CURIS INC - Quarter Report: 2010 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2010

OR

Commission File Number: 000-30347

CURIS, INC.

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s Telephone Number, Including Area Code: (617) 503-6500

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.    x  Yes    ¨  No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every interactive data file required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    ¨  Yes    ¨  No

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

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

As of October 25, 2010, there were 75,638,689 shares of the registrant’s common stock outstanding.

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CURIS, INC. AND SUBSIDIARIES QUARTERLY REPORT ON FORM 10-Q

INDEX

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CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

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CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)

(unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

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CURIS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

1. Nature of Business

Curis, Inc. (the “Company” or “Curis”) is a drug discovery and development company that is committed to leveraging its innovative signaling pathway drug technologies in seeking to develop next generation targeted cancer therapies. Curis is building upon its past experiences in targeting signaling pathways, including the Hedgehog signaling pathway, in its efforts to develop targeted cancer therapies. Curis conducts research programs both internally and through strategic collaborations.

The Company operates in a single reportable segment, which is the research and development of innovative cancer therapeutics. The Company expects that any successful products would be used in the health care industry and would be regulated in the United States by the U.S. Food and Drug Administration, or FDA, and in overseas markets by similar regulatory agencies.

The Company is subject to risks common to companies in the biotechnology industry including, but not limited to, development by its competitors of new or better technological innovations, dependence on key personnel, its ability to protect proprietary technology, its ability to successfully advance discovery, preclinical and clinical stage drug candidates in its internally funded programs, unproven technologies and drug development approaches, reliance on corporate collaborators and licensees to successfully research, develop and commercialize products based on the Company’s technologies, its ability to comply with FDA government regulations and approval requirements as well as its ability to execute on its business strategies and obtain adequate financing to fund its operations.

The Company’s future operating results will largely depend on the magnitude of payments from its current and potential future corporate collaborators and the progress of drug candidates currently in its research and development pipeline. The results of the Company’s operations will vary significantly from year to year and quarter to quarter and depend on, among other factors, the timing of its entry into new collaborations, if any, the timing of the receipt of payments from new or existing collaborators and the cost and outcome of any preclinical development or clinical trials then being conducted. The Company anticipates that existing capital resources at September 30, 2010 should enable the Company to maintain its current and planned operations into the second half of 2012. The Company’s ability to continue funding its planned operations beyond the second half of 2012 is dependent upon, among other things, the success of its collaborations with Genentech and Debiopharm and receipt of additional cash payments under these collaborations, its ability to control expenses and its ability to raise additional funds through equity or debt financings (see Note 7), new collaborations or other sources of financing.

2. Basis of Presentation

The accompanying consolidated financial statements of the Company have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. These statements, however, are condensed and do not include all disclosures required by accounting principles generally accepted in the United States of America for complete financial statements and should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2009, as filed with the Securities and Exchange Commission on March 3, 2010.

In the opinion of management, the unaudited financial statements contain all adjustments (all of which were considered normal and recurring) necessary for a fair statement of the Company’s financial position at September 30, 2010, the results of operations condensed for the three- and nine-month periods ended September 30, 2010 and 2009 and cash flows for the nine month periods ended September 30, 2010 and 2009. The preparation of the Company’s Condensed Consolidated Financial Statements in conformity with accounting principles generally accepted in the U.S., referred to herein as U.S. GAAP, requires management to make estimates and assumptions that affect the reported amounts and disclosure of certain assets and liabilities at the balance sheet date. Such estimates include revenue recognition, the collectibility of receivables, the carrying value of property and equipment and goodwill, and the value of certain investments and liabilities, including the value of its warrant liability. Actual results may differ from such estimates.

These interim results are not necessarily indicative of results to be expected for a full year or subsequent interim periods.

3. Revenue Recognition

The Company’s business strategy includes entering into collaborative license and development agreements with biotechnology and pharmaceutical companies for the development and commercialization of the Company’s product

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)—(Continued)

candidates. The terms of these agreements may provide for the Company’s licensees and collaborators to agree to make non-refundable up-front license fee payments, research and development funding payments, contingent cash payments based upon achievement of clinical development and regulatory objectives and royalties on product sales if any products are successfully commercialized. For a complete discussion of the Company’s revenue recognition policy, see Note 2(c) included in its annual report on Form 10-K, as previously filed with the Securities and Exchange Commission on March 3, 2010 as well as Note 13 related to new revenue accounting pronouncements.

Amounts received prior to satisfying the Company’s revenue recognition criteria are recorded as deferred revenue in the accompanying Consolidated Balance Sheets. As of September 30, 2010, the Company had no deferred revenue related to its collaborations. In the first quarter of 2010, the Company recognized $476,000 in revenue that was deferred at December 31, 2009 as it had no ongoing material performance obligations under the respective agreements.

4. Debiopharm License Agreement

During the nine months ended September 30, 2010, the Company recorded $11,333,000 in license fee revenues from its August 2009 Hsp90 license agreement with Debiopharm SA. Under the terms of this agreement the Company received a $2,000,000 up-front license fee upon execution of the agreement in August 2009. The Company amortized this payment over its estimated performance period under this agreement, which concluded during the first quarter of 2010 and resulted in the recognition of $333,000 in license fee revenue during the nine-month period ended September 30, 2010. In addition, the Company earned $8,000,000 under this agreement in March 2010 upon acceptance by French regulatory authorities of Debiopharm’s clinical trial application for Hsp90 inhibitor, Debio 0932, and $3,000,000 in July 2010 upon Debiopharm’s treatment of the fifth patient in its ongoing phase I clinical trial. The Company recorded $3,000,000 and $11,000,000 as revenue within “License Fees” in the Revenues section of its Condensed Consolidated Statement of Operations for the three and nine months ended September 30, 2010 because the Company has no ongoing material performance obligations under the agreement.

5. Genentech, Inc. Collaboration

In the first quarter of 2009, the Company received a payment of $6,000,000 from Genentech, Inc. under the parties’ June 2003 Hedgehog pathway inhibitor collaboration. This payment was made upon Genentech’s initiation of a pivotal phase II clinical trial of GDC-0449, an orally-administered small molecule Hedgehog pathway inhibitor, as a single-agent therapy for patients with metastatic or locally advanced basal cell carcinoma. The Company has recorded this amount as revenue within “License Fees” in the Revenues section of its Condensed Consolidated Statement of Operations for the nine months ended September 30, 2009 because the Company has no ongoing material performance obligations under the collaboration.

6. Fair Value Measurements

The Company discloses fair value measurements based on a framework outlined by U.S. GAAP, which requires expanded disclosures regarding fair value measurements. U.S. GAAP also defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Market participants are buyers and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact, and (iv) willing to transact.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)—(Continued)

In accordance with the fair value hierarchy, the following table shows the fair value as of September 30, 2010 and December 31, 2009, of those financial assets that are measured at fair value on a recurring basis, according to the valuation techniques the Company used to determine their fair market value. No financial assets are measured at fair value on a nonrecurring basis at September 30, 2010 or December 31, 2009.

