EyePoint Pharmaceuticals, Inc. - Quarter Report: 2008 December (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended December 31, 2008

OR

For the transition period from              to             

COMMISSION FILE NUMBER 000-51122

pSivida Corp.

(Exact name of registrant as specified in its charter)

(617) 926-5000

(Registrant’s telephone number, including area code)

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

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  ¨    NO  x

There were 18,262,345 shares of the registrant’s common stock, $0.001 par value, outstanding as of February 9, 2009.

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PSIVIDA CORP. AND SUBSIDIARIES

INDEX TO FORM 10-Q

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PART I. UNAUDITED FINANCIAL INFORMATION

PSIVIDA CORP. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(In thousands except share amounts)

See notes to condensed consolidated financial statements

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PSIVIDA CORP. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands except per share amounts)

See notes to condensed consolidated financial statements

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PSIVIDA CORP. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

(Unaudited)

(In thousands, except share amounts)

See notes to condensed consolidated financial statements

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PSIVIDA CORP. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

See notes to condensed consolidated financial statements

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PSIVIDA CORP. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The accompanying condensed consolidated financial statements of pSivida Corp. and subsidiaries (the “Company”) for the three and six months ended December 31, 2008 and 2007 are unaudited. Certain information in the footnote disclosures of these financial statements has been condensed or omitted in accordance with the rules and regulations of the Securities and Exchange Commission (the “SEC”). These financial statements should be read in conjunction with the Company’s audited consolidated financial statements and footnotes included in its Annual Report on Form 10-K for the fiscal year ended June 30, 2008. The balance sheet amounts at June 30, 2008 in this report were derived from the Company’s audited financial statements. In the opinion of management, these statements have been prepared on the same basis as the audited consolidated financial statements as of and for the year ended June 30, 2008, and include all adjustments that are necessary for the fair presentation of the Company’s financial position, results of operations and cash flows for the periods indicated. The preparation of financial statements in accordance with generally accepted accounting principles requires management to make assumptions and estimates that affect, among other things, (i) reported amounts of assets and liabilities; (ii) disclosure of contingent assets and liabilities at the date of the consolidated financial statements; and (iii) reported amounts of revenues and expenses during the reporting period. The results of operations for the three and six months ended December 31, 2008 are not necessarily indicative of the results that may be expected for the entire year or any future period.

pSivida Corp., incorporated in Delaware, develops miniaturized, injectable, drug delivery systems.

The Company’s lead development product, Iluvien™, delivers fluocinolone acetonide (“FA”) for the treatment of diabetic macular edema (“DME”). Formerly known as Medidur™ FA for DME, Iluvien is in fully recruited Phase III clinical trials. The Company has licensed certain of its drug delivery technology to Alimera Sciences (“Alimera”) for the development of Iluvien and certain other ophthalmic products. The Company also has two products approved by the Food and Drug Administration (“FDA”): Retisert^® for the treatment of uveitis and Vitrasert^® for the treatment of AIDS-related cytomegalovirus (“CMV”) retinitis. The Company has licensed both of these products and the technologies underlying them to Bausch & Lomb Incorporated (“Bausch & Lomb”). The Company has a worldwide collaborative research and license agreement with Pfizer, Inc. (“Pfizer”) under which Pfizer may develop additional ophthalmic products.

The Company owns the rights to develop and commercialize a modified form of silicon known as BioSilicon™, which has potential therapeutic applications. The most advanced BioSilicon product candidate, BrachySil™, delivers a therapeutic P32, a radioactive form of phosphorus used to treat cancer, directly to solid tumors. The Company has completed an initial safety and efficacy clinical trial of BrachySil for the treatment of pancreatic cancer and is conducting a follow-on dose-ranging clinical trial.

Throughout this quarterly report on Form 10-Q, references to “$” are to U.S. dollars and references to A$ are to Australian dollars.

Business Risks and Uncertainties

The Company’s prospects, and ultimately its ability to achieve success, including profitable operations, are subject to risks and uncertainties that include, but are not limited to, maintaining its key collaboration agreements with Alimera and Pfizer; uncertainties regarding the achievement of milestones and other contingent contractual payment events; failure to prove safety and efficacy of Iluvien or BrachySil; inability to raise capital; continued losses and lack of profitability; inability to derive revenues from Retisert; termination of license agreements; inability to pay any registration penalties; inability to develop, or obtain regulatory approval for, new products; inability to protect intellectual property or infringement of others’ intellectual property; inability to obtain partners to develop and market products; competition; risks and costs of international business operations; manufacturing problems; insufficient third-party reimbursement for products; failure to retain key personnel; product liability; failure to comply with laws; failure to achieve and maintain effective internal control over financial reporting; impairment of intangibles; volatility of stock price; possible dilution through exercise of outstanding warrants and stock options or future stock issuances; and possible influence by Pfizer. The Company cannot be certain that it will be able to maintain its existing collaboration agreements, achieve additional collaboration arrangements or obtain other sources of funding, if and when needed, on acceptable terms, or at all, or that the Company will be able to achieve revenues sufficient for profitable operations.

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Liquidity

Cash and cash equivalents totaled approximately $9.8 million at December 31, 2008 compared to $15.6 million at June 30, 2008. The Company believes that it can fund its operations as currently conducted through at least December 31, 2010. This expectation is based on the assumptions that the Company continues to receive the Pfizer quarterly $500,000 research and development funding, Alimera continues to fund the development of Iluvien, the Company resumes receiving Retisert royalties from Bausch & Lomb during the fiscal year ending June 30, 2010 and the Company receives the scheduled conditional note payments from Alimera. However, whether and when the Company will require or desire to raise additional capital will depend upon many other factors, including, but not limited to:

In addition, the Company’s future cash position beyond December 31, 2010 also depends significantly on the regulatory approval and marketing of Iluvien. Alimera has agreed to pay the Company $25.0 million upon FDA approval of Iluvien and a 20% share in the future profits of Iluvien. There is no assurance that the FDA will approve Iluvien or that Iluivien will achieve market acceptance even if it is approved by the FDA.

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Recently Adopted Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, for purposes such as derivative valuation and impairment analysis, and expands disclosures about fair value measurements. Under the standard, fair value measurements are to be separately disclosed by level within a fair value hierarchy. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements. Pursuant to FASB Staff Position (“FSP”) No. 157-2, issued in February 2008, the application of SFAS 157 for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in financial statements on a non-recurring basis may be deferred until fiscal years beginning after November 15, 2008. The Company adopted SFAS 157 as of July 1, 2008, with the exception of the application of the statement to non-recurring nonfinancial assets and nonfinancial liabilities. See Note 11 for additional details.

In July 2008, the Company adopted SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — Including an Amendment of FASB Statement No. 115” (“SFAS 159”). SFAS 159 permits companies to choose to measure selected financial assets and liabilities at fair value, with changes in fair value recognized in earnings each reporting period. Prior to July 2008, the Company recorded derivative liabilities at fair value in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, as amended. The adoption of SFAS 159 had no impact on the Company’s consolidated financial position and results of operations as management did not elect the fair value option for any other financial assets and liabilities.

In June 2007, the FASB issued Emerging Issues Task Force (“EITF”) Issue No. EITF 07-03, “Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities” (“EITF 07-03”), which requires nonrefundable advance payments for future research and development activities to be capitalized and recognized as an expense as the goods are delivered or the related services are performed. The Company adopted EITF 07-03 as of July 1, 2008 and the adoption did not have any impact on its consolidated financial statements.

Recently Issued Accounting Pronouncements

In November 2007, the FASB issued EITF Issue No. 07-01, “Accounting for Collaborative Arrangements” (“EITF 07-01”). EITF 07-01 defines a collaborative arrangement as a contractual arrangement in which the parties are (i) active participants to the arrangement; and (ii) exposed to significant risks and rewards that depend upon the commercial success of the endeavor. It also addresses the appropriate statement of operations presentation for activities and payments between the participants in a collaborative arrangement as well as for costs incurred and revenue generated from transactions with third parties. EITF 07-01 will be effective for the Company’s fiscal year beginning July 1, 2009. The Company is evaluating the potential impact of adopting EITF 07-01 on its consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141 (revised), “Business Combinations” (“SFAS 141R”), which provides revised guidance for recognition and measurement of identifiable assets and goodwill acquired, liabilities assumed, and any noncontrolling interest in the acquiree at fair value. SFAS 141R requires the acquirer to recognize the assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date. SFAS 141R also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. SFAS 141R is required to be applied prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The Company will be required to adopt SFAS 141R in connection with business combination transactions, if any, after June 30, 2009.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133” (“SFAS 161”). SFAS 161 amends and expands the disclosure requirements for derivative instruments and hedging activities, with the intent to provide users of financial statements with an enhanced understanding of (a) how and why an entity uses derivative instruments; (b) how derivative instruments and related hedged items are accounted for under FASB Statement No. 133 and its related interpretations; and (c) how derivative instruments and related hedged items affect an entity’s financial statements. The Company will be required to adopt SFAS 161 as of January 1, 2009.

In April 2008, the FASB issued FSP No. 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP 142-3”). FSP 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). The objective of FSP 142-3 is to improve the consistency between the useful life of a recognized intangible asset under SFAS 142 and the period of

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expected cash flows used to measure the fair value of the asset under SFAS 141R and other accounting principles. FSP 142-3 applies to all intangible assets, whether acquired in a business combination or otherwise, and early adoption is prohibited. The Company will be required to adopt FSP 142-3 for its fiscal year beginning July 1, 2009. The Company is currently evaluating the potential impact of adopting FSP 142-3 on its consolidated financial statements.

The Company has historically financed its operations primarily through the sale of equity securities.

Share Offering

In July 2007, the Company completed a sale of 3,600,500 units at a price of $5.00 per unit for gross proceeds of $18.0 million. Each unit consisted of (i) one common share; and (ii) one warrant to purchase 0.4 common share, with a warrant exercise price of $6.60 per share. Of the total, 1,300,000 units were purchased by Pfizer in accordance with the terms of the Collaborative Research and License Agreement dated April 3, 2007. A total of 72,010 warrants, with a warrant exercise price of $6.60, were issued to the placement agents in connection with the offering. In addition, the Company simultaneously completed a sale of common shares and warrants at the equivalent price of A$5.84 per unit under the same terms and conditions noted above. This sale of 513,699 units resulted in additional gross proceeds of approximately $2.6 million. Aggregate share issue costs for these transactions totaled approximately $2.2 million.

Warrants to Purchase Common Shares

At December 31, 2008, the Company had outstanding warrants to purchase common shares that were denominated in $ with a weighted average remaining life at December 31, 2008 of 3.2 years, as follows:

At December 31, 2008, the Company had outstanding warrants to purchase common shares that were denominated in A$ with a weighted average remaining life at December 31, 2008 of 2.2 years, as follows:

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At December 31, 2008 and 2007, the weighted average exercise price of these warrants translated to $ was $6.59 and $8.75, respectively.

The Company has collaborative license and development agreements with strategic partners for the development and commercialization of products utilizing the Company’s technologies. The terms of these agreements typically include multiple deliverables by the Company (for example, license rights, providing research and development services and manufacturing of clinical materials) in exchange for consideration to the Company of some combination of non-refundable license fees, funding of research and development activities, payments based upon achievement of clinical development and sales milestones, and royalties in the form of a designated percentage of product sales or profits. Multiple element arrangements are analyzed to determine whether the deliverables can be separated or whether they must be accounted for as a single unit of accounting in accordance with EITF No. 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables”.

For arrangements that are accounted for as a single unit of accounting, payments under the arrangement are recognized as revenue on a straight-line basis over the period the Company expects to complete its performance obligations. The cumulative amount of revenue earned is limited to the cumulative amount of payments received as of the period ending date. If the Company cannot reasonably estimate when its performance obligations either cease or become inconsequential, then revenue recognition is deferred until the Company can reasonably estimate when the performance obligations cease or become inconsequential. Deferred revenue amounts are classified as current liabilities to the extent that revenue is expected to be recognized within one year. Significant management judgment is required in determining the level of effort required under an arrangement and the period over which the Company is expected to complete its performance obligations under an arrangement.

The Company’s significant license and collaboration agreements are summarized below.

Alimera Sciences, Inc.

In March 2008, the Company and Alimera amended and restated their February 2005 license and collaboration agreement relating to Iluvien (the “Alimera Agreement”), the companies’ Phase III investigative treatment for diabetic macular edema (“DME”), and certain other products. In exchange for current and future consideration to the Company, the Company decreased its share in the future profits of Iluvien from 50% to 20%.

Consideration received at closing consisted of (i) $12.0 million in cash and (ii) cancellation of $5.7 million of accrued development cost liabilities, including related penalties and accrued interest, owed by the Company to Alimera as of March 14, 2008. The Company’s performance period under the Alimera Agreement ends December 31, 2009. Accordingly, from the effective date, the aggregate $18.3 million of deferred revenue, consisting of the aforementioned current consideration and an additional $650,000 of previously received but unamortized milestone payments, is being recognized as revenue on a straight-line basis over the 21.5 month performance period through December 31, 2009.

Other consideration, exclusive of the Company’s 20% profit share, includes (i) conditional principal and interest payments of up to approximately $21.0 million through September 2012 under a note issued by Alimera; (ii) a $25.0 million milestone payment due upon FDA approval of Iluvien; and (iii) the assumption by Alimera of all financial responsibility for the development of licensed products under the collaboration agreement, including reimbursement of approved development costs incurred by the Company in support of the ongoing clinical studies of Iluvien and anticipated regulatory submissions. All payments received from Alimera during the performance period will be recognized as revenue during the performance period using the cumulative catch-up method. All payments received after December 31, 2009 will be recognized as revenue when earned.

For the three and six months ended December 31, 2008, revenue related to the Alimera Agreement totaled $2.9 million and $5.7 million, respectively, which represented 100% of the Company’s collaborative research and development revenue for these periods.

Pfizer

In April 2007, the Company and Pfizer entered into a Collaborative Research and License Agreement (the “Pfizer Agreement”), which superseded a December 2006 research agreement. Under the Pfizer Agreement, the parties have implemented a joint research

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program aimed at developing certain ophthalmic products using the Company’s Durasert™ drug delivery technology. In addition to potential development and sales related milestone payments, Pfizer pays the Company a minimum of $500,000 per quarter in consideration of the Company’s costs in performing the research program. These payments commenced in calendar year 2008 and continue until the earlier of the commencement of the first Phase III clinical trial for a licensed product candidate or the termination of the Agreement.

The two Pfizer agreements have been combined for accounting purposes and, following an evaluation of the multiple deliverables in accordance with the provisions of EITF 00-21, the Company concluded that there was a single unit of accounting. The Company is evaluating the timing of the deliverables and other obligations under the Pfizer Agreement and, as a result, all payments received from Pfizer through December 31, 2008, totaling $3.2 million, have been classified in deferred revenue as a non-current liability.

Intrinsiq

In January 2008, the Company and Intrinsiq Materials Cayman Limited (“Intrinsiq”) entered into an agreement pursuant to which Intrinsiq acquired an exclusive license to develop and commercialize nutraceutical and food science applications of BioSilicon, and certain related assets, for $1.2 million. Intrinsiq paid $730,000 through December 2008 and the final $500,000 in January 2009. In addition, subject to Intrinsiq’s unilateral right to terminate the license upon 90 days prior written notice, Intrinsiq will be obligated to pay the Company minimum royalties of $3.55 million through April 2014, of which the first $450,000 payment is due in July 2009.

The parties are obligated to enter into a manufacture and supply agreement, which has not yet been consummated. Accordingly, the Company is unable to determine the period of its performance obligations in accordance with EITF 00-21. The total amount received through December 31, 2008 of $730,000 has been classified as a non-current liability at December 31, 2008.

A summary of intangible assets at December 31, 2008 and June 30, 2008 is as follows:

Amortization of intangible assets totaled $820,000 and $1.8 million during the three and six month periods ended December 31, 2008, respectively and $986,000 and $2.0 million for the three and six month periods ended December 31, 2007, respectively. The carrying value of intangible assets at December 31, 2008 of $27.9 million will be amortized on a straight-line basis over the remaining estimated useful life of 9 years. Of the total net book value at December 31, 2008, approximately $9.5 million was attributable to the Retisert product and $18.4 million was attributable to the BioSilicon technology.

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The Company has an outstanding note receivable from GEM Global Yield Fund (“GEM”), issued in connection with the fiscal year 2007 sale of a former wholly-owned subsidiary, that matured on April 12, 2008. During the fourth quarter of fiscal 2008, the Company demanded payment of the note and, based upon preliminary negotiations, the Company reduced the carrying value of the note and accrued interest by $325,000 to its estimated net realizable value of $1.3 million at June 30, 2008. As a result of ongoing negotiations, the Company reduced the carrying value of the note to $667,000 at September 30, 2008. At December 31, 2008, based upon the Company’s inability to reach agreement with GEM after further discussions, the Company recorded a charge to operations for the remaining carrying value of the note. The provision for losses on the note receivable of $667,000 and $1.3 million for the three and six months ended December 31, 2008, respectively, is included in general and administrative expense in the condensed consolidated statements of operations.

In connection with several capital raising transactions during the years ended June 30, 2008 and 2007, the Company issued units consisting of common shares together with detachable warrants to purchase additional common shares over a specified time period. In certain of these transactions, the warrants were denominated in A$, which is different than the Company’s $ functional currency. To the extent that the potential exercise of such warrants would result in a variable amount of proceeds in the Company’s functional currency, the fair value of the warrants was recorded as a derivative liability, with a corresponding reduction in additional paid-in capital, subject to revaluation of the liability on a marked-to-market basis through profit and loss. The fair value of the warrants was determined using a Black-Scholes model. The net reduction in the fair values of these derivative liabilities for the three and six months ended December 31, 2008 resulted in income recognized of $226,000 and $1.6 million, respectively, compared to income recognized of $1.8 million and $6.0 million for the three and six months ended December 31, 2007, respectively.

The Company records compensation cost on a straight-line basis over the award’s requisite service period for all share-based awards granted. Grant date fair value of stock option awards (less estimated forfeitures) is determined using the Black-Scholes option valuation model.

Employee Share Option Plan

The Company’s Employee Share Option Plan (the “Plan”) provided for the issuance of non-qualified stock options to eligible employees and directors. Option grants under the Plan have requisite service periods ranging from immediate vesting to 3-year ratable annual vesting, a contractual life of five years and are denominated in A$. As of June 2008, no further options will be granted under the Plan.

During the three and six months ended December 31, 2007, 136,250 options were granted under the Plan. The exercise prices of all outstanding options under the Plan at December 31, 2008 were in excess of the market price of the Company’s common shares at that date and, accordingly, the options had an aggregate intrinsic value of $0. A total of 55,000 and 9,583 options vested during the three months ended December 31, 2008 and 2007, respectively. At December 31, 2008, there were 442,061 options vested and expected to vest in the future, with an aggregate intrinsic value of $0 and a weighted-average remaining contractual term of 1.85 years.

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The following table provides a reconciliation of stock option activity under the Plan for the six months ended December 31, 2008:

At December 31, 2008 the weighted average exercise prices of outstanding and exercisable options translated into $ were $20.60 and $25.06, respectively.

2008 Incentive Plan

The pSivida Corp. 2008 Incentive Plan (the “2008 Plan”) provides for the issuance of a maximum of 1,750,000 common shares in satisfaction of stock-based awards to management, key employees, consultants and directors. A total of 620,000 and 1,221,000 options were granted during the three and six-month periods ended December 31, 2008, respectively, with ratable annual vesting periods ranging from 1 to 4 years and a 10-year life.

The Company measures the fair value of options on their grant date using the Black-Scholes option-pricing model. Based upon limited option exercise history, the Company has used the “simplified” method outlined in SEC Staff Accounting Bulletin No. 107 to estimate the expected life of stock option grants. Expected volatility is based on historical volatility of our stock over the expected life of the option. The risk-free interest rate is based on the weighted-average of U.S. Treasury rates over the expected life of the stock option.

Key weighted average assumptions used to apply this option pricing model to the 2008 Plan were as follows:

The following table provides a reconciliation of stock option activity under the 2008 Plan for the six months ended December 31, 2008:

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For option grants to non-executives, an estimated annual forfeiture rate of 5% per year was used to determine awards expected to vest and to calculate stock-based compensation. Additional expense will be recorded if the actual forfeiture rate is lower than estimated, and a recovery of prior year expense will be recorded if the actual forfeiture rate is higher than estimated.

Estimates of fair value may not represent actual future events or the value to be ultimately realized by persons who receive stock option awards.

The weighted average grant date fair value of stock options granted pursuant to the 2008 Plan for the three and six months ended December 31, 2008 was $0.84 and $1.43, respectively. The exercise prices of all outstanding options under the 2008 Plan at December 31, 2008 are in excess of the market price of the Company’s common shares at that date and, accordingly, the options have an aggregate intrinsic value of $0. At December 31, 2008, there were 1,175,653 options expected to vest in the future with an aggregate intrinsic value of $0 and a weighted-average remaining contractual term of 9.8 years.

Nonvested Stock Issued to CDS Employees

On December 30, 2005, the Company issued 224,798 nonvested common shares with a fair value of $26.40 per common share to employees of Control Delivery Systems, Inc. (“CDS”) in exchange for their nonvested CDS stock. The portion of the fair value attributable to the employees’ pre-acquisition service period was included as part of the CDS acquisition cost and the value attributable to the post-acquisition service period was ratably expensed over the vesting period.

The following table presents a reconciliation of the activity related to the issuance of these nonvested common shares:

Stock-Based Compensation Expense

Stock-based compensation expense related to the Company’s stock option plans, including amortization of nonvested common shares, was charged to operations for the three and six month periods ended December 31, 2008 and 2007, as follows:

At December 31, 2008, there was approximately $1.5 million of unrecognized compensation expense, net of estimated forfeitures, related to nonvested stock-based payment awards under the Company’s option plans. This compensation cost is expected to be recognized over a weighted average period of 2.1 years and will be adjusted for any future changes in estimated forfeitures.

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Options Issued in Exchange for CDS Options

On December 30, 2005, as part of the consideration for the acquisition of CDS, the Company issued 43,112 fully vested stock options with a fair value of $15.48 per share in exchange for outstanding CDS options. The following table presents a reconciliation of the activity related to the issuance of these options:

The weighted average remaining contractual life of these exercisable options at December 31, 2008 was 0.75 year.

The Company applies SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”), which requires the Company to recognize deferred tax assets and liabilities for estimated future tax consequences of events that have been recognized in the financial statements or tax returns. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to reverse. A valuation allowance is established if, based on management’s review of both positive and negative evidence, it is more likely than not that all or a portion of the deferred tax asset will not be realized. The Company’s historical losses from operations represent significant evidence that indicates the need for a valuation allowance. A valuation allowance has been established for the net deferred tax assets. During the three and six months ended December 31, 2008, the Company recognized a current income tax benefit of $290,000 and $786,000, respectively, related to prior and current years foreign research and development credits earned by its U.K. subsidiary.

The Company adopted FASB Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”) on July 1, 2007. The implementation of FIN 48 did not have any impact on the Company’s consolidated financial position or results of operations. From adoption through December 31, 2008, the Company had no significant unrecognized tax benefits in the accompanying unaudited condensed consolidated financial statements. The Company does not expect that the amounts of unrecognized tax benefits will change significantly within the next 12 months. We expect that future changes in unrecognized tax benefit will not have an impact on the Company’s effective tax rate due to the existence of valuation allowances.

The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. As of December 31, 2008, the Company had no accrued penalties or interest related to uncertain tax positions.

Basic net loss per share was computed by dividing the net loss by the weighted average number of common shares outstanding during the period. Diluted net loss per share was computed by dividing the net loss by the sum of (i) the weighted average number of common shares outstanding and (ii) the weighted average number of common shares that would be issued on the conversion of all dilutive securities outstanding. Potentially dilutive shares were not included in the calculation of diluted net loss per share for each of the three and six month periods ended December 31, 2008 and 2007 as their inclusion would be anti-dilutive.

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Potentially dilutive shares at December 31, 2008 and 2007 are summarized as follows:

Comprehensive loss for the three and six month periods ended December 31, 2008 and 2007 was as follows:

In September 2006, the FASB issued SFAS 157, which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. The Company adopted SFAS 157 on July 1, 2008. SFAS 157 establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs, where available. The three levels of the fair value hierarchy are described as follows:

As of December 31, 2008, the Company’s derivative liabilities were classified as Level 3. The Company valued the derivative liabilities using the Black-Scholes model, for which observable market inputs included the Company’s share price, historical volatility and risk-free interest rate.

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The following table summarizes the Company’s assets and liabilities carried at fair value measured on a recurring basis at December 31, 2008 by valuation hierarchy:

The reconciliation of the Company’s liabilities measured at fair value on a recurring basis using unobservable inputs (Level 3) is as follows:

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Note Regarding Forward-Looking Statements

Various statements made in this Quarterly Report on Form 10-Q are forward-looking and involve a number of risks and uncertainties. All statements that address activities, events or developments that we intend, expect or believe may occur in the future are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (Securities Act), and Section 21E of the Securities Exchange Act of 1934, as amended (Exchange Act). We often, although not always, identify forward-looking statements by using words or phrases such as the following: “likely”, “expect”, “intend”, “anticipate”, “believe”, “estimate”, “plan”, “project”, “forecast” and “outlook”.

The following are some of the factors that could cause actual results to differ materially from the forward-looking statements: maintaining key collaboration agreements with Alimera and Pfizer; modification of existing terms of key collaboration agreements with Alimera and Pfizer; uncertainties regarding the achievement of milestones and other contingent contractual payment events; failure to prove safety and efficacy of Iluvien or BrachySil; inability to raise capital; continued losses and lack of profitability; inability to derive revenue from Retisert; termination of license agreements; inability to pay any registration penalties; inability to develop or obtain regulatory approval for new products; inability to protect intellectual property or infringement of others’ intellectual property; inability to obtain partners to develop and market products; competition; risks and costs of international business operations; manufacturing problems; insufficient third-party reimbursement for products; failure to retain key personnel; product liability; failure to comply with laws; failure to achieve and maintain effective internal control over financial reporting; impairment of intangibles; volatility of stock price; possible dilution through exercise of outstanding warrants and stock options or future stock issuances; possible influence by Pfizer; and other factors that may be described in our filings with the Securities and Exchange Commission. Further information on these risk factors is included in Item 1A. “Risk Factors” of our Annual Report on Form 10-K for the year ended June 30, 2008. You should read and interpret any forward-looking statements together with these risks. Any forward-looking statement applies only as of the date on which that statement is made. We do not undertake to publicly update or revise our forward-looking statements even if experience or future changes make it clear that any projected results expressed or implied in such statements will not be realized.

Our Business

We develop miniaturized, injectable, drug delivery systems. Our lead development product, Iluvien™, delivers fluocinolone acetonide (FA) for the treatment of diabetic macular edema (DME). Formerly known as Medidur™ FA for DME, Iluvien is in fully recruited Phase III clinical trials. We have licensed certain of our drug delivery technology to Alimera Sciences, Inc. (Alimera) for the development of Iluvien and certain other ophthalmic products. We also have two products approved by the Food and Drug Administration (FDA): Retisert^® for the treatment of uveitis and Vitrasert^® for the treatment of AIDS-related cytomegalovirus (CMV) retinitis. We have licensed both of these products and the technologies underlying them to Bausch & Lomb Incorporated (Bausch & Lomb). We have a worldwide collaborative research and license agreement with Pfizer Inc. (Pfizer) under which Pfizer may develop additional ophthalmic products.

We own the rights to develop and commercialize a modified form of silicon known as BioSilicon™, which has potential therapeutic applications. Our most advanced BioSilicon product candidate, BrachySil™, delivers a therapeutic P32, a radioactive form of phosphorus used to treat cancer, directly to solid tumors. We have completed an initial safety and efficacy clinical trial of Brachysil for the treatment of pancreatic cancer and are conducting a follow-on dose-ranging clinical trial.

BioSilicon™, BrachySil™ and Medidur™ are our trademarks. Retisert® and Vitrasert® are Bausch & Lomb’s trademarks, and Iluvien™ is Alimera’s trademark.

Summary of Critical Accounting Policies

The preparation of consolidated financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. These estimates, judgments and assumptions, which management believes are reasonable under the circumstances and are based upon the information available at the time, cannot be made with certainty. These estimates, judgments and assumptions may change as new events occur or as additional information is obtained, and actual results may differ from these estimates under different assumptions or conditions. Critical accounting policies are those policies that affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. We believe that our critical accounting policies include our policies regarding revenue recognition for license agreements and valuation of long-lived assets, including intangibles. For a more detailed discussion of these critical accounting policies, please refer to our Annual Report on Form 10-K for the fiscal year ended June 30, 2008, as filed with the SEC.

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Results of Operations

Three Months Ended December 31, 2008 Compared to Three Months Ended December 31, 2007:

Revenue

Revenue increased by approximately $2.8 million to $3.0 million for the three months ended December 31, 2008 from $128,000 for the three months ended December 31, 2007. The increase was attributable to revenue recognized in connection with the March 2008 amended collaboration agreement with Alimera.

The Company recorded approximately $18.3 million of deferred revenue at the effective date of the Alimera amendment and has received additional cash consideration of approximately $1.4 million through December 31, 2008. The $11.1 million balance of deferred revenue at December 31, 2008 will be recognized as revenue ratably over the performance period through December 2009, or approximately $2.8 million per quarter. Future cash consideration received by the Company pursuant to the Alimera agreement prior to December 31, 2009 will also be recognized ratably over the performance period, including immediate catch-up revenue recognition of that portion of the consideration represented by the period from the amendment effective date to the date of receipt.

Pursuant to a June 2005 advance royalty agreement, Bausch & Lomb has retained (a) 50% of Retisert royalties otherwise payable to the Company through June 30, 2007 and (b) 100% of Retisert royalties otherwise payable to the Company subsequent to June 30, 2007. As of December 31, 2008, Bausch & Lomb is entitled to continue to retain 100% of the next $1.9 million of Retisert royalties otherwise payable to the Company. Accordingly, we currently do not expect to record any Retisert royalty income from Bausch & Lomb through the quarter ending December 31, 2009.

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Royalties retained by Bausch & Lomb pursuant to the advance royalty agreement that would otherwise have been payable to the Company for the three months ended December 31, 2008 were $458,000. This was a 15% decrease from $541,000 otherwise payable to the Company in the same quarter a year earlier and a 4% decrease from $478,000 otherwise payable to the Company in the immediately preceding quarter.

Research and Development

Research and development decreased by approximately $2.9 million, or 58%, to approximately $2.1 million for the three months ended December 31, 2008 from approximately $4.9 million for the three months ended December 31, 2007. This decrease was primarily attributable to (i) the absence of $2.5 million of Iluvien co-development costs incurred in the prior year period as a result of the assumption by Alimera of all financial responsibility for the development of licensed products under the amended collaboration agreement and (ii) a decrease of approximately $300,000 of UK-based research and development costs attributable to the relative strengthening of the dollar to the Pound Sterling currency. As a result of the amended Alimera agreement, the Company does not expect to incur future costs for the development of Iluvien. Assuming that average exchange rates remain substantially equivalent to the current period rate, we currently expect research and development expense for the remaining quarters of fiscal 2009 to increase by less than 10% compared to the current quarterly period.

General and Administrative

General and administrative decreased by $884,000, or 27%, to approximately $2.3 million for the three months ended December 31, 2008 from approximately $3.2 million for the three months ended December 31, 2007. This decrease was primarily attributable to (i) reduced legal, audit and related consulting fees of approximately $1.1 million, largely due to the effects of having reincorporated in the U.S. in June 2008; and (ii) the absence of $200,000 of prior period costs for market development research for certain product candidates, which were partially offset by a $667,000 provision for losses on the note receivable from GEM. We currently expect general and administrative expense for the remaining quarters of fiscal 2009 to increase by approximately 5% compared to the current quarterly period, exclusive of the $667,000 provision for losses.

Change in Fair Value of Derivatives

Change in fair value of derivatives represented income of $226,000 for the three months ended December 31, 2008 compared to income of approximately $1.8 million for the three months ended December 31, 2007.

During the years ended June 30, 2008 and 2007, the Black-Scholes value of detachable warrants issued in share offerings denominated in Australian dollars (A$) was recorded as a derivative liability, subject to revaluation at subsequent reporting dates. The change in fair value of derivatives for each of the three months ended December 31, 2008 and 2007 was primarily attributable to a net decrease in the market price of our common shares during each period. The derivative liability balance of $374,000 at December 31, 2008 will be subject to future revaluation through the date of expiration, or earlier exercise, of the underlying warrants.

Interest Income

Interest income decreased by $132,000, or 71%, to $55,000 for the three months ended December 31, 2008 from $187,000 for the three months ended December 31, 2007. This decrease was attributable to (i) a combination of lower average interest-bearing cash equivalent balances and reduced money market interest rates and (ii) the absence in this year’s quarter of interest accrued in the prior year’s quarter on the $1.5 million note receivable from GEM in connection with the April 2007 sale of our former subsidiary, AION Diagnostics Limited.

Interest Expense

Interest expense of $151,000 was accrued for the three months ended December 31, 2007 on the portion of shared Iluvien product candidate co-development costs that we elected not to pay under the terms of the original Alimera collaboration agreement. In connection with the amended collaboration agreement with Alimera, effective March 14, 2008, the total co-development costs, including associated penalties and accrued interest, then owed by the Company to Alimera were cancelled and, accordingly, no interest expense was incurred during the three months ended December 31, 2008.

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Income Tax Benefit

Income tax benefit of $274,000 for the three months ended December 31, 2008 was predominantly due to the recognition of foreign research and development tax credits earned by our U.K. subsidiary, and included approximately $200,000 related to the prior year. A deferred income tax benefit of $16,000 was recorded for the three months ended December 31, 2007. For each of the three months ended December 31, 2008 and 2007, our ability to record income tax benefits associated with losses before income taxes was limited due to a valuation allowance recorded on our net deferred tax assets.

Six Months Ended December 31, 2008 Compared to Six Months Ended December 31, 2007:

Revenue

Revenue increased by approximately $5.6 million to $5.8 million for the six months ended December 31, 2008 from $231,000 for the six months ended December 31, 2007. The increase was attributable to revenue recognized in connection with the March 2008 amended collaboration agreement with Alimera.

Royalties retained by Bausch & Lomb pursuant to the advance royalty agreement that would otherwise have been payable to the Company for the six months ended December 31, 2008 were $936,000. This was a 11% decrease from approximately $1.05 million otherwise payable to the Company for the six months ended December 31, 2007 and a 17% increase from $798,000 otherwise payable to the Company for the immediately preceding six month period ended June 30, 2008.

Research and Development

Research and development decreased by approximately $4.1 million, or 49%, to approximately $4.3 million for the six months ended December 31, 2008 from approximately $8.4 million for the six months ended December 31, 2007. This decrease was primarily attributable to (i) the absence of $3.6 million of Iluvien co-development costs incurred in the prior year period as a result of the assumption by Alimera of all financial responsibility for the development of licensed products under the amended collaboration agreement and (ii) a decrease of approximately $480,000 of UK-based research and development costs attributable entirely to the relative strengthening of the dollar to the Pound Sterling currency.

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General and Administrative

General and administrative increased by approximately $228,000, or 5%, to approximately $5.3 million for the six months ended December 31, 2008 from approximately $5.1 million for the six months ended December 31, 2007. This increase was primarily attributable to a $1.3 million current year provision for losses on the note receivable from GEM partially offset by (i) reduced legal, audit and related consulting fees of approximately $900,000, largely due to the effects of having reincorporated in the U.S. in June 2008; and (ii) reduced market development research for certain product candidates of $160,000.

Change in Fair Value of Derivatives

Change in fair value of derivatives represented income of approximately $1.6 million for the six months ended December 31, 2008 compared to income of approximately $6.0 million for the six months ended December 31, 2007.

During the years ended June 30, 2008 and 2007, the Black-Scholes value of detachable warrants issued in share offerings denominated in A$ was recorded as a derivative liability, subject to revaluation at subsequent reporting dates. The change in fair value of derivatives for each of the six months ended December 31, 2008 and 2007 was primarily attributable to net decreases in the market price of our common shares during the periods.

Interest Income

Interest income decreased by $280,000, or 68%, to $133,000 for the six months ended December 31, 2008 from $413,000 for the six months ended December 31, 2007. This decrease was attributable to (i) a combination of lower average interest-bearing cash equivalent balances and reduced money market interest rates and (ii) the absence in the current year period of interest accrued in the prior year on the $1.5 million GEM note receivable.

Interest Expense

Interest expense of $301,000 was accrued for the six months ended December 31, 2007 on the portion of shared Iluvien product candidate co-development costs that we elected not to pay under the original Alimera collaboration agreement. In connection with the amended collaboration agreement with Alimera, effective March 14, 2008, the total co-development costs, including associated penalties and accrued interest, then owed by the Company to Alimera were cancelled and, accordingly, no interest expense was incurred during the six months ended December 31, 2008.

Income Tax Benefit

Income tax benefit of $759,000 for the six months ended December 31, 2008 was predominantly due to the recognition of foreign research and development tax credits earned by our U.K. subsidiary, and included approximately $700,000 related to prior years. A deferred income tax benefit of $224,000 was recorded for the six months ended December 31, 2007. The absence of any deferred tax benefit in the current year period is attributable to the fact that our ability to record tax benefits associated with losses incurred was limited by the amount of deferred tax liabilities recorded.

Liquidity and Capital Resources

We have incurred operating losses since inception and, at December 31, 2008, we had a total accumulated deficit of $225.9 million. Our research and development and general and administrative costs, in the aggregate, have exceeded our revenues, including revenues related to our two commercialized products, and, accordingly, our operations have historically generated negative cash flows. We generally expect negative cash flows from operations on a quarterly basis at least until such time as one or more of our product candidates achieves regulatory approval and commences commercial sales. Since our inception, we have relied primarily on sales of equity and debt securities and the proceeds from license fees and collaboration payments to fund our operations.

Cash and cash equivalents totaled approximately $9.8 million at December 31, 2008 compared to $15.6 million at June 30, 2008. We believe we can fund our operations as currently conducted through at least December 31, 2010. This expectation is based on the assumptions that we continue to receive the Pfizer quarterly $500,000 research and development funding, Alimera continues to fund the development of Iluvien, we resume receiving Retisert royalties from Bausch & Lomb during the fiscal year ending June 30, 2010 and we receive the scheduled conditional note payments from Alimera. However, whether and when we will require or desire to raise additional capital will depend upon many other factors, including, but not limited to:

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In addition, our future cash position beyond December 31, 2010 also depends significantly on the regulatory approval and marketing of Iluvien. Alimera has agreed to pay us $25.0 million upon FDA approval of Iluvien and a 20% share in the future profits of Iluvien. There is no assurance that the FDA will approve Iluvien or that Iluivien will achieve market acceptance even if it is approved by the FDA.

The downturn in the economy and the disruptions in the financial and credit markets have made it significantly more difficult and more expensive to obtain financing. If we determine that it is desirable or necessary to raise additional capital in the future, we do not know if it will be available when needed or on terms favorable to us or our stockholders. If available, additional equity financing may be dilutive to stockholders, debt financing may involve restrictive covenants or other unfavorable terms and potential dilutive equity, and funding through collaboration agreements may be on unfavorable terms including requiring us to relinquish rights to certain of our technologies or products. If adequate financing is not available if and when needed, we may be required to delay, reduce the scope of or eliminate one or more of our research or development programs, postpone the pursuit of product candidates and new business opportunities, or otherwise reduce our cash requirements.

Our consolidated statements of cash flows for the six months ended December 31, 2008 and 2007 are summarized as follows: