HERON THERAPEUTICS, INC. /DE/ - Quarter Report: 2009 September (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 September 30, 2009

OR

For the transition period from            to            

Commission File Number 001-33221

A.P. PHARMA, INC.

(Exact name of registrant as specified in its charter)

(650) 366-2626

(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 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 definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

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

At November 9, 2009, the number of outstanding shares of the Company’s common stock, par value $.01, was 39,376,111.

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A.P. Pharma, Inc

INDEX

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PART I. Financial Information

A.P. Pharma, Inc.

Condensed Balance Sheets

(in thousands)

See accompanying notes to condensed financial statements.

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A.P. Pharma, Inc.

Condensed Statements of Operations

(in thousands, except per share amounts)

(unaudited)

See accompanying notes to condensed financial statements.

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A.P. Pharma, Inc.

Condensed Statements of Cash Flows

(in thousands)

(unaudited)

See accompanying notes to condensed financial statements.

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A.P. Pharma, Inc.

Notes to Condensed Financial Statements

September 30, 2009 and 2008 (unaudited)

(1) BUSINESS AND BASIS OF PRESENTATION

A.P. Pharma, Inc. (the “Company”, “we”, “our”, or “us”) is a specialty pharmaceutical company focused on developing pharmaceutical products using our proprietary Biochronomer™ polymer-based drug delivery technology. Our primary focus is on our lead product candidate, APF530, which during 2008 completed a pivotal Phase III clinical trial for the prevention of chemotherapy-induced nausea and vomiting (“CINV”). In May 2009 we submitted our new drug application (“NDA”) for approval of APF530 to the U.S. Food and Drug Administration (“FDA”). The NDA was accepted for review by the FDA in July 2009 and based on the Prescription Drug User Fee Act (“PDUFA”), the FDA has issued an action date of March 18, 2010.

Our core Biochronomer technology, on which APF530 and our other products are based, consists of bioerodible polymers designed to release drugs over a defined period of time. We have completed over 100 in vivo and in vitro studies demonstrating that our Biochronomer technology is potentially applicable to a range of therapeutic areas, including prevention of nausea and vomiting, pain management, control of inflammation and treatment of ophthalmic diseases. We have also completed comprehensive animal and human toxicology studies that have established that our Biochronomer polymers are safe and well tolerated. Furthermore, our Biochronomer technology can be designed to deliver drugs over periods varying from days to several months.

In addition to our lead drug candidate, we have a pipeline of other product candidates that use our Biochronomer technology. One product candidate, an undisclosed opiate for a long-acting pain management product, has been licensed on a world-wide basis to Merial Limited (“Merial”) for use with cats and dogs. Further development of our pipeline products has been temporarily deferred in order to focus our resources on the APF530 NDA and negotiations of a commercialization partnership for this product.

The accompanying unaudited condensed financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. All adjustments (all of which are of a normal recurring nature) considered necessary for a fair presentation have been included. We have evaluated subsequent events through November 16, 2009, which is the date that these financial statements were issued. Operating results for the three and nine months ended September 30, 2009 are not indicative of the results that may be expected for the year ending December 31, 2009 or for any other period. The condensed balance sheet as of December 31, 2008 has been derived from the audited financial statements as of that date but it does not include all of the information and notes required by U.S. GAAP. These condensed financial statements and the notes thereto should be read in conjunction with the audited financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2008 filed with the Securities and Exchange Commission (the “SEC”) on March 31, 2009 (our “2008 10-K”).

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with U.S. GAAP requires our management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. On an on-going basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies and estimates are discussed in our 2008 10-K.

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A.P. Pharma, Inc.

Notes to Condensed Financial Statements—(Continued)

September 30, 2009 and 2008 (unaudited)

Accounting Pronouncements

With the exception of those discussed below, and those adopted and discussed in Note 2, there have been no recent accounting pronouncements or changes in accounting pronouncements during the nine months ended September 30, 2009, as compared to the recent accounting pronouncements described in our 2008 10-K, that are of significance, or potential significance to the Company.

In June 2009, the Financial Accounting Standards Board (“FASB”) approved the “FASB Accounting Standards Codification” (“ASC”), as the single source of authoritative nongovernmental Generally Accepted Accounting Principles, or GAAP, in the United States. The ASC was effective for interim and annual periods ending after September 15, 2009, and we adopted it July 1, 2009. The adoption of the ASC did not have a material impact on our financial position or results of operations.