The following table rolls forward the fair value of the Company’s warrant liability, the fair value of which is determined by Level 3 inputs for the nine months ended September 30, 2010:

7. Common Stock and Warrant Liability

On January 27, 2010, the Company completed a registered direct offering of 6,449,288 units with each unit consisting of (i) one share of the Company’s common stock and (ii) one warrant to purchase 0.25 of one share of common stock at a purchase price of $2.52 per unit. The Company received net proceeds from the sale of the units, after deducting offering expenses, of approximately $14,942,000.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)—(Continued)

In connection with this offering, the Company issued warrants to purchase an aggregate of 1,612,322 shares of common stock. The warrants have an initial exercise price of $3.55 per share and a five-year term. The warrants include certain protective features for the benefit of the warrantholder, including an exercise price adjustment clause and a possible cash-settlement option in the event of a change of control until the later to occur of (i) two years from the date of original issuance of the warrant and (ii) the date upon which Genentech or Roche submits a new drug application (NDA) for GDC-0449. Due to these terms, the warrants were deemed to be a liability and, therefore, the fair value of the warrants was recorded in the liability section of the Condensed Consolidated Balance Sheet as of September 30, 2010. The Company estimated that the fair value of the warrants at issuance was $2,180,000 using a Black-Scholes option pricing model under various probability-weighted outcomes which take into consideration the protective, but limited, cash-settlement feature of the warrants with the following assumptions assigned to the varying outcomes: expected volatilities of 69.8% and 80%, risk free interest rates ranging from 1.42% to 2.38%, expected lives of three to five years and no dividends. The Company estimated that the fair value of the warrants at September 30, 2010 was $1,082,000 using this same model with the following assumptions assigned to the varying outcomes: expected volatilities of 77.7% and 95.2%, risk free interest rates ranging from 0.6% to 1.1%, expected lives of three to four years and no dividends. The warrants will be revalued each reporting period with updated assumptions, and the resulting change in fair value of the warrant liability will be recognized in the Consolidated Statement of Operations. The Company recorded other income of approximately $208,000 and $1,098,000 for the three and nine months ended September 30, 2010, respectively, as a result of a change in the fair value of the warrant liability that was primarily due to a decrease in the Company’s stock price since issuance of the warrants.

As of December 31, 2009, the Company had warrants outstanding to purchase an aggregate of 1,742,671 shares of its common stock at an exercise price of $1.02 per share under its August 2007 private placement, all of which had been accounted for within stockholders’ equity. In the first quarter of 2010, the Company received proceeds of $1,778,000 upon the exercise of all of these warrants. In the third quarter of 2009, the Company received proceeds of $2,700,000 upon the exercise of warrants to purchase an aggregate of 2,632,198 shares of the Company’s common stock that were also issued under this same private placement.

8. Micromet Settlement

On February 4, 2010, the Company entered into a settlement, mutual release and termination agreement with Micromet, Inc. to resolve a claim filed by the Company relating to a June 2001 agreement between the Company and Micromet’s wholly owned subsidiary Micromet AG associated with the Company’s Single Chain Peptide technology. Under the June 2001 agreement, Micromet AG acquired from the Company certain intellectual property assets relating to single chain antibodies, including patents and license agreements. Pursuant to the settlement agreement, Micromet made a final payment of $4,000,000 during the first quarter of 2010 to the Company in order to settle the dispute and discharge and terminate all future payment obligations that would have arisen under the June 2001 Agreement. The Company has recorded the $4,000,000 within the “License fee” revenue line item in the Consolidated Statement of Operations for the six months ended June 30, 2010. During the first quarter of 2010, the Company incurred approximately $1,526,000 in legal fees and expenses through the settlement date. During the nine months ended September 30, 2009, the Company had incurred $631,000 related to this matter. No significant charges have been incurred since the quarter ended March 31, 2010. These costs are included within the “General and Administrative” expense line item of the Consolidated Statement of Operations for the respective periods.

9. Accrued Liabilities

Accrued liabilities consist of the following:

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)—(Continued)

10. Entry into New Facility Lease

Effective September 16, 2010, the Company entered into a lease agreement with the Trustees of Lexington Office Realty Trust pursuant to which the Company has agreed to lease 24,529 square feet of property to be used for office, research and laboratory located at 4 Maguire Road in Lexington, Massachusetts. The Company intends to move all of its operations currently conducted at 45 Moulton Street, Cambridge, Massachusetts to the newly leased property before the 45 Moulton Street lease expiration date of December 31, 2010.

The term of the lease agreement commences on the later of December 1, 2010 or the date that contractually-specified building upgrades, modifications and repairs are substantially complete to allow for the Company to occupy the leased property and expires seven years and two months from such date. The Company currently anticipates that the term will begin on December 1, 2010. The Company has the option to extend the term for one additional five-year period upon the Company’s written notice to the lessor at least one year and no more than 18 months in advance of the extension. The Company also has the option to terminate the lease agreement after three years, referred to as the early termination option, upon the Company’s written notice to the lessor no later than the second anniversary of the rent commencement date as defined in the lease agreement. Concurrently with such notice, the Company is required to pay a termination fee to the lessor equal to the sum of two months base rent at the rate for the third year of the term and 65.46% of the value of certain transaction expenses incurred by the lessor. The maximum fee for exercising this early termination option is $772,000.

The total cash obligation for the base rent over the initial term of the lease agreement is approximately $4,401,000. In addition to the base rent, the Company is also responsible for its share of operating expenses and real estate taxes, in accordance with the terms of the lease agreement. The Company has provided a security deposit to the lessor in the form of an irrevocable letter of credit in the amount of $278,000, and has classified this amount as a restricted long-term investment in the Company’s Consolidated Balance Sheet as of September 30, 2010. The security deposit may be reduced by up to $125,000 over time in accordance with the terms of the lease agreement. The lessor has agreed to pay up to $789,000 for certain upgrades and repairs to be made to the leased property.

If the Company is considered in default under the terms of the lease agreement and fails to cure such default in the applicable time period, the lessor may terminate the lease agreement and the Company will be required to pay the difference between the remaining rent payments through the expiration of the lease agreement and any rental income from reletting the leased property over such time period, after deducting any expenses incurred in connection with such reletting. Circumstances which may be considered a default under the lease agreement include the failure to timely pay any rent obligations and the filing by the Company of a petition for liquidation or reorganization under bankruptcy law.

11. Accounting for Stock-Based Compensation

As of June 30, 2010, the Company had two shareholder-approved, share-based compensation plans: the 2010 Stock Incentive Plan and the 2010 Employee Stock Purchase Plan. These plans were adopted by the Board of Directors in April 2010 and approved by shareholders in June 2010. The Company can issue up to 6,000,000 shares of its common stock pursuant to awards granted under the 2010 Stock Incentive Plan and a total of up to 500,000 shares of common stock may be purchased under the 2010 Employee Stock Purchase Plan.

