employees and non-employee directors at a weighted average exercise price of $2.38 and weighted average fair value of $0.66 as determined by the Black-Scholes option pricing model. These options represent a total fair market value of approximately $5.4 million based upon the June 30, 2008 fair market value of $1.22. The following table illustrates the effect of changing significant variables on the estimated fair value using the Black-Scholes option pricing model of our options granted during the three month period ended June 30, 2008. In each analysis, the remaining variables are held constant:

If expected stock volatility for the options granted during the three month period ended June 30, 2008 increased or decreased by 10% (all other variables held constant) the impact on our reported net loss would not have been material.

Non-cash compensation expense is recognized on a straight-line basis over the applicable vesting periods of one to five years based on the fair value of such stock-based awards on the grant date. We anticipate expected term and estimated volatility will remain within the ranges listed above in the near term, however, unanticipated business or other conditions may change which could result in differing future results.

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In June 2008 we granted stock options to four non-employee members of our Scientific Advisory Board. For stock options granted as consideration for services rendered by non-employees, we recognize compensation expense in accordance with the requirements of SFAS 123(R), Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” and EITF 00-18 “Accounting Recognition for Certain Transactions involving Equity Instruments Granted to Other Than Employees,” as amended. Non-employee option grants are recorded as an expense over the vesting period of the underlying stock options. At the end of each financial reporting period prior to vesting, the value of these options, as calculated using the Black-Scholes option pricing model, will be re-measured using the fair value of our common stock and the non-cash compensation recognized during the period will be adjusted accordingly. Since the fair value of options granted to non-employees is subject to change in the future, the amount of the future compensation expense will include fair value re-measurements until the stock options are fully vested. During the three month period ended June 30, 2008, we recognized expense of approximately $38,000 relating to options granted to non-employee members of our Scientific Advisory Board.

Impairment of Long-Lived Assets, Assets Held for Sale and Inventory Reserve

Long-lived assets, such as property, plant and equipment and inventory, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Conditions that would necessitate an impairment include a significant decline in the observable market value of an asset, a significant change in the extent or manner in which an asset is used, or any other significant adverse change that would indicate that the carrying amount of an asset or group of assets is not recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. Long-lived assets are considered held for sale when certain criteria are met, including whether management has committed to a plan to sell the asset, whether the asset is available for sale in its immediate condition, and whether the sale is probable within one year of the reporting date. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell and are no longer depreciated. The assets and liabilities of a disposed group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet. At June 30, 2008, laboratory and manufacturing equipment having a net realizable value of approximately $0.4 million, net of estimated costs to sell, was held for sale. As a result, the capital lease obligation related to these assets in the amount of $0.4 million was reclassified from long-term to short-term in the accompanying condensed consolidated balance sheets. We anticipate completing the sale of these assets in the third quarter of 2008.

At June 30, 2008, the cost basis of our inventory was approximately $2.7 million, composed of $0.1 million of Nascobal^® active pharmaceutical ingredient (“API”) and materials, and $2.6 million of calcitonin-salmon API and materials for our nasal calcitonin-salmon product which is pending FDA approval. Apotex has filed a generic application for its nasal calcitonin-salmon product with a filing date that has priority over our ANDA for our generic nasal calcitonin-salmon product. In May 2008, we learned of a confidential legal settlement between Novartis, the reference drug manufacturer, and Apotex, the generic manufacturer with filing priority. This has created uncertainty over our ability to launch our nasal calcitonin-salmon product and has caused us to reassess the value of our inventory. At June 30, 2008 we considered the carrying amount of this inventory to likely not be recoverable. Accordingly, we recorded a non-cash impairment charge of approximately $2.6 million to cost of goods sold related to the write-down of inventory in the second quarter of 2008. It is possible that we may receive partial or full reimbursement under the terms of our contractual arrangement with Par Pharmaceutical should we not be able to use this material in connection with our manufacturing arrangement, but the amount and timing of any such reimbursement are not determinable at this time.

Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. We continue to record a valuation allowance for the full amount of deferred tax assets since realization of such tax benefits is not considered to be more likely than not.

Recently Issued Accounting Standards

Effective January 1, 2008, we adopted SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), for financial assets and liabilities. This standard defines fair value, provides guidance for measuring fair value and requires certain disclosures. This standard does not require any new fair value measurements, but rather applies to all other accounting pronouncements that require or permit

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fair value measurements. This standard does not apply measurements related to share-based payments. SFAS 157 discusses valuation techniques, such as the market approach (comparable market prices), the income approach (present value of future income or cash flow), and the cost approach (cost to replace the service capacity of an asset or replacement cost). The statement utilizes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The following is a brief description of those three levels:

Level 1: Observable inputs such as quoted prices (unadjusted) in active markets for identical assets or liabilities.

Level 2: Inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly. These include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active.