In October 2009, the FASB issued ASU No. 2009-13, “Multiple-Deliverable Revenue Arrangements” or ASU 2009-13. ASU 2009-13, amends existing revenue recognition accounting pronouncements that are currently within the scope of FASB Accounting Standards Codification, or ASC 605-25 (previously included within EITF 00-21, “Revenue Arrangements with Multiple Deliverables” or EITF 00-21). The consensus to EITF Issue No. 08-01, “Revenue Arrangements with Multiple Deliverables” or EITF 08-01, provides accounting principles and application guidance on whether multiple deliverables exist, how the arrangement should be separated, and the consideration allocated. This guidance eliminates the requirement to establish the 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. EITF 00-21 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 EITF 00-21, if the fair value of all of the elements in the arrangement was not determinable, then revenue was deferred until all of the items were delivered or fair value was determined. This new approach is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. We are currently evaluating the potential impact of this standard on our financial position and results of operations.

(2) CASH EQUIVALENTS AND MARKETABLE SECURITIES

At September 30, 2009 and December 31, 2008, the amortized cost and estimated fair value of investments in debt securities and cash equivalents are set forth in the tables below:

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A.P. Pharma, Inc.

Notes to Condensed Financial Statements—(Continued)

September 30, 2009 and 2008 (unaudited)

At September 30, 2009 and December 31, 2008 all available-for sale investments are expected to mature within one year.

We consider our investments in marketable securities as available-for-sale and, accordingly, we have recorded these investments at fair value. Our cash, cash equivalents and marketable securities as of September 30, 2009 and December 31, 2008 consist of approximately 97% and 95%, respectively, of a money market fund containing U.S. Government-backed or collateralized overnight securities and the remainder in asset-backed securities with the underlying assets consisting of pools of residential mortgages. There is no decline in the fair value of the asset–backed securities as of September 30, 2009. There were no realized gains or losses for the three or nine months ended September 30, 2009 or 2008.

Fair Value Measurements

The tables that follow summarize the basis used to measure certain assets at fair value on a recurring basis in our balance sheet at September 30, 2009 and December 31, 2008 (in thousands).

The three tier value hierarchy utilized prioritizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs other than the quoted prices in active markets that are observable either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which require us to develop our own assumptions. The hierarchy requires us to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value. On a recurring basis, we measure our available-for-sale securities at fair value.

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A.P. Pharma, Inc.

Notes to Condensed Financial Statements—(Continued)

September 30, 2009 and 2008 (unaudited)

The following methods and assumptions were used to determine the fair value of each class of assets recorded at fair value in the balance sheets:

Cash equivalents: Cash equivalents consist of highly rated money market funds with maturities of one year or less, and are purchased daily at par value with specified yield rates. Due to the high ratings and short-term nature of these funds, we consider all cash equivalents as Level 1 inputs.

Short-term available-for-sale investments at fair value: Fair values are based on quoted market prices, where available. These fair values are obtained from third party pricing services, which generally use Level 1 or Level 2 inputs for the determination of fair value. Third party pricing services normally derive the security prices through recently reported trades for identical or similar securities making adjustments through the reporting date based upon available market observable information. For securities not actively traded, the third party pricing services may use quoted market prices of comparable instruments or discounted cash flow analyses, incorporating inputs that are currently observable in the markets for similar securities. Inputs that are often used in valuation methodologies include, but are not limited to, benchmark yields, reported trades, broker/dealer quotes, issuer spreads, benchmark securities, bids, offers and reference data. We utilize third party pricing services to obtain fair value and we generally obtain one price for each individual security. We review the fair value hierarchy classification. Changes in the observability of valuation inputs may result in a reclassification of levels for certain securities within the fair value hierarchy.

Investment securities are exposed to various risks, such as interest rate, market and credit. Due to the level of risk associated with certain investment securities and the level of uncertainty related to changes in the value of investment securities, it is possible that changes in these risk factors in the near term could have an adverse impact on our results of operations or stockholders’ equity.

The carrying amounts reflected in our balance sheets for cash, accounts receivable, accounts payable and accrued expenses approximate fair value because of the short-term nature of these items.

Effective January 1, 2009, we implemented ASC 820-10 (previously known as Statement of Financial Standards No. 157, “Fair Value Measurements,” or SFAS 157), for our non-financial assets and liabilities that are re-measured at fair value on a non-recurring basis. The adoption of SFAS 157 for our non-financial assets and liabilities that are re-measured at fair value on a non-recurring basis did not have an impact on our financial position or results of operations; however, could have an impact in future periods.

Effective the second quarter of 2009, we implemented ASC 820-10-65-4, (previously known as FSP FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly,” or FSP FAS 157-4). FSP FAS 157-4 provides additional guidelines for making fair value measurements more consistent with the principles presented in SFAS 157 and provides guidance in determining whether a market is active or inactive, and whether a transaction is distressed. This FSP is applicable to all assets and liabilities (i.e. financial and non-financial) and requires enhanced disclosures, including interim and annual disclosure of the input and valuation techniques (or changes in techniques) used to measure fair value and the defining of the major security types comprising debt and equity securities held based upon the nature and risk of the security. The adoption of this FSP did not have a material impact our financial position or results of operations.

Effective the second quarter of 2009, we implemented ASC 825-10-65-1, previously known as FSP FAS 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments,” or FSP FAS 107-1. FSP FAS 107-1 amended Statement of Financial Accounting Standards No. 107, “Disclosures about Fair Value of Financial Instruments,” and APB Opinion No. 28, “Interim Financial Reporting” to require disclosures about the fair value of financial instruments in interim as well as in annual financial statements. The adoption of this FSP did not have a material impact our financial position or results of operations.

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A.P. Pharma, Inc.

Notes to Condensed Financial Statements—(Continued)

September 30, 2009 and 2008 (unaudited)

In August 2009, the FASB issued Accounting Standards Update No. 2009-05, “Measuring Liabilities at Fair Value,” or ASU 2009-05. ASU 2009-05 amends ASC Topic 820, “Fair Value Measurements”. Specifically, ASU 2009-05 provides clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using one or more of the following methods: 1) a valuation technique that uses a) the quoted price of the identical liability when traded as an asset or b) quoted prices for similar liabilities or similar liabilities when traded as assets and/or 2) a valuation technique that is consistent with the principles of Topic 820 of the ASC (e.g. an income approach or market approach). ASU 2009-05 also clarifies that when estimating the fair value of a liability, a reporting entity is not required to adjust to include inputs relating to the existence of transfer restrictions on that liability. The adoption of this standard did not have an impact on our financial position or results of operations; however, this standard may impact us in future periods.

Impairments

We adopted the provisions of ASC 320-10-65-1 (previously known as FSP FAS 115-2/124-2) on April 1, 2009. FSP No. FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-than-Temporary Impairments,” amended the other-than-temporary impairment model for debt securities. The impairment model for equity securities was not affected.

Under this FSP, an other-than-temporary impairment must be recognized through earnings if an investor has the intent to sell the debt security or if it is more likely than not that the investor will be required to sell the debt security before recovery of its amortized cost basis. However, even if an investor does not expect to sell a debt security, it must evaluate expected cash flows to be received and determine if a credit loss has occurred. In the event of a credit loss, only the amount associated with the credit loss is recognized in income. The amount of loss relating to other factors is recorded in accumulated other comprehensive income. The FSP also requires additional disclosures regarding the calculation of credit losses and the factors considered in reaching a conclusion that an investment is not other-than-temporarily impaired. The adoption of the FSP did not have a material impact on our financial position or results of operations.

We conduct periodic reviews to identify and evaluate each investment that has an unrealized loss, in accordance with FSP FAS 115-1, “The Meaning of Other-than-Temporary Impairment and its Application to Certain Investments,” or FSP FAS 115-1, and FSP FAS 115-2. An unrealized loss exists when the current fair value of an individual security is less than its amortized cost basis. Unrealized losses on available-for-sale securities that are determined to be temporary, and not related to credit loss, are recorded, net of tax, in accumulated other comprehensive income.

For available-for-sale debt securities with unrealized losses, management performs an analysis to assess whether we intend to sell or whether we would more likely than not be required to sell the security before the expected recovery of the amortized cost basis. Where we intend to sell a security, or may be required to do so, the security’s decline in fair value is deemed to be other-than-temporary and the full amount of the unrealized loss is recorded within earnings as an impairment loss.

Regardless of our intent to sell a security, we perform additional analysis on all securities with unrealized losses to evaluate losses associated with the creditworthiness of the security. Credit losses are identified where we do not expect to receive cash flows sufficient to recover the amortized cost basis of a security.

For equity securities, when assessing whether a decline in fair value below our cost basis is other-than-temporary, we consider the fair market value of the security, the duration of the security’s decline, and the financial condition of the issuer. We then consider our intent and ability to hold the equity security for a period of time sufficient to recover our carrying value. Where we have determined that we lack the intent and ability to hold an equity security to its expected recovery, the security’s decline in fair value is deemed to be other-than-temporary and is recorded within earnings as an impairment loss.

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A.P. Pharma, Inc.

Notes to Condensed Financial Statements—(Continued)

September 30, 2009 and 2008 (unaudited)

No impairment losses were recognized through earnings related to available-for-sale securities during the three or nine months ended September 30, 2009 or 2008.

For the three and nine months ended September 30, 2009 and 2008, we recognized in other comprehensive income (loss), $5,000, $43,000, ($9,000) and ($25,000), respectively, in gains (charges) associated with the temporary impairment of available-for-sale securities primarily related to mortgage and asset-backed securities.

(3) NET LOSS PER SHARE INFORMATION

Basic and diluted net loss per share is computed by dividing net loss by the weighted average number of common shares outstanding. Diluted net loss per share excludes the effect of potentially dilutive securities because they are anti-dilutive. Such potentially dilutive securities at September 30, 2009 include outstanding stock options for 3,231,840 common shares and unearned restricted stock awards for 140,000 common shares.

(4) STOCK-BASED COMPENSATION

The following table shows the stock-based compensation expense for all awards (in thousands except per share amounts):

The following table summarizes option activity for the nine months ended September 30, 2009:

Employee Stock Purchase Plan. We adopted an Employee Stock Purchase Plan (the “Purchase Plan”) in 1997. Qualified employees may elect to have a certain percentage of their salary withheld to purchase shares of our common stock under the Purchase Plan. The purchase price per share is equal to 85% of the fair market value of the stock on specified dates. Sales under the Purchase Plan in the nine month periods ended September 30, 2009 and 2008 were 57,336 and 26,103 shares at an average price of $0.42 and $1.03, respectively. Shares available for future purchase under the Purchase Plan are 200,007 at September 30, 2009.

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A.P. Pharma, Inc.

Notes to Condensed Financial Statements—(Continued)

September 30, 2009 and 2008 (unaudited)

(5) COMPREHENSIVE LOSS

Comprehensive loss for the three and nine months ended September 30, 2009 and 2008 consists of the following (in thousands):

(6) INCOME TAXES

There is no provision for income taxes for the three or nine months ended September 30, 2009 or 2008 because we incurred net operating losses.

(7) STOCKHOLDERS’ EQUITY

At our annual meeting in May 2009, our shareholders approved an amendment to our Amended and Restated Certificate of Incorporation to increase the total number of shares of common stock authorized for issuance from 50,000,000 to 100,000,000 shares. They also approved an amendment to increase by 200,000 the number of shares of common stock reserved for issuance under our Employee Stock Purchase Plan.

On December 18, 2006, we entered into a Preferred Shares Rights Agreement. As part of this agreement, preferred stock purchase rights (“the rights”) were distributed to stockholders of record as of January 2, 2007 (and to each person who acquires our common stock after that date unless determined otherwise by the board of directors) at the rate of one right for each share of common stock held. The rights become exercisable only upon the acquisition, or the acquisition of the right to acquire, by a person or group of affiliated or associated persons, of 20% (amended to 34% or more with regard to Tang Capital Partners, LP and its affiliates and 30% or more with regard to Baker Brothers Investments in conjunction with our October 2009 financing – see Note 10) or more of the outstanding shares of our common stock. Once exercisable, each right entitles the holder to purchase, at a price of $44.00, one one-thousandth of a share of Series A Participating Preferred Stock. For a limited period of time following the announcement of any such acquisition or offer, the rights are redeemable by us at a price of $0.01 per right. If the rights are not redeemed or exchanged, each right will then entitle the holder to receive, upon exercise of such right, a number of shares of our common stock having a then current value equal to two times the purchase price of such right. Similarly, if the rights are not redeemed or exchanged and following the acquisition of 20% (amended to 34% or more with regard to Tang Capital Partners, LP and its affiliates an 30% or more with regard to Baker Brothers Investments) or more of the outstanding shares of our common stock by a person or group of affiliated or associated persons, (i) we consolidate with or merge into another entity, (ii) another entity consolidates with or merges into us or (iii) we sell or otherwise transfer 50% or more of its consolidated assets or earning power, each right will then entitle the holder to receive, upon exercise of such right, a number of shares of common stock of the acquiring company having a then current value equal to two times the purchase price. For a limited period of time after the exercisability of the rights, each right, at the discretion of the board of directors, may be exercised for such number of shares of common stock determined in accordance with the rights agreement. We have initially reserved 200,000 shares of preferred stock pursuant to the exercise of these rights. These rights expire on December 31, 2016.

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A.P. Pharma, Inc.

Notes to Condensed Financial Statements—(Continued)

September 30, 2009 and 2008 (unaudited)

(8) DISCONTINUED OPERATIONS

We completed the sale of certain assets of our Analytical Standards division as well as certain technology rights for our topical pharmaceutical and cosmeceutical product lines and other assets (“cosmeceutical and toiletry business”) in February 2003 and July 2000, respectively.

The Analytical Standards division and cosmeceutical and toiletry business are reported as discontinued operations for all periods presented in the accompanying Condensed Statements of Operations.

Loss from discontinued operations represents primarily the loss attributable to changes in estimates of our cosmeceutical and toiletry business that was sold to RP Scherer on July 25, 2000, as follows (in thousands):

Basic and diluted loss per common share from discontinued operations was nil and less than $0.01 per share for the three and nine months ended September 30, 2009 and 2008, respectively.

The cash provided by discontinued operations of $19,000 in 2008 relates primarily to royalties received from GFS Chemicals, Inc. (“GFS”), a privately held company based in Columbus, Ohio, from sales of Analytical Standards products.

On February 13, 2003, we completed the sale of our Analytical Standards division to GFS. In this transaction, we received $2.1 million on closing and were entitled to receive royalties on sales of Analytical Standards products for a period of five years following the sale at rates ranging from 5% to 15%. As of March 31, 2008, all royalties due from GFS have been received.

In conjunction with the terms of an agreement with RP Scherer, a subsidiary of Cardinal Health, pursuant to which we sold certain technology rights associated with our cosmeceutical and toiletry business, we guaranteed a minimum gross profit percentage on RP Scherer’s combined sales of products to Ortho Neutrogena and Dermik (“Gross Profit Guaranty”). The guaranty period initially commenced on July 1, 2000 and was to end on the earlier of July 1, 2010 or the end of two consecutive guaranty periods where the combined gross profit on sales to Ortho and Dermik equals or exceeds the guaranteed gross profit (the “two period test”). The Gross Profit Guaranty expense totaled $944,000 for the first seven guaranty years and in those years profits did not meet the two period test. Effective March 2007, in conjunction with a sale of assets by RP Scherer’s successor company to an Amcol International subsidiary (“Amcol”), a new agreement was signed between us and Amcol to provide continuity of product supply to Ortho and Dermik. This new agreement potentially extends the Gross Profit Guaranty period an additional three years to July 1, 2013, unless it is terminated earlier with the two period test. Amcol has indicated that its costs differ from those it charged historically to the RP Scherer successor company to produce the products. We have not paid any Gross Profit Guaranty amount asserted by Amcol, and have requested documentation of their actual costs. As there is no minimum amount of Gross Profit Guaranty due, no accrual for the guaranty is estimable for future years. A liability of $621,000 related to the amount due under Gross Profit Guarantees is included in accrued disposition costs as of September 30, 2009 and December 31, 2008.

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A.P. Pharma, Inc.

Notes to Condensed Financial Statements—(Continued)

September 30, 2009 and 2008 (unaudited)

(9) SIGNIFICANT AGREEMENTS

Merial

In September 2009, we entered into a world-wide license and development agreement with Merial, a world leading animal health company, for a long-acting pain management product for cats and dogs. The license and development agreement follows a successful proof-of concept agreement. Under the terms of the new agreement, we received an upfront license fee and will receive development funding and potential future milestones that are in addition to royalties following commercialization.

Remaining deliverables associated with the license relate primarily to improvements during the development phase. Given the unique nature of the improvements, we are unable to obtain objective, reliable evidence of its fair value and as a result, we considered the license and improvements as one unit of accounting and will recognize as revenue the upfront license fee based on proportional performance over the development phase.

Development funding will be recognized as revenue as services are delivered and the milestone payment when the performance milestone is achieved.

We recognized $106,000 related to development services to Merial in the third quarter of 2009.

RHEI Pharmaceuticals

On September 29, 2009 we terminated the License Agreement (“Agreement”) dated October 1, 2006 between us and RHEI. RHEI owed the Company a milestone payment following the announcement of acceptance for filing of a NDA for our APF530 product candidate by the FDA on July 20, 2009. RHEI did not make such milestone payment in the time required under the terms of the Agreement and was provided notice by us of RHEI’s cure period. RHEI remained in default of this payment and, as a result, the Company elected to terminate the Agreement for cause. No material termination penalties apply to the Company for the termination of the Agreement.

Revenue of $1million, previously deferred, in conjunction with the RHEI Agreement was recognized in September 2009 and is included in contract revenue.

(10) SUBSEQUENT EVENTS

In October 2009, in a private placement, we sold approximately 8 million shares of our common stock at a price of $0.88 per share and warrants to purchase approximately 4 million shares of our common stock, exercisable through January 7, 2015, at $0.88 per share. The purchasers paid $0.125 per underlying share for the warrants. Additionally, the purchasers have the right to purchase up to 5.2 million shares of common stock (second tranche) at $0.97 per share prior to May 14, 2010 and paid $0.125 per share for the right to purchase such shares in the second tranche. The exercise price and/or the number of shares of common stock issuable upon exercise of the warrants or in connection with the second tranche may be adjusted in certain circumstances

Aggregate proceeds from the October 2009 financing were approximately $8.1 million.

In connection with the financing, we will prepare and file a registration statement with the SEC within 30 days of the closing of the October 2009 financing for purposes of registering the resale of the shares purchased, as well as the shares of common stock issuable upon exercise of the warrants. We will use our best efforts to cause the registration statement to be declared effective by the SEC within 90 days of the closing of the October 2009 financing (or 120 days in the event the registration statement is reviewed by the SEC). If we fail to meet either of these deadlines, fail to meet filing or effectiveness deadlines with respect to any additional registration statements required by our agreement or fail to keep any registration statements continuously effective (with limited exceptions), we may be obligated to pay to the holders of the shares and warrants liquidated damages in the amount of 1% per month of the purchase price for the shares and warrants, up to a maximum cap of 8%.

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A.P. Pharma, Inc.

Notes to Condensed Financial Statements—(Continued)

September 30, 2009 and 2008 (unaudited)

Effective October 28, 2009, we transferred the listing of our common stock from The NASDAQ Global Market to the NASDAQ Capital Market. Our securities continue to trade under the symbol “APPA”. As of the date of this filing, we believe the October 2009 financing enables us to meet the initial equity listing requirements for The NASDAQ Capital Market as illustrated in the table below.

The table below presents a summary of our balance sheet as of September 30, 2009 on an actual basis and on a pro forma as adjusted basis to include the net proceeds of our October 2009 financing.

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Forward-looking Statements

This Form 10-Q contains “forward-looking statements” as defined by the Private Securities Reform Act of 1995. These forward-looking statements involve risks and uncertainties including uncertainties associated with capital resources and liquidity, timely development and regulatory approval of product candidates, establishment of new corporate alliances, progress in research and development programs, launch and acceptance of new products and other risks and uncertainties identified in the our filings with the Securities and Exchange Commission. We caution investors that forward-looking statements reflect our analysis only on their stated date. We do not intend to update them except as required by law.

Results of Operations for the Three and Nine Months Ended September 30, 2009 and 2008

Contract revenue, which is derived from work performed under collaborative research and development arrangements, was $1.1 million, $0.1 million, $1.1 million and $0.3 million for the three months ended September 30, 2009 and 2008 and the nine months ended September 30, 2009 and 2008, respectively. Contract revenues for the three and nine months ended September 30, 2009 include $1,000,000 of revenue recognized on termination of our agreement with RHEI (see Note 9 – Significant Agreements to our financial statements). The amount of contract revenue varies from period to period depending on the level of activity requested of us by our collaborators. In September 2009, we entered into an agreement with Merial for a long-acting pain management product for cats and dogs. As a result of this agreement, we anticipate contract revenues over the near term to increase.

Our revenue has been derived principally from contract revenue. In January 2006, we completed the sale of our rights to royalties on sales of Retin-A Micro® and Carac® for up to $30 million. We received proceeds of $25 million upon the closing of the transaction and received a $2.5 million milestone payment in June 2007. We may receive up to an additional $2.5 million based on the satisfaction of certain predetermined milestones. As a result of this transaction, there were no royalties for the nine months ended September 30, 2009 or 2008. We will not record additional royalty revenue on sales of Retin-A Micro® and Carac® in future periods.

Research and development expense for the three months ended September 30, 2009 decreased to $1.4 million from $5.1 million for the three months ended September 30, 2008. Research and development expense for the nine months ended September 30, 2009 decreased to $6.4 million from $16.7 million for the nine months ended September 30, 2008. The decreases in research and development expenses for the three and nine months ended September 30, 2009 as compared with comparable periods in 2008 are primarily due to decreased expenditures related to APF530, largely as a result of the completion of our Phase III trial and related costs for APF530. Additionally, in late 2008 we placed our other product candidates “on hold” to focus our financial and managerial resources on APF 530. As a result, we had reductions in force in November 2008 and May 2009, resulting in lower payroll and related expenses. Research and development expense is expected to increase as a result of pre-commercialization activities.

General and administrative expense decreased for the three months ended September 30, 2009 to $0.9 million from $1.3 million for the three months ended September 30, 2008. General and administrative expense decreased to $2.9 million for the nine months ended September 30, 2009 as compared with $3.2 million for the comparable period of 2008. General and administrative expense decreased primarily as a result of decreases in professional fees, outside services and other general and administrative expenses as a result of cost containment measures. Changes in the rate of general and administrative expenses for the remaining quarters of 2009 will depend primarily on the achievement of corporate goals and stock-based compensation and/or retention efforts.

Net interest income was $0.0 million, $0.1 million, $0.0 million, and $0.5 million for the three months ended September 30, 2009 and 2008 and the nine months ended September 30, 2009 and 2008, respectively. The decrease was primarily due to lower average balances of cash, cash equivalents and marketable securities, as a result of operating losses and lower interest rates. In response to the current world-wide financial situation, we have invested most of our available cash equivalents in a lower risk money market fund containing U.S. Government-backed or collateralized overnight securities.

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Loss from discontinued operations represents the gross profit guarantee from the cosmeceutical and toiletries business which was sold to RP Scherer Corporation in July 2000. We have been unable to obtain information regarding quantities or costs associated with the gross profit guarantee and as a result have not recorded any gross profit guarantee in 2009.

Capital Resources and Liquidity

Cash, cash equivalents and marketable securities decreased to $1.6 million at September 30, 2009 from $10.5 million at December 31, 2008 due primarily to our net loss for the nine months ended September 30, 2009, which includes $1million of revenue from termination of the RHEI agreement (see Note 9 – Significant Agreements)

Net cash used in continuing operating activities for the nine months ended September 30, 2009 was $9.0 million, compared to net cash used of $18.3 million for the nine months ended September 30, 2008. The decrease in net cash used by continuing operating activities in 2009 was mainly due to the decreased loss for the nine months ended September 30, 2009, as well as changes in accrued expenses, deferred revenue and accounts receivable, as compared to the same period in 2008.

Net cash provided by investing activities for the nine months ended September 30, 2009 was $0.6 million compared to net cash provided of $0.4 million from investing activities for the nine months ended September 30, 2008. The change in 2009 from 2008 in cash flows associated with investing activities was primarily due to minimal purchases of property and equipment.

To date, we have financed our operations, including technology and product research and development, through the sale of common stock, royalties received on sales of Retin-A Micro® and Carac®, income from collaborative research and development fees, the proceeds received from the sales of our Analytical Standards division and our cosmeceutical and toiletry business, interest earned on short-term investments and the sale of our interest in the royalty income from Retin-A Micro® and Carac®.

At September 30, 2009, we had cash, cash equivalents and marketable securities of $1.6 million and working capital of ($0.1) million. In October 2009, we sold approximately 8 million shares of common stock, and warrants to purchase additional stock for gross proceeds of approximately $8.1 million. We believe this financing enables us to meet the initial equity listing requirements for The NASDAQ Capital Market, as well as enable us to fund our operations through 2010, based on our expected spending levels and certain anticipated positive cash inflows.

Our capital requirements going forward will depend on numerous factors including, among others: our ability to enter into licensing agreements and collaborative research and development arrangements; time required to gain regulatory approvals for our product candidates; progress of product candidates; investment in new research and development programs; resources that we devote to self-funded products; potential acquisitions of technology, product candidates or businesses; and the costs of defending or prosecuting any patent opposition or litigation necessary to protect our proprietary technology.

Below is a summary of fixed payments related to certain contractual obligations (in thousands). This table excludes amounts already recorded on our condensed balance sheet as current liabilities at September 30, 2009.

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Off-Balance Sheet Arrangements

As of September 30, 2009 we did not have any off-balance sheet arrangements.

Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments. We manage our interest rate risk by maintaining an investment portfolio primarily consisting of debt instruments of high credit quality and relatively short average maturities. Due to the financial crisis and our anticipated cash flow requirements, we have 97% of our available cash, cash equivalents and marketable securities in cash and a money market fund containing U.S. Government-backed or collateralized overnight securities.

Evaluation of disclosure controls and procedures: We carried out an evaluation, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as defined in Rule 13a-15(e) and 15(d)-15(e) of the Securities and Exchange Act of 1934. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of September 30, 2009, the end of period covered by this report, our disclosure controls and procedures were effective at the reasonable assurance level.

Changes in internal controls: During the three months ended September 30, 2009, there have been no significant changes in our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

Not applicable.

The following are new or modified risk factors that should be read in conjunction with the risk factors disclosed in our 2008 10-K:

Our common stock may be delisted from The NASDAQ Capital Market, which could negatively impact the price of our common stock and our ability to access the capital markets.

Our common stock is now listed on The NASDAQ Capital Market. The listing standards of The NASDAQ Capital Market require that a company maintain stockholders’ equity of at least $2.5 million. While our financing in October 2009 (see Note 10) results in proceeds to us of approximately $8.1 million, we are awaiting acknowledgement by The NASDAQ Stock Market, or NASDAQ, that we meet the $2.5 million stockholders’ equity requirement for continued listing on The NASDAQ Capital Market. Separately, as announced on September 21, 2009, we received notice from NASDAQ that we did not satisfy the $1.00 minimum bid price requirement, and that we have been granted through March 15, 2010 to regain compliance with the minimum bid price requirement. If we are not in compliance with the minimum bid price requirement by that date, we will be entitled to a second 180-calendar day grace period, through September 13, 2010, to evidence compliance with the minimum bid price requirement so long as we satisfy all criteria for initial listing on The Nasdaq Capital Market (except for bid price) as of March 15, 2010.

Should we fail to comply with the minimum listing standards applicable to issuers listed on The NASDAQ Capital Market, our common stock may be delisted from The NASDAQ Capital Market. If our common stock is delisted, it could reduce the price of our common stock and the levels of liquidity available to our stockholders. In addition, the delisting of our common stock could materially adversely affect our access to the capital markets, and any limitation on liquidity or reduction in the price of our common stock could materially adversely affect our ability to raise capital on terms acceptable to us or at all. Delisting from The NASDAQ Capital Market could also result in other negative implications, including the potential loss of confidence by suppliers, customers and employees, the loss of institutional investor interest and fewer business development opportunities.

Further concentration in shareholder ownership could influence strategic actions.

In October 2009, Tang Capital Partners, LP and its affiliates, including Tang Capital Management, LLC and its Managing Director, Kevin C. Tang, increased their ownership of our common stock to 29%, and Baker Brothers Investments and its affiliates increased their beneficial ownership of our common stock to 17%. Mr. Tang is also a member of our board. Such a concentration of common stock ownership could significantly influence corporate actions on various strategic matters, including for example receptivity to collaborations and merger or sale overtures.

Not applicable.

Not applicable.

Not applicable.

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Not applicable.

**Exhibit 10.1 Development and License Agreement dated as of September 11, 2009, between the Company and Merial Limited.

Exhibit 10.2 Securities Purchase Agreement, dated as of October 19, 2009, by and among the Company and the purchasers listed therein, filed as Exhibit 10.1 to the Company’s Form 8-K filed on October 22, 2009 and incorporated by reference herein.

Exhibit 10.3 Registration Rights Agreement, dated as of October 22, 2009, by and among the Company and the purchasers listed therein, filed as Exhibit 10.2 to the Company’s Form 8-K filed on October 22, 2009 and incorporated by reference herein.

Exhibit 10.4 Form of Warrant to Purchase Shares of Common Stock, filed as Exhibit 10.3 to the Company’s Form 8-K filed on October 22, 2009 and incorporated by reference herein

Exhibit 10.5 Second Amendment to Preferred Shares Rights Agreement, dated as of October 20, 2009, by and between the Company and Computershare Trust Company N.A., filed as Exhibit 10.4 to the Company’s Form 8-K filed on October 22, 2009 and incorporated by reference herein.

Exhibit 31.1 Certification of Chief Executive Officer pursuant to Rules 13A-15(f) Promulgated under the Securities Exchange Act of 1934 as amended.

Exhibit 31.2 Certification of Chief Financial Officer pursuant to Rules 13A-15(f) Promulgated under the Securities Exchange Act of 1934 as amended.

Exhibit 32 Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES

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

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