The 2010 Stock Incentive Plan permits the granting of incentive and non-qualified stock options and stock awards to employees, officers, directors, and consultants of the Company and its subsidiaries at prices determined by the Company’s Board of Directors. Options become exercisable as determined by the Board of Directors and expire up to 10 years from the date of grant. The 2010 Stock Incentive Plan uses a “fungible share” concept under which each share of stock subject to awards granted as options and stock appreciation rights, will cause one share per share under the award to be removed from the available share pool, while each share of stock subject to awards granted as restricted stock, restricted stock units, other stock-based awards or performance awards where the price charged for the award is less than 100% of the fair market value of the Company’s common stock will cause 1.22 shares per share under the award to be removed from the available share pool. As of September 30, 2010, the Company had granted options to purchase 31,000 shares of the Company’s common stock, each with an exercise price equal to the fair market value on the date of grant.

Under the 2010 Employee Stock Purchase Plan, eligible employees may purchase shares of the Company’s common stock at 85% of the lower closing market price of the common stock at the beginning or ending date of the purchase period, as defined. The Company has two six-month purchase periods per year, with the initial purchase period under the plan commencing on June 15, 2010 and ending on December 14, 2010.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)—(Continued)

In the first quarter of 2010, the Company’s shareholder-approved, share-based 2000 Stock Incentive Plan had expired in accordance with its terms and its 2000 Director Stock Option Plan had no available shares remaining under the plan. No additional awards will be made under these plans, although all outstanding awards under these plans will remain in effect. For a complete discussion of the Company’s former share-based compensation plans, see Note 5 included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009, as previously filed with the Securities and Exchange Commission on March 3, 2010.

During the nine months ended September 30, 2010 and consistent with past practices, the Company’s Board of Directors granted options to purchase a total of 878,500 shares of the Company’s common stock to officers and employees of the Company, of which options to purchase 872,500 shares of common stock were granted under the 2000 Stock Incentive Plan prior to its expiration and options to purchase 6,000 shares of common stock were granted under the 2010 Stock Incentive Plan. These options vest over a four-year period and bear exercise prices that are equal to the closing market price of the Company’s common stock on the NASDAQ Global Market on the grant date.

During the nine months ended September 30, 2010, the Company’s Board of Directors also granted options to its non-employee directors to purchase 235,000 shares of common stock under the 2000 and 2010 Stock Incentive Plans. Of this amount, options to purchase 210,000 shares of common stock were granted under the 2000 Stock Incentive Plan prior to its expiration, were fully vested on the February 2, 2010 grant date and bear exercise prices that are equal to the closing market price of the Company’s common stock on the NASDAQ Global Market on the date of grant. The remaining options to purchase 25,000 shares of common stock were granted under the 2010 Stock Incentive Plan to a newly appointed director and will vest over a four-year period and bear an exercise price that is equal to the closing market price of the Company’s common stock on the NASDAQ Global Market on the June 3, 2010 grant date.

Employee and Director Grants

In determining the fair value of stock options, the Company uses the Black-Scholes option pricing model. The Company calculated the Black-Scholes value of employee options awarded during the nine months ended September 30, 2010 and 2009 using the Black-Scholes valuation model based on the assumptions noted in the following table:

The stock price volatility and expected terms utilized in the calculation involve management’s best estimates at that time, both of which impact the fair value of the option calculated under the Black-Scholes methodology and, accordingly, the expense that is to be recognized over the life of the option. In determining the expense recorded in the Company’s Consolidated Statements of Operations, the Company has applied an estimated forfeiture rate to the remaining unvested awards based on historical experience, as adjusted. This estimate is evaluated quarterly and the forfeiture rate is adjusted as necessary. If the actual number of forfeitures differs from management’s estimates, additional adjustments to compensation expense may be required in future periods.

The aggregate intrinsic value of employee options outstanding at September 30, 2010 was $718,000, of which $531,000 related to exercisable options. The weighted average grant-date fair values of stock options granted during the nine months ended September 30, 2010 and 2009 were $1.46 and $1.18, respectively. As of September 30, 2010, there was approximately $2,103,000, net of the impact of estimated forfeitures, of unrecognized compensation cost related to unvested employee and director stock option awards outstanding under the 2000 and 2010 Stock Incentive Plans that is expected to be recognized as expense over a weighted average period of 2.27 years. The intrinsic values of employee stock options exercised during the nine months ended September 30, 2010 and 2009 were $124,000 and $79,000, respectively. The total fair values of vested stock options for the nine months ended September 30, 2010 and 2009 were $2,030,000 and $1,270,000, respectively.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)—(Continued)

The Company recorded $317,000 and $1,680,000 in compensation expense for the three and nine months ended September 30, 2010, respectively, and $438,000 and $1,412,000 in compensation expense for the three and nine months ended September 30, 2009, respectively, related to employee and director stock option grants. Certain stock options to purchase a total of 816,500 shares of the Company’s common stock were issued to employees of the Company in 2008 and 2007 in which vesting was tied to a performance condition. These options immediately vested upon the consummation of a collaboration, licensing or other similar agreement regarding programs under the Company’s targeted cancer programs that included an up-front cash payment of at least $10,000,000 excluding any equity investment in the Company and subject to the employee’s continued employment. The Company’s Compensation Committee of its Board of Directors determined that the performance condition underlying these options was met in conjunction with the Debiopharm licensing agreement. Receipt of the March 2010 payment from Debiopharm resulted in the immediate vesting of these options and the Company recorded approximately $477,000 in additional stock compensation expense during the nine months ended September 30, 2010.

Non-Employee Grants

The Company has periodically granted stock options to consultants for services. These options were issued at or above their fair market value on the date of grant and have various vesting dates from date of grant, ranging from 3.5 months to 4 years. Should the Company or the consultant terminate the consulting agreement, any unvested options will be cancelled. Unvested non-employee options are marked-to-market, which means that as the Company’s stock price fluctuates, the related expense either increases or decreases. The Company recorded no expense related to non-employee stock options for the three months ended September 30, 2010 and reversed expense of $16,000 for the nine months ended September 30, 2010, as a result of a decline in the Company’s stock price during the period. The Company recognized expense of $31,000 and $73,000 related to non-employee stock options for the three and nine months ended September 30, 2009, respectively. As of September 30, 2010, the Company had recorded $1,000 in deferred compensation related to unvested non-employee options.

Total Stock-Based Compensation Expense

For the three and nine months ended September 30, 2010 and 2009, the Company recorded employee and non-employee stock-based compensation expense to the following line items in its Costs and Expenses section of the Consolidated Statements of Operations and Comprehensive Income (Loss):

The table below summarizes options outstanding and exercisable under the 2010 Stock Incentive Plan, the 2000 Stock Incentive Plan and the 2000 Director Stock Option Plan at September 30, 2010:

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)—(Continued)

12. Income (Loss) Per Common Share

The Company applies ASC Topic 260 - Earnings per Share, which establishes standards for computing and presenting earnings per share. Basic income (loss) per common share is computed using the weighted-average number of shares outstanding during the period. Diluted income per common share is computed using the weighted-average number of shares outstanding during the period plus the incremental shares outstanding assuming the exercise of dilutive stock options, restricted stock and outstanding warrants.

The following summarizes the effect of dilutive securities on diluted income per common share for the nine months ended September 30, 2010:

The weighted-average diluted shares outstanding for the nine months ended September 30, 2010 excludes the dilutive effect of approximately 3,789,171 shares of common stock underlying stock options and 1,612,322 shares of common stock underlying warrants since such options and warrants have an exercise price in excess of the average market value of the Company’s common stock during the respective period.

Diluted net loss per common share is the same as basic net loss per common share for the three months ended September 30, 2010 and for the three and nine months ended September 30, 2009, as the effect of the potential common stock equivalents is antidilutive due to the Company’s net loss position for these periods. Antidilutive securities consist of stock options and warrants outstanding as of the respective reporting periods are as follows:

13. New Accounting Pronouncements

In January 2010, the Company adopted a new U.S. GAAP accounting standard which amends existing revenue recognition accounting guidance to provide accounting principles and application guidance on whether multiple deliverables exist, how the arrangement should be separated, and the consideration allocated. This new guidance eliminates the requirement to establish objective evidence of fair value of undelivered products and services and instead provides for separate revenue recognition based upon management’s estimate of the selling price for an undelivered item when there is no other means to determine the fair value of that undelivered item. The superseded guidance previously required that the fair value of the undelivered item be the price of the item either sold in a separate transaction between unrelated third parties or the price charged for each item when the item is sold separately by the vendor. This was difficult to determine when the product was not individually sold because of its unique features. Under the superseded guidance, if the fair value of all of the undelivered elements in the arrangement was not determinable, then revenue was deferred until all of the items were delivered or fair value was determined. The adoption of the new standard was done on a prospective basis and did not impact the Company’s financial position or results of operations as of and for the three and nine months ended September 30, 2010. This standard may impact the Company in the event it completes future transactions or modifies existing collaborative relationships.

In January 2010, the FASB issued Accounting Standards Update 2010-06 Fair Value Measurement and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. This guidance provides for the following new required disclosures related to fair value measurements: 1) the amounts of and reasons for significant transfers in and out of level one and level two inputs and 2) separate presentation of purchases, sales, issuances, and

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settlements on a gross basis rather than as one net number for level three reconciliations. The guidance also clarifies existing disclosures as follows: 1) provide fair value measurement disclosures for each class of assets and liabilities and 2) provide disclosures about the valuation techniques and inputs used for both recurring and nonrecurring level two or level three inputs. The new disclosures and clarifications of existing disclosures were effective for the Company beginning January 1, 2010 and have been included in this quarterly report. Disclosures about purchases, sales, issuances, and settlements in the roll forward of activity for level three fair value measurements will be effective for the Company beginning January 1, 2011.

In April 2010, the FASB issued Accounting Standards Update (ASU) No. 2010-17, Revenue Recognition — Milestone Method (ASU 2010-017). ASU 2010-017 provides guidance in applying the milestone method of revenue recognition to research or development arrangements. Under this guidance management may recognize revenue contingent upon the achievement of a milestone in its entirety, in the period in which the milestone is achieved, only if the milestone meets all the criteria within the guidance to be considered substantive. This ASU is effective on a prospective basis for research and development milestones achieved in fiscal years, beginning on or after June 15, 2010, which for the Company is fiscal 2011. Early adoption is permitted; however, the Company plans to implement ASU No. 2010-17 prospectively, as such, the effect of this guidance will be limited to future transactions. The Company does not expect adoption of this standard to have a material impact on its financial position or results of operations as the Company does not currently have any research and development arrangements which will be accounted for under the milestone method.

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The following discussion of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and the related notes appearing elsewhere in this report.

Overview

We are a drug discovery and development company that is committed to leveraging our innovative signaling pathway drug technologies in seeking to develop next generation targeted cancer therapies. We are building upon our experience in modulating signaling pathways, including the Hedgehog signaling pathway, in our effort to develop our targeted cancer therapies. We conduct our research programs both internally and through strategic collaborations.

Hedgehog Pathway Inhibitor Program. Our most advanced program is our Hedgehog pathway inhibitor program under collaboration with Genentech, Inc., a member of the Roche Group. The lead drug candidate being developed under this program is GDC-0449, a first-in-class orally-administered small molecule Hedgehog pathway inhibitor.

Genentech and Roche are currently conducting two clinical trials of GDC-0449, including a pivotal phase II trial in advanced basal cell carcinoma, or BCC. Advanced BCC is a severe form of the disease that includes cutaneous BCCs that are considered inoperable by the treating physician as well as BCCs that have metastasized to other tissues and organs. This pivotal study was initiated in February 2009 and Roche has stated that it expects results in the first half of 2011 and, pending successful results, that Roche could also file regulatory approval submissions in 2011. Genentech previously reported compelling proof-of-concept data from a phase I clinical trial of GDC-0449 in patients suffering from advanced BCC, including the observation of a 55% response rate in 33 advanced BCC patients. In the phase I study of GDC-0449, the most frequent adverse events included muscle spasms, altered taste, weight loss and hyponatremia.

In October 2010, Genentech initiated a phase II clinical trial of GDC-0449 as a single-agent therapy for patients with operable BCC in which Genentech expects to evaluate GDC-0449 in approximately 50 patients with operable nodular BCC in a US-based, open label, two-cohort clinical trial. All patients will receive a 150 mg daily oral dose of GDC-0449 for 12 weeks. The primary outcome measure for the first cohort is the rate of complete histological clearance of the target nodular BCC lesions at the time of tumor excision (which may occur up to 12 weeks following initiation of treatment) while the primary outcome measure for the second cohort is the rate of durable complete clearance of target nodular BCC lesions at the time of excision (which may occur up to 36 weeks following initiation of treatment). The secondary outcome measure for both cohorts is to determine the time to complete histological clinical clearance of target nodular BCC lesions.

In addition to clinical trials being conducted directly by Genentech and Roche, GDC-0449 is also currently being tested in other cancers in NCI-sponsored trials under a collaborative relationship between Genentech and the NCI, including in pancreatic, small cell lung, esophageal, stomach, breast and prostate cancers, among others.

Genentech previously completed phase II clinical trials of GDC-0449 in advanced ovarian and metastatic colorectal cancer. In October 2010, Genentech reported that the median time to disease progression in the phase II ovarian cancer study was 7.5 months for patients who received GDC-0449 compared to 5.8 months for patients who received placebo (HR=0.791, p=0.3944). Genentech concluded that these results did not demonstrate sufficient clinically meaningful improvement in progression-free survival to warrant additional clinical testing of GDC-0449 in ovarian cancer. No obvious new safety signals were observed, and ongoing trials in other tumor types have not been impacted by this decision. Genentech concluded that further research is needed to determine whether there is a role for GDC-0449 in the treatment of appropriately selected patients with ovarian cancer.

In June 2010, Roche informed us that the phase II clinical trial in first-line metastatic colorectal cancer patients did not meet its primary endpoint of extending the time from randomization to disease progression or death in study patients who received GDC-0449 in addition to the current standard of care of bevacizumab and chemotherapy when compared to those patients that received only the current standard of care treatment. Roche will not be progressing GDC-0449 into phase III testing in this indication.

Network Targeted Cancer Programs. Our internal drug development efforts are focused on our targeted cancer programs that seek to inhibit multiple signaling pathways using single novel small molecule drug candidates. We believe that this approach of targeting multiple nodes in cancer signaling pathway networks may provide a better therapeutic effect than many of the cancer drugs currently marketed or in development since our drug candidates are being designed to disrupt the cancer network environment in several additional important targets when compared to other cancer drugs.

Our lead candidate from these programs is CUDC-101, a small molecule compound that is the first-in-class compound designed to simultaneously target histone deacetylase, or HDAC, epidermal growth factor receptor, or EGFR, and

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human epidermal growth factor receptor 2, or Her2, all of which are validated cancer targets. In April 2010, we completed a dose escalation phase I clinical trial in which we treated 25 patients and have established 275 milligrams per meter squared as our maximum tolerated dose. In August 2010, we initiated a phase Ib expansion trial to test CUDC-101 in approximately 40 patients with specific tumor types, including head and neck, breast, gastric and liver cancers and have treated 14 patients in this trial as of October 25, 2010. We expect that we will amend the phase Ib expansion study protocol to include up to 10 additional patients with non-small cell lung cancer.

We also anticipate initiating a phase I clinical trial of CUDC-101 in head and neck cancer patients by the end of 2010 or the first quarter of 2011. The primary objectives of the phase I portion of this study are expected to be to evaluate the safety and tolerability of CUDC-101 when administered in combination with cisplatin and radiation. On determination of the maximum tolerated dose and assuring the otherwise successful completion of the phase I trial, we expect that we will conduct a randomized phase II two arm trial in which head and neck patients will receive cisplatin and radiation plus or minus CUDC-101. The phase II part of the study would seek to evaluate whether the addition of CUDC-101 can improve the efficacy and durability of cisplatin and radiation therapy. We continue to progress additional proprietary preclinical programs and currently expect that we will select an additional small molecule inhibitor from our preclinical portfolio in later this year or early 2011.

Hsp90 Program. In August 2009, we granted a worldwide, exclusive royalty-bearing license to our Hsp90 inhibitor technology, including CUDC-305 to Debiopharm S.A., a Swiss pharmaceutical development company, or Debiopharm. CUDC-305 has since been renamed Debio 0932 by Debiopharm. Debiopharm has assumed all future development responsibility for Debio 0932 and Debiopharm or a Debiopharm licensee will incur all future costs related to the development, registration and commercialization of products under the agreement. During the first quarter of 2010, we received $8,000,000 from Debiopharm upon approval from French regulatory authorities of its clinical trial application, or CTA, to begin phase I clinical trials for evaluating the safety of Debio 0932 in patients suffering from advanced solid tumors or lymphoma. In April 2010, Debiopharm treated the first patient in the phase I clinical trial of this molecule, and we received an additional $3,000,000 payment from Debiopharm in the third quarter of 2010 upon Debiopharm’s treatment of the fifth patient in this phase I clinical trial. Our next contingent payment under this license agreement is payable upon Debiopharm’s treatment of the fifth patient in a phase II clinical trial.

Our Collaborations. We are currently a party to a June 2003 collaboration with Genentech relating to our Hedgehog pathway inhibitor technologies, an April 2005 collaboration with Genentech relating to the Wnt signaling pathway, and an August 2009 license agreement with Debiopharm relating to our Hsp90 inhibitor technology. Our past and current collaborations have generally provided for research, development and commercialization programs to be wholly or majority-funded by our collaborators and provide us with the opportunity to receive additional contingent cash payments if specified development and regulatory approval objectives are achieved, as well as royalty payments upon the successful commercialization of any products based upon the collaborations. We are currently not receiving any research funding and we do not expect to receive such funding in the future from Genentech or Debiopharm under our current agreements with these parties. We currently expect to incur only nominal research and development costs under our June 2003 collaboration with Genentech related to the maintenance of licenses. In addition, as a result of our licensing agreements with various universities, we are obligated to make payments to these university licensors when we receive certain payments from Genentech. As of September 30, 2010, we have paid an aggregate of $900,000 related to such agreements. We also expect to incur general and administrative costs associated with our share of intellectual property costs under our June 2003 collaboration with Genentech. We do not expect to incur any material future costs related to our Hsp90 technologies that have been licensed to Debiopharm.

Key Operational Drivers. Since our inception, we have funded our operations primarily through license fees, contingent cash payments, research and development funding from our corporate collaborators, the private and public placement of our equity securities and debt financings and the monetization of certain royalty rights. On an annual basis, we have never been profitable and have an accumulated deficit of $716,622,000 as of September 30, 2010. We expect to incur significant operating losses for the next several years as we devote substantially all of our resources to our research and development programs. We will need to generate significant revenues to achieve annual profitability and do not expect to achieve profitability in the foreseeable future, if at all. We believe that near term key drivers to our success will include:

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In the longer term, a key driver to our success will be our ability, and the ability of any current or future collaborator or licensee, to successfully commercialize drugs based upon our proprietary technologies.

Financial Operations Overview

General. Our future operating results will largely depend on the magnitude of payments from our current and potential future corporate collaborators and the progress of drug candidates currently in our research and development pipeline. The results of our operations will vary significantly from year to year and quarter to quarter and depend on, among other factors, the timing of our entry into new collaborations, if any, the timing of the receipt of payments, if any, from new or existing collaborators and the cost and outcome of any preclinical development or clinical trials then being conducted. We anticipate that existing capital resources as of September 30, 2010 should enable us to maintain current and planned operations into the second half of 2012. Our ability to continue funding our planned operations beyond the second half of 2012 is dependent on future contingent payments that we may receive from Debiopharm or Genentech upon the achievement of development and regulatory approval objectives, our ability to manage our expenses and our ability to raise additional funds through additional corporate collaborations, equity or debt financings, or from other sources of financing. We expect that our expenses associated with the clinical development of CUDC-101 will increase, resulting in an overall increase in our research and development expenses for future periods as compared to prior years.

A discussion of certain risks and uncertainties that could affect our liquidity, capital requirements and ability to raise additional funds is set forth under “Part II, Item 1A—Risk Factors.”

Revenue. Substantially all of our revenues to date have been derived from license fees, research and development payments, and other amounts that we have received from our strategic collaborators and licensees. We do not expect to generate any revenue from the direct sale of products for several years, if ever. We currently receive no research funding for our programs under collaboration with Genentech and Debiopharm and we do not expect to receive such funding in the future under these collaborations. Accordingly, our only source of revenues and/or cash flows from operations for the foreseeable future will be up-front license payments and funded research and development that we may receive under new collaboration agreements, if any, contingent cash payments for the achievement of development objectives, if any are met, under new collaborations or our existing collaborations with Genentech and Debiopharm, and royalty payments that are contingent upon the successful commercialization of any products based upon these collaborations. For example, in July 2010, we earned a $3,000,000 contingent payment under our agreement with Debiopharm for the treatment of the fifth patient in the phase I clinical trial of Debio 0932. The next contingent payment that we would be eligible for under the agreement would be upon Debiopharm’s treatment of the fifth patient in a phase II clinical trial, assuming that the compound successfully completes the ongoing phase I trial and that Debiopharm advances Debio 0932 into phase II clinical testing. Our ability to enter into new collaborations and our receipt of additional payments under our existing collaborations with Genentech and Debiopharm cannot be assured, nor can we predict the timing of any such arrangements or payments, as the case may be.

Research and Development. Research and development expense consists of costs incurred to discover, research and develop our drug candidates. These expenses consist primarily of salaries and related expenses for personnel including stock-based compensation expense as well as outside service costs including clinical research organizations and medicinal chemistry. Research and development expenses also include the costs of supplies and reagents, consulting, and occupancy and depreciation charges. We expense research and development costs as incurred. We are currently incurring only nominal research and development expenses under our Hedgehog pathway inhibitor collaboration with Genentech related to the maintenance of third-party licenses to certain background technologies. For each contingent payment, if any, received under the Hedgehog pathway inhibitor collaboration, we would be obligated to make payments to certain third-party licensors and recognize the related expense.

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Our research and development programs, both internal and under collaboration, are summarized in the following table:

In the chart above, “Pivotal Phase II” means that Genentech is currently treating human patients in a pivotal phase II clinical trial, the primary objective of which is a therapeutic response in human patients. The endpoints of this clinical trial, if positive, may serve as the basis for a future new drug application submission by Genentech or Roche. “Phase II” means that Genentech is currently evaluating the results of a phase II clinical trial treating human patients, the primary objective of which is a therapeutic response. “Phase Ib” means that we are currently treating human patients with specific tumor types including head and neck, breast, gastric and liver cancers at the maximum tolerated dose from our phase I dose escalation clinical trial, the principal purpose of which is to evaluate the safety and tolerability of the compound being tested. “Phase I” means that Debiopharm is currently treating human patients in a phase I clinical trial, the principal purpose of which is to evaluate the safety and tolerability of the compound being tested. “Preclinical” means that we are seeking to obtain evidence of therapeutic efficacy and safety in preclinical models of human disease of one or more compounds within a particular class of drug candidates.

Because of the early stages of development of these programs, our ability and that of our collaborators and licensees to successfully complete preclinical and clinical studies of these drug candidates, and the timing of completion of such programs, is highly uncertain. There are numerous risks and uncertainties associated with developing drugs which may affect our and our collaborators’ future results, including:

We cannot reasonably estimate or know the nature, timing and estimated costs of the efforts necessary to complete the development of, or the period in which material net cash inflows are expected to commence from any of our drug candidates. Any failure to complete the development of our drug candidates in a timely manner could have a material adverse effect on our operations, financial position and liquidity.

A further discussion of some of the risks and uncertainties associated with completing our research and development programs on schedule, or at all, and some consequences of failing to do so, are set forth below in “Part II, Item 1A—Risk Factors.”

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General and Administrative. General and administrative expense consists primarily of salaries, stock-based compensation expense and other related costs for personnel in executive, finance, accounting, business development, legal, information technology, corporate communications and human resource functions. Other costs include facility costs not otherwise included in research and development expense, insurance, and professional fees for legal, patent and accounting services. Patent costs include certain patents covered under collaborations, a portion of which is reimbursed by collaborators and a portion of which is borne by us.

Critical Accounting Policies and Estimates

The preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States requires that we make estimates and assumptions that affect the reported amounts and disclosures in the financial statements. Such estimates and judgments include the assumptions underlying the valuation of our warrant liability, carrying value of property and equipment and intangible assets, revenue recognition, the collectability of receivables and the value of certain investments and liabilities. We base our estimates on historical experience and on various other factors that we believe to be appropriate under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. In determining the fair value of our warrant liability, changes to the probabilities underlying the assumptions used in valuing our warrant liability, such as our stock price as of the reporting period, expected stock price and volatility, could materially impact our financial statements from quarter to quarter. Actual results may differ from these estimates under different assumptions or conditions. We set forth our critical accounting policies and estimates in our annual report on Form 10-K for the year ended December 31, 2009, which is on file with the SEC. There have been no material changes as of September 30, 2010.

Recently Issued Accounting Standards

In January 2010, we adopted a new U.S. GAAP accounting standard which amends existing revenue recognition accounting guidance to provide accounting principles and application guidance on whether multiple deliverables exist, how the arrangement should be separated, and the consideration allocated. This new guidance eliminates the requirement to establish objective evidence of fair value of undelivered products and services and instead provides for separate revenue recognition based upon management’s estimate of the selling price for an undelivered item when there is no other means to determine the fair value of that undelivered item. The superseded guidance previously required that the fair value of the undelivered item be the price of the item either sold in a separate transaction between unrelated third parties or the price charged for each item when the item is sold separately by the vendor. This was difficult to determine when the product was not individually sold because of its unique features. Under the superseded guidance, if the fair value of all of the undelivered elements in the arrangement was not determinable, then revenue was deferred until all of the items were delivered or fair value was determined. The adoption of the new standard was done on a prospective basis and did not impact our financial position or results of operations as of and for the three and nine months ended September 30, 2010. This standard may impact us in the event we complete future transactions or modify existing collaborative relationships.

In January 2010, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update, or ASU, 2010-06 Fair Value Measurement and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. This guidance provides for the following new required disclosures related to fair value measurements: 1) the amounts of and reasons for significant transfers in and out of level one and level two inputs and 2) separate presentation of purchases, sales, issuances, and settlements on a gross basis rather than as one net number for level three reconciliations. The guidance also clarifies existing disclosures as follows: 1) provide fair value measurement disclosures for each class of assets and liabilities and 2) provide disclosures about the valuation techniques and inputs used for both recurring and nonrecurring level two or level three inputs. The new disclosures and clarifications of existing disclosures were effective beginning January 1, 2010. Disclosures about purchases, sales, issuances, and settlements in the roll forward of activity for level three fair value measurements will be effective beginning January 1, 2011.

In April 2010, the FASB issued ASU No. 2010-17, Revenue Recognition — Milestone Method (ASU 2010-017). ASU 2010-017 provides guidance in applying the milestone method of revenue recognition to research or development arrangements. Under this guidance management may recognize revenue contingent upon the achievement of a milestone in its entirety, in the period in which the milestone is achieved, only if the milestone meets all the criteria within the guidance to be considered substantive. This ASU is effective on a prospective basis for research and development milestones achieved in fiscal years, beginning on or after June 15, 2010, which for us is fiscal 2011. Early adoption is permitted; however, we plan to implement ASU No. 2010-17 prospectively, as such, the effect of this guidance will be limited to future transactions. We do not expect adoption of this standard to have a material impact on our financial position or results of operations as we do not currently have any research and development arrangements which will be accounted for under the milestone method.

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Results of Operations

Three-Month Periods Ended September 30, 2010 and September 30, 2009

Revenues. Total revenues are summarized as follows:

Total revenues increased by $2,477,000 to $3,242,000 for the three months ended September 30, 2010 as compared to $765,000 for the same period in the prior year, primarily as a result of the increase in license fee revenue recognized under our August 2009 license agreement with Debiopharm. During the three months ended September 30, 2010, we recorded license fee revenues of $3,000,000 which represented a contingent payment from Debiopharm upon treatment of the fifth patient in its phase I clinical trial in July 2010. We recorded license fee revenue of $667,000 for the three months ended September 30, 2009 related to the amortization of the $2,000,000 up-front license fee that we received from Debiopharm in August 2009. The performance period under this license agreement began in August 2009 and concluded during the first quarter of 2010.

Research and Development Expenses. Research and development expenses are summarized as follows:

Our research and development expenses increased by $713,000, or 31%, to $3,009,000 for the three months ended September 30, 2010 as compared to $2,296,000 for the same period in the prior year. Spending relating to CUDC-101 increased $557,000 from the prior year period due to the initiation of a phase Ib expansion trial in August 2010. This increase is primarily related to outside services consisting of clinical research organizations, patient costs, and formulation and manufacturing costs of clinical material. In addition, spending on our other targeted cancer programs increased $477,000 from the prior year period. This increase is comprised primarily of employee-related costs, including salaries, lab supplies and facility costs, as employees from the Debio 0932 program were reallocated to continue our ongoing efforts to select additional preclinical candidates for future clinical development. As a result of licensing the program to Debiopharm in August 2009, spending related to the Debio 0932 program decreased by $276,000 during the three months ended September 30, 2010 as compared to the prior year period.

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General and Administrative Expenses. General and administrative expenses are summarized as follows:

General and administrative expenses decreased by $567,000, or 22%, to $1,999,000 for the three months ended September 30, 2010 as compared to $2,566,000 for the same period in the prior year. Fees for legal services decreased $235,000 during the three months ended September 30, 2010 as compared to the same period in the prior year. We incurred $272,000 in legal expenses related to an arbitration proceeding that we filed against our former collaborator, Micromet, during the three months ended September 30, 2009. In February 2010, we entered into a settlement, mutual release and termination agreement with Micromet and did not incur any costs related to this matter during the three months ended September 30, 2010. Consulting services decreased $329,000 during the three months ended September 30, 2010 as compared to the same period in prior year as a result of business development efforts used to facilitate the licensing agreement with Debiopharm in August 2009 that were not incurred in the current year period. Stock-based compensation expense also decreased by $108,000 in the three months ended September 30, 2010 as compared to the same period in the prior year as a result of a decline in the grant date fair values of stock options expensed in the three months ended September 30, 2010 as compared to the three months ended September 30, 2009.

Offsetting these decreases, personnel costs increased $140,000 during the three months ended September 30, 2010 as compared to the same period in the prior year resulting from the payment of discretionary bonuses to our executive officers upon receipt of the $3,000,000 payment from Debiopharm in July 2010 and the increase to our executive officers’ compensation in the first quarter of 2010 to eliminate the pay reductions implemented in October 2008. In addition, we accrued for non-officer bonuses and a 401(k) matching contribution in the 2010 period that we did not accrue in the 2009 period.

Change in fair value of warrant liability. In connection with our January 2010 registered direct offering, we issued warrants to purchase an aggregate of 1,612,322 shares of common stock, which became exercisable as of the closing of the transaction. The warrants have an initial exercise price of $3.55 per share and have a five-year term. The fair value of the warrants was estimated at $2,180,000 on the January 2010 issuance date, and $1,290,000 as of June 30, 2010, using a Black-Scholes option pricing model under various probability-weighted outcomes which take into consideration the protective features for the benefit of the warrantholder that includes a possible cash-settlement option in the event of a change of control until the later to occur of (i) two years from the date of original issuance of the warrant and (ii) the date upon which Genentech or Roche submits a new drug application, or NDA for GDC-0449. We applied the following assumptions assigned to the various outcomes: expected volatilities ranging from 69.8% to 80%, risk free interest rates ranging from 1.42% to 2.38%, expected lives of three to five years and no dividends. Expected volatility was based on our historical volatility commensurate with the term of the warrants. The fair value of the warrants was recorded as a long-term liability. The warrants will be revalued each reporting period with updated assumptions, and the resulting change in fair value of the warrant liability will be recognized in the income statement. We estimated that the fair value of these warrants as of September 30, 2010 was $1,082,000 and we recorded a gain of approximately $208,000 for the three months ended September 30, 2010 as a result of the decrease in the fair value of the warrant liability from June 30, 2010.

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Nine-Month Periods Ended September 30, 2010 and September 30, 2009

Revenues. Total revenues are summarized as follows:

Total revenues increased by $9,033,000, or 132% to $15,899,000 for the nine months ended September 30, 2010 from $6,866,000 for the same period in 2009, primarily related to an increase in our license fee revenues. We recorded license fee revenue of $333,000 and $667,000 for the nine months ended September 30, 2010 and 2009, respectively, related to the amortization of the $2,000,000 up-front license fee that we received in August 2009 under our Hsp90 license agreement with Debiopharm. The performance period under this license agreement began in August 2009 and concluded during the first quarter of 2010. During the nine months ended September 30, 2010, we also recorded license fee revenues of $11,000,000, comprised of an $8,000,000 contingent payment from Debiopharm upon acceptance by French regulatory authorities of Debiopharm’s clinical trial application for Debio 0932 in February 2010 and a $3,000,000 contingent payment from Debiopharm upon treatment of the fifth patient in this phase I clinical trial in July 2010.

During the nine months ended September 30, 2010, we also received settlement proceeds of $4,000,000 from Micromet pursuant to the settlement agreement that we entered into with Micromet in February 2010. The settlement payment was made by Micromet to resolve a contract claim we filed related to our June 2001 agreement with Micromet. Because this settlement discharged and terminated all future payment obligations that would have arisen under the June 2001 agreement, we do not expect to receive any additional revenues from Micromet.

During the nine months ended September 30, 2009, we received and recognized $6,000,000 in license revenue as a result of Genentech’s initiation of a pivotal phase II clinical trial in advanced BCC. Future contingent payments under our Genentech agreement are tied to the successful achievement of clinical and regulatory objectives. We believe that if results from one or more of Genentech’s currently ongoing clinical trials are positive, that we may receive additional contingent payments from Genentech in 2011.

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Research and Development Expenses. Research and development expenses are summarized as follows:

Our research and development expenses increased by $228,000, or 3%, to $7,721,000 for the nine months ended September 30, 2010 as compared to $7,493,000 for the same period in the prior year. The increase in research and development expenses was primarily the result of an increase of $1,986,000 in spending relating to our other targeted cancer programs from the prior year period as we continue to conduct research in our ongoing efforts to select additional preclinical candidates for future development. In addition, spending related to outside services and clinical costs increased $624,000 over the prior year period for our CUDC-101 program, for which we completed a phase I trial in May 2010 and initiated a phase Ib expansion trial in August 2010. We expect that a majority of our research and development expenses for the foreseeable future will be incurred in support of our research and development efforts for CUDC-101 and other targeted cancer programs.

Offsetting these increases, spending related to the Debio 0932 program decreased $1,987,000 from the prior year period as Debiopharm assumed all future costs of the program in August 2009. During the nine months ended September 30, 2009, we also incurred expenses of $300,000 in sublicense payments that we were required to make as a result of the $6,000,000 that we received from Genentech during this same period for the achievement of a clinical development objective related to our Hedgehog pathway inhibitor program. No such expenses were incurred under the Genentech collaboration during the nine months ended September 30, 2010.

General and Administrative Expenses. General and administrative expenses are summarized as follows:

General and administrative expenses increased by $1,515,000, or 23%, to $8,206,000 for the nine months ended September 30, 2010 as compared to $6,691,000 for the prior year period. This increase was primarily due to increased spending for legal services and personnel costs. We incurred $1,526,000 for the nine months ended September 30, 2010 as compared to $631,000 for the prior year period in expenses related to the Micromet arbitration proceeding, an increase of $895,000. The remainder of the increase in legal fees of $145,000 resulted from costs associated with various corporate matters and increased patent costs. In addition, personnel costs increased $538,000 as the result of payment of discretionary bonuses to our executive officers upon receipt of contingent payments received from Debiopharm as well as the increase to our executive officers’ compensation in the first quarter of 2010 to eliminate the pay reductions implemented in October 2008. No bonuses were paid to our executive officers in the prior year period. Stock-based compensation also increased $176,000 over the prior year period primarily related to vesting of certain performance-based options in the first quarter of 2010.

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Offsetting these increases, consulting and professional services decreased $252,000 from the prior year period primarily as the result of business development efforts used to facilitate the licensing agreement with Debiopharm.

Change in fair value of warrant liability. The change in the fair value of the warrant liability from the closing date of January 27, 2010 resulted in a gain of approximately $1,098,000 for the nine months ended September 30, 2010, primarily as a result of the decrease of our stock price during this period.

Liquidity and Capital Resources

Sources of Liquidity

We have financed our operations primarily through license fees, contingent cash payments and research and development funding from our collaborators and licensors, the private and public placement of our equity securities, debt financings and the monetization of certain royalty rights.

At September 30, 2010, our principal sources of liquidity consisted of cash, cash equivalents, and marketable securities of $43,698,000, excluding restricted investments of $497,000. Our cash and cash equivalents are highly liquid investments with a maturity of three months or less at date of purchase and consist of time deposits and investments in money market funds with commercial banks and financial institutions, short-term commercial paper, and government obligations. We maintain cash balances with financial institutions in excess of insured limits. While as of the date of this filing, we are not aware of any downgrades, material losses, or other significant deterioration in the fair value of our cash equivalents or marketable securities since September 30, 2010, no assurance can be given that further deterioration in conditions of the global credit and financial markets would not negatively impact our current portfolio of cash equivalents or marketable securities or our ability to meet our financing objectives. Further dislocations in the credit market may adversely impact the value and/or liquidity of marketable securities owned by us.

On January 27, 2010, we completed a registered direct offering of 6,449,288 units with each unit consisting of (i) one share of our common stock and (ii) one warrant to purchase 0.25 of one share of common stock at a purchase price of $2.52 per unit. We received net proceeds from the sale of the units, after deducting offering expenses, of approximately $14,942,000. In connection with this offering, we issued warrants to purchase an aggregate of 1,612,322 shares of common stock, which became exercisable as of the closing of the transaction. The warrants have an exercise price of $3.55 per share and have a five year term.

Cash Flows

The use of our cash flows for operations has primarily consisted of salaries and wages for our employees, facility and facility-related costs for our office and laboratory, fees paid in connection with preclinical studies, laboratory supplies, consulting fees and legal fees. During 2008, we began incurring clinical costs associated with our phase I clinical trial of CUDC-101. We expect that costs associated with clinical studies will increase in future periods assuming that CUDC-101 advances into further stages of clinical testing and other of our targeted cancer drug candidates reach clinical trials.

Net cash provided by operating activities was $2,090,000 for the nine-month period ended September 30, 2010 as compared to cash used of $4,461,000 for the nine-month period ended September 30, 2009. Cash provided by operating activities during the nine-month period ended September 30, 2010 was primarily the result of our net income for the period of $1,171,000, as well as non-cash charges consisting of stock-based compensation, changes in the fair value of our warrant liability, non-cash interest expense and depreciation totaling $1,068,000. In addition, changes in certain operating assets and liabilities affected operating cash during the nine-month period ended September 30, 2010, including a decrease of $476,000 in deferred revenue primarily related to our August 2009 license agreement with Debiopharm, which was offset by a decrease of $321,000 in our accounts receivable.

Cash used in operating activities during the nine-month period ended September 30, 2009 was primarily the result of our net loss for the period of $7,117,000. In addition, changes in certain operating assets and liabilities decreased operating cash during the nine-month period ended September 30, 2009, including a decrease of $676,000 in our accounts payable and accrued liabilities and an increase of $120,000 in our accounts receivables. Offsetting these decreases were an increase in our deferred revenue of $1,458,000 as a result of our August 2009 license agreement with Debiopharm and noncash items, including stock-based compensation expense of $1,485,000 and depreciation expense of $566,000.

We expect to continue to use cash in operations as we continue to seek to advance our targeted cancer drug programs through preclinical testing and into clinical development. In addition, in the future we may owe royalties and other contingent payments to our licensors based on the achievement of developmental milestones, product sales and other specified objectives.

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Investing activities used cash of $14,648,000 for the nine-month period ended September 30, 2010 as compared to $1,809,000 in the nine-month period ended September 30, 2009. Cash used by investing activities for the nine months ended September 30, 2010 resulted principally from $14,271,000 in net investment activity as well as an increase of $281,000 in restricted cash related to a security deposit for a new facility lease entered into in September 2010. Cash used by investing activities for the nine months ended September 30, 2009 resulted principally from $1,795,000 in net investment activity.

Financing activities provided cash of approximately $16,897,000 for the nine-month period ended September 30, 2010, resulting principally from the issuance of 6,449,288 shares of common stock and warrants under our January 2010 registered direct offering, which provided $14,942,000 in net proceeds. In addition, warrants for an aggregate of 1,742,671 shares of common stock were exercised under our August 2007 private placement providing approximately $1,778,000 in proceeds. The remaining cash of $177,000 was provided by the exercise of stock options. Financing activities provided cash of approximately $2,915,000 for the nine-month period ended September 30, 2009, resulting principally from the exercise of warrants for an aggregate of 2,632,198 shares of common stock under this same private placement providing approximately $2,700,000 in proceeds. The remaining cash was provided by the exercise of stock options and purchases of common stock under our employee stock purchase plan.

Funding Requirements

We have incurred significant losses since our inception. As of September 30, 2010, we had an accumulated deficit of approximately $716,622,000. We will require substantial funds to continue our research and development programs and to fulfill our planned operating goals. In particular, our currently planned operating and capital requirements include the need for working capital to support our research and development activities for CUDC-101 and other small molecules that we are seeking to develop from our pipeline of targeted cancer programs, and to fund our general and administrative costs and expenses.

We have historically derived a substantial portion of our revenue from the research funding portion of our collaboration agreements. However, we have no current source of research funding revenue. We expect that our only source of cash flows from operations for the foreseeable future will be: