Paratek Pharmaceuticals, Inc. - Annual Report: 2008 (Form 10-K)

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

For the fiscal year ended: December 31, 2008

or

Commission file number: 000-51967

TRANSCEPT PHARMACEUTICALS, INC.

(Exact name of registrant as specified in its charter)

1003 W. Cutting Blvd., Suite #110

Point Richmond, California 94804

(510) 215-3500

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive office)

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.    Yes  ¨    No  x

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

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

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

The aggregate market value of the common stock of the registrant held by non-affiliates of the registrant on June 30, 2008, the last business day of the registrant’s second fiscal quarter was: $43,014,117.

As of March 26, 2009 there were 13,113,954 shares of the registrant’s common stock outstanding.

Documents incorporated by reference: Items 10, 11, 12, 13, and 14 of Part III incorporate information by reference from the Proxy Statement to be filed with the Commission within 120 days of the end of our fiscal year pursuant to General Instruction G(3) to Form 10-K.

Table of Contents

TABLE OF CONTENTS

Table of Contents

Special Note Regarding Forward-Looking Statements

This report contains forward-looking statements that are based upon current expectations within the meaning of the Private Securities Litigation Reform Act of 1995. Transcept intends that such statements be protected by the safe harbor created thereby. Forward-looking statements involve risks and uncertainties and actual Transcept results and the timing of events may differ significantly from those results discussed in the forward-looking statements. Examples of such forward-looking statements include, but are not limited to, statements about or relating to:

Transcept undertakes no obligation to, and expressly disclaims any obligation to, revise or update the forward-looking statements made herein or the risk factors whether as a result of new information, future events or otherwise. Forward-looking statements involve risks and uncertainties, which are more fully discussed in the “Risk Factors” section and elsewhere in this Annual Report, including, but not limited to, those risks and uncertainties relating to:

1

Table of Contents

Intermezzo^®, Bimucoral^®, Transcept Pharmaceuticals, Inc.™, and Asentar™ are registered and unregistered trademarks in the United States and other jurisdictions. Other trademarks and trade names referred to in this Annual Report on Form 10-K are the property of their respective owners.

2

Table of Contents

PART I

Background and Merger of Novacea, Inc. and Transcept Pharmaceuticals, Inc.

Transcept Pharmaceuticals, Inc., or Transcept, was incorporated in Delaware in 2001 as Novacea, Inc., or Novacea. Prior to January 2008, Novacea had been principally engaged as a biopharmaceutical company focused on in-licensing, developing and commercializing novel therapies for the treatment of cancer. In November 2007, Novacea stopped all clinical trials for its lead product candidate, Asentar™. Asentar™ had been in a Phase 3 clinical trial for the treatment of androgen-independent prostate cancer that was terminated as a result of an imbalance of deaths between the treatment and control arms of the trial. In connection with a decision to further reduce spending and preserve capital resources, in 2008 Novacea also terminated early stage clinical trials for its second product candidate, AQ4N. After ending all of its clinical trials, Novacea began to explore potential strategic alternatives, established processes for identifying and evaluating those alternatives, and committed to a restructuring plan that reduced spending while maintaining the capabilities needed to conduct minor activities related to Asentar™ and AQ4N. By December 31, 2008 this plan reduced the Novacea workforce to nine employees, each of whom was primarily involved in financial and administrative roles.

On January 30, 2009, Novacea completed a business combination with Transcept Pharmaceuticals, Inc., or TPI, in accordance with the terms of the Agreement and Plan of Merger and Reorganization among Novacea, Pivot Acquisition, Inc., a wholly owned subsidiary of Novacea, or Pivot, and TPI, dated as of August 29, 2008, as amended on December 23, 2008 by the Amendment to Agreement and Plan of Merger and Reorganization and collectively referred to as the Merger Agreement, pursuant to which TPI merged with Pivot and became a wholly owned subsidiary of Novacea. In connection with the closing of the merger, Novacea conducted a 1-for-5 reverse stock split of its common stock, the name of Novacea was changed to “Transcept Pharmaceuticals, Inc.”, and the name of TPI became Pivot Acquisition, Inc. Following the closing of the Merger, the business conducted by Transcept became primarily the business conducted by TPI immediately prior to the Merger.

Under the terms of the Merger Agreement, Novacea issued shares of common stock to the TPI stockholders at the rate of 0.14134 shares of common stock, on a post 1-for-5 reverse split basis, for each share of TPI common stock outstanding. Transcept also assumed all of the stock options and stock warrants of TPI outstanding as of January 30, 2009, with each share of common stock of TPI underlying such options and warrants being converted to 0.14134 shares of Transcept common stock. After consummation of the merger the former TPI stockholders, option holders and warrant holders owned approximately 61.24% of the Transcept common stock on a fully-diluted basis and the stockholders, option holders and warrant holders of Novacea prior to the Merger owned, as of the closing, approximately 38.76% of the Transcept common stock on a fully-diluted basis. Immediately following the completion of the Merger and the reverse stock split, Transcept had approximately 13.1 million shares of common stock outstanding.

The issuance of the shares of Transcept common stock to the former stockholders of TPI was registered with the Securities and Exchange Commission, or SEC, on a Registration Statement on Form S-4 (SEC File No. 333-153844).

Novacea securities listed on the NASDAQ Global Market, trading under the ticker symbol “NOVC,” were suspended for trading as of the close of business on Friday, January 30, 2009 and trading of Transcept securities on the NASDAQ Global Market under the ticker symbol “TSPT” commenced on Monday, February 2, 2009.

In this Annual Report, “Transcept,” “the Company,” “we,” “our” and “us” refers to the public company formerly known as Novacea and now known as Transcept Pharmaceuticals, Inc., and, as successor to the business of TPI, includes activities taking place with respect to the business of TPI prior to the merger of TPI and Novacea, as applicable.

3

Table of Contents

Overview

Transcept is a specialty pharmaceutical company focused on the development and commercialization of proprietary products that address important therapeutic needs in the field of neuroscience. The lead Transcept product candidate, Intermezzo^®, is a sublingual low dose formulation of zolpidem that has been developed for use as-needed for the treatment of insomnia when a middle of the night awakening is followed by difficulty returning to sleep.

According to IMS Health, an independent market research firm, the U.S. market for prescription products to treat insomnia was approximately $2.2 billion in 2003 and grew to approximately $3.9 billion for the 12 months ended December 31, 2008. Data from a recent major study from the Stanford Sleep Epidemiology Center indicates that middle of the night awakening is the most common form of insomnia in the United States and affects approximately one-third of the population at least three times each week. Despite the prevalence of middle of the night awakening, there is no sleep aid currently approved for use specifically in the middle of the night when patients awaken and have difficulty returning to sleep.

Transcept has completed all scheduled clinical trials on behalf of Intermezzo^® and submitted a New Drug Application, or NDA, to the U.S. Food and Drug Administration, or FDA, on September 30, 2008, which was accepted for filing on December 15, 2008. The FDA has assigned the Intermezzo^® NDA a July 30, 2009 PDUFA date, the statutorily determined target date for the FDA to have a response to the Transcept NDA submission. Transcept holds world-wide commercial and development rights to Intermezzo^® and plans to commercialize the product in the United States with a specialty sales force initially focusing on psychiatrists and potentially to other physicians who are the highest prescribers of insomnia products. Transcept plans to market to other physician audiences through a primary care marketing alliance in the United States and with one or more marketing and development alliances in major international markets.

Transcept believes that Intermezzo^® is positioned to be the first commercially available sleep aid specifically for use in the middle of the night when patients awaken and have difficulty returning to sleep. Intermezzo^® has been uniquely designed for this indication and employs the following product features:

Known active agent. The active pharmaceutical ingredient in Intermezzo^® is zolpidem tartrate, cited by IMS Health as the most commonly prescribed agent for the treatment of insomnia in the United States, with over one billion zolpidem tablets prescribed in 2008 in the United States. Approved as the active ingredient in Ambien^® in 1992, zolpidem has a well established record of safety and efficacy.

Rapid bioavailability. Transcept believes that rapid bioavailability—the delivery of the active pharmaceutical ingredient into systemic circulation—is a key product feature for a sleep aid intended to be used in the middle of night. Intermezzo^® is formulated as a sublingual tablet, or a dosage form that dissolves under the tongue, using Transcept proprietary technology to facilitate more rapid absorption as compared to swallowed zolpidem tablet formulations, such as Ambien^®.

Low dose. Transcept expects Intermezzo^® to be available in doses that are 65% and 72% lower than the comparable doses of Ambien^® and Ambien CR^®, respectively. In Phase 3 clinical studies, this low dose returned patients to sleep rapidly and allowed them to awaken about four hours after taking their medication in the middle of the night, without next day residual effects as compared to placebo. Transcept believes that Intermezzo^® 1.75 and 3.5 mg doses are the lowest doses of zolpidem that have been reported to induce sleep in a manner statistically superior to placebo.

4

Table of Contents

Transcept Strategy

The Transcept goal is to become a leading developer and marketer of pharmaceutical products that fill important therapeutic needs in the field of neuroscience. Transcept efforts to achieve this goal are driven by the following key strategies:

The Intermezzo^® Opportunity

Overview of the insomnia market

According to IMS Health, the U.S. market for prescription sleep aids was approximately $2.2 billion in 2003 and grew to approximately $3.9 billion for the 12 months ended December 31, 2008. According to the U.S. Department of Health and Human Services, between 50 and 70 million Americans report significant sleep problems.

Middle of the night awakening: the most common insomnia symptom

The 2003 National Sleep Foundation, or NSF, “Sleep in America” poll of the U.S. population between the ages of 55 and 84 described waking up during the night as the most prevalent insomnia symptom, affecting 33% of respondents. Based on the 2005 NSF poll data, Transcept estimates that middle of the night awakening is 50% more common than difficulty going to sleep at bedtime among the general population. The 2008 NSF poll found that 42% of respondents described being “awake a lot during the night.”

Based on a recently published study of nearly 9,000 individuals, the Stanford Sleep Epidemiology Research Center has estimated that about one-third of adults in the United States experience middle of the night awakenings at least three times each week. The study concluded that more than 90% of those subjects who

5

Table of Contents

reported middle of the night awakenings reported that this insomnia symptom persisted for at least six months. In the Stanford study, fewer than 25% of this middle of the night awakening group reported difficulty going to sleep at bedtime.

The FDA has not previously approved any sleep aid specifically for use in the middle of the night when patients awaken and have difficulty returning to sleep. The most commonly prescribed sleep aids are formulated at doses that are sufficiently high to produce seven to eight hours of sleep. Such seven to eight hour products can be used at bedtime to prevent a middle of the night awakening, however, their prolonged duration of action makes them unsuitable for use in the middle of the night when an awakening occurs, as this may increase the risk of residual sedative effects the following morning.

Middle of the night awakenings typically do not occur every night, thus bedtime use of a high dose sleep aid to prevent an awakening requires that the patient either predict which night an awakening might occur, or take a seven to eight hour product every night. The result is that patients may use their sleep aid more often than necessary, and at a higher dose than necessary, as compared to a fast-acting, low dose sleep aid that would be used only on the nights and at the time when an awakening actually occurs.

Intermezzo^®—potential to be the first sleep aid approved specifically for use in the middle of the night when patients awaken and have difficulty returning to sleep

If approved, Transcept believes that Intermezzo^® will be the first sleep aid approved specifically for use in the middle of the night when patients awaken and have difficulty returning to sleep. In clinical trials, the unique Intermezzo^® characteristics of rapid bioavailability and low dose enabled patients to return to sleep quickly and awaken in four hours without the residual effects that have been reported when seven to eight hour zolpidem products were taken in the middle of the night.

Intermezzo^® is a sublingual tablet utilizing a proprietary formulation intended to enhance the absorption of the active sleep medication, zolpidem. Zolpidem is the most frequently prescribed sleep aid in the United States, with, according to IMS Health, over one billion tablets prescribed in 2008 in the United States. Transcept believes that Intermezzo^® contains the lowest dose of zolpidem that has been reported to induce sleep in a manner statistically superior to placebo, and is expected to be available in doses that are 65% and 72% lower than the comparable doses of Ambien^® and Ambien CR^®, respectively.

Intermezzo^®: Bimucoral^® Technology

Intermezzo^® differs from previous formulations of zolpidem, both in dose and route of administration, and is designed to be the first sleep aid approved specifically for use in the middle of the night when patients awaken and have difficulty returning to sleep. The Intermezzo^® sublingual dosage form is formulated to rapidly deliver zolpidem to allow patients to return to sleep quickly. In order to permit patients to take Intermezzo^® in the middle of the night and yet awaken four hours later without hangover effects, Intermezzo^® employs a significantly reduced zolpidem dose of 3.5 mg for adults under 65 and 1.75 mg for those patients over 65. Transcept believes they are the lowest doses of zolpidem reported to be effective in inducing sleep in a manner significantly superior to placebo.

6

Table of Contents

Intermezzo^® utilizes Bimucoral^® technology, a bicarbonate-carbonate binary buffer system, or a chemical combination that modifies the pH of saliva, to convert water-soluble zolpidem tartrate into its fat-soluble free-base form, which is more readily absorbed through the tissues of the mouth. Transcept believes that this formulation facilitates rapid absorption, leading to measurable zolpidem blood levels within five minutes after administration of a 3.5 mg Intermezzo^® tablet. Data from a comparative bioavailability study indicates that 10 to 20 minutes after dosing, as demonstrated by area under the curve, an accepted estimation of overall systemic exposure, zolpidem exposure as delivered by Intermezzo^® is notably higher than that created by a swallowed 10 mg zolpidem tablet. This is despite the fact that the 10 mg swallowed formulation contains nearly three times the Intermezzo^® 3.5 mg dose. Data from this study demonstrating enhanced bioavailability is illustrated below:

Bioavailability comparison study (n=33):

Intermezzo^® 3.5 mg vs. Ambien^® 10 mg (n=33)

Intermezzo^® Clinical Development Program

The Intermezzo^® clinical development program consisted of a total of 12 studies. Four studies were early stage bioavailability trials and utilized prototype formulations. These were completed prior to the submission of the investigational new drug application, or IND, in April 2005. Eight additional studies were conducted, including two Phase 3 clinical trials that were included in the Intermezzo^® NDA. Transcept believes that these studies include the data requested by FDA for the submission of an NDA for Intermezzo^® for use as-needed for the treatment of insomnia when a middle of the night awakening is followed by difficulty returning to sleep.

The basis for clinical trial dose selection was initially provided by a pharmacokinetic and pharmacodynamic study which demonstrated rapid bioavailability and also indicated that sedation reached peak levels within 20 minutes after dosing, as measured with the Digit Symbol Substitution Test, or DSST, a standard objective test of cognitive function. Despite this rapid effect, sedation levels returned to baseline within about three hours, suggesting that patients might be able to awaken in the morning after a middle of the night use of Intermezzo^® without residual sedative effects.

7

Table of Contents

The clinical safety and efficacy of Intermezzo^® is supported by two Phase 3 clinical studies. The first Phase 3 trial was a double-blind crossover study conducted in sleep laboratories in 82 patients. This study analyzed both the objective and subjective effects of Intermezzo^® on middle of the night awakenings. Transcept believes this trial is among the largest crossover sleep laboratory studies reported. The second Phase 3 trial was a double-blind parallel group outpatient study in 294 patients which analyzed subjective outcomes when patients used Intermezzo^® as needed at home at the time they awakened and had difficulty returning to sleep.

In both of these clinical trials, Intermezzo^® met its primary clinical endpoint by enabling patients to return to sleep after a middle of the night awakening more rapidly than placebo. After going back to sleep, patients tended to remain asleep longer than those on placebo and awoke without evidence of residual effects as compared to placebo.

Pivotal Phase 3 sleep laboratory study

The Phase 3 sleep laboratory clinical trial was designed as an 82 patient randomized, double-blind, placebo controlled, three-way crossover study to evaluate the safety and efficacy of Intermezzo^® 1.75 mg and 3.5 mg when taken for a scheduled middle of the night awakening in subjects with insomnia characterized by difficulty returning to sleep. Transcept believes that this is among the largest crossover sleep laboratory studies reported to date. The study was conducted in five U.S. clinical sites and each treatment period consisted of two consecutive nights of dosing followed by a 5 to 12 day washout period. The first period consisted of two baseline nights in the sleep laboratory, followed by randomized two night treatment periods using placebo and Intermezzo^® 1.75 and 3.5 mg.

8

Table of Contents

The figure below compares the time to sleep onset measured in the objective Phase 3 sleep laboratory study as produced by Intermezzo^® 1.75 mg and 3.5 mg compared to placebo. The left hand bar graph compares sleep onset time in all patients in the study and demonstrates that 3.5 mg Intermezzo^® returned patients to sleep in the middle of the night approximately 23 minutes faster than placebo. The right hand bar graph examines only those patients whose middle of the night awakenings were particularly prolonged, in that they experienced awakenings at the baseline observation lasting more than an hour. Despite the more prolonged middle of the night awakenings of this patient subset, the 3.5 mg Intermezzo^® dose returned these patients to sleep approximately 28 minutes faster than placebo. All of these differences were statistically significant.

Phase 3 Sleep Laboratory Study (n=82)

Placebo vs. Intermezzo^® 1.75 mg and 3.5 mg

Objective Latency to Persistent Sleep following a middle of the night awakening

9

Table of Contents

Patients in the Phase 3 sleep laboratory study, when treated with either the 1.75 mg or 3.5 mg Intermezzo^® dose, were more likely to fall asleep within 10 to 20 minutes than when these same patients received placebo. On the baseline nights, with one exception, no patients had returned to sleep within 20 minutes. However, on the subsequent treatment nights when patients were given Intermezzo^® 3.5 mg, 75% of the same patients returned to sleep at or before the 20 minute time point.

Phase 3 Sleep Laboratory Study (n=82)

Baseline and placebo vs. Intermezzo^® 1.75 mg and 3.5 mg:

Proportion of patients asleep vs. time following a middle of the night awakening

10

Table of Contents

In the sleep laboratory study, neither Intermezzo^® dose produced residual hangover effects the morning after middle of the night dosing as compared to placebo. Residual hangover effects were measured objectively by the Digit Symbol Substitution Test, or DSST, a standard objective test of cognitive function, and using the Visual Analog Scale, or VAS, a subjective assessment of morning sleepiness and alertness.

Phase 3 Sleep Laboratory Study (n=82)

Residual effects of Intermezzo^® 1.75 mg and 3.5 mg vs. placebo

DSST (objective) and VAS (subjective) scores

11

Table of Contents

Pivotal Phase 3 outpatient study

The Phase 3 outpatient clinical trial was designed as a 294 patient randomized, double-blind, placebo controlled study to evaluate the safety and efficacy of Intermezzo^® 3.5 mg for use as-needed for the treatment of insomnia when a middle of the night awakening is followed by difficulty returning to sleep. The study was conducted in 25 U.S. clinical sites and the study duration included a two week baseline period, followed by a 28 day double-blind treatment period.

The Phase 3 outpatient study confirmed the positive results of the Phase 3 sleep laboratory study: Intermezzo^® improved time to sleep onset after a middle of the night awakening by 18 minutes versus placebo, a difference that was statistically significant. The figure below compares the patient reported time to sleep onset of Intermezzo^® 3.5 mg as compared to placebo and baseline.

Phase 3 Outpatient Study, Placebo vs. Intermezzo^® 3.5 mg (n=294)

Latency to Sleep Onset (LSO^MOTN) 4 week average

12

Table of Contents

Each morning during the Phase 3 outpatient study patients reported their level of sleepiness on a nine point scale. Patients taking Intermezzo^® 3.5 mg. reported feeling less sleepy and more alert than patients taking placebo, a difference that was statistically significant.

Phase 3 Outpatient Study (n=294)

Next day sleepiness/alertness scores, 4 week average

(0 to 9 scale: 0 = sleepiness, 9 = awake and alert)

Commercialization

Transcept maintains the worldwide commercial rights to its product candidates and plans to combine its own U.S. specialty sales and marketing team with the efforts of one or more marketing partners to sell products in the United States and elsewhere in the world. In the United States, IMS Health estimates that prescriptions for sleep products are written by a concentrated group of high prescribing psychiatrists and primary care physicians who in 2007 generated approximately 30% of the $4.3 billion prescription sleep aid market; and a larger group of primary care and other physicians whose prescribing accounts for the balance of the market.

The proposed Transcept Intermezzo^® launch strategy will contain the following key elements:

13

Table of Contents

Exploratory Clinical Development Programs

Transcept is seeking additional product opportunities that can be of importance in the field of neuroscience. In this regard, Transcept is evaluating drug product concepts for the treatment of OCD in patients who do not respond to conventional therapeutics alone. Atypical anti-psychotics have been shown to be useful in the treatment of OCD, and it is thought that drugs of this class, such as risperidone, currently marketed as Risperdal^® by Johnson & Johnson, may be effective through their action as dopamine antagonists. The Transcept strategy is to augment the dopamine antagonist effects of risperidone and other similar agents, with the dopamine down-regulation produced by ondansetron, currently marketed as Zofran^® by GlaxoSmithKline, to provide more effective treatments to control OCD in patients who are resistant to conventional therapies. Transcept has completed an open-label exploratory clinical study to examine the use of a range of low doses of risperidone and ondansetron in the treatment of this disorder. This study has yielded initial results that Transcept and its advisors believe to be encouraging and Transcept is currently evaluating product development strategies to pursue this opportunity.

In-Licensing

Transcept has an active in-licensing effort underway to identify and secure the rights to patents and development rights relating to the use of existing drugs in the field of neuroscience, and to identify and secure the rights to one or more approved products that can be effectively sold by the sales and marketing team Transcept is building. In this regard, in February 2008, Transcept submitted an application seeking the rights to patents filed by the National Institutes of Mental Health, a division of the National Institutes of Health, or NIH, relating to the use of intravenous and other dosage forms of scopolamine in the treatment of major depressive disorder. On August 4, 2008, NIH published in the U.S. Federal Register a “Prospective Grant of Exclusive License: The Development of Human Therapeutics for the Treatment of Depression,” providing notice of NIH intent to grant Transcept an exclusive license in this regard. This notice was subject to a comment period, and during that time an appeal was made by a competing company also seeking rights to this opportunity.

In February 2009, the NIH sent a further notice granting both Transcept and the competing company a co-exclusive license. Transcept intends to appeal this decision and continues to seek exclusive rights to the NIH patent applications relating to dosage forms of scopolamine in the treatment of major depressive disorder. There can be no assurance that negotiations with the NIH will lead to a mutually satisfactory licensing agreement.

Competition

If Intermezzo^® receives FDA marketing approval, it will compete against well-established products currently used in the treatment of insomnia, both branded and generic. Potentially competitive products include branded formulations of zolpidem, such as Ambien^® and Ambien CR^® marketed by Sanofi-Aventis, generic formulations of zolpidem, Lunesta^®, marketed by Sepracor, Inc., Rozerem^™, marketed by Takeda Pharmaceuticals Company Limited, Sonata^® , marketed by King Pharmaceuticals, Inc. and generic forms of this product, and a number of other pharmaceutical agents, including antidepressants and antipsychotics, that are

14

Table of Contents

prescribed off-label. None of the currently marketed sleep aids that have FDA approval are specifically approved for use in the middle of the night when patients awaken and have difficulty returning to sleep. However, many of these products can be used to prevent middle of the night awakenings by prophylactic use at bedtime.

The market for prescription sleep products has evolved significantly over the last 30 years. Until about 30 years ago, the market was dominated by barbiturate sedative-hypnotics such as Seconal^® and Nembutal^®. These were superseded by the benzodiazepine class of sedative-hypnotics including Dalmane^®, Restoril^™ and Halcion^®. Zolpidem, which is a more selective GABAa agonist and a member of the non-benzodiazepine class of sleep aids, was introduced in the United States in 1993 under the Ambien^® brand, and, according to IMS Health, rapidly achieved the dominant position in the prescription sleep aid market. The patent for Ambien expired in April 2007, and shortly thereafter the FDA approved generic manufacture of zolpidem by multiple pharmaceutical companies. The pricing of generically manufactured zolpidem is significantly lower than branded formulations of zolpidem and other non-generic sleep aids. Combined sales of generic zolpidem products accounted for approximately 42% of the U.S. prescription market for sleep aids. According to IMS Health, over one billion branded and generic zolpidem tablets were prescribed in the United States in 2008. An extended release version of zolpidem was launched successfully as Ambien CR^® in 2005, and, according to IMS Health, held a 10.0% U.S. prescription market share in December 2008.

Other branded prescription sleep aids include Lunesta^® (eszopiclone), marketed by Sepracor, Inc., which was approved in December 2004 by the FDA and launched in the first quarter of 2005, and Rozerem^™ (ramelteon), which is marketed by Takeda Pharmaceuticals Company Limited. Rozerem^™ is the only currently marketed prescription sleep aid of the melatonin agonist drug class, and was also introduced in 2005. According to IMS Health, in December 2008, Lunesta^® held a 7.7% U.S. prescription market share and Rozerem^™ held a 1.2% U.S. prescription market share.

There exist a number of other agents that are used to treat insomnia. These include Sonata^®, a short-acting sleep aid marketed by King Pharmaceuticals, Inc., which lost patent protection in June 2008. Although not specifically approved or promoted for the treatment of middle of the night awakenings, some physicians prescribe Sonata^® off-label for this purpose. There are also a number of other pharmaceutical agents including antidepressants and antipsychotics that are not approved for the treatment of insomnia but are frequently prescribed off-label owing to their ancillary sedative effects.

In addition to current products for the treatment of insomnia, a number of new prescription products may enter the insomnia market over the next several years. These may include the following:

15

Table of Contents

There are a variety of other drugs intended as sleep aids under earlier stages of development. With the exceptions of indiplon, and a possible new formulation of Zolpimist^™, as noted above, Transcept believes that all of these product candidates are intended to act for an extended seven to eight hour time period and are not being developed for as-needed treatment of middle of the night awakenings at the time they occur.

Manufacturing

Transcept does not have or intend to develop internal clinical supply or commercial manufacturing capabilities for Intermezzo^®, or other Transcept product candidates. Transcept has entered into an agreement with Patheon Inc., or Patheon, for the manufacture of the Intermezzo^® tablet. Transcept has also entered into agreements with Plantex USA, Inc., or Plantex, as the sole source supplier of a special form of zolpidem tartrate, a specially manufactured form of the active pharmaceutical ingredient of Intermezzo^®, and with SPI Pharma, Inc., or SPI, as a supplier of certain key excipients used in Intermezzo^®, one of which is sourced solely through SPI. Transcept has agreements with Anderson Packaging Inc., or Anderson, and Sharp Corporation, or Sharp, for packaging of Intermezzo^® and has entered into agreements with Mikart, Inc., or Mikart, to qualify them as a backup commercial supplier of finished product and as a backup commercial supplier of a key Intermezzo^® excipient. All of these supply and manufacturing agreements contain customary commercial terms for pharmaceutical companies regarding forecasting, payment, pricing, ordering, current good manufacturing practices, or cGMP, compliance and quality. All such agreements provide for Transcept to pay for supplies within 30 days of being invoiced upon their shipment, and, except for the agreements with Mikart as described below, none of these agreements contain minimum purchase requirements. Other than the agreements with Sharp and Patheon, all agreements set forth four quarters of forecasting, with the first such quarter’s forecast being a binding firm order. The agreements with Sharp and Patheon contain similar forecasting provisions, except that the Sharp agreement sets forth a 12-month rolling forecast, with the first three months of such forecast being a binding firm order, and the Patheon agreement sets forth 18-month, non-binding forecasting, but with a requirement that firm orders be separately placed three months prior to expected delivery. A further description of the termination provisions and certain other terms is set forth below.

Manufacturing Services Agreement with Patheon

In October 2006, Transcept entered into the Manufacturing Services Agreement with Patheon. Under the agreement, Transcept is required to obtain Intermezzo^® tablets from Patheon, provided that Transcept retains the ability to qualify a secondary supplier for a portion of its supply requirements from that secondary supplier. The initial term of the Manufacturing Services Agreement expires in December 2014, but is automatically renewed for three year periods, subject to 24 month prior notice of an election not to renew. The agreement is terminable prior to the end of term by either party for breach or insolvency of the other party, and by Transcept on 30 days’ notice in the event of regulatory prevention from, or six month notice for a determination by Transcept to cease, commercialization of Intermezzo^®, or upon 24 months’ prior notice for any business reason.

Supply Agreement with Plantex

In March 2006, Transcept entered into the Supply Agreement with Plantex. Under the agreement, Transcept is required to obtain specially manufactured zolpidem tartrate from Plantex, provided that Transcept retains the ability to qualify a secondary supplier for a portion of its supply requirements from that secondary supplier. The initial term of the Supply Agreement expires on the earlier to occur of five years from the launch of Intermezzo^®

16

Table of Contents

or ten years from the date of the agreement. The agreement is terminable prior to the end of the term by either party for breach or insolvency of the other party, and is terminable by Plantex upon 24 months’ prior notice if Plantex discontinues production of a special form of zolpidem tartrate.

Agreements with SPI

In June 2006 and in July 2007, Transcept entered into a Supply and License Agreement and a Supply Agreement, respectively, with SPI, each for the manufacture of certain excipients used in the manufacture of Intermezzo^®. Under the Supply Agreement, Transcept is required to obtain the excipient, referred to as buffered soda, that is covered by such agreement from SPI, provided that Transcept retains the ability to qualify a secondary supplier for a portion of its supply requirements from that secondary supplier. In addition, the Supply Agreement contains a license for patent rights with regard to buffered soda. Such license is described further in the section entitled “Transcept Business—Intellectual Property and Proprietary Technology.”

The term of the Supply and License Agreement initially was set to expire five years from the date of such agreement, but was amended in March 2008 to extend the term to ten years from the original date of the agreement. This agreement is terminable prior to the end of the term by either party for breach or insolvency of the other party.

The initial term of the Supply Agreement expires on the earlier to occur of the 10^th anniversary of commercial sale of Intermezzo^® or the 13^th anniversary of the date of the agreement. This agreement is terminable prior to the end of the term by either party for breach or insolvency of the other party, and is terminable by SPI on 90 days’ notice if minimum purchase requirements are not met after 2010, or upon 12 months’ notice with such termination not being effective until the third anniversary of certain qualifications of an alternate supplier.

Packaging and Supply Agreement with Anderson

In September 2006, Transcept entered into a Packaging and Supply Agreement with Anderson. The initial term of the Packaging and Supply Agreement expires on the fifth anniversary of the execution of the agreement, and thereafter automatically renews for one year periods unless one year prior notice is given by either party of an intent not to renew. This agreement is terminable prior to the end of the term by either party for breach or insolvency of the other party.

Packaging and Supply Agreement with Sharp

In June 2008, Transcept entered into a Packaging and Supply Agreement with Sharp. The initial term of the Packaging and Supply Agreement expires on the fifth anniversary of the approval by the FDA of the NDA for Intermezzo^®, and is renewable for three year terms upon mutual agreement of Transcept and Sharp prior to 180 days before the end of the then current term. This agreement is terminable prior to the end of the term by either party for breach or insolvency of the other party.

Agreements with Mikart

In January 2008, Transcept entered into a Supply and Sublicense Agreement with Mikart. Pursuant to the terms of the Supply and Sublicense Agreement, Transcept granted to Mikart a non-exlusive sublicense in accordance with the terms of the Supply Agreement between Transcept and SPI described above to allow Mikart to act as a back-up supplier of buffered soda. Such agreement requires Transcept to purchase at least two batches of buffered soda (a total of approximately 420 kilograms) from Mikart within 24 months following the initial commercial sale of Intermezzo^®, with the first such batch required to be purchased within 12 months of such date. The term of the Supply and Sublicense Agreement expires on the earlier to occur of the 10^th anniversary of the first commercial sale of Intermezzo^® or the 13^th anniversary of the date of the agreement. This agreement may

17

Table of Contents

be terminated prior to the end of the term by either party for breach by the other party, or by Transcept if certain preparation activities are not completed within a year of the date of the agreement. In addition, Transcept can terminate the agreement upon 45 days’ prior notice to Mikart, and payment to Mikart of a termination fee, at any time after the second anniversary of the first commercial sale of Intermezzo^®.

In August 2008, Transcept entered into a Manufacturing and Supply Agreement with Mikart for back-up supply of manufactured Intermezzo^® tablets. Within the first 12 months after the FDA qualifies and approves Mikart as a supplier of Intermezzo^® tablets, such agreement requires Transcept to purchase at least three batches of tablets from Mikart, with any individual batch either containing 1.75 mg of zolpidem (in which case a batch means 500,000 tablets) or 3.5 mg of zolpidem (in which case a batch means 1,500,000 tablets). Mikart and Transcept may also mutually agree on an alternate number of Intermezzo^® tablets constituting a batch for purposes of such agreement. The term of the Manufacturing and Supply Agreement expires on the 10^th anniversary of FDA qualification and approval of Mikart as a supplier of Intermezzo^® tablets, but is automatically renewed for three year periods, subject to 18-month prior notice of an election not to renew. This agreement may be terminated prior to the end of the term by either party for breach by the other party, or by Transcept if the FDA does not qualify Mikart as a supplier of Intermezzo^® tablets.

Manufacturers and suppliers of Transcept product candidates are subject to current cGMP requirements, U.S. Drug Enforcement Administration, or DEA, regulations and other rules and regulations prescribed by foreign regulatory authorities. Transcept depends on its third party suppliers and manufacturers for continued compliance with cGMP requirements and applicable foreign standards. Transcept has identified alternates for certain of the above-listed suppliers and plans to have such alternate suppliers qualified by the FDA and other regulatory authorities after potential approval of the Intermezzo^® NDA.

Government Regulation

Prescription drug products are subject to extensive regulation by the FDA, including regulations that govern the testing, manufacturing, safety, efficacy, labeling, storage, record keeping, distribution, import, export, advertising and promotion of such products under the Federal Food Drug and Cosmetic Act, or FFDCA, and its implementing regulations, and by comparable agencies and laws in foreign countries. Failure to comply with applicable FDA or other regulatory requirements may result in a variety of administrative or judicially imposed sanctions, including FDA refusal to approve pending applications, suspension or termination of clinical trials, Warning Letters, civil or criminal penalties, recall or seizure of products, partial or total suspension of production or withdrawal of a product from the market.

FDA approval is required before any new unapproved drug, including a new use or new dosage form of a previously approved drug, can be marketed in the United States. All applications for FDA approval must contain, among other things, information relating to safety and effectiveness, pharmaceutical formulation, stability, manufacturing, processing, packaging and labeling.

New Drug Approval

A new drug approval by the FDA generally involves, among other things:

18

Table of Contents

The preclinical and clinical testing and approval process requires substantial time, effort and financial resources, and Transcept cannot be certain that any approvals for its product candidates or any indications will be granted on a timely basis, if at all.

Preclinical tests include laboratory evaluation of product chemistry, formulation and stability, as well as studies to evaluate toxicity in animals. The results of preclinical tests, together with manufacturing information and analytical data, are submitted as part of an IND to the FDA. The IND automatically becomes effective 30 days after acceptance by the FDA, unless the FDA, within the 30 day time period, raises concerns or questions about the conduct of the clinical trial, including concerns that human research subjects will be exposed to unreasonable health risks. In such a case, the IND sponsor and the FDA must resolve any outstanding concerns before the clinical trial can begin. The submission of an IND may not result in FDA authorization to commence a clinical trial. Further, an independent institutional review board, or IRB, for each medical center proposing to conduct the clinical trial must review and approve the plan for any clinical trial before it commences at that center and it must monitor the study until completed. The FDA, the IRB, or the sponsor may suspend a clinical trial at any time on various grounds, including a finding that the subjects or patients are being exposed to an unacceptable health risk. Clinical testing also must satisfy extensive Good Clinical Practice, or GCP, regulations, including regulations for obtaining informed consent by each patient.

For purposes of an NDA submission and approval, human clinical trials are typically conducted in the following four sequential phases, which may overlap:

Controlled clinical trials conducted for Transcept drug candidates must be included in a clinical trials registry database that is available and accessible to the public through the internet. Failure to properly participate in the clinical trial database registry could result in significant civil monetary penalties.

The submission of an NDA is no guarantee that the FDA will find it complete and accept it for filing. The FDA reviews all NDAs submitted before it accepts them for filing. It may refuse to file the application and

19

Table of Contents

request additional information rather than accept the application for filing, in which case, the application must be resubmitted with the supplemental information. After the application is deemed filed by the FDA, agency staff of the FDA will review an NDA to determine, among other things, whether a product is safe and efficacious for its intended use.

In 1992, under the Prescription Drug User Fee Act, or PDUFA, the FDA agreed to specific goals for improving the drug review time and created a two-tiered system of review times—Standard Review and Priority Review. Standard Review is applied to a drug that offers at most, only minor improvement over existing marketed therapies. The 2007 amendments to PDUFA set a goal that a Standard Review of an NDA be accomplished within a ten-month timeframe. A Priority Review designation is given to drugs that offer major advances in treatment, or provide a treatment where no adequate therapy exists. The goal of the FDA for completing a Priority Review is six months. The FDA strives to, and usually does, meet these review goals, but is not legally required to do so in every case. Transcept believes that the review of the Intermezzo^® NDA will be a Standard Review. The review process is often significantly extended by FDA requests for additional information or clarification. The FDA has substantial discretion in the approval process and may disagree with an applicant’s interpretation of the data submitted in its NDA. As part of this review, the FDA may refer the application to an advisory committee for review, evaluation and recommendation as to whether the application should be approved. The FDA is not bound by the recommendation of an advisory committee, but it generally follows such recommendations. The FDA may deny approval of an NDA if the applicable regulatory criteria are not satisfied, or it may require additional clinical data or additional pivotal Phase 3 clinical trials. Even if such data are submitted, the FDA may ultimately decide that the NDA does not satisfy the criteria for approval. Data from clinical trials may be subject to different interpretation, and the FDA may interpret data differently than Transcept. Under new legislation in 2007 that granted significant new powers to the FDA, many of which are aimed at improving the safety of drug products before and after approval, the FDA may determine that a risk evaluation and mitigation strategy, or REMS, is necessary to ensure that the benefits of a new product outweigh its risks. If required, a REMS may include various elements, such as publication of a medication guide, patient package insert, a communication plan to educate healthcare providers of the drug’s risks, limitations on who may prescribe or dispense the drug, or other measures that the FDA deems necessary to assure the safe use of the drug.

Once the NDA is approved, the FDA may withdraw product approval if ongoing regulatory requirements are not met or if safety problems occur after the product reaches the market. In addition, the FDA may require testing, including Phase 4 studies, and surveillance programs to monitor the effect of approved products which have been commercialized, and the FDA has the power to prevent or limit further marketing of a product based on the results of these post-marketing programs. Drugs may be marketed only for the approved indications and in accordance with the provisions of the approved label. Further, if there are to be any material modifications to the drug, including changes in indications, labeling, or manufacturing processes or facilities, Transcept will likely be required to submit and obtain FDA approval of a new or supplemental NDA, which may require Transcept to develop additional data or conduct additional and extensive preclinical studies and clinical trials.

Section 505(b)(2) New Drug Applications

As an alternate path to FDA approval for modifications of products previously approved by the FDA, an applicant may submit an NDA under Section 505(b)(2) of the FFDCA. Section 505(b)(2) was enacted as part of the Drug Price Competition and Patent Term Restoration Act of 1984, also known as the Hatch-Waxman Act. This statutory provision permits the filing of an NDA where at least some of the information required for approval comes from studies not conducted by or for the applicant and for which the applicant has not obtained a right of reference from the owner of the data. The Hatch-Waxman Act permits the applicant to rely upon the FDA findings of safety and effectiveness of a drug that has obtained FDA approval based on preclinical or clinical studies conducted by others. In addition to relying on FDA prior findings of safety and effectiveness for a referenced drug product, the FDA may require companies to perform additional preclinical or clinical studies to support approval of the modification to the referenced product. Transcept has submitted the initial NDA for

20

Table of Contents

Intermezzo^®, which was accepted for filing on December 15, 2008, under Section 505(b)(2), and relies on the extensive information that has been collected for immediate release zolpidem products, which contain the approved active drug agent that is incorporated in Intermezzo^®. To the extent that a Section 505(b)(2) application relies on a prior FDA finding of safety and effectiveness of a previously-approved product, the applicant is required to certify to the FDA concerning any patents listed for the referenced product in the FDA publication called “Approved Drug Products with Therapeutic Equivalence Evaluations,” otherwise known as the “Orange Book.” Specifically, the applicant must certify in the application that:

In the Intemezzo^® NDA that was accepted for filing on December 15, 2008, Transcept has made appropriate certification based on the listed and unexpired patents, if any, for the referenced drug product. Currently, there are no unexpired patents for immediate release zolpidem products listed in the Orange Book.

In the event that one or more patents is listed in the Orange Book for the referenced product, including patents listed after Transcept submitted its NDA for Intermezzo^®, Transcept may also be required to evaluate the applicability of these patents to Intermezzo^® and submit additional patent certifications. A paragraph III certification, stating that a listed patent has not expired, but will expire on a particular date, may delay the approval of Intermezzo^® until the expiration of the patent. A paragraph IV certification, stating that a listed patent is invalid, unenforceable, or not infringed by Intermezzo^® may require Transcept to notify the patent owner and the holder of the NDA for the referenced product of the existence of the Intermezzo^® NDA, and may result in patent litigation against Transcept and the entry of a 30-month stay of FDA ability to issue final approval to the Intermezzo^® 505(b)(2) NDA.

If Transcept obtains FDA approval for Intermezzo^® it could obtain three years of Hatch-Waxman marketing exclusivity. Under this form of exclusivity, the FDA would be precluded from approving a marketing application for a duplicate of Intermezzo^®, a product candidate that the FDA views as having the same conditions of approval as Intermezzo^® (for example, the same indication, the same route of delivery and/or other conditions of use), or a 505(b)(2) NDA submitted to FDA with Intermezzo^® as the reference drug, for a period of three years from the date of Intermezzo^® approval, although the FDA may accept and commence review of such applications. This form of exclusivity may not prevent the FDA from approving an NDA that relies only on its own data to support the change or innovation. Further, if another company obtains approval for a product candidate for the same conditions of approval that Transcept is studying for Intermezzo^® before Intermezzo^® received approval, the Intermezzo^® approval could be blocked until the other company’s three-year Hatch-Waxman marketing exclusivity expires.

Manufacturing cGMP Requirements

Transcept and its contract manufacturers are required to comply with applicable FDA manufacturing requirements contained in the FDA cGMP regulations. cGMP regulations require, among other things, quality control and quality assurance as well as the corresponding maintenance of records and documentation. The manufacturing facilities for active pharmaceutical ingredients, or APIs, and finished drug products must meet cGMP requirements to the satisfaction of the FDA, and pass a pre-approval inspection before Transcept can use them to manufacture its products. Transcept and its third-party manufacturers are also subject to periodic inspections of facilities by the FDA and other authorities, including inspection of the procedures and operations used in the testing and manufacture of Transcept products to assess continued compliance with applicable regulations.

21

Table of Contents

The API used to manufacture some of our product candidates originates outside the United States. The FDA could increase its diligence with regard to foreign sourced materials and manufacturing processes which may result in increased costs of maintaining foreign manufacturing and could lengthen or delay the regulatory review process required to gain approval for our product candidates.

Failure to comply with statutory and regulatory requirements subjects a manufacturer to possible legal or regulatory action, including adverse publicity, Warning Letters, the seizure or recall of products, injunctions, consent decrees placing significant restrictions on or suspending manufacturing operations, and civil and criminal penalties. Adverse patient experiences with the product received by Transcept must be reported to the FDA and could result in the imposition of market restriction through labeling changes or in product removal. Product approvals may be withdrawn if compliance with regulatory requirements is not maintained or if problems concerning safety or efficacy of the product occur following approval.

Other Regulatory Requirements

With respect to post-market product advertising and promotion, the FDA imposes a number of complex regulations on entities that advertise and promote pharmaceuticals, which include, among others, standards for direct-to-consumer advertising, industry-sponsored scientific and educational activities, and promotional activities involving the internet, as well as a prohibition on off-label promotion. The FDA has very broad enforcement authority under the FFDCA, and failure to abide by these regulations can result in penalties, including the issuance of a Warning Letter directing entities to correct deviations from FDA standards, a requirement that future advertising and promotional materials be pre-cleared by the FDA, and state and federal civil and criminal investigations and prosecutions. Numerous other laws, not administered by the FDA, also apply to the promotion of pharmaceuticals, alleged violations of which may also result in state and federal civil and criminal investigation and prosecutions.

Transcept is also subject to various laws and regulations regarding laboratory practices, the experimental use of animals, and the use and disposal of hazardous or potentially hazardous substances in connection with Transcept activities. In each of these areas, as above, the FDA and other agencies have broad regulatory and enforcement powers, including the ability to levy fines and civil penalties, suspend or delay issuance of approvals, seize or recall products, and withdraw approvals, any one or more of which could have a material adverse effect on Transcept.

DEA Regulation

Zolpidem, the active pharmaceutical ingredient in Intermezzo^®, is classified as a schedule IV controlled substance by the DEA. As a result, manufacturing of zolpidem is subject to regulation by the DEA. Controlled substances are those drugs that appear on one of five schedules promulgated and administered by the DEA under the Controlled Substances Act, or CSA. The CSA governs, among other things, the distribution, record keeping, handling, security, and disposal of controlled substances. Transcept, as well as third-party suppliers of Transcept who handle zolpidem, must be registered by the DEA in order to engage in these activities, and are subject to periodic and ongoing inspections by the DEA and similar state drug enforcement authorities to assess ongoing compliance with DEA regulations. Any failure by Transcept or its third party suppliers to comply with these regulations could lead to a variety of sanctions, including the revocation, or a denial of renewal, of DEA registration, injunctions, or civil or criminal penalties and loss of supply.

Third-Party Reimbursement and Pricing Controls

In the United States and elsewhere, sales of pharmaceutical products depend in significant part on the availability of coverage and reimbursement to providers and the consumer from third-party payors, such as government and private insurance plans. Third-party payors are increasingly challenging the prices charged for

22

Table of Contents

medical products and services. Transcept products may not be considered cost effective, and coverage and reimbursement may not be available or sufficient to allow sales of Transcept products on a competitive and profitable basis.

In the United States, there have been, and Transcept expects that there will continue to be, a number of federal and state proposals to implement similar governmental pricing control. While Transcept cannot predict whether such legislative or regulatory proposals will be adopted, the adoption of such proposals could have a material adverse effect on the business, financial condition and profitability of Transcept.

Medicare

Two principal payors in the United States are Medicaid and Medicare. Transcept expects that in the United States many patients who are treated with Intermezzo^® will be Medicare beneficiaries. The Centers for Medicare and Medicaid Services, or CMS, is the agency within the Department of Health and Human Services that administers both Medicare and Medicaid. CMS has the authority not to cover particular products or services if it determines that they are not “reasonable and necessary” for the treatment of Medicare beneficiaries. CMS may make a national coverage determination, or NCD, for a product, which establishes on a nationwide basis the indications that will be covered, and any restrictions or limitations. However, for most new drugs that are eligible for payment, CMS does not create an NCD, and Transcept does not plan to request one. Nevertheless, CMS or a third party may request an NCD independent of Transcept. If such request is made, Transcept can not assure investors that such NCD will contain favorable coverage terms.

If there is no NCD, the local Medicare contractors that are responsible for administering the program on a state or regional basis have the discretion to deny coverage and reimbursement for the drug or issue a local coverage determination, or LCD. These LCDs can include both coverage criteria for the drug and frequency limits for the administration of the drug. Overturning restrictive LCDs in the various regions can be a time-consuming and expensive process.

Effective January 1, 2006, Congress enacted a prescription drug benefit known as Medicare Part D. CMS contracts with numerous managed care plans and drug benefit plans to deliver the drug benefit. These plans develop formularies that determine which products are covered and at what co-pay level. If Medicare coverage for Intermezzo^® is available, CMS will reimburse through Part D. While CMS evaluates Part D plans’ proposed formularies for potentially discriminatory practices, the plans have considerable discretion in establishing formularies, establishing tiered co-pay structures and placing prior authorization and other restrictions on the utilization of specific products. Moreover, Part D plan sponsors are permitted and encouraged to negotiate rebates with manufacturers. Revenue for Intermezzo^® will be substantially affected by its formulary status on Part D plans and the rebates that Part D plan sponsors are able to negotiate.

Medicaid

Medicaid is a federal and state entitlement program that pays for medical assistance for certain individuals and families with low incomes and resources and who meet other eligibility requirements. Medicaid became law in 1965 and is jointly funded by the federal and state governments (including the District of Columbia and the territories) to assist states in furnishing medical assistance to eligible needy persons. Medicaid is the largest source of funding for medical and health-related services for the indigent population of the United States.

Transcept expects Intermezzo^® to be eligible for reimbursement under Medicaid and, therefore, subject to rebates under the Medicaid Drug Rebate Program established by the Omnibus Budget Reconciliation Act of 1990. Under the Medicaid Drug Rebate Program, Transcept would pay a rebate to each participating state agency for each unit of product reimbursed by Medicaid. The basic amount of the rebate for each product is the greater of 15.1% of the Average Manufacturer Price (AMP) of that product, or the difference between AMP and the best price available from Transcept to any non-excluded customer. The rebate amount also includes an inflation

23

Table of Contents

adjustment if AMP increases faster than a specified inflation index. The rebate amount is calculated quarterly based on Transcept reports of its current AMP and best price for each of its products to CMS. AMPs and best price may be recalculated after they are initially submitted based on the availability of additional data or because of additional analysis of prices that have been reported.

Several state Medicaid programs have implemented Preferred Drug Lists, or PDLs, and more states may adopt this practice. Products placed on a state Medicaid program’s PDL are not subject to restrictions on their utilization by Medicaid patients, such as the need to obtain authorization prior to prescribing. If Intermezzo^® is not included on Medicaid PDLs, use of it in the Medicaid program may be adversely affected. In some states that have adopted PDLs, Transcept may be required to provide substantial supplemental rebates to state Medicaid authorities in order for Intermezzo^® to be included on the PDL.

Pharmaceutical manufacturers, as a condition of participation in the Medicaid Drug Rebate Programs, must enter into an agreement with the Secretary of the Department of Health and Human Services to participate in the 340B program, enacted by the PHS Act. Under the 340B programs pharmaceutical manufacturers are required to extend discounts based on the Medicaid rebate to a variety of health care entities referred to as covered entities. These covered entities include health care providers that receive health services grants from the PHS, as well as certain hospitals that serve a disproportionate share of Medicare and Medicaid beneficiaries.

Section 603 of the Veteran’s Health Care Act of 1992 requires manufacturers of covered drugs to enter into a master agreement with the Secretary of the Department of Veteran Affairs, or VA, in order to have their drugs covered under Medicaid. The master agreement requires the manufacturer to make its products available for federal procurement by listing them on the Federal Supply Schedule. In addition, the master agreement requires the manufacturer to enter into a Pharmaceutical Pricing Agreement, or PPA, with the VA. Under the PPA, the manufacturer agrees to sell its drugs to the “Big Four” federal agencies—the VA, the Department of Defense, the PHS and the Coast Guard—at or below a Federal Ceiling Price, which is set at 76% of a calculation called the Non-Federal Average Manufacturer Price (non-FAMP), minus an additional discount.

Another source of reimbursement for drug products is state Pharmaceutical Assistance Programs, or SPAPs. Many of these programs were created by states to aid low-income elderly or persons with disabilities who do not qualify for Medicaid. Transcept would pay rebates to some SPAPs and, if they are considered qualified programs by CMS, the prices Transcept provided these entities would be excluded from the Medicaid best price of Transcept.

Private Insurance Reimbursement

Commercial insurers usually offer pharmacy benefits. If private insurers decide to cover Intermezzo^®, they will reimburse for the drug in a variety of ways, depending on the insurance plan’s policies, employer and benefit manager input and contracts with their physician network. Private insurers tend to adopt reimbursement methodologies for a product similar to those adopted by Medicare. Revenue for Intermezzo^® may be materially and adversely affected if private payors make unfavorable reimbursement decisions or delay making favorable reimbursement decisions.

The continuing efforts of government and third-party payors to contain or reduce the costs of health care through various means may reduce potential revenues Transcept may receive from sales of Intermezzo^®, if approved. These payers’ efforts could decrease the price that Transcept receives for products it may sell, including Intermezzo^®. In addition, third-party insurance coverage may not be available to patients for Transcept products at all, especially in light of the availability of low-cost generic zolpidem therapeutics, regardless of the fact that such products are not designed or indicated to treat middle of the night awakenings. Third-party payors could also impose conditions that must be met by patients prior to providing coverage for use of Transcept products. For instance, insurers may establish a “step-edit” system that requires a patient to utilize a lower price alternative product prior to becoming eligible to purchase a higher price product that may be better targeted to the

24

Table of Contents

condition being treated. There can be no assurance that third-party payors will not similarly require a patient to first use generic zolpidem or other sleep aids prior to being eligible for insurance coverage of Intermezzo^® use.

If government and third-party payors do not provide adequate coverage and reimbursement levels for Transcept products, or if price controls or step-edit systems are enacted, Transcept product revenues will suffer.

Intellectual Property and Proprietary Technology

The success of Transcept will depend in part on its ability to protect Intermezzo^® and future products and product candidates by obtaining and maintaining a strong proprietary position both in the United States and in other countries. To develop and maintain its proprietary position, Transcept will rely on patent protection, regulatory protection, trade secrets, know-how, continuing technological innovations and licensing opportunities.

The active and many of the inactive ingredients in Intermezzo^® have been known and used for many years and, therefore, are no longer subject to patent protection. Accordingly, pending patent applications of Transcept are directed to the particular formulations and methods of use of zolpidem, the API in Intermezzo^®. There can be no assurance that these applications will result in patents being issued, and, even if issued, such patents may not prevent others from marketing formulations using the same active and inactive ingredients in similar but different formulations. Currently pending patent applications that cover Intermezzo^® have claims that are directed to both formulation and methods of use and are summarized below:

In addition to the applications directed to Intermezzo^®, Transcept has filed patent applications for various other formulations and methods of use of drugs including sumatriptan, pilocarpine, ondansetron, and ondansetron in combination with atypical antipsychotic drugs. Transcept currently has no plans to pursue development of products relating to the sumatriptan, pilocarpine and ondansetron patents, but is evaluating opportunities relating to ondansetron in combination with atypical antipsychotic drugs. These applications are summarized below.

The patent positions of pharmaceutical companies like Transcept are generally uncertain and involve complex legal, scientific and factual questions. In addition, the coverage claimed in a patent application can be significantly reduced before the patent is issued. Consequently, Transcept does not know whether any of its patent applications will result in the issuance of patents or, if any patents are issued, whether they will provide significant proprietary protection or will be circumvented or challenged and found to be unenforceable or invalid. In limited instances, patent applications in the United States and certain other jurisdictions are maintained in

25

Table of Contents

secrecy until patents issue, and since publication of discoveries in the scientific or patent literature often lags behind actual discoveries, Transcept cannot be certain of the priority of inventions covered by pending patent applications. Moreover, Transcept may have to participate in interference proceedings declared by the U.S. Patent and Trademark Office to determine priority of invention or in opposition proceedings in a foreign patent office, any of which could result in substantial cost to Transcept, even if the eventual outcome is favorable. There can be no assurance that a court of competent jurisdiction would hold the patents, if issued, valid. An adverse outcome could subject Transcept to significant liabilities to third parties, require disputed rights to be licensed from third parties or require Transcept to cease using such technology. To the extent Transcept determines it to be prudent, Transcept intends to bring litigation against third parties that Transcept believes are infringing its patents.

Transcept also relies on trade secret protection for its confidential and proprietary information. No assurance can be given that others will not independently develop substantially equivalent proprietary information and techniques or otherwise gain access to Transcept trade secrets or disclose such technology or that Transcept can meaningfully protect its trade secrets. However, Transcept believes that the substantial costs and resources required to develop technological innovations will help it protect Transcept products.

Transcept requires its employees, consultants and members of its scientific advisory board to execute confidentiality agreements upon the commencement of employment, consulting or collaborative relationships with Transcept. These agreements provide that all confidential information developed or made known during the course of the relationship with Transcept be kept confidential and not disclosed to third parties except in specific circumstances. In the case of employees, the agreements provide that all inventions resulting from work performed for Transcept, utilizing the property or relating to the business of Transcept and conceived or completed by the individual during employment shall be the exclusive property of Transcept to the extent permitted by applicable law. There can be no assurance, however, that these agreements will provide meaningful protection or adequate remedies for Transcept trade secrets in the event of unauthorized use or disclosure of such information.

Employees

As of January 30, 2009 Transcept had 33 employees, 6 of whom hold Ph.D., Pharm.D., or equivalent degrees. A total of 19 employees were engaged in research and development, 3 were in sales, marketing and business development, and 11 were in administration and finance. No Transcept employees are represented by a labor union or subject to a collective bargaining agreement. Transcept has not experienced any work stoppages and considers its relations with its employees to be good.

Available Information

Availability of Reports. Transcept is a reporting company under the Securities Exchange Act of 1934, as amended, and files reports, proxy statements and other information with the SEC. The public may read and copy any of our filings at the SEC’s Public Reference Room at 100 F Street N.E., Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Because Transcept makes filings to the SEC electronically, you may access this information at the SEC’s Internet site: www.sec.gov. This site contains reports, proxies and information statements and other information regarding issuers that file electronically with the SEC.

Web Site Access. Our Internet web site address is www.transcept.com. Transcept makes available, free of charge at the “Investor Relations” portion of this web site, annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the 1934 Act as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Reports of beneficial ownership filed pursuant to Section 16(a) of the 1934 Act are also available on this web site. Information in, or that can be accessed through, this web site is not part of this annual report on Form 10-K.

26

Table of Contents

In evaluating the business of Transcept, you should carefully consider the following risks in addition to the other information in this report. Any of the following risks could materially and adversely affect Transcept business, results of operations, financial condition or your investment in Transcept securities, and many are beyond Transcept control. It is not possible to predict or identify all such factors and, therefore, you should not consider any of the above risks to be a complete statement of all the potential risks or uncertainties that Transcept faces.

In the following discussion, “Transcept” refers to the public company formerly known as Novacea, Inc. and now known as Transcept Pharmaceuticals, Inc., and (as successor to the business of the private company formerly known as Transcept Pharmaceuticals, Inc., or TPI, that is now the wholly owned subsidiary of Transcept following the merger of TPI and Novacea) also relates to activities taking place with respect to the business of TPI prior to the merger of TPI and Novacea. For further discussion of the merger of TPI and Novacea, see the section entitled “Business—Background and Merger of Novacea, Inc. and Transcept Pharmaceuticals, Inc.”

Transcept has had a brief operating history that may make it difficult for you to evaluate the potential success of its business and has a history of incurring losses.

Transcept was founded in January 2001 under its former name Novacea, Inc., and in January 2009 underwent a merger with TPI, a private company founded in 2002 whose business is currently conducted by Transcept. Transcept, in continuing the business of TPI, remains a development stage company. Transcept operations to date have been limited to organizing and staffing, acquiring, developing and securing its technology and undertaking preclinical studies and clinical trials. Transcept has not yet demonstrated an ability to obtain regulatory approval and manufacture marketed products to U.S. Food and Drug Administration, or FDA, and other regulatory standards or to conduct sales and marketing activities. Consequently, any predictions you make about the future success or viability of Transcept may not be as accurate as they would be if Transcept had a longer operating history.

Furthermore, the business of Transcept that is being continued from TPI is not profitable and has incurred losses in each year since its inception. TPI net loss for the years ended December 31, 2008, 2007 and 2006 was $20.0 million, $20.4 million and 13.6 million, respectively. As of December 31, 2008, TPI had an accumulated deficit of $65.1 million. Transcept expects to continue to incur losses for the foreseeable future, and expects its accumulated deficit to increase as it continues its research, development and commercialization efforts with respect to Intermezzo^® and other product candidates. If Intermezzo^® or other Transcept product candidates do not gain or maintain regulatory approval or market acceptance, Transcept may never become profitable or may not be able to sustain profitability, even if achieved.

The success of Transcept depends substantially on its ability to obtain regulatory approval for its lead product candidate, Intermezzo^®.

The success of Transcept depends substantially on obtaining regulatory approval for its most advanced product candidate, Intermezzo^®, for use as needed for the treatment of insomnia when a middle of the night awakening is followed by difficulty returning to sleep, or middle of the night awakening. Regulatory approval to market pharmaceutical products in the United States requires the completion of extensive non-clinical and clinical evaluations of a product candidate, referred to as clinical trials, to demonstrate substantial evidence of safety and efficacy of the candidate, as well as development of manufacturing processes that demonstrate the ability to reliably and consistently produce the candidate under current Good Manufacturing Practice, or cGMP, regulations. Each of these elements requires pharmaceutical development companies to exercise certain judgments concerning applicable regulatory requirements and to predict what the regulatory authority will ultimately deem acceptable. There can be no assurance that the results of the clinical trials for Intermezzo^® or its

27

Table of Contents

manufacturing processes will satisfy the regulatory requirements for approval. A failure to meet these requirements would significantly delay or prevent approval of Intermezzo^® and seriously harm the ability of Transcept to generate revenue.

The FDA required Transcept to complete at least two adequate and well-controlled Phase 3 clinical trials for the Intermezzo^® indication before submission of a New Drug Application, or NDA. These trials were completed, and Transcept submitted the NDA for Intermezzo^® on September 30, 2008, which was accepted for filing on December 15, 2008. Although Transcept analyses of the two Phase 3 studies of Intermezzo^® indicated that their primary endpoints were met, the FDA may not agree with these analyses and may require that Transcept complete additional expensive and time consuming studies or perform other testing to support an approval. In addition, although the FDA agreed to accept pharmacokinetic data for approval of the 1.75 mg elderly dose, the FDA may change its position during the course of its NDA review.

The FDA has not approved a pharmaceutical product specifically to treat middle of the night awakening. There can be no assurance that the FDA will approve this new indication within the insomnia category, or that the FDA will not require additional clinical trials for one or both doses, or for special population subgroups, to support potential marketing approval for Intermezzo^® in this new indication. While Transcept believes that the results of the clinical trials for Intermezzo^® meet FDA guidance to support potential approval of Intermezzo^®, the FDA may not agree or may reconsider its guidance, require more clinical trials or otherwise require additional data or studies to justify this new indication in the insomnia market for which approval of Intermezzo^® is being sought. If Transcept does not obtain regulatory approval for Intermezzo^® specifically to treat middle of the night awakening, the ability of Transcept to market Intermezzo^® will be eliminated or substantially impaired, and the business of Transcept will suffer.

Transcept is seeking approval for Intermezzo^® under Section 505(b)(2) of the Federal Food, Drug and Cosmetic Act, which permits applicants to rely in part on clinical and non-clinical data generated by third parties. Specifically, Transcept is relying in part on third party data with respect to zolpidem, which is the active ingredient in Intermezzo^® and the previously approved insomnia products Ambien^® and Ambien CR^®. There can be no assurance that the FDA will not require Transcept to conduct additional non-clinical or clinical studies or otherwise obtain new supplementary data with respect to some or all of the data upon which Transcept intends to rely.

In addition, Transcept has limited experience in preparing, submitting and prosecuting regulatory filings, including NDAs and other applications necessary to gain regulatory approvals. If Transcept does not receive regulatory approval from the FDA, Transcept will not be able to commercialize Intermezzo^® in the United States. Further, if the FDA delays approval as a result of requirements to conduct additional clinical studies, commercialization of Intermezzo^® could be significantly delayed. Significant delay or the inability to commercialize Intermezzo^® in the United States would significantly harm Transcept business and financial prospects.

If Transcept is unable to establish a sales, marketing and distribution infrastructure or enter into strategic alliances to perform these functions, it may not be successful in commercializing its product candidates.

In order to commercialize Intermezzo^® or any other product candidates successfully, Transcept must acquire or internally develop a sales, marketing and distribution infrastructure and/or enter into strategic alliances to perform these services. Transcept intends to develop its own specialty sales force to initially target high prescribers of sleep medicines, but has no experience in building a sales and marketing organization. The development of sales, marketing and distribution infrastructure is difficult, time consuming and requires substantial financial and other resources. If Transcept cannot successfully develop the infrastructure to market and commercialize Intermezzo^®, its ability to generate revenues may be harmed, and Transcept may be required to enter into strategic alliances to have such activities carried out on its behalf, which may not be on favorable terms. Factors that may hinder Transcept efforts to develop an internal sales, marketing and distribution infrastructure include:

28

Table of Contents

Transcept intends to enter into one or more strategic alliances to further address the U.S. market and to potentially address markets outside the United States. Transcept may not be able to enter into any such alliance on acceptable terms, if at all, and may face competition in its search for alliance partners. If Transcept is not able to collaborate with an alliance partner, its efforts to commercialize Intermezzo^® may be less successful.

Transcept may require substantial additional funding and may be unable to raise capital when needed.

TPI had cash, cash equivalents and marketable securities of $11.7 million at December 31, 2008. Transcept estimated in connection with its recently completed merger that the combined cash, cash equivalents and marketable securities of TPI and Novacea on January 30, 2009 was estimated to be approximately $92 million. Subsequent to the close of the merger in the first quarter of 2009, Transcept paid financial advisory fees incurred in connection with the merger of $2.0 million and retired in full all remaining debt of TPI owed to Hercules Technology Growth Capital for $2.7 million. For the year ended December 31, 2008, TPI used cash of $20.1 million in operating activities. Transcept expects its negative cash flows from operations to continue for the foreseeable future and beyond potential regulatory approval and product launch of Intermezzo^®. Transcept expects that negative cash flows from operations will increase relative to its historic use of cash as a result of additional administrative, accounting, and legal costs associated with being a public company. In addition, Transcept expects to incur substantial expenses relating to the potential commercial launch of Intermezzo^®. If management’s assumptions concerning the timing of potential product approval and launch prove incorrect as a result of FDA or other regulatory approval delays or other factors, the cash, cash equivalents and marketable securities of Transcept may prove insufficient to fund Transcept operations through the commercial launch of Intermezzo^®.

Transcept expects to deploy a substantial majority of the available cash toward the development of sales and marketing programs for Intermezzo^®. As a result, the development and potential regulatory approval of additional Transcept product candidates is likely to require additional funding which may not be available at and as of the time needed on commercially reasonable terms, if at all.

If Intermezzo^® does not gain regulatory approval or does not achieve market acceptance, Transcept will not generate any revenue. Transcept cannot assure you that it will ever be profitable even if it commercializes Intermezzo^®. If Transcept fails to achieve and maintain profitability, or if it is unable to fund its continuing losses, investors could lose all or part of their investment.

Intermezzo^® and other Transcept product candidates may not achieve market acceptance even if Transcept obtains regulatory approvals.

Even if Transcept receives regulatory approvals for the commercial sale of Intermezzo^® or other product candidates, the commercial success of these product candidates will depend upon, among other things, acceptance by physicians and patients. Market acceptance of, and demand for, any product that Transcept develops and commercializes will depend on many factors, including:

29

Table of Contents

If Intermezzo^® or other Transcept product candidates fail to gain market acceptance, Transcept may be unable to earn sufficient revenue to continue its business.

Transcept will face substantial competition from large companies with established products.

Transcept is seeking approval of Intermezzo^® for use as needed for the treatment of insomnia when a middle of the night awakening is followed by difficulty returning to sleep, an indication that Transcept believes represents an opportunity in the broader insomnia therapeutic market. The insomnia market is large, deeply commercialized and characterized by intense competition among large, established pharmaceutical companies with well funded and staffed sales and marketing organizations and far greater name recognition than Transcept.

If Intermezzo^® receives marketing approval, it will compete in this large market against well-established branded products with significant advertising support, as well as with generic competitors selling zolpidem and other sleep aids at a fraction of the price at which Transcept will most likely seek to sell Intermezzo^®.

Transcept believes that Intermezzo^® , if approved, will be the first sleep aid approved by the FDA specifically for use in the middle of the night when patients awaken and have difficulty returning to sleep. However, currently marketed seven to eight hour therapeutics can also treat this condition when used to deliver a prophylactic dose at the beginning of the night. The most directly competitive currently-marketed products in the United States are Ambien^® and Ambien CR^®, marketed by Sanofi-Aventis, and the multiple generic manufacturers of zolpidem. Zolpidem, in both its branded and generic forms, is the most widely-prescribed drug in the United States for treatment of insomnia. Additionally, Lunesta^®, marketed by Sepracor, Inc., can similarly treat middle of the night awakenings by providing a prophylactic dose at bed-time in order to avoid a middle of the night awakening, and short duration products such as Sonata, marketed by King Pharmaceuticals, Inc., have been used off-label for the as-needed treatment of middle of the night awakenings. Other drugs, such as the antidepressant generic trazadone, are also widely prescribed off-label for the treatment of insomnia.

Other companies may develop products to compete with Intermezzo^®.

Transcept is aware of several products currently in development which may compete with Intermezzo^®. Neurocrine Biosciences received an approvable letter, pending additional clinical and pre-clinical studies, from the FDA for its product candidate, indiplon, proposed to be used for sleep initiation and middle of the night dosing. There are many other companies working to develop new products and other therapies to treat insomnia, including but not limited to Orexo AB, NovaDel Pharma, Inc., Sanofi-Aventis, Eli Lilly and Company, GlaxoSmithKline in conjunction with Actelion Ltd., and Somaxon Pharmaceuticals, Inc. Several of these compounds are already marketed for other indications, and some, including Zolpimist^™, an orally administered spray for which NovaDel Pharma, Inc. received marketing approval from the FDA in December 2008, and Edluar^™, a sublingual tablet for which Orexo received marketing approval from the FDA in March 2009, use zolpidem as the active pharmaceutical ingredient and are formulated for the purported absorption of zolpidem across the tissues of the mouth. NovaDel Pharma, Inc. also recently announced that it commenced development of a low-dose version of Zolpimist™ for the treatment of middle-of-the-night awakenings with the intent to enter such product candidate into clinical trials. Furthermore, new developments, including the development of other drug technologies and methods of treating conditions, occur in the biopharmaceutical industry at a rapid pace. Any of these developments may negatively affect the commercial prospects of Intermezzo^®.

Many potential competitors, either alone or together with their partners, have substantially greater financial resources, research and development programs, clinical trial and regulatory experience, expertise in prosecution of intellectual property rights, and manufacturing, distribution and sales and marketing capabilities than Transcept. As a result of these factors, these competitors may:

30

Table of Contents

Governmental and third-party payors may impose restrictions or reimbursement or pricing controls that could limit product revenues.

The continuing efforts of government and third-party payors to contain or reduce the costs of health care through various means may reduce potential revenues Transcept may receive from sales of Intermezzo^®, if approved. In particular, third-party insurance coverage may not be available to patients for Intermezzo^® or other Transcept products, especially in light of the availability of low-cost generic zolpidem therapeutics, regardless of the fact that such products are not specifically designed or indicated to specifically treat middle of the night awakening. Government and third-party payors could also impose price controls and other conditions that must be met by patients prior to providing coverage for use of Transcept products. For example, insurers may establish a “step-edit” system that requires a patient to utilize a lower price alternative product prior to becoming eligible for reimbursement of a higher price product. If government and third-party payors do not provide adequate coverage and reimbursement levels for Transcept products, or if price controls, prior authorization or step-edit systems are enacted, Transcept product revenues will suffer.

Negative publicity and documented side effects concerning products used to treat patients in the insomnia market may harm the ability of Transcept to commercialize Intermezzo^® or other product candidates.

Products containing zolpidem, the active ingredient in Intermezzo^®, are widely marketed. Zolpidem use has been implicated with negative effects, such as sleepwalking and amnesia, and has the potential to cause physical or psychological dependence. Furthermore, zolpidem is classified as a Schedule IV substance under the Comprehensive Drug Abuse and Prevention Control Act of 1970, and is subject to certain packaging, prescription and purchase volume limitations. There can be no assurance that additional negative publicity or increased governmental controls on the use of zolpidem or other compounds used in products for the insomnia market would not inhibit or prevent Transcept from commercializing Intermezzo^® or other product candidates. Furthermore, negative publicity concerning zolpidem and other hypnotic pharmaceuticals could cause the FDA to make approval of new products for the insomnia market more difficult, by requiring additional or different non-clinical or clinical studies or taking other actions, out of safety or other concerns, or could lead to reduced consumer usage of sleep aids, including both zolpidem products and Intermezzo^®.

If Transcept enters into strategic alliances to market Intermezzo^® or for other purposes it will be dependent upon the efforts of its alliance partners.

Although Transcept believes that it has sufficient resources to carry out its plans to commercialize Intermezzo^® to psychiatrists and high-prescribing physicians on its own, Transcept intends to enter into one or more strategic alliances to commercialize Intermezzo^®, if approved, and may decide to enter into additional strategic alliances for the development of other product candidates. Any strategic alliance Transcept enters into may contain unfavorable terms, for example, with respect to product candidates covered, control over decisions and responsibilities, termination rights, payment, and other significant terms. The ability of Transcept to receive any significant revenue from its product candidates covered by a strategic alliance will be dependent on the efforts of the alliance partner and may result in lower levels of income to Transcept than if Transcept marketed or developed its product candidates entirely on its own. The alliance partner may not fulfill its obligations or carry out marketing activities for Transcept product candidates as diligently as Transcept would like. Transcept could

31

Table of Contents

also become involved in disputes with its partner, which could lead to delays in or termination of commercialization programs and time-consuming and expensive litigation or arbitration. If an alliance partner terminates or breaches its agreement, or otherwise fails to complete its obligations in a timely manner, the chances of successfully developing or marketing Transcept product candidates would be materially and adversely affected.

Additionally, depending upon the alliance partner that Transcept chooses, other companies that might otherwise be interested in developing or marketing products with Transcept could be less inclined to do so because of the relationship of Transcept with the alliance partner. If the ability of Transcept to work with present or future alliance partners is adversely affected as a result of a collaboration agreement, Transcept business prospects may be limited and the financial condition of Transcept may be impaired. There can be no assurance that Transcept will be able to enter into such a strategic alliance, or that if Transcept does, it is on a time frame and on economic terms that are favorable to Transcept.

Even if Transcept product candidates receive regulatory approval, they will be subject to ongoing regulatory requirements and may face regulatory or enforcement action.

Any product candidate for which Transcept receives regulatory approval, together with related third-party manufacturing facilities and processes, post-approval clinical data, and advertising and promotional activities for the product, will be subject to significant review, oversight and ongoing and changing regulation by the FDA and other regulatory agencies. Failure to comply with regulatory requirements may subject Transcept to administrative and judicially-imposed sanctions. These may include warning letters, adverse publicity, civil and criminal penalties, injunctions, product seizures or detention, product recalls, total or partial suspension of production, and refusal to approve pending product marketing applications.

Even if Transcept receives regulatory approval to market a particular product candidate, the approval could be conditioned on Transcept conducting additional costly post-approval studies or could limit the indicated uses included in Transcept labeling. Moreover, the product may later cause adverse effects that limit or prevent its widespread use, force Transcept to withdraw it from the market or impede or delay the ability to obtain regulatory approvals in additional countries.

The FDA has also requested that all manufacturers of sedative-hypnotic pharmaceutical products modify their product labeling to include strong language concerning potential risks. These risks include severe allergic reactions and complex sleep-related behaviors, which may include sleep-driving. The FDA also recommended that pharmaceutical manufacturers conduct clinical studies to investigate the frequency with which sleep-driving and other complex behaviors occur in association with individual drug products. Transcept has not conducted such studies, and it is unclear how and to what extent, if any, these requests and recommendations will affect Intermezzo^® or other Transcept product candidates.

If the manufacturers upon whom Transcept relies fail to produce in the volumes and quality that Transcept requires on a timely basis, or to comply with stringent regulations applicable to pharmaceutical manufacturers, Transcept may face delays in the development and commercialization of, or be unable to meet demand for, its products, if any, and may lose potential revenues.

Transcept does not manufacture Intermezzo^®, and it does not plan to develop the capacity to do so. Transcept has a primary manufacturing and supply agreement with Patheon, Inc. to manufacture commercial supply of Intermezzo^®. Transcept also has agreements with Mikart, Inc. to qualify it as a backup commercial supplier of finished product, as well as a backup commercial manufacturer of a key excipient used in the manufacture of Intermezzo^®, Anderson Packaging, Inc. as a primary packager of Intermezzo^®, and Sharp Corporation to supply sample packaging. Transcept relies upon SPI Pharma, Inc. as a supplier for certain key excipients contained within Intermezzo^®, for one of such excipients as the sole source, and upon Plantex USA, Inc. as its sole source for a special form of zolpidem tartrate. These agreements have set terms of duration, some of which automatically renew for successive one or three year periods. The first to expire among these

32

Table of Contents

agreements, the Packaging and Supply Agreement with Anderson Packaging, Inc., has a term that ends in September of 2011, although such agreement automatically renews for one year periods thereafter. A further description of the terms of these agreements is set forth in the section entitled “Transcept Business—Manufacturing.”

The manufacture of pharmaceutical products requires significant expertise and capital investment, including the development of advanced manufacturing techniques and process controls. Manufacturers of pharmaceutical products often encounter difficulties in production, particularly in scaling up initial production. These problems include difficulties with production costs and yields, quality control, including stability of the product candidate and quality assurance testing, shortages of qualified personnel, as well as compliance with strictly enforced federal, state and foreign regulations. Transcept third-party manufacturers and key suppliers may not perform as agreed or may terminate their agreements. Additionally, Transcept third-party manufacturers and key suppliers may experience manufacturing difficulties due to resource constraints or as a result of labor disputes, unstable political environments at foreign facilities or financial difficulties. For example, a supplier with a manufacturing facility in Israel may face geopolitical risk that could prevent it from providing supplies from such facility. If these manufacturers or key suppliers were to encounter any of these difficulties, or otherwise fail to comply with their contractual obligations, the ability of Transcept to launch Intermezzo^® or any other product candidate, if approved, would be jeopardized.

In addition, all manufacturers and suppliers of pharmaceutical products must comply with current good manufacturing practice, or cGMP, requirements enforced by the FDA through its facilities inspection program. The FDA is likely to conduct inspections of Transcept third-party manufacturer and key supplier facilities as part of its review of any Transcept NDAs. If Transcept third-party manufacturers and key suppliers are not in compliance with cGMP requirements, it may result in a delay of approval, particularly if these sites are supplying single source ingredients required for the manufacture of Intermezzo^®. These cGMP requirements include quality control, quality assurance and the maintenance of records and documentation. Furthermore, regulatory qualifications of manufacturing facilities are applied on the basis of the specific facility being used to produce supplies. As a result, if a manufacturer for Transcept shifts production from one facility to another, the new facility must go through a complete regulatory qualification process and be approved by regulatory authorities prior to being used for commercial supply. Transcept manufacturers may be unable to comply with these cGMP requirements and with other FDA, state and foreign regulatory requirements. A failure to comply with these requirements may result in fines and civil penalties, suspension of production, suspension or delay in product approval, product seizure or recall, or withdrawal of product approval. If the safety of any quantities supplied is compromised due to a Transcept third-party manufacturer or key supplier failure to adhere to applicable laws or for other reasons, Transcept may not be able to obtain regulatory approval for or successfully commercialize its products.

Transcept does not have alternate manufacturers qualified at this time with respect to the commercial supply of Intermezzo^®, nor does it have alternate manufacturers identified or qualified with respect to the commercial supply of several of the key ingredients and packaging materials used in Intermezzo^®. If Transcept needs to change to other manufacturers, prior approval by the FDA and comparable foreign regulators will be required. In addition, Transcept would likely have to incur significant costs and expend significant efforts to educate the new manufacturer with respect to, or to help the new manufacturer independently develop, the processes necessary for production. Manufacturing and supply switching costs in the pharmaceutical industry can be very high, and switching manufacturers or key suppliers can frequently take 12 to 18 months to complete, although in certain circumstances such a switch may be significantly delayed or prevented by regulatory and other factors.

Any of these factors could cause Transcept to delay or suspend regulatory submissions, required regulatory approvals or commercialization of Intermezzo^® or any other product candidate that Transcept develops, entail higher costs or result in Transcept being unable to effectively commercialize its products, if any are approved. Furthermore, if Transcept manufacturers fail to deliver the required commercial quantities of raw materials, including active pharmaceutical ingredient, key excipients or finished product on a timely basis and at commercially reasonable prices, Transcept would be unable to meet demand for its products and it would lose potential revenues.

33

Table of Contents

Transcept clinical trials may fail to demonstrate adequately the safety and efficacy of its product candidates, which could prevent or delay regulatory approval and commercialization.

Before obtaining regulatory approvals for the commercial sale of Transcept product candidates, Transcept must demonstrate through lengthy, complex and expensive preclinical testing and clinical trials that the product candidate is both safe and effective for use in each target indication. The results obtained in completed clinical trials and non-clinical studies may not be predictive of results from ongoing or future trials.

Transcept trial results may be negatively affected by factors that had not been fully anticipated prior to commencement of the trial. Such trials may fail to demonstrate efficacy in the treatment of the intended disorder. Although Transcept designs its clinical trial protocols to address known factors that may negatively affect results, there can be no assurance that protocol designs will be adequate or that factors that Transcept may or may not be aware of or anticipate will not have a negative effect on the results of its clinical trials. Once a study has commenced, Transcept may voluntarily suspend or terminate the study if at any time it believes that there is an unacceptable safety risk to patients. Clinical trials in other indications or in different or progressively larger patient populations could reveal more frequent, more severe or additional side effects that were not seen in earlier studies. These side effects could interrupt, delay or halt clinical trials of Transcept product candidates and could result in the FDA or other regulatory authorities stopping further development of or denying approval of Transcept product candidates. Based on results at any stage of clinical trials, Transcept may decide to repeat or redesign a trial, modify its regulatory strategy or even discontinue development of one or more of its product candidates.

If Transcept product candidates are not shown to be both safe and effective in clinical trials, the resulting delays in developing other compounds and conducting associated non-clinical testing and clinical trials, as well as the potential need for additional financing, would have a material adverse effect on Transcept business, financial condition and results of operations.

Transcept relies on third parties to conduct its non-clinical and clinical trials. If these third parties do not perform as contractually required or otherwise expected, Transcept may not be able to obtain regulatory approval for its product candidates.

Transcept does not currently conduct non-clinical and clinical trials on its own, and instead relies on third parties, such as contract research organizations, medical institutions, clinical investigators and contract laboratories, to assist it with its non-clinical and clinical trials. Transcept is also required to comply with regulations and standards, commonly referred to as Good Clinical Practice, for conducting, recording and reporting the results of clinical trials to assure that data and reported results are credible and accurate and that the trial participants are adequately protected. If these third parties did not successfully carry out their duties with regard to Intermezzo^® development, or fail to successfully carry out their duties to Transcept as it relates to meeting future regulatory obligations or expected deadlines, if the third parties need to be replaced, or if the quality or accuracy of the data they obtained during the development of Intermezzo^® or in the future is compromised due to the failure to adhere to Transcept clinical protocols or regulatory requirements or for other reasons, Transcept non-clinical development activities or clinical trials may be extended, delayed, suspended or terminated, and Transcept may not be able to obtain regulatory approval for its product candidates, including Intermezzo^®.

Delays in the commencement or completion of clinical testing could result in increased costs to Transcept and delay its ability to generate revenues.

Transcept does not know whether future clinical trials will begin on time or be completed on schedule, if at all. The commencement and completion of clinical trials can be disrupted for a variety of reasons, including difficulties in:

34

Table of Contents

A clinical trial may also be suspended or terminated by Transcept or the FDA or other regulatory authorities due to a number of factors, including:

In addition, changes in regulatory requirements and guidance may occur and Transcept may need to amend clinical trial protocols to reflect these changes, which could impact the cost, timing or successful completion of a clinical trial. If Transcept experiences delays in the commencement or completion of its clinical trials, the commercial prospects for its product candidates and its ability to generate product revenues will be harmed. Many of the factors that cause, or lead to, a delay in the commencement or completion of clinical trials may also lead to the denial of regulatory approval of a product candidate.

Transcept may face potential product liability exposure, and if successful claims are brought against it, Transcept may incur substantial liability for a product candidate and may have to limit such candidate’s commercialization.

The use of Transcept product candidates (including those pursued by Novacea prior to the merger of Novacea and TPI) in clinical trials and the sale of any products for which Transcept obtains marketing approval exposes it to the risk of product liability claims. Product liability claims might be brought against Transcept by consumers, health care providers, pharmaceutical companies or others selling Transcept products. If Transcept cannot successfully defend itself against these claims, it will incur substantial liabilities. Transcept is also obligated under certain circumstances to indemnify suppliers and others with whom it has contractual relationships for product liability claims such entities might incur with respect to Transcept products and product candidates. Regardless of merit or eventual outcome, liability claims may result in:

Although Transcept currently has product liability insurance coverage for its clinical trials with limits that it believes are customary and adequate to provide it with coverage for foreseeable risks associated with Transcept development efforts, this insurance coverage may not reimburse it or may be insufficient to reimburse it for the actual expenses or losses Transcept may suffer. Moreover, insurance coverage is becoming increasingly

35

Table of Contents

expensive and, in the future, Transcept may not be able to maintain insurance coverage at a reasonable cost or in sufficient amounts to protect it against losses due to liability. Transcept intends to expand its insurance coverage to include the sale of commercial products if it obtains marketing approval for Intermezzo^®, but it may be unable to obtain such product liability insurance on commercially reasonable terms.

Transcept depends on key personnel and if Transcept is not able to retain them, its business will suffer.

Transcept is highly dependent on the principal members of its management and scientific staff, including but not limited to Glenn A. Oclassen, its President and Chief Executive Officer, and Nikhilesh N. Singh, its Chief Scientific Officer. The competition for skilled personnel among biopharmaceutical companies in the San Francisco Bay Area is intense and the employment services of Transcept scientific, management and other executive officers are terminable at-will. If Transcept loses one or more of these key employees, its ability to implement and execute its business strategy successfully could be seriously harmed. Replacing key employees may be difficult and may take an extended period of time because of the limited number of individuals in the biopharmaceutical industry with the breadth of skills and experience required to develop, gain regulatory approval of and commercialize products successfully. Transcept does not carry key man life insurance on any of its key personnel other than Nikhilesh N. Singh.

If Transcept does not raise additional capital, it may be forced to delay, reduce or eliminate its development programs and commercialization efforts.

The future capital requirements of Transcept will depend on, and could increase significantly as a result of, many factors, including:

Transcept may need to seek additional funding through strategic alliances or through public or private sales of its equity securities. In addition, Transcept may obtain equipment leases and may pursue opportunities to obtain debt financing in the future. There can be no assurance, however, that strategic alliances, additional equity or debt financing will be available on reasonable terms, if at all. If adequate funds are not available, Transcept may be required to delay, reduce the scope of, or eliminate one or more of its then existing or planned development, commercialization or expansion activities.

Raising additional funds by issuing securities or through licensing arrangements may cause dilution to existing stockholders, restrict Transcept operations or require Transcept to relinquish proprietary rights.

To the extent that Transcept raises additional capital by issuing equity securities, the existing Transcept stockholders’ ownership will be diluted. Any debt financing Transcept enters into may involve covenants that restrict its operations. These restrictive covenants may include limitations on additional borrowing and specific restrictions on the use of Transcept assets, as well as prohibitions on the ability of Transcept to create liens, pay dividends, redeem its stock or make investments. In addition, if Transcept raises additional funds through licensing arrangements, it may be necessary to relinquish potentially valuable rights to potential products or proprietary technologies, or grant licenses on terms that are not favorable to Transcept.

36

Table of Contents

The commercial success, if any, of Intermezzo^® depends, in part, on the rights Transcept is seeking through certain patent applications.

The potential commercial success of Intermezzo^® depends on patents that may issue in connection with two families of patent applications that Transcept has pending with the U.S. Patent and Trademark Office, or USPTO, each family covering, respectively, certain formulations and/or methods of use of zolpidem. In addition, Transcept has pending certain foreign equivalent patent applications with respect to formulations and manufacture of zolpidem for use in treatment of middle of the night awakening, as well as applications covering combinations and methods of use of ondansetron in conjunction with atypical antipsychotic drugs. There can be no assurance that the pending patent applications of Transcept, those applications Transcept may file in the future, or those applications Transcept may license from third parties, will result in patents being issued in a timely manner, or at all. Even if patents issue, the claims in such patents may not issue in a form that will be advantageous to Transcept, may not encompass Intermezzo^® or other Transcept product candidates and their unique features, and may not provide Transcept with proprietary protection or competitive advantages. For instance, competitors may be able to engineer around the Transcept formulation patent applications with alternate formulations that deliver therapeutic effects similar to potential products covered by the Transcept zolpidem formulation patent applications. Other drug companies may also be able to develop generic versions of Transcept products if Transcept is unable to maintain its proprietary rights. For example generic drug makers may attempt to introduce generic low dose zolpidem products similar to Transcept products immediately after the expiration of Hatch-Waxman marketing exclusivity and prior to the expiration of patents that may be issued relating to Intermezzo^®. Furthermore, among other limitations, the method of use patent applications that have been filed to encompass Intermezzo^® are limited in scope to certain uses of zolpidem, so potential competitors could develop similar products using active pharmaceutical ingredients other than zolpidem. Any patents Transcept has obtained or does obtain may be challenged by re-examination, opposition, or other administrative proceeding, or may be challenged in litigation, and such challenges could result in a determination that the patent is invalid.

The active, and many of the inactive, ingredients in Intermezzo^®, including generically manufactured zolpidem, have been known and used for many years and, therefore, are no longer subject to patent protection. Accordingly, certain of the Transcept pending patent applications are directed to the particular formulations of these ingredients in Transcept products, and their use. Although Transcept believes its formulations and their use are patentable and provide a competitive advantage, even if such patents are issued, such patents may not prevent others from marketing formulations using the same active and inactive ingredients in similar but different formulations. Moreover, if Transcept patents were successfully challenged and ruled to be invalid, Transcept would be exposed to a greater risk of direct competition.

Failure to obtain effective patent protection for Intermezzo^® and other Transcept product candidates would allow for products to be marketed by competitors that would undermine Transcept sales, marketing and collaboration efforts, and reduce or eliminate Transcept revenues. In addition, both the patent application process and the process of managing patent disputes can be time consuming and expensive.

If Transcept is unable to maintain and enforce its proprietary rights, Transcept may not be able to compete effectively or operate profitably.

The commercial success of Transcept will depend, in part, on obtaining and maintaining patent protection, trade secret protection and regulatory protection of its proprietary technology and information as well as successfully defending against third-party challenges to its proprietary technology and information. Transcept will be able to protect its proprietary technology and information from use by third parties only to the extent that it has valid and enforceable patents, trade secrets or regulatory protection to cover them and it has exclusive rights to utilize them.

The commercial success of Transcept will continue to depend in part on the patent rights it owns, the patent rights it has licensed, the patent rights of its suppliers and the patent rights Transcept plans to obtain related to future products it may market. The success of Transcept also depends on its and its licensors’ and suppliers’

37

Table of Contents

ability to maintain these patent rights against third-party challenges to their validity, scope or enforceability. Further, Transcept does not fully control the patent prosecution of the patents and patent applications it has licensed. There is a risk that licensors to Transcept will not devote the same resources or attention to the prosecution of the licensed patent applications as Transcept would if it controlled the prosecution of the patent applications, and the resulting patent protection, if any, may not be as strong or comprehensive as if Transcept had prosecuted the applications itself. The patent positions of biopharmaceutical companies can be highly uncertain and involve complex legal and factual questions for which important legal principles remain unresolved. No consistent policy regarding the breadth of claims allowed in such companies’ patents has emerged to date in the United States. The patent situation outside the United States is even more uncertain. Changes in either the patent laws or in interpretations of patent laws in the United States or other countries may diminish the value of Transcept intellectual property. Accordingly, Transcept cannot predict the breadth of claims that may be allowed or enforced in its patents or in third-party patents. For example:

Transcept also relies on trade secrets to protect its technology, especially where it does not believe patent protection is appropriate or obtainable. However, trade secrets are difficult to protect. While Transcept seeks to protect confidential information, in part, by confidentiality agreements with its employees, consultants, contractors, or scientific and other advisors, they may unintentionally or willfully disclose Transcept information to competitors. If Transcept was to enforce a claim that a third party had illegally obtained and was using Transcept trade secrets, it would be expensive and time consuming, and the outcome would be unpredictable. In addition, courts outside the United States are sometimes less willing to protect trade secrets.

If Transcept is not able to defend the patent or trade secret protection position of its technologies and product candidates, then Transcept will not be able to exclude competitors from developing or marketing competing products, and Transcept may not generate enough revenue from product sales, if any, to justify the cost of development of Transcept product candidates and to achieve or maintain profitability.

If Transcept is sued for infringing intellectual property rights of other parties, such litigation will be costly and time consuming, and an unfavorable outcome would have a significant adverse effect on the business of Transcept.

Although Transcept believes that it would have valid defenses to allegations that its current product candidates, production methods and other activities infringe the valid and enforceable intellectual property rights of any third parties of which it is aware, Transcept cannot be certain that a third party will not challenge its position in the future. Other parties may own patent rights that might be infringed by Transcept products or other activities. There has been, and Transcept believes that there will continue to be, significant litigation and

38

Table of Contents

demands for licenses in the life sciences industry regarding patent and other intellectual property rights. Competitors or other patent holders may assert that Transcept products and the methods Transcept employs are covered by their patents. These parties could bring claims against Transcept that would cause it to incur substantial expenses and, if successful against Transcept, could cause it to pay substantial damages or possibly prevent it from commercializing its product candidates. Further, if a patent infringement suit were brought against Transcept, Transcept could be forced to stop or delay research, development, manufacturing or sales of the product or product candidate that is the subject of the suit.

As a result of patent infringement claims, or in order to avoid potential claims, Transcept may choose to seek, or be required to seek, a license from the third party and would most likely be required to pay license fees or royalties or both. These licenses may not be available on acceptable terms, or at all. Even if Transcept was able to obtain a license, the rights may be non-exclusive, which would give competitors access to the same intellectual property. Ultimately, Transcept could be prevented from commercializing a product, or be forced to cease some aspect of its business operations if, as a result of actual or threatened patent infringement claims, Transcept or its collaborators are unable to enter into licenses on acceptable terms. This could harm the business of Transcept significantly.

Transcept may incur substantial costs as a result of litigation or other proceedings relating to patent and other intellectual property rights.

In the event a competitor infringes upon a Transcept patent or other intellectual property right, litigation to enforce Transcept intellectual property rights or to defend Transcept patents against challenge, even if successful, could be expensive and time consuming and could require significant time and attention from Transcept management. Transcept may not have sufficient resources to enforce Transcept intellectual property rights or to defend Transcept patents against challenges from others.

The pharmaceutical industry is characterized by extensive litigation and administrative proceedings over patent and other intellectual property rights. Transcept could therefore become subject to litigation that could be costly, result in the diversion of Transcept management’s time and efforts, and require Transcept to pay damages. Whether a product infringes a patent involves complex legal and factual issues, the determination of which is often uncertain. Transcept competitors may assert that they own U.S. or foreign patents containing claims that cover Transcept products, components of Transcept products, or the methods Transcept employs in making or using Transcept products. In addition, Transcept may become a party to an interference proceeding declared by the USPTO to determine the priority of inventions. Because patent applications can take many years to issue, and in many instances, at least 18 months to publish, there may be applications now pending of which Transcept is unaware, which may later result in issued patents that contain claims that cover Transcept products. There could also be existing patents, of which Transcept is unaware, that contain claims that cover one or more components of its products. As the number of participants in Transcept’s industry increases, the possibility of patent infringement claims against us also increases.

Any interference proceeding, litigation, or other assertion of claims against Transcept may cause Transcept to incur substantial costs, could place a significant strain on Transcept financial resources, divert the attention of Transcept management from Transcept core business and harm Transcept’s reputation. If the relevant patents were upheld as valid and enforceable and Transcept was found to infringe, it could be required to pay substantial damages and/or royalties and could be prevented from selling Transcept products unless Transcept could obtain a license or were able to redesign its products to avoid infringement. Any such license may not be available on reasonable terms, if at all. If Transcept fails to obtain any required licenses or make any necessary changes to Transcept products or technologies, it may be unable to make, use, sell, or otherwise commercialize one or more of its products. In addition, if Transcept is found to willfully infringe, it could be required to pay treble damages, among other penalties.

39

Table of Contents

If Transcept fails to comply with its obligations in the agreements under which it licenses rights to products or technology from third parties, Transcept could lose license rights that are important to its business.

Transcept is a party to a number of agreements that include technology licenses that are important to its business and expects to enter into additional licenses in the future. For example, Transcept holds licenses from SPI Pharmaceuticals, Inc. relating to key excipients used in the manufacture of Intermezzo^®. If Transcept fails to comply with these agreements, the licensor may have the right to terminate the license, in which event Transcept would not be able to market products covered by the license, including Intermezzo^®.

Transcept may be subject to damages resulting from claims that Transcept or its employees have wrongfully used or disclosed alleged trade secrets of former employers.

Many Transcept employees were previously employed at universities or other biotechnology or pharmaceutical companies, including competitors or potential competitors. Although no claims against Transcept are currently pending, Transcept may be subject to claims that these employees or Transcept itself have inadvertently or otherwise used or disclosed trade secrets or other proprietary information of former employers. Litigation may be necessary to defend against these claims. If Transcept fails in defending such claims, in addition to paying monetary damages, it may lose valuable intellectual property rights or personnel. A loss of key research personnel or their work product could hamper or prevent the ability of Transcept to commercialize certain potential products, which could severely harm its business. Even if Transcept is successful in defending against these claims, litigation could result in substantial costs and be a distraction to management.

If Transcept agreements with employees, consultants, advisors and corporate partners fail to protect its intellectual property, proprietary information or trade secrets, it could have a significant adverse effect on Transcept.

Transcept has taken steps to protect its intellectual property and proprietary technology, by entering into confidentiality agreements and intellectual property assignment agreements with its employees, consultants, advisors and corporate partners. However, such agreements may not be enforceable or may not provide meaningful protection for Transcept trade secrets or other proprietary information in the event of unauthorized use or disclosure or other breaches of the agreements, and Transcept may not be able to prevent such unauthorized disclosure. Monitoring unauthorized disclosure is difficult, and Transcept does not know whether the steps it has taken to prevent such disclosure are, or will be, adequate. Furthermore, the laws of some foreign countries may not protect Transcept intellectual property rights to the same extent as do the laws of the United States.

The stock price of Transcept is expected to be volatile.

The market price of Transcept common stock could be subject to significant fluctuations. Market prices for securities of early-stage pharmaceutical, biotechnology and other life sciences companies have historically been particularly volatile. Some of the factors that may cause the market price of Transcept common stock to fluctuate include:

40

Table of Contents

Moreover, the stock markets in general have experienced substantial volatility that has often been unrelated to the operating performance of individual companies. These broad market fluctuations may also adversely affect the trading price of Transcept common stock.

In the past, following periods of volatility in the market price of a company’s securities, stockholders have often instituted class action securities litigation against those companies. Such litigation, if instituted, could result in substantial costs and diversion of management attention and resources, which could significantly harm the profitability and reputation of Transcept.

Anti-takeover provisions in charter documents and under Delaware law could make an acquisition of Transcept more difficult and may prevent attempts by stockholders to replace or remove management.

Provisions in certificate of incorporation and bylaws of Transcept may delay or prevent an acquisition or a change in management. These provisions include a classified board of directors, a prohibition on actions by written consent of stockholders and the ability of the board of directors to issue preferred stock without stockholder approval. In addition, because Transcept is incorporated in Delaware, it is governed by the provisions of Section 203 of the Delaware General Corporation Law, which prohibits stockholders owning in excess of 15% of outstanding voting stock from merging or combining with Transcept. Although Transcept believes these provisions collectively will provide for an opportunity to receive higher bids by requiring potential acquirors to negotiate with the Transcept board of directors, they would apply even if the offer may be considered beneficial by some stockholders. In addition, these provisions may frustrate or prevent any attempts by stockholders to replace or remove then current management by making it more difficult for stockholders to replace members of the board of directors, which is responsible for appointing the members of management.

Transcept has never paid dividends on its capital stock, and does not anticipate that it will pay any cash dividends in the foreseeable future.

Transcept has not paid cash dividends on any of its classes of capital stock to date, and the current expectation of Transcept is that it will retain its future earnings to fund the development and growth of its business. As a result, capital appreciation, if any, of Transcept common stock will be the sole source of gain, if any, for the foreseeable future.

Future sales of shares by existing stockholders could cause the stock price of Transcept to decline.

If existing stockholders sell, or indicate an intention to sell, substantial amounts of common stock in the public market after the lock-up and other legal restrictions on resale entered into by securityholders of Transcept

41

Table of Contents

in connection with the merger of Novacea and TPI lapse, the trading price of the common stock of Transcept could decline. Based on shares outstanding as of January 30, 2009, Transcept had a total of approximately 13.1 million shares of common stock outstanding. Of these shares, only approximately 4.6 million shares of common stock were not subject to lock-up agreements.

The lock-up agreements entered into in connection with the merger of TPI and Novacea provide that 50% of the shares subject to the lock-up agreements will be released from such restrictions three months from the January 30, 2009 closing date, and the remainder of the shares subject to such restrictions will be released six months from such closing date. After the last period of the lock-up agreements expire, based on shares outstanding as of January 30, 2009, up to an additional approximately 8.5 million shares of common stock will cease to be subject to lock-up agreements, approximately 8.1 million of which will be held by Transcept directors, executive officers and other affiliates and will be subject to volume limitations under Rule 144 under the Securities Act and various vesting agreements. In addition, 1,631,454 shares of common stock that are subject to outstanding options of Transcept as of January 30, 2009 will become eligible for sale in the public market to the extent permitted by the provisions of various vesting agreements, the lock-up agreements and Rules 144 and 701 under the Securities Act. If these additional shares are sold, or if it is perceived that they will be sold, in the public market, the trading price of Transcept common stock could decline.

If the ownership of Transcept common stock is highly concentrated, it may prevent stockholders from influencing significant corporate decisions and may result in conflicts of interest that could cause the stock price of Transcept to decline.

Executive officers, directors of Transcept and their affiliates beneficially own or control approximately 64% of the outstanding shares of Transcept common stock as of January 30, 2009. Accordingly, these executive officers, directors and their affiliates, acting as a group, will have substantial influence over the outcome of corporate actions requiring stockholder approval, including the election of directors, any merger, consolidation or sale of all or substantially all of the assets of Transcept or any other significant corporate transactions. These stockholders may also delay or prevent a change of control of Transcept, even if such a change of control would benefit the other stockholders. The significant concentration of stock ownership may adversely affect the trading price of Transcept common stock due to investors’ perception that conflicts of interest may exist or arise.

None.

As of completion of the merger between Novacea and TPI on January 30, 2009, the operational headquarters of Transcept was located in Pt. Richmond, California, where Transcept leases approximately 26,900 square feet of space under two separate leases, the first of which for approximately 14,600 square feet of space expires in May 2013, and the second of which for approximately 12,300 square feet of space also expires in May 2013. Of the 26,900 square feet of space in Pt. Richmond, California, approximately 3,000 square feet is product development laboratory space and the remainder is general office space. Transcept also leases approximately 25,288 square feet of general office space in South San Francisco, California, the location of the headquarters of Novacea prior to the completion of the merger between Novacea and TPI, under a lease that expires in October 2012. Transcept believes that its current facilities are suitable and adequate for its current needs.

From time to time, we may be involved in litigation relating to claims arising out of our operations. Transcept is not currently involved in any material legal proceedings.

None.

42

Table of Contents

PART II

Market Information

Transcept common stock is traded on the NASDAQ Global Market under the symbol “TSPT”. Prior to the completion of the merger of Novacea and TPI, the ticker symbol used for Novacea common stock on the NASDAQ Global Market was “NOVC”. The following table sets forth, for the period indicated, the high and low sales prices per share of Novacea common stock, for each quarterly period for the last two years, as reported on the NASDAQ Global Market.

On January 30, 2009, Novacea completed a business combination with TPI. Novacea securities listed on the NASDAQ Global Market, trading under the ticker symbol “NOVC,” were suspended for trading as of the close of business on Friday, January 30, 2009 and trading of Transcept securities on the NASDAQ Global Market under the ticker symbol “TSPT” commenced on Monday, February 2, 2009.

The closing price of Transcept common shares as reported by the NASDAQ Stock Market on March 26, 2009 was $3.08 per share. As of March 26, 2009 there were approximately 147 holders of record of our common stock.

Dividend Policy

No dividends have been declared or paid on Transcept common stock. Transcept does not anticipate that it will pay any cash dividends on its common stock in the foreseeable future.

Issuer Purchases of Equity Securities

There were no repurchases of Novacea common stock during the fourth quarter of fiscal 2008.

Securities Authorized For Issuance Under Equity Compensation Plans

Information relating to compensation plans under which equity securities are authorized for issuance is set forth under Item 12—“Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” of this Annual Report on Form 10-K.

Performance Graph

The following graph and table compare:

43

Table of Contents

The graph and table assume $100 was invested on the starting date at the price indicated above and that dividends, if any, were reinvested on the date of payment without payment of any commissions. The performance shown in the graph and table represents past performance and should not be considered an indication of future performance.

The information provided above under the heading “Performance Graph” is not “soliciting material” and shall not be considered “filed” with the SEC or incorporated by reference in any filing under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date hereof and irrespective of any general incorporation language in any such filing.

44

Table of Contents

Because the business combination of Novacea and TPI was not completed until January 30, 2009, the selected financial data set forth below presents information from the financial statements of Novacea and does not address the financial condition or results of operations of TPI. For additional financial information on TPI, please see the financial statements filed with the Transcept Current Report on Form 8-K/A submitted to the SEC on the date of this Annual Report on Form 10-K.

The following selected financial data has been derived from our audited financial statements. The information below is not necessarily indicative of the results of future operations and should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and Item 1A, “Risk Factors,” of this Form 10-K, and the financial statements and related notes thereto included in Item 8 of this Form 10-K, in order to fully understand factors that may affect the comparability of the information presented below. All per share amounts reflect a 1-for-3.5 reverse stock split effective May 2006 and a 1-for-5 reverse stock split effective January 2009.

45

Table of Contents

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains certain statements that are not strictly historical and are “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995 and involve a high degree of risk and uncertainty. Actual results may differ materially from those projected in the forward-looking statements due to other risks and uncertainties. All forward-looking statements included in this section are based on information available to Transcept Pharmaceuticals, Inc., or Transcept, as of the date hereof, and Transcept assumes no obligation to update any such forward-looking statement, except as required by law.

Merger of Novacea, Inc. with Transcept Pharmaceuticals, Inc.

Description of the Merger

On January 30, 2009, Novacea, Inc, or Novacea, whose financial statements as of and for the year ended December 31, 2008 are included in this Annual Report on Form 10-K as required by SEC rules, completed its merger with Transcept Pharmaceuticals, Inc., a private specialty pharmaceutical company focused on the development and commercialization of proprietary products that address important therapeutic needs in neuroscience. Transcept Pharmaceuticals, Inc. is referred to as TPI when referencing the private company prior to the merger. The public company after the merger is referred to as Transcept.

As a result of the merger, which was implemented pursuant to an Agreement and Plan of Merger and Reorganization dated as of August 29, 2008, as amended on December 23, 2008, TPI became a wholly-owned subsidiary of Novacea. As merger consideration, Novacea issued to the former TPI stockholders shares of Novacea common stock, and assumed outstanding options and warrants to acquire TPI capital stock, such that immediately after the merger, the former securityholders of TPI represented approximately 61% of the fully diluted capitalization of Novacea. Novacea was renamed Transcept Pharmaceuticals, Inc. Beginning February 2, 2009, the Novacea shares began trading on the NASDAQ Global Market under the Transcept name and symbol, “TSPT”.

Impact of the Merger on Our Business

Following the merger, the business of Transcept as the newly named public company became the business of TPI. Transcept does not intend to continue the business or operations of Novacea and, in particular, will not devote resources to further clinical development or commercialization of the former product candidates of Novacea. Each of the executive officers of Novacea resigned in connection with the merger, and the former executive officers of TPI became the executive officers of Transcept as a public company. Following the merger, the Transcept board of directors consists of a total of ten members, six of whom were designated by TPI and four of whom were designated by Novacea.

Accounting Implications of the Reverse Merger; Future Financial Statements as TPI/Transcept

Under generally accepted accounting principles in the United States, the merger is treated as a “reverse merger” under the purchase method of accounting. For accounting purposes, TPI is considered to have acquired Novacea, and for purposes of future filings with the SEC, beginning with the Quarterly Report on Form 10-Q for the quarter ending March 31, 2009, the historical financial statements for annual and quarterly periods ending on or prior to December 31, 2008 will be the historical financial statements of TPI. However, because the merger was not completed as of December 31, 2008, the financial statements of Novacea are required to be provided in this Annual Report on Form 10-K, and this section discusses the operating results and financial condition of Novacea as of and for the required periods ended December 31, 2008.

For more information about the operating results and financial condition of Transcept, you should review the Transcept Current Report on Form 8-K/A, filed with the SEC on the same date as this Annual Report on

46

Table of Contents

Form 10-K, which contains the audited financial statements of TPI as of December 31, 2008 and 2007 and for the three years in the period ended December 31, 2008 and for the period from inception (January 8, 2002) to December 31, 2008. In addition, for more information about the merger and Transcept, please review the Registration Statement on Form S-4 filed with the SEC in connection with the merger as declared effective by the SEC on December 29, 2008 (SEC File No. 333-153844).

Overview of Novacea Business

Prior to the termination of its clinical trials, the reduction in its workforce and in its operating plan, and its focus on evaluating strategic alternatives, all as described in the registration statement relating to the merger with TPI, Novacea was an operating biopharmaceutical company focused on in-licensing, developing and commercializing novel therapies for the treatment of cancer. Novacea had two clinical-stage oncology product candidates, Asentar^™ and AQ4N. In late 2007 and early 2008, Novacea stopped all of its development activities related to these oncology product candidates. In January 2009, Novacea terminated its licenses to Asentar^™ and AQ4N, and returned the rights to the product candidates to the licensors.

The following chronology illustrates the events leading up to the discontinuation of the clinical trials of Novacea, the reduction in its workforce and in its operating plan, and its focus on evaluating strategic alternatives:

47

Table of Contents

Research and Development Expenses. During the period when Novacea was developing its product candidates, its research and development expenses consisted primarily of costs for personnel, including salaries and benefits; regulatory activities; pre-clinical studies; clinical trials; materials and supplies; and allocations of other research and development-related costs.

General and Administrative Expenses. The general and administrative expenses of Novacea consisted primarily of salaries and related costs for its personnel in executive, business development, marketing, human resources, external communications, finance and other administrative functions, as well as consulting costs, including market research and business consulting. Other costs included professional fees for legal and accounting services, insurance and facility costs.

Results of Operations

Presented below are Novacea results of operations for the year ended December 31, 2008 compared to the year ended December 31, 2007, and for the year ended December 31, 2007 compared to the year ended December 31, 2006.

The following table reflects year over year changes in selected line items from the Novacea statements of operations (in thousands, except percentages).

Collaboration Revenue

In July 2007, Novacea received non-refundable upfront payments from Schering totaling $60 million, including $35 million as reimbursement for past research and development expenses and a license fee of $25 million. Through the termination date of the Collaboration Agreement on April 4, 2008, Novacea had recognized revenues from the upfront payments ratably over an estimated six-year development period starting on June 26, 2007 and ending on June 30, 2013. Novacea believed that this period for revenue recognition represented substantially the entire period for which it would have significant participatory obligations for Asentar^™. As a result of the termination of the Collaboration Agreement with Schering on April 4, 2008, Novacea recognized as

48

Table of Contents

revenue during the second quarter of 2008 the previously deferred revenue balance of $52.4 million related to the upfront payments. The deferred revenue balance related to the upfront payments from Schering was zero as of December 31, 2008.

Revenue from reimbursement for the research and development efforts on Asentar^™ was recognized as the related costs were incurred. In August 2008, Novacea and Schering agreed that the final payment of $5.7 million, representing reimbursement for the Novacea research and development efforts on Asentar^™ of $4.3 million for the first quarter of 2008 and of $1.4 million for the second quarter of 2008, would cover all development costs and wind-down costs under the Collaboration Agreement and Novacea would not be entitled to any additional monies from Schering in connection with the Collaboration Agreement. Additionally, with the termination of the Collaboration Agreement, Novacea is no longer eligible to receive from Schering any pre-commercial milestone payments or royalties on worldwide sales of Asentar^™. The $5.7 million payment was received in September 2008. All payments received from Schering are non-refundable.

Collaboration revenue was $60.6 million for the year ended December 31, 2008, $16.7 million for the year ended December 31, 2007, and $0.4 million for the year ended December 31, 2006. There was a $43.9 million increase in collaboration revenue from 2007 to 2008, primarily due to the recognition of the deferred revenue from Schering described above. Revenue for 2007 was due to $11.5 million in reimbursement for Novacea research and development efforts on Asentar^™ and $5.2 million related to the amortization of upfront payments under the Collaboration Agreement with Schering. Revenue for 2006 was attributable to development milestones achieved in 2006 under two agreements with Aventis Pharmaceuticals, Inc. related to Asentar^™ clinical studies.

Research and Development Expenses

The following table summarizes Novacea research and development expenses:

Year Ended December 31, 2008 Compared with Year Ended December 31, 2007

Research and development expenses for the year ended December 31, 2008 were $11.7 million compared to $36.1 million for the year ended December 31, 2007. This represents a decrease in research and development expenses of $24.4 million, or 68%, between 2008 and 2007.

Research and development expenses associated with Asentar^™ were $7.8 million for the year ended December 31, 2008, compared to $25.4 million for the year ended December 31, 2007. The $17.6 million, or 69%, decrease between 2008 and 2007 was due primarily to the lower level of clinical development activities in the ASCENT-2 Phase 3 clinical trial of AIPC, which began in the first quarter of 2006 and was terminated in November 2007. The reduction in development activity was partially offset by restructuring charges of $0.7 million in 2008. The activities for Asentar^™ in 2008 were focused primarily on winding-down and finalizing the analysis of the ASCENT-2 Phase 3 clinical trial and preparing a complete response to the FDA regarding releasing the clinical hold on the IND application for Asentar^™. In September 2008, Novacea received notice from the FDA that the agency had released the clinical hold on Asentar^™. In January 2009, Novacea returned the product rights to Asentar^™ to its licensors.

49

Table of Contents

In the past, certain research and development expenses for Asentar^™ had been subject to reimbursement from Schering under the Collaboration Agreement, which was terminated by Schering in April 2008. The expenses were recorded as research and development expenses and the reimbursement of such costs were recorded as revenue as costs were incurred by Novacea. For periods subsequent to the second quarter of 2008, Novacea was not entitled to receive any additional reimbursement from Schering under the Collaboration Agreement for remaining activities by Novacea on Asentar^™ and Novacea no longer recognized any related reimbursement revenue.

Research and development expenses associated with AQ4N were $1.3 million for the year ended December 31, 2008, compared to $5.8 million for the year ended December 31, 2007. The $4.5 million, or 78%, decrease between 2008 and 2007 resulted primarily from reduced development activities and product manufacturing expenses for AQ4N. The reduction in development activity was partially offset by restructuring charges of $0.3 million in 2008. In October 2007, Novacea initiated a Phase 2 clinical trial of AQ4N for the treatment of acute lymphoblastic leukemia, or ALL. However, this trial was discontinued in January 2008 in connection with the decision to scale back clinical development activities for AQ4N in order to preserve capital resources. In May 2008, Novacea decided that its future AQ4N development efforts would focus on completing the necessary activities on the Phase 1b portion of the Phase 1b/2a GBM trial, which had completed enrollment, while placing the Phase 2a portion of the trial on hold prior to patient enrollment. In January 2009, Novacea returned the product rights to AQ4N to its licensor.

Other research and development expenses were $2.4 million for the year ended December 31, 2008, compared to $3.7 million for the year ended December 31, 2007. The $1.3 million, or 35%, decrease between 2008 and 2007 resulted primarily from cost savings associated with reduced internal and related external activities associated with the general research and development efforts of Novacea partially offset by a $0.2 million restructuring charge and $0.1 million in accelerated depreciation of property and equipment.

Stock-based compensation expense included in research and development expenses was $0.2 million for the year ended December 31, 2008, compared to $1.1 million for the year ended December 31, 2007. The decrease in stock-based compensation resulted primarily from reduced headcount during 2008.

Year Ended December 31, 2007 Compared with Year Ended December 31, 2006

Research and development expenses for the year ended December 31, 2007 were $36.1 million compared to $21.8 million for the year ended December 31, 2006, an increase of $14.3 million, or 65%.

Research and development expenses associated with Asentar^™ were $25.4 million for the year ended December 31, 2007 compared to $12.9 million for the year ended December 31, 2006. The $12.5 million increase was due in part to a sublicensing fee of $3.8 million paid to Oregon Health & Science University and a sublicensing fee of $1.3 million paid to the University of Pittsburgh, equal to 15% and 5%, respectively, of the $25 million license fee received from Schering under the Collaboration Agreement, the clinical development activities in the ASCENT-2 Phase 3 clinical trial for Asentar^™, which began in the first quarter of 2006 and was terminated in November 2007, combined with the costs of preparing for a Phase 2 clinical trial in advanced pancreatic cancer initiated in September 2007, and placed on hold in November 2007 related to the termination of the ASCENT-2 Phase 3 clinical trial.

Research and development expenses associated with AQ4N were $5.8 million for the year ended December 31, 2007 compared to $2.0 million for the year ended December 31, 2006. The $3.8 million increase was due primarily to a $1.4 million upfront payment made under a novation and license agreement with BTG International Limited, or BTG, entered into in 2007, the clinical development activities and product manufacturing expenses for AQ4N, then in a Phase 1b/2a clinical trial that began in the fourth quarter of 2006, in combination with radiation and chemotherapy, for the treatment of glioblastoma multiforme, and the costs of preparing for the planned initiation of additional AQ4N clinical trials in leukemia and lymphoma. In October

50

Table of Contents

2007, Novacea initiated a Phase 2 clinical trial of AQ4N for the treatment of acute lymphoblastic leukemia, or ALL, however, this trial was discontinued in January 2008 in connection with the Novacea decision to scale back clinical development activities for AQ4N in order to preserve capital resources.

Other research and development expenses were approximately $3.7 million for the year ended December 31, 2007 compared to $3.3 million for the year ended December 31, 2006. This $0.4 million increase resulted primarily from costs associated with higher internal and related external activities associated with advancing the Novacea general research and development efforts.

Research and development expenses associated with vinorelbine oral for the year ended December 31, 2007 were nil compared to $3.2 million for the year ended December 31, 2006. Vinorelbine oral research and development expenses in 2006 primarily reflect development activities on the product candidate and the expenses associated with the Novacea achievement of a development milestone in the first quarter of 2006. During the fourth quarter of 2006, Novacea exercised its right to terminate its existing agreements related to vinorelbine oral and to return to the licensor all product rights in the United States and Canada.

Research and development expenses associated with stock-based compensation were $1.1 million for the year ended December 31, 2007 compared to $0.4 million for the year ended December 31, 2006. The increase in stock-based compensation resulted primarily from additional stock options and restricted stock units granted to Novacea employees during 2007.

General and Administrative Expenses

General and administrative expenses for the year ended December 31, 2008 were $16.9 million, compared to $17.3 million for the year ended December 31, 2007. The decrease of $0.4 million, or 2%, between 2008 and 2007 in general and administrative expenses was mainly due to a $1.4 million decrease in marketing-related expenses, a $1.0 million decrease in compensation and benefits, a $0.8 million decrease in stock-based compensation, a $0.6 million decrease in recruiting expense, and a $0.2 million decrease in employee travel expenses, partially offset by a $2.0 million increase in legal and consulting expenses primarily related to evaluating strategic alternatives and the merger with TPI, a $1.1 million increase in depreciation and amortization expense, including accelerated depreciation, and a $0.5 million increase in restructuring-related expense.

General and administrative expenses for the year ended December 31, 2007 were $17.3 million compared to $11.3 million for the year ended December 31, 2006. The $6.0 million, or 53%, increase in general and administrative expenses was mainly due to a $2.1 million increase in stock-based compensation, resulting primarily from additional stock options and restricted stock units granted to Novacea employees during 2007, a $1.6 million increase in consulting, legal and audit fees, including legal and other fees related to entering the Collaboration Agreement with Schering, a $1.0 million increase in compensation and benefits, a $0.5 million increase in facilities-related costs, and a $0.4 million increase in recruiting expenses. These increases in expenses were due partially to higher administrative and corporate support of the Novacea research and development activities for its ASCENT-2 Phase 3 clinical trial and additional clinical and other development activities for Asentar^™ and AQ4N.

Interest and Other Income, Net

Interest and other income, net, was $2.8 million for the year ended December 31, 2008, compared to $4.1 million for the year ended December 31, 2007. The decrease of $1.3 million, or 32%, between 2008 and 2007 resulted from lower investment yields offset by higher average investment balances.

Interest and other income, net, for the year ended December 31, 2007 was $4.1 million compared to $3.1 million for the year ended December 31, 2006. The 2007 increase of $1.0 million, or 32%, resulted primarily from higher investment balances resulting from the availability of the net proceeds from the Collaboration agreement with Schering completed in the second quarter of 2007 and higher investment yields.

51

Table of Contents

Income Taxes

Novacea uses the liability method for accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax reporting bases of assets and liabilities and are measured using enacted tax rates and laws that are expected to be in effect when the differences are expected to reverse. Currently, there is no provision for income taxes as Novacea has an accumulated deficit to date.

As of December 31, 2008, Novacea had net operating loss carry-forwards for federal income tax purposes of approximately $78.3 million and research credits of approximately $2.2 million, which will expire beginning in the year 2021. Novacea also had state net operating loss carry-forwards of approximately $78.1 million, which expire beginning in 2014. Additionally, Novacea had state research credits of approximately $2.1 million, which have no expiration date. Certain amounts included in these carry-forwards will be recorded to equity, rather than a benefit to income tax expense, when they reduce cash taxes payable.

Novacea did not record a benefit from its net operating loss carry-forwards because it believed that it was uncertain that Novacea would have sufficient income from future operations to realize the carry-forwards prior to their expiration. Accordingly, Novacea established a full valuation allowance against the deferred tax asset arising from the carry-forwards.

Utilization of the net operating loss carry-forwards and credits may be subject to a substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code of 1986, as amended, and similar state provisions. Such limitations may also result from the change in ownership resulting from the Company’s merger with TPI. The annual limitation may result in the expiration of net operating loss carry-forwards and credits before utilization.

Liquidity and Capital Resources

Novacea Liquidity and Capital Resources as of December 31, 2008

At December 31, 2008, Novacea had cash, cash equivalents and marketable securities of $85.1 million, held in accounts managed by third party financial institutions, which consisted of invested cash and cash in its operating account. The interest-bearing investments include money market funds, commercial paper, U.S. corporate debt and U.S. government sponsored enterprise issues. Through December 31, 2008, Novacea had not experienced material realized losses nor has Novacea lacked access to its cash, cash equivalents and marketable securities. However, Transcept can provide no assurances that the realizable value of its investments or access to its cash, cash equivalents and marketable securities will not be impacted negatively by adverse conditions in the financial markets.

The following table summarizes net cash provided by (used in) the Novacea operating, investing and financing activities:

Net Cash Provided by (Used in) Operating Activities

Net cash used in operating activities for the year ended December 31, 2008 of $10.9 million was primarily attributable to operating activities and those activities related to evaluating strategic alternatives and the merger with TPI and payments of accounts payable and accrued liabilities, offset partially by research and development reimbursement payments from Schering. Net cash provided by operating activities of $15.6 million for the year ended December 31, 2007 was primarily attributable to the $60.0 million in upfront payments received from

52

Table of Contents

Schering under the Collaboration Agreement that were recorded as deferred revenue and an increase in accounts payable and accrued liabilities resulting principally from increased research and development activities, offset partially by the Novacea net loss and an increase in accounts receivable of $11.5 million due from Schering under the Collaboration Agreement. Net cash used in operating activities for the year ended December 31 2006, was $26.6 million, primarily attributable to the Novacea net loss, partially offset by an increase in accrued liabilities resulting principally from increased research and development activities.

Net Cash Provided by (Used in) Investing Activities

Net cash provided by investing activities for the year ended December 31, 2008 of $1.0 million was due primarily to net maturities of short-term investments. Net cash used in investing activities of $18.5 million for the year ended December 31, 2007 was primarily due to net purchases of short-term investments, and purchases of property and equipment. Net cash used in investing activities was $34.9 million for the year ended December 31, 2006, due primarily to net purchases of short-term investments.

Net Cash Provided by Financing Activities

Net cash provided by financing activities for the year ended December 31, 2008 of $0.1 million was due primarily to proceeds from the issuance of Novacea common stock from the exercise of outstanding stock options. Net cash provided by financing activities for the year ended December 31, 2007 of $13.2 million was due primarily to proceeds from the Novacea sale to Schering of 298,173 shares of its common stock for an aggregate purchase price of $12.0 million under a Common Stock Purchase Agreement, pursuant to the terms of the Collaboration Agreement, and the issuance of Novacea common stock from the exercise of outstanding stock options. Net cash provided by financing activities for the year ended December 31, 2006 of $39.9 million was primarily related to net proceeds from the sale of common stock in the Novacea initial public offering, the sale of convertible preferred stock and the issuance of Novacea common stock from the exercise of outstanding stock options.

Liquidity and Capital Resource Effects of the Merger with Transcept

On the same date as this Annual Report on Form 10-K, Transcept filed with the SEC a Current Report on Form 8-K/A that included, in addition to historical audited financial statements of TPI, an unaudited pro forma condensed combined balance sheet of Novacea and TPI as of December 31, 2008 indicating pro forma combined cash, cash equivalents and marketable securities of Transcept totaling approximately $97 million. As indicated below, after completion of the merger between Novacea and TPI, Novacea and Transcept subsequently used cash resources of approximately $4.7 million to pay transaction costs and to repay outstanding indebtedness.

Based on currently available information, Transcept believes that the additional cash resources made available through the merger with Novacea will enable it to carry out plans to commercialize its lead product candidate, Intermezzo^®, subject to FDA approval.

Transcept expects full year 2009 research and development expenses to remain consistent with the 2008 TPI research and development expense levels until such time as Transcept initiates development of pipeline product candidates or any post-approval clinical development activities for Intermezzo^®.

Full year 2009 general and administrative expenses are expected to increase as compared to 2008 as Transcept increases its administrative infrastructure to comply with the requirements of being a publicly traded company and prepares for the potential commercialization of Intermezzo^®, if approved by the FDA. The timing and amount of such increase as it relates to commercialization expenses will be largely dependent upon the Transcept ability to obtain FDA approval of the NDA for Intermezzo^® and efforts to secure a primary care marketing partner in the United States, as well as the terms and timing of such an event. Transcept can make no assurances that its activities to identify and secure such a relationship will result in a completed collaboration.

53

Table of Contents

Based on the foregoing assumptions concerning the timing of product approvals, if any, and levels of expense, Transcept currently expects the combined cash, cash equivalents, and marketable securities balances of Novacea and TPI to be sufficient to satisfy Transcept liquidity requirements for at least the next twelve months. These assumptions are subject to substantial risks and uncertainties, however, relating, among other factors, to the likelihood and timing of product approvals, costs associated with the commercial launch of Intermezzo^®, the timing and terms of any marketing or other collaboration agreements, and clinical development of other product candidates. To the extent the current Transcept projections prove inaccurate, Transcept could require additional financing sooner than it currently anticipates. There can be no assurances that financing will be available when or as needed or on commercially reasonable terms. As indicated below, global financial and economic conditions have deteriorated substantially within the last year, and obtaining financing on reasonable terms has become increasingly difficult, particularly for smaller biotechnology companies.

Merger Related Uses of Cash

Shortly after the January 30, 2009 close of the merger, Transcept repaid in full its outstanding credit obligations to Hercules Technology Growth Capital in the approximate amount of $2.7 million and also paid financial advisory fees of approximately $2.0 million.

In May 2008, Novacea adopted retention bonus and severance payment arrangements, pursuant to which Novacea agreed to make retention and severance payments to those non-executive employees who remain employed by Novacea, in accordance with the terms and conditions of retention bonus and severance payment arrangements, to assist Novacea with final wind-down activities related to the clinical programs, to maintain operations, and to evaluate potential strategic alternatives. The payment of retention bonuses and severance was contingent upon the completion of a defined transaction by Novacea, such as the merger with TPI on January 30, 2009, and was subject to continued employment through the date of the merger, or upon earlier termination by Novacea of the non-executive employee. Certain non-executive employees who were terminated during 2008 received retention bonuses and severance payments of $1.0 million in total on their termination dates. On January 30, 2009, Novacea made retention bonus and severance payments to non-executive employees that totaled $0.6 million.

Executive officers who remained with Novacea following the workforce reduction in accordance with the terms and conditions of retention bonus arrangements would also be eligible to receive retention payments. The payment of the retention bonuses was contingent upon the completion of a defined transaction by Novacea, such as the merger with TPI completed on January 30, 2009, and was subject to the employee’s continued employment through that date, or upon earlier termination by Novacea of the executive officer. Two executive officers who were terminated as of October 1, 2008 received retention payments of $0.3 million in total on their termination date. On January 30, 2009, Novacea made retention bonus payments to two executive officers that totaled $0.4 million upon termination of the executives’ employment. Additionally, in accordance with the terms of the severance payment arrangements, severance payments totaling approximately $1.8 million will be made to four Novacea executive officers in 2009 related to the completion of the merger with TPI and the related termination of their employment.

Potential Impact of Global Market and Economic Conditions on Transcept Liquidity

In the United States and around the world, recent market and economic conditions have been unprecedented and challenging, with tighter credit conditions and slower growth through 2008. During 2008 and into 2009, continued concerns about the systemic impact of the availability and cost of credit, energy costs, geopolitical issues, the U.S. mortgage market, a declining real estate market in the U.S. and added concerns fueled by the federal government interventions in the U.S. financial and credit markets have contributed to instability in both U.S. and international capital and credit markets and diminished expectations for the U.S. and global economy. These conditions, combined with volatile oil prices, declining business and consumer confidence and increased unemployment have contributed to volatility of unprecedented levels and an economic slowdown.

54

Table of Contents

As a result of these market conditions, the cost and availability of capital and credit has been and may continue to be adversely affected by illiquid credit markets and wider credit spreads. If volatile and adverse market conditions continue, they may limit the ability of Transcept to timely borrow or access the capital and credit markets to meet liquidity needs, resulting in an adverse effect on the financial condition and results of operations of Transcept. In addition, the biotechnology industry has fluctuated significantly in the past and has experienced significant downturns in connection with, or in anticipation of, deterioration in general economic conditions, and Transcept cannot accurately predict the severity or duration of any downturn.

Off-Balance Sheet Arrangements

As of December 31, 2008, Novacea had no off-balance sheet arrangements, as defined under Regulation S-K Item 303(a)(4).

Contingencies

There are no legal proceedings or other matters as of December 31, 2008 that are expected to have a material adverse effect on the financial position of either Novacea or TPI, or the results of operations or cash flows of either Novacea or TPI.

On April 1, 2008, a former officer of Novacea filed a complaint in San Mateo County Superior Court against Novacea alleging three separate breaches of contract and/or failure to take certain actions with respect to Novacea securities held by the former officer. Effective on or about December 12, 2008, Novacea and the former officer of Novacea that filed the complaint executed a settlement agreement and general release settling all claims of the former officer. Novacea subsequently paid the former officer $950,000 in December 2008 in connection with the settlement.

Contractual Obligations and Commitments

The combined Transcept contractual obligations and commitments (including those of both Novacea and TPI) as of December 31, 2008 include potential purchase commitments and future minimum lease payments under operating leases, as shown in the following table:

Total Contractual Obligations

(in thousands)

55

Table of Contents

In June 2007, Novacea entered into an operating lease for its corporate facilities, located in South San Francisco, California. The Novacea lease for the corporate facilities is non-cancelable and has a five year term. The lease provides for periodic rent increases based upon previously negotiated or consumer price indexed adjustments.

In January 2009, Novacea terminated its licenses to Asentar^™ and AQ4N, and returned the rights to the product candidates to the licensors. Under the termination provisions of one of the licenses, Novacea was obligated to make a payment of approximately $0.3 million in January 2009. This amount was included in Novacea accounts payable as of December 31, 2008 and not included in the table above.

Recently Issued Accounting Pronouncements

Statement of Financial Accounting Standards No. 141 (Revised 2007), Business Combinations (SFAS No. 141R). In December 2007 Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards, or SFAS No. 141R, Business Combinations, or SFAS No. 141R. SFAS No. 141R establishes principles and requirements for recognizing and measuring assets acquired, liabilities assumed and any noncontrolling interest in the acquiree in a business combination. SFAS No. 141R also provides guidance for recognizing and measuring goodwill acquired in a business combination, including capitalizing at the acquisition date the fair value of acquired in-process research and development, and requires the acquirer to disclose information it needs to evaluate and understand the financial effect of the business combination. SFAS No. 141R is effective for business combinations for which the acquisition date is on or after December 15, 2008; therefore, the merger of Novacea and TPI, which was completed on January 30, 2009, will be accounted for in accordance with SFAS No. 141R.

Critical Accounting Policies

This discussion and analysis of the financial condition and results of operations of Novacea is based on its financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as revenue and expenses during the reporting periods. Novacea evaluated its estimates and judgments on an ongoing basis. Novacea based its estimates on historical experience and on various other factors that it believed were reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Therefore, actual results could differ materially from those estimates under different assumptions or conditions.

Fair Value Measurements. Effective January 1, 2008, Novacea adopted SFAS No. 157, Fair Value Measurements, or SFAS No. 157, on a prospective basis for financial assets and liabilities, which required that Novacea determine the fair value of financial assets and liabilities using the fair value hierarchy established in SFAS No. 157. In February 2008, FASB issued FASB Staff Position No. FAS 157-2, Effective Date of FASB Statement No. 157, which provides a one year deferral of the effective date of SFAS No. 157 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed in the financial statements at fair value at least annually.

SFAS No. 157 defines “fair value” as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, or an exit price. Where

56

Table of Contents

available, fair value is based on observable market prices or parameters or derived from such prices or parameters. Where observable prices or inputs are not available, valuation models are applied. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on several factors, including the instruments’ complexity.

Beginning January 1, 2008, assets and liabilities recorded at fair value are categorized based upon the level of judgment associated with inputs used to measure their value. SFAS No. 157 defines a three-level valuation hierarchy for disclosure of fair value measurements as follows:

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. Where quoted prices are available in an active market, securities are classified as Level 1 of the valuation hierarchy. Level 1 securities include highly liquid money market funds. If quoted market prices are not available for the specific security, then Novacea estimates fair value by using pricing models, quoted prices of securities with similar characteristics or discounted cash flows. Level 2 instruments include commercial paper, U.S. corporate debt, and U.S. government sponsored enterprise issues.

During the year ended December 31, 2008, there were no significant changes to the valuation models used for purposes of determining the fair value of Level 2 assets, and there were no assets characterized as Level 3.

Revenue Recognition. Novacea applied the revenue recognition criteria outlined in Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements, and Emerging Issues Task Force Issue No. 00-21, Revenue Arrangements with Multiple Deliverables.

Revenue arrangements with multiple components are divided into separate units of accounting if certain criteria are met, including whether the delivered component has stand-alone value to the customer, and whether there is objective and reliable evidence of the fair value of the undelivered items. Consideration received is allocated among the separate units of accounting based on their respective fair values. Applicable revenue recognition criteria are then applied to each of the units.

Revenue is recognized when the four basic criteria of revenue recognition are met:

For each source of revenue, Novacea complied with the above revenue recognition criteria in the following manner:

57

Table of Contents

Research and Development Cost. Research and development expenditures are charged to operations as incurred, pursuant to SFAS No. 2, Accounting for Research and Development Costs. The costs to acquire technologies to be used in research and development, but which have not reached technological feasibility and have no alternative future use are expensed when incurred. Payments to licensors that relate to the achievement of pre-approval development milestones are recorded as research and development expense when incurred. Research and development costs for activities conducted through third parties with whom Novacea contracts are expensed as the costs are incurred. To the extent Novacea makes a payment to a third party vendor representing a refundable deposit, such payment is recorded as a prepaid expense. These third party vendors may include contract research organizations, third-party manufacturers of drug material and clinical supplies and other vendors.

Prior to ending all of its clinical trials and exploring potential strategic alternatives, investigator costs related to patient enrollment were accrued as patients entered the trials. Novacea monitored patient enrollment levels and related activities to the extent possible through internal reviews and correspondence and discussions with external vendors in order to estimate its incurred expenses. Due to the possibility of incomplete or inaccurate information, Novacea may underestimate or overestimate activity levels and related expenses associated with any of its clinical trials at a given point in time. In such an event, Novacea would record adjustments to research and development expenses in future periods when the actual activity level becomes known. In the past, Novacea has not had to make any material adjustments to research and development expenses due to deviations between the estimates used in determining its accruals for clinical trial expenses and the actual clinical trial expenses incurred. Additionally, Novacea does not expect material adjustments to research and development expenses to result from changes in the nature and level of clinical trial activity and related expenses that are currently subject to estimation.

Stock-Based Compensation. On January 1, 2006, Novacea adopted the fair value recognition provisions of SFAS No. 123R, Share-Based Payment—An Amendment of FASB Statements No. 123 and 95, or SFAS No. 123R. Novacea adopted SFAS No. 123R using the prospective transition method. Under the prospective transition method, beginning January 1, 2006, compensation cost recognized includes:

58

Table of Contents

Novacea uses the Black-Scholes option pricing model to determine the fair value of stock options. The determination of the fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by the Novacea stock price as well as assumptions regarding a number of complex and subjective variables. These variables include expected Novacea stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rates and expected dividends.

Novacea estimates the expected term of options using the “simplified” method, as illustrated in Staff Accounting Bulletin No. 107. As Novacea has been operating as a public company for a period of time that is shorter than its estimated expected option term, it is unable to use actual price volatility data. Therefore, Novacea estimates the volatility of its common stock based on volatility of similar entities. Novacea bases the risk-free interest rate that it uses in the option pricing model on U.S. Treasury zero-coupon issues with remaining terms similar to the expected term on the options. Novacea does not anticipate paying any cash dividends in the foreseeable future and therefore uses an expected dividend yield of zero in the option pricing model. Novacea is required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. Novacea uses historical data to estimate pre-vesting option forfeitures and record stock-based compensation expense only for those awards that are expected to vest. All stock-based payment awards are amortized on a straight-line basis over the requisite service periods of the awards, which are generally the vesting periods.

Calculating stock-based compensation expense requires the input of highly subjective assumptions, which represent the best estimates of Novacea and involve inherent uncertainties and the application of management judgment. Estimates of stock-based compensation expenses are significant to the Novacea financial statements, but these expenses are based on the Black-Scholes option valuation model and do not result in the payment of cash by Novacea.

See Note 1 to the Novacea Financial Statements included in this Annual Report on Form 10-K for further information regarding Novacea’s stock-based compensation.

Income Taxes

Novacea uses the liability method for accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax reporting bases of assets and liabilities and are measured using enacted tax rates and laws that are expected to be in effect when the differences are expected to reverse. Currently, there is no provision for income taxes as Novacea has an accumulated deficit to date.

As of December 31, 2008, Novacea had net operating loss carry-forwards for federal income tax purposes of approximately $78.3 million and research credits of approximately $2.2 million, which will expire beginning in the year 2021. Novacea also had state net operating loss carry-forwards of approximately $78.1 million, which expire beginning in 2014. Novacea also had state research credits of approximately $2.1 million, which have no expiration date. Certain amounts included in these carry-forwards will be recorded to equity, rather than a benefit to income tax expense, when they reduce cash taxes payable.

Novacea did not record a benefit from its net operating loss carry forwards because it believed that it was uncertain that Novacea would have sufficient income from future operations to realize the carry-forwards prior to their expiration. Accordingly, Novacea established a valuation allowance against the deferred tax asset arising from the carry-forwards.

Utilization of the net operating loss carry-forwards and credits may be subject to a substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code of 1986, as amended, and similar state provisions. Such limitations may also result from the change in ownership resulting from the Company’s merger with TPI. The annual limitation may result in the expiration of net operating loss carry-forwards and credits before utilization.

59

Table of Contents

Concentration of credit risk for Transcept consists principally of cash, cash equivalents, and marketable securities. Transcept’s exposure to market risk is limited primarily to interest income sensitivity, which is affected by changes in the general level of United States interest rates, particularly because the majority of Transcept investments are in short-term debt securities.

The Transcept investment policy restricts investments to high-quality investments and limits the amounts invested with any one issuer. The goals of the Transcept investment policy are as follows: preservation of capital; fulfillment of liquidity needs; and fiduciary control of cash and investments. Some of the securities in which Transcept invests may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if Transcept holds a security that was issued with an interest rate fixed at the then-prevailing rate and the prevailing interest rate later rises, the principal amount of the Transcept investment will probably decline. To minimize this risk, in accordance with its investment policy, Transcept maintains its portfolio of cash equivalents, short-term marketable securities and restricted cash in a variety of securities, including commercial paper, money market funds, government and non-government debt securities and certificates of deposit. The risk associated with fluctuating interest rates is limited to the Transcept investment portfolio. As of December 31, 2008, all of the investments of Novacea and TPI were in money market accounts, certificates of deposit or investment grade corporate debt. Due to the short-term nature of these investments, a 10% movement in market interest rates would not have a material impact on the total fair market value of the combined TPI and Novacea portfolio as of December 31, 2008.

60

Table of Contents

Index to Financial Statements

61

Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders of Transcept Pharmaceuticals, Inc.

We have audited the accompanying balance sheets of Novacea, Inc. as of December 31, 2008 and 2007 and the related statements of operations, convertible preferred stock and stockholders’ equity (net capital deficiency), and cash flows for each of the three years in the period ended December 31, 2008. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Novacea, Inc. at December 31, 2008 and 2007, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles.

/s/ Ernst & Young LLP

Palo Alto, California

March 26, 2009

62

Table of Contents

Novacea, Inc.

Balance Sheets

(in thousands, except for share and per share amounts)