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

Our financial assets subject to fair value measurements and the necessary disclosures are as follows (amounts in thousands):

In February 2008, the Financial Accounting Standards Board, or FASB, issued FASB Staff Position No. FAS 157-2, “Effective Date of FASB Statement No. 157”, which provides a one year deferral of the effective date of SFAS 157 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed in the financial statements at fair value at least annually. Therefore, we adopted the provisions of SFAS 157 with respect to our financial assets and liabilities only.

In June 2007, the FASB ratified the consensus reached by the Emerging Issues Task Force on EITF Issue No. 07-03, “Accounting for Nonrefundable Advance Payments for Goods or Services Received for Use in Future Research and Development Activities” (“EITF 07-03”). EITF 07-03 provides that nonrefundable advance payments for goods or services that will be used or provided for future research and development activities should be deferred and capitalized and that such amounts should be recognized as an expense as the related goods are delivered or the related services are performed, and provides guidance with respect to evaluation of the expectation of goods to be received or services to be provided. We adopted the provisions of EITF 07-03 effective January 1, 2008. The adoption of EITF 07-03 did not have a significant impact on our consolidated financial position or results of operations.

In December 2007, the FASB issued SFAS No. 141(Revised 2007), “Business Combinations” (“SFAS 141R”), which replaces SFAS 141, while retaining the fundamental requirements in SFAS 141 that the acquisition method of accounting be used for all business combinations and that an acquirer be identified for each business combination. SFAS 141R changes how business acquisitions are accounted for and establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any non-controlling interest in the acquiree and the goodwill acquired both on the acquisition date and in subsequent periods, and also establishes disclosure requirements which will enable users to evaluate the nature and financial effects of the business combination. SFAS 141R is effective for fiscal years beginning after December 15, 2008. Early adoption is not permitted. We are in the process of evaluating the impact that SFAS 141R will have on our future consolidated financial statements.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of Accounting Research Bulletin No. 51” (“SFAS 160”). SFAS 160 amends Accounting Research Bulletin No. 51 to establish accounting and reporting standards for the non-controlling ownership interests in a subsidiary and for the deconsolidation of a subsidiary, and changes the way the consolidated statement of operations is presented by requiring consolidated net income (loss) to be reported at amounts that include the amounts attributable to both the parent and the non-controlling interest, as well as disclosure, on the face of the statement of operations of those amounts. SFAS 160 also establishes a single method of accounting for changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation, and requires gain recognition in income when a subsidiary is deconsolidated. SFAS 160 also requires expanded disclosures that clearly identify and distinguish between the interests of the parent and the interests of the non-controlling owners. SFAS 160 is effective for fiscal years beginning after December 15, 2008. We have not yet determined the effect that the application of SFAS 160 will have on our consolidated financial statements.

In December 2007, the FASB ratified the consensuses reached in EITF Issue No. 07-1, “Collaborative Arrangements” (“EITF 07-1”). EITF 07-1 defines collaborative arrangements and establishes reporting requirements for transactions between participants in a collaborative arrangement and between participants in the arrangements and third parties. Under EITF 07-1, payments

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between participants pursuant to a collaborative arrangement that are within the scope of other authoritative accounting literature on income statement classification should be accounted for using the relevant provisions of that literature. If the payments are not within the scope of other authoritative accounting literature, the income statement classification for the payments should be based on an analogy to authoritative accounting literature or if there is no appropriate analogy, a reasonable, rational, and consistently applied accounting policy election. EITF 07-1 also provides disclosure requirements and is effective for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. The effect of applying EITF 07-1 will be reported as a change in accounting principle through retrospective applications to all prior periods presented for all collaborative arrangements existing as of the effective date, unless it is impracticable. We must adopt EITF 07-1 no later than our first quarter of fiscal 2009. EITF 07-1 will not have an effect on our assets, liabilities, stockholders’ equity, cash flows or net results of operations.

In June 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles”(“SFAS 162”). SFAS 162 identifies the sources of generally accepted accounting principles and provides a framework, or hierarchy, for selecting the principles to be used in preparing U.S. GAAP financial statements for nongovernmental entities, and makes the GAAP hierarchy explicitly and directly applicable to preparers of financial statements. The hierarchy of authoritative accounting guidance is not expected to change current practice but is expected to facilitate the FASB’s plan to designate as authoritative its forthcoming codification of accounting standards. This statement is effective 60 days following the SEC’s approval of the PCAOB’s related amendments to remove the GAAP hierarchy from its auditing standards.

Consolidated Results of Operations

Comparison of Quarterly Results of Operations

Percentage comparisons have been omitted within the following table where they are not considered meaningful. All amounts, except amounts expressed as a percentage, are presented in thousands in the following table.

Comparison of the Three Months and Six Months Ended June 30, 2007 to the Three and Six Months Ended June 30, 2008

Revenue. We had revenue from certain significant customers, as a percentage of total revenue, as follows: