UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

 

 

 

Commission File Number: 000-51863

 

VANDA PHARMACEUTICALS INC.

(Exact name of registrant as specified in its charter)

 

 

 

(240) 599-4500

 

(Registrant’s telephone number, including area code)

 

 

 

 

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

 

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

 

(Do not check if a smaller reporting company)

 

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

 

As of November 6, 2008, there were 26,653,478 shares of the registrant’s common stock issued and outstanding.

 

 

Vanda Pharmaceuticals Inc.
(A Development Stage Enterprise)

 

Form 10-Q Index

 

For the Three and Nine Months Ended September 30, 2008

 

 

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

 

Business organization

 

Vanda Pharmaceuticals Inc. (Vanda or the Company) is a biopharmaceutical company focused on the development and commercialization of small molecule therapeutics, with exclusive worldwide commercial rights to two product candidates in clinical development for various central nervous system disorders. Vanda commenced its operations in 2003. The Company’s lead product candidate, iloperidone, is a compound for the treatment of schizophrenia and bipolar disorder. The Company submitted a New Drug Application (NDA) for iloperidone in schizophrenia to the United States Food and Drug Administration (FDA) on September 27, 2007. On November 27, 2007, the FDA accepted the NDA for iloperidone in schizophrenia. In July 2008, the Company announced that the FDA had determined that Vanda’s NDA was not approvable, which will require the Company, among other things, to conduct additional studies and submit that data before the FDA will approve iloperidone for commercial sale for the treatment of schizophrenia. In September 2008, the Company met with the FDA to discuss the FDA’s determination. The FDA asked the Company to provide a complete response to the not-approvable letter, which the Company submitted on November 6, 2008. The timing or outcome of any FDA review of the response is uncertain at this time. As a result, the Company has suspended all iloperidone-related activities pending further review. The Company’s second product candidate, tasimelteon (VEC-162), is a compound for the treatment of sleep and mood disorders. In November 2006 Vanda announced positive top-line results from the Phase III trial of tasimelteon in transient insomnia. In June 2008 the Company announced positive top-line results from the Phase III trial of tasimelteon in chronic primary insomnia. Tasimelteon is also ready for Phase II trials for the treatment of depression. The Company’s rights to a third product candidate, VSF-173, a compound for the treatment of excessive sleepiness, were terminated as a result of the Company’s failure to satisfy a specific development milestone within the time period specified in the license agreement pursuant to which the Company was granted such rights.

 

Capital resources

 

Since its inception, the Company has devoted substantially all of its efforts to business planning, research and development, market research, recruiting management and technical staff, acquiring operating assets and raising capital. Accordingly, the Company is considered to be in the development stage as defined in Statement of Financial Accounting Standards (SFAS) No. 7, Accounting and Reporting by Development Stage Enterprises.

 

The Company’s activities will necessitate significant uses of working capital for the foreseeable future. The Company’s capital requirements will depend on many factors, including the success of the Company’s research and development efforts, the satisfaction of certain regulatory requirements, payments received under contractual agreements with other parties, if any, and the status of competitive products. However, given the recent decision by the FDA with respect to the NDA for iloperidone, and that the additional studies required by the FDA prior to its approval of iloperidone would require significant capital in excess of the Company’s currently available resources, the Company’s management intends to operate under a reduced spending plan, and believes that the Company’s existing cash, cash equivalents and marketable securities will be sufficient to fund operations at least through the fourth quarter of 2009. In budgeting for its activities, the Company has relied on a number of assumptions, including assumptions that the Company will not conduct any additional clinical trials for either the oral or injectable formulations of iloperidone, that it will not expend funds on the bipolar indication for iloperidone, that it will not engage in any further commercial activities related to iloperidone, that it will not engage in further in-licensing activities, that it will not receive any proceeds from potential partnerships, that it will not conduct additional trials for tasimelteon, that it will be able to retain its key personnel, that it will amend the NDA for iloperidone and continue to seek FDA approval, that it will

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

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

 

continue to evaluate clinical and pre-clinical compounds for potential development, and that it will not incur any significant contingent liabilities.

 

The Company may need to raise additional funds if one or more of its assumptions proves to be incorrect or if it chooses to resume its commercialization efforts with respect to iloperidone, expand its product development efforts, conduct additional clinical trials for one or more of its product candidates or seek to acquire additional product candidates, and the Company may decide to raise additional funds even before they are needed if the conditions for raising capital are favorable. However, the Company may not be able to raise additional funds on acceptable terms, or at all. If the Company is unable to secure sufficient capital to fund its research and development activities, the Company may not be able to continue operations, or the Company may have to enter into collaboration agreements that could require the Company to share commercial rights to its products to a greater extent or at earlier stages in the drug development process than is currently intended. These collaborations, if consummated prior to proof-of-efficacy or safety of a given product candidate, could impair the Company’s ability to realize value from that product candidate.

 

Basis of presentation

 

The accompanying unaudited condensed consolidated financial statements of Vanda Pharmaceuticals Inc. have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) and the rules and regulations of the Securities and Exchange Commission (SEC) for interim financial information. Accordingly, they do not include all the information and footnotes required by GAAP for complete financial statements and should be read in conjunction with the Company’s consolidated financial statements for the year ended December 31, 2007 included in the Company’s annual report on the Form 10-K. The financial information as of September 30, 2008 and for the periods of the three and nine months ended September 30, 2008 and 2007 and for the period from March 13, 2003 (inception) to September 30, 2008, is unaudited, but in the opinion of management all adjustments, consisting only of normal recurring accruals, considered necessary for a fair statement of the results of these interim periods have been included. The condensed consolidated balance sheet data as of December 31, 2007 was derived from audited financial statements but does not include all disclosures required by GAAP.

 

The results of the Company’s operations for any interim period are not necessarily indicative of the results that may be expected for any other interim period or for a full fiscal year. The financial information included herein should be read in conjunction with the consolidated financial statements and notes in the Company’s annual report incorporated by reference in the Form 10-K for the year ended December 31, 2007.

 

 

Use of estimates

 

The preparation of financial statements in conformity with GAAP requires management to make estimates that affect the reported amounts of assets and liabilities at the date of the financial statements, disclosure of contingent assets and liabilities, and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

 

Cash and cash equivalents

 

For purposes of the condensed consolidated balance sheets and condensed consolidated statements of cash flows, cash equivalents represent highly-liquid investments with a maturity of three months or less at the date of purchase.

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

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

 

Marketable securities

 

The Company classifies all of its marketable securities as available-for-sale securities. The Company’s investment policy requires the selection of high-quality issuers, with bond ratings of AAA to A1+/P1. Available-for-sale securities are carried at fair value, with the unrealized gains and losses reported as a component of stockholders’ equity in accumulated other comprehensive income/loss. Interest and dividend income is recorded when earned and included in interest income. Premiums and discounts on marketable securities are amortized or accreted, respectively, to maturity and included in interest income. The Company uses the specific identification method in computing realized gains and losses on the sale of investments, which would be included in the condensed consolidated statements of operations when generated. Marketable securities with a maturity of more than one year as of the balance sheet date are classified as long-term securities.

 

Concentrations of credit risk

 

Financial instruments which potentially subject the Company to significant concentrations of credit risk consist primarily of cash, cash equivalents and marketable securities. The Company places its cash, cash equivalents and marketable securities with highly-rated financial institutions. The Company is monitoring one corporate note affected by the current credit crisis. The note is expected to mature in May 2009 and the Company expects minimal losses, if any. At September 30, 2008, the Company maintained all of its cash, cash equivalents and marketable securities in three financial institutions. Deposits held with these institutions may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand, and the Company believes there is minimal risk of losses on such balances.

 

Employee stock-based compensation

 

The Company accounts for the stock-based compensation expenses in accordance with the Financial Accounting Standards Board (FASB) revised SFAS No. 123, Share-Based Payment (SFAS 123(R)) adopted on January 1, 2006. Accordingly, compensation costs for all stock-based awards to employees and directors are measured based on the grant date fair value of those awards and recognized over the period during which the employee or director is required to perform service in exchange for the award. The Company recognizes the expense over the award’s vesting period.

 

For stock awards granted subsequent to January 1, 2006, expenses are amortized under the accelerated attribution method. For stock awards granted prior to January 1, 2006, expenses are amortized under the accelerated attribution method for options that were modified after the original grant date and under the straight-line attribution method for all other options. As stock-based compensation expense recognized in the condensed consolidated statements of operations for the three and nine months ended September 30, 2008 and 2007 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Pre-vesting forfeitures on the options granted subsequent to 2006 were estimated to be approximately 2% based on the Company’s historical experience.

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

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

 

Total stock-based compensation expense recognized during the three and nine months ended September 30, 2008 and 2007 and the period from March 13, 2003 (inception) to September 30, 2008 was comprised of the following:

 

 

As of September 30, 2008, approximately $16.1 million of total unrecognized compensation costs related to non-vested awards are expected to be recognized over a weighted average period of 1.36 years.

 

As of September 30, 2008, the Company had two equity incentive plans, the Second Amended and Restated Management Equity Plan (the 2004 Plan) and the 2006 Equity Incentive Plan (the 2006 Plan) that were adopted in December 2004 and April 2006, respectively. An aggregate of 1,158,799 shares were subject to outstanding options granted under the 2004 Plan as of September 30, 2008, and no additional options will be granted under this plan. As of September 30, 2008 there are 3,451,250 shares of the Company’s common stock reserved under the 2006 Plan of which 3,096,689 shares were subject to outstanding options to employees and non-employees.

 

Options are subject to terms and conditions established by the compensation committee of the board of directors. None of the stock-based awards are classified as a liability as of September 30, 2008. Option awards have 10-year contractual terms and all options granted prior to December 31, 2006, options granted to new employees, and certain options granted to existing employees vest and become exercisable on the first anniversary of the grant date with respect to 25% of the shares subject to the option awards. The remaining 75% of the shares subject to the option awards vest and become exercisable monthly in equal installments thereafter over three years. Certain option awards granted to existing employees after December 31, 2006 vest and become exercisable monthly in equal installments over four years. The initial stock options granted to directors upon their election vest and become exercisable in equal monthly installments over a period of four years, while the subsequent annual stock option grants to directors vest and become exercisable in equal monthly installments over a period of one year. Certain option awards to executives and directors provide for accelerated vesting if there is a change in control of the Company.

 

The fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton option pricing model that uses the assumptions noted in the following table. Expected volatility rates are based on historical volatility of the common stock of comparable entities and other factors due to the lack of historic information of the Company’s publicly traded common stock. The expected term of options granted is based on the transition approach provided by Staff Accounting Bulletin (SAB) No. 110 as the options meet the “plain vanilla” criteria required by this guidance. The risk-free interest rates are based on the U.S. Treasury yield for a

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

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

 

period consistent with the expected term of the option in effect at the time of the grant. The Company has not paid dividends to its stockholders since its inception and does not plan to pay dividends in the foreseeable future.

 

Assumptions used in the Black-Scholes-Merton option pricing model for employee and director stock options granted during the nine months ended September 30, 2008 and 2007 were as follows:

 

 

A summary of option activity for the 2004 Plan is presented below:

 

 

A summary of option activity for the 2006 Plan is presented below:

 

 

The weighted average grant-date fair value of options granted during the nine months ended September 30, 2008 was $3.02 per share. For the nine months ended September 30, 2008 and 2007 the Company received a total of $0 and $103,176, respectively, in cash from options exercised under the stock-based arrangements.

 

Accrued expenses

 

Management is required to estimate accrued expenses as part of the process of preparing financial statements. The estimation of accrued expenses involves identifying services that have been performed on the Company’s behalf, and then estimating the level of service performed and the associated cost incurred for such services as of each balance sheet date in the financial statements. Accrued expenses include professional service fees, such as lawyers and accountants, contract service fees, such as those under contracts with clinical monitors,

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

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

 

data management organizations and investigators in conjunction with clinical trials, fees to contract manufacturers in conjunction with the production of clinical materials, and fees for marketing and other commercialization activities. Pursuant to management’s assessment of the services that have been performed on clinical trials and other contracts, the Company recognizes these expenses as the services are provided. Such management assessments include, but are not limited to: (1) an evaluation by the project manager of the work that has been completed during the period, (2) measurement of progress prepared internally and/or provided by the third-party service provider, (3) analyses of data that justify the progress, and (4) management’s judgment.

 

Research and development expenses

 

The Company’s research and development expenses consist primarily of fees for services provided by third parties in connection with the clinical trials, costs of contract manufacturing services, milestone license fees, costs of materials used in clinical trials and research and development, cost for regulatory consultants and filings, depreciation of capital resources used to develop products, all related facilities costs, and salaries, other employee related costs and stock-based compensation for the research and development personnel. The Company expenses research and development costs as they are incurred, including payments made to date under the license agreements. Manufacturing-related costs are also included in research and development expenses as the Company does not yet have FDA approval for any of its product candidates. Costs related to the acquisitions of intellectual property have been expensed as incurred since the underlying technology associated with these acquisitions were made in connection with the Company’s research and development efforts and have no alternative future use. Milestone payments are accrued in accordance with SFAS No. 5, Accounting for Contingencies, when it is deemed probable that the milestone event will be achieved.

 

General and administrative expenses

 

General and administrative expenses consist primarily of salaries, other employee related costs and stock-based compensation for personnel serving executive, business development, marketing, finance, accounting, information technology and human resource functions, facility costs not otherwise included in research and development expenses, insurance costs and professional fees for legal, accounting and other professional services. General and administrative costs also include third party expenses incurred to support business development, marketing and other business activities related to the Company’s product candidate iloperidone.

 

Income taxes

 

The Company accounts for income taxes under the liability method in accordance with the provisions of SFAS No. 109, Accounting for Income Taxes (SFAS 109), which requires companies to account for deferred income taxes using the asset and liability method. Under the asset and liability method, current income tax expense or benefit is the amount of income taxes expected to be payable or refundable for the current year. A deferred income tax asset or liability is recognized for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and tax credits and loss carryforwards. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Tax rate changes are reflected in income during the period such changes are enacted. Changes in ownership may limit the amount of net operating loss carryforwards that can be utilized in the future to offset taxable income.

 

Segment information

 

Management has determined that the Company operates in one business segment which is the development and commercialization of pharmaceutical products.

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

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

 

Recent accounting pronouncements

 

In October 2008, the FASB issued Staff Position No. FSP FAS 157-3 “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (FSP FAS 157-3) which amends FAS 157 to include guidance on how to determine the fair value of a financial asset in an inactive market and which is effective immediately on issuance, including prior periods for which financial statements have not been issued. The implementation of FSP FAS 157-3 did not have a material impact on the Company’s financial position and results of operations.

 

In December 2007, the FASB issued SFAS No. 141 (revised 2007) (SFAS 141R), Business Combinations and SFAS No. 160 (SFAS 160), Noncontrolling Interests in Consolidated Financial Statements, an amendment of Accounting Research Bulletin No. 51. SFAS 141R will change how business acquisitions are accounted for and will impact financial statements both on the acquisition date and in subsequent periods. SFAS 160 will change the accounting and reporting for minority interests, which will be recharacterized as noncontrolling interests and classified as a component of equity. SFAS 141R and SFAS 160 will be applied to acquisitions that close in years beginning after December 15, 2008. Early adoption is not permitted. These pronouncements are not expected to have significant impact on the Company’s results of operations and financial condition.

 

In December 2007, the FASB ratified EITF Issue 07-1, Accounting for Collaborative Arrangements (EITF 07-1). The consensus prohibits the equity method of accounting for collaborative arrangements under APB 18, The Equity Method of Accounting for Investments in Common Stock, unless a legal entity exists. Payments between the collaborative partners will be evaluated and reported in the income statement based on applicable GAAP. Absent specific GAAP, the participants to the arrangement will apply other existing GAAP by analogy or apply a reasonable and rational accounting policy consistently. The guidance in EITF 07-1 is effective for periods that begin after December 15, 2008 and will apply to arrangements in existence as of the effective date. The effect of the new consensus will be accounted for as a change in accounting principle through retrospective application. The Company is currently evaluating the impact of EITF 07-1 on its results of operations and financial condition.

 

 

Net loss attributable to common stockholders per share is calculated in accordance with SFAS No. 128, Earnings per Share and SAB No. 98. Basic earnings per share (EPS) is calculated by dividing the net income or loss attributable to common stockholders by the weighted average number of shares of common stock outstanding, reduced by the weighted average unvested shares of common stock subject to repurchase.

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

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

 

Diluted EPS is computed by dividing the net income or loss attributable to common stockholders by the weighted average number of other potential common stock outstanding for the period. Other potential common stock includes stock options and warrants to purchase common stock, but only to the extent that their inclusion is dilutive. The Company incurred a net loss in all periods presented, causing inclusion of any potentially dilutive securities to have an anti-dilutive effect, resulting in dilutive loss per share attributable to common stockholders and basic loss per share attributable to common stockholders being equivalent. The Company did not have any common shares issued for nominal consideration as defined under the terms of SAB No. 98, which would be included in EPS calculations.

 

 

 

The following is a summary of the Company’s available-for-sale marketable securities as of September 30, 2008:

 

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

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

 

The following is a summary of the Company’s available-for-sale marketable securities as of December 31, 2007:

 

 

 

The following is a summary of the Company’s prepaid expenses, deposits and other current assets, as of September 30, 2008, and December 31, 2007:

 

 

 

The following is a summary of the Company’s property and equipment — at cost, as of September 30, 2008, and December 31, 2007:

 

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

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

 

Depreciation and amortization expense for the nine months ended September 30, 2008 and 2007 were $403,141 and $446,806, respectively, and for the period from March 13, 2003 (inception) to September 30, 2008 was $2,371,997.

 

 

The following is a summary of accrued liabilities, as of September 30, 2008, and December 31, 2007:

 

 

 

Operating leases

 

The Company has commitments totaling approximately $5.8 million under operating real estate leases for its headquarters located in Rockville, Maryland, expiring in 2016.

 

Consulting fees

 

The Company has engaged a regulatory consultant to assist in the Company’s efforts to obtain FDA approval of the iloperidone NDA. The Company has committed to initial consulting expenses in the aggregate amount of $2.0 million pursuant to this engagement, $122,000 of which was expensed in the third quarter of 2008, and the remainder of which will be expensed in the fourth quarter of 2008. In addition, the Company may retain the services of the consultant on a monthly basis from and after January 1, 2009 through December 31, 2010. In the event that the iloperidone NDA is approved by the FDA, the Company will be obligated to pay the consultant a success fee of $6.0 million, which amount will be offset by the aggregate amount of all monthly retainer fees previously paid to the consultant (Success Fee). In addition to these fees, the Company is obligated to reimburse the consultant for its ordinary and necessary business expenses incurred in connection with its engagement. The Company may terminate the engagement at any time; however, the Company will remain obligated to pay any remaining Success Fee if the iloperidone NDA is approved by the FDA following such termination.

 

Guarantees and indemnifications

 

The Company has entered into a number of standard intellectual property indemnification agreements in the ordinary course of its business. Pursuant to these agreements, the Company has agreed to indemnify, hold harmless, and to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally the Company’s business partners or customers, in connection with any U.S. patent or any copyright or other intellectual property infringement claim by any third party with respect to the Company’s products. The term of these indemnification agreements is generally perpetual from the date of execution of the agreement. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited. Since inception, the Company has not incurred costs to defend

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

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

 

lawsuits or settle claims related to these indemnification agreements. The Company also agreed to indemnify its officers and directors for certain events or occurrences, subject to certain limits. The Company believes that the fair value of the indemnification agreements is minimal, and accordingly the Company has not recognized any liabilities relating to these agreements as of September 30, 2008.

 

License agreements

 

The Company’s rights to develop and commercialize the clinical-stage product candidates are subject to the terms and conditions of licenses granted to the Company by other pharmaceutical companies.

 

Iloperidone.  The Company acquired exclusive worldwide rights to patents for iloperidone through a sublicense agreement with Novartis. A predecessor company of sanofi-aventis, Hoechst Marion Roussel, Inc. (HMRI), discovered iloperidone and completed early clinical work on the compound. In 1996, following a review of its product portfolio, HMRI licensed its rights to the iloperidone patents to Titan Pharmaceuticals, Inc. on an exclusive basis. In 1997, soon after it had acquired its rights, Titan sublicensed its rights to iloperidone on an exclusive basis to Novartis. In June 2004, the Company acquired exclusive worldwide rights to these patents to develop and commercialize iloperidone through a sublicense agreement with Novartis. In partial consideration for this sublicense, the Company paid Novartis an initial license fee of $500,000 and is obligated to make future milestone payments to Novartis of less than $100 million in the aggregate (the majority of which are tied to sales milestones), as well as royalty payments to Novartis at a rate which, as a percentage of net sales, is in the mid-twenties. In November 2007, the Company met a milestone under this license agreement relating to the acceptance of its filing of the NDA for iloperidone for the treatment of schizophrenia and made a license payment of $5 million to Novartis.

 

The rights with respect to the patents to develop and commercialize iloperidone may terminate, in whole or in part, if the Company fails to meet certain development or commercialization milestones relating to the time it takes for the Company to launch iloperidone commercially following regulatory approval, and the time it takes for the Company to receive regulatory approval following the submission of an NDA or equivalent foreign filing. Additionally, the Company’s rights may terminate in whole or in part if the Company does not meet certain other obligations under the sublicense agreement to make royalty and milestone payments, if the Company fails to comply with requirements in the sublicense agreement regarding its financial condition, or if the Company does not abide by certain restrictions in the sublicense agreement regarding other development activities.

 

Tasimelteon.  In February 2004, the Company entered into a license agreement with Bristol-Myers Squibb (BMS) under which the Company received an exclusive worldwide license under certain patents and patent applications, and other licenses to intellectual property, to develop and commercialize tasimelteon. In partial consideration for the license, the Company paid BMS an initial license fee of $500,000 and is obligated to make future milestone payments to BMS of less than $40 million in the aggregate (the majority of which are tied to sales milestones) as well as royalty payments based on the net sales of tasimelteon at a rate which, as a percentage of net sales, is in the low teens. The Company is also obligated under this agreement to pay BMS a percentage of any sublicense fees, upfront payments and milestone and other payments (excluding royalties) that the Company receives from a third party in connection with any sublicensing arrangement, at a rate which is in the mid-twenties. The Company has agreed with BMS in the license agreement for tasimelteon to use commercially reasonable efforts to develop and commercialize tasimelteon and to meet certain milestones in initiating and completing certain clinical work. During March 2006, the Company met its first milestone relating to the initiation of the Phase III clinical trial for tasimelteon and recorded a license fee expense of $1,000,000.

 

BMS holds certain rights with respect to tasimelteon in the license agreement. If the Company has not agreed to one or more partnering arrangements to develop and commercialize tasimelteon in certain significant

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

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

 

markets with one or more third parties after the completion of the Phase III program, BMS has the option to exclusively develop and commercialize tasimelteon on its own on pre-determined financial terms, including milestone and royalty payments. If the Company seeks a co-promotion agreement for tasimelteon, BMS has a right of first negotiation to enter into such an agreement with the Company.

 

Either party may terminate the tasimelteon license agreement under certain circumstances, including a material breach of the agreement by the other. In the event that BMS has not exercised its option to reacquire the rights to tasimelteon and the Company terminates the license, or if BMS terminates the license due to the Company’s breach, all rights licensed and developed by the Company under this agreement will revert or otherwise be licensed back to BMS on an exclusive basis.

 

VSF-173.  In June 2004, the Company entered into a license agreement with Novartis under which the Company received an exclusive worldwide license to develop and commercialize VSF-173. In consideration for the license, the Company paid Novartis an initial license fee of $500,000. The Company was also obligated to make future milestone payments to Novartis of less than $50 million in the aggregate (the majority of which are tied to sales milestones) and royalty payments at rates which, as a percentage of net sales, range from the low-to-mid teens. In March 2007, the Company met its first milestone under this license agreement relating to the initiation of the Phase II clinical trial for VSF-173, and recorded a license fee expense of $1,000,000.

 

On November 3, 2008, the Company received written notice from Novartis that the license agreement had terminated in accordance with its terms as a result of the Company’s failure to satisfy a specific development milestone within the time period specified in the license agreement. As a result, the Company no longer has any rights with respect to VSF-173 and Novartis has a non-exclusive worldwide license to all information and intellectual property generated by or on behalf of the Company related to its development of VSF-173. The Company is currently evaluating any options that it may have with respect to VSF-173, which may include the possibility of entering into a new license agreement or other arrangement with Novartis to allow the Company to resume its development of VSF-173; however, there can be no assurance that the Company will be able to enter into such an agreement or arrangement on acceptable terms, or at all.

 

Future license payments.  No amounts were recorded as liabilities nor were any contractual obligations relating to the license agreements included in the condensed consolidated financial statements as of September 30, 2008, since the amounts, timing and likelihood of these future payments are unknown and will depend on the successful outcome of future clinical trials, regulatory filings, favorable FDA regulatory approvals, growth in product sales and other factors.

 

Research and development and marketing agreements

 

The Company entered into agreements with several organizations to provide services relating to clinical development, clinical manufacturing activities and marketing services under fee service arrangements. The Company’s current agreements for these services may be terminated on no more than 60 days notice without incurring additional charges, other than charges for work completed but not paid for through the effective date of termination and other costs incurred by the Company’s contractors in closing out work in progress as of the effective date of termination.

 

 

On January 1, 2007, the Company adopted the provisions of Financial Accounting Standards Board Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes. The adoption of FIN No. 48 did not have a material effect on the Company’s financial position or results of operations. In addition, there are no uncertain tax positions whose resolution in the next twelve months is expected to materially affect operating

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

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

 

results. The Company accounts for income taxes using the asset and liability method. Deferred income taxes are recognized by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The measurement of deferred tax assets is reduced, if necessary, by a valuation allowance for any tax benefits for which future realization is uncertain.

 

The Company has not recorded any tax provision or benefit for the nine months ended September 30, 2008 or 2007, except for an estimated tax expense resulting from the research and development agreement with the Company’s former subsidiary in Singapore for the nine months ended September 30, 2007. The Company has provided a valuation allowance for the full amount of its net deferred tax assets since realization of any future benefit from deductible temporary differences and net operating loss cannot be sufficiently assured at September 30, 2008 and December 31, 2007.

 

Under the Tax Reform Act of 1986, the amounts of and benefits from the operating loss carryforwards may be impaired in certain circumstances. Events which cause limitations in the amount of net operating losses that the Company may utilize in any one year include, but are not limited to, a cumulative ownership change of more than 50%, as defined, over a three year period. Trading in shares of the Company’s common stock has resulted in “ownership changes” as defined in Section 382 of the Internal Revenue Code of 1986, as amended (the Code). As a result, the Company’s net operating loss carry forwards totaling $104 million at December 31, 2007 are subject to an annual limitation pursuant to the provisions of Section 382 of the Code, which the Company estimates to be significant.

 

 

In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with GAAP, and expands disclosures about fair value measurements. In February 2008, the FASB agreed to delay the effective date of SFAS 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis, to fiscal years beginning after November 15, 2008. The Company has adopted the provisions of SFAS 157 as of January 1, 2008, for financial instruments. Although the adoption of SFAS 157 did not materially impact its financial condition, results of operations, or cash flow, the Company is now required to provide additional disclosures as part of its financial statements. Under FAS No. 159, entities are permitted to choose to measure many financial instruments and certain other items at fair value. The Company did not elect the fair value measurement option under FAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - including an amendment to FAS 115” (SFAS 159), for any of its financial assets or liabilities.

 

SFAS 157 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include:

 

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

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

 

 

As of September 30, 2008, the Company held certain assets that are required to be measured at fair value on a recurring basis. The Company makes use of observable market based inputs to calculate fair value, in which case the measurements are classified within Level 2. The Company currently does not have non-financial assets and non-financial liabilities that are required to be measured at fair value on a recurring basis.

 

 

 

On September 25, 2008, the board of directors of the Company authorized and declared a dividend distribution of one preferred share purchase right (each a Right and collectively the Rights) for each share of common stock of the Company outstanding as of October 6, 2008 (the Record Date). The description and terms of the Rights are set forth in the Rights Agreement dated as of September 25, 2008, as the same may be amended from time to time (the Rights Agreement), between the Company and American Stock Transfer & Trust Company, LLC, as Rights Agent. Additionally, for each share of common stock issued between the Record Date and the Distribution Date (as defined in the Rights Agreement), one Right will be issued. Each Right entitles the registered holder to purchase from the Company one one-thousandth of a share of the Company’s Series A Junior Participating Preferred Stock (the Preferred Stock), at a price of $6.00 per one one-thousandth of a share of Preferred Stock, subject to adjustment. In general, if any person, together with such person’s affiliates and associates, acquires 15% or more of the outstanding shares of the Company’s common stock or if any person who was, together with such person’s affiliates and associates, the beneficial owner of 15% or more of the outstanding shares of the Company’s common stock as of the date of the adoption or first public announcement of the Rights Agreement, becomes the beneficial owner of additional shares of common stock (each such person, an Acquiring Person), then there would be a triggering event causing significant dilution in the voting power of such Acquiring Person. Until there is a triggering event, the Rights trade with the Company’s common stock. The Rights Agreement will continue in effect until September 25, 2018, unless earlier redeemed or exchanged, as provided in the Rights Agreement.

 

 

On November 3, 2008 the Company received written notice from Novartis that its license agreement with respect to VSF-173, pursuant to which the Company had an exclusive worldwide license to develop and commercialize VSF-173, had terminated in accordance with its terms as a result of the Company’s failure to satisfy a specific development milestone within the time period specified in the license agreement. As a result, the Company will no longer have any rights with respect to VSF-173 and Novartis has a non-exclusive worldwide license to all information and intellectual property generated by the Company or on the Company’s behalf related to the Company’s development of VSF-173. The Company is currently evaluating any options with respect to VSF-173, which may include the possibility of entering into a new license agreement or other arrangement with Novartis to allow the Company to resume its development of VSF-173; however, there can be no assurance that the Company will be able to enter into such an agreement or arrangement on acceptable terms, or at all. As of September 30, 2008 the Company had no recorded assets related to this contract.

 

Various statements in this report are “forward-looking statements” under the securities laws. Words such as, but not limited to, “believe,” “expect,” “anticipate,” “estimate,” “intend,” “plan,” “targets,” “likely,” “will,” “would,” and “could,” and similar expressions or words, identify forward-looking statements. Forward-looking statements are based upon current expectations that involve risks, changes in circumstances, assumptions and uncertainties. Vanda Pharmaceuticals Inc. (Vanda or the Company) is at an early stage of development and may not ever have any products that generate significant revenue. Important factors that could cause actual results to differ materially from those reflected in our forward-looking statements include, among others:

 

 

All written and verbal forward-looking statements attributable to us or any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this section. We caution investors not to rely too heavily on the forward-looking statements we make or that are made on our behalf. We undertake no obligation, and specifically decline any obligation, to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

 

We encourage you to read the discussion and analysis of our financial condition and our condensed consolidated financial statements contained in this quarterly report on Form 10-Q. We also encourage you to read Item 1A “Risk Factors” of Part II of this quarterly report on Form 10-Q, which contains a more complete discussion of the risks and uncertainties associated with our business. In addition to the risks described above and in Item 1A of this report, other unknown or unpredictable factors also could affect our results. There can be no assurance that the actual results or developments anticipated by us will be realized or, even if substantially realized, that they will have the expected consequences to, or effects on, us. Therefore, no assurance can be given that the outcomes stated in such forward-looking statements and estimates will be achieved.

 

Overview

 

We are a biopharmaceutical company focused on the development and commercialization of clinical-stage product candidates for central nervous system disorders, with exclusive worldwide commercial rights to two product candidates in clinical development. Our lead product candidate, iloperidone is a compound for the treatment of schizophrenia and bipolar disorder. On November 27, 2007 the United States Food and Drug Administration (FDA) accepted our New Drug Application (NDA) for iloperidone in schizophrenia. In July 2008, we announced that the FDA had determined that our NDA was not approvable, which will require us, among other things, to conduct additional studies and submit that data before the FDA will approve iloperidone for commercial sale for the treatment of schizophrenia. In September 2008, we met with the FDA to discuss

the FDA’s determination. The FDA asked us to provide a complete response to the not-approvable letter, which we submitted on November 6, 2008. The timing or outcome of any FDA review of the response is uncertain at this time. As a result, we have suspended all iloperidone-related activities pending further review. Our second product candidate, tasimelteon (VEC-162) is a compound for the treatment of sleep and mood disorders. In November 2006 we announced positive top-line results from our Phase III trial of tasimelteon in transient insomnia. In June 2008 the Company announced positive top-line results from the Phase III trial of tasimelteon in chronic primary insomnia. Tasimelteon is also ready for Phase II trials for the treatment of depression.

 

We will have to conduct additional Phase III trials for tasimelteon in chronic sleep disorders prior to our filing of an NDA for tasimelteon. Assuming successful outcomes of our clinical trials and approval by the FDA, we expect to commercialize iloperidone with our own sales force in the U.S. and through a partnership in non-U.S. markets, and expect to commercialize tasimelteon through a partnership with a global pharmaceutical company, although we have not yet identified such a global partner.

 

We are a development stage enterprise and have accumulated net losses of approximately $217.5 million since the inception of our operations through September 30, 2008. We have no product revenues to date and have no approved products for sale. Since we began our operations in March 2003, we have devoted substantially all of our resources to the in-licensing and clinical development of our product candidates. Our future operating results will depend largely on our ability to successfully develop and commercialize our lead product candidate, iloperidone, and on the progress of other product candidates currently in our research and development pipeline. The results of our operations will vary significantly from year-to-year and quarter-to-quarter and depend on a number of factors, including risks related to our business, risks related to our industry, and other risks which are detailed in Item 1A “Risk Factors” of Part II of this quarterly report on Form 10-Q.

 

Our activities will necessitate significant uses of working capital for the foreseeable future. Our capital requirements will depend on many factors, including the success of our research and development efforts, the satisfaction of certain regulatory requirements, payments received under contractual agreements with other parties, if any, and the status of competitive products. However, given the recent decision by the FDA with respect to the NDA for iloperidone, and that the additional studies required by the FDA prior to its approval of iloperidone would require significant capital in excess of our currently available resources, our management intends to operate under a reduced spending plan, and believes that our existing cash, cash equivalents and marketable securities will be sufficient to fund operations at least through the fourth quarter of 2009. In budgeting for our activities, we have relied on a number of assumptions, including assumptions that we will not conduct any additional clinical trials for either of the oral or injectable formulations of iloperidone, that we will not expend funds on the bipolar indication for iloperidone, that we will not engage in any further commercial activities related to iloperidone, that we will not engage in further in-licensing activities, that we will not receive any proceeds from potential partnerships, that we will not conduct additional trials for tasimelteon, that we will be able to retain our key personnel, that we will amend the NDA for iloperidone and continue to seek FDA approval, that we will continue to evaluate clinical and pre-clinical compounds for potential development, and that we will not incur any significant contingent liabilities.

 

We may need to raise additional funds if one or more of our assumptions proves to be incorrect or if we choose to resume our commercialization efforts with respect to iloperidone, expand our product development efforts, conduct additional clinical trials for one or more of our product candidates or seek to acquire additional product candidates, and we may decide to raise additional funds even before they are needed if the conditions for raising capital are favorable. In our capital-raising efforts, we may seek to sell additional equity or debt securities or obtain a bank credit facility. The sale of additional equity or debt securities, if convertible, could result in dilution to our stockholders. The incurrence of indebtedness would result in increased fixed obligations and could also result in covenants that would restrict our operations. However, we may not be able to raise additional funds on acceptable terms, or at all. If we are unable to secure sufficient capital to fund our research and development activities, we may not be able to continue operations, or we may have to enter into collaboration agreements that could require us to share commercial rights to our products to a greater extent or at earlier stages in the drug development process than is currently intended. These collaborations, if consummated prior to proof-of-efficacy or safety of a given product candidate, could impair our ability to realize value from that product candidate.

Iloperidone.  Iloperidone is our product candidate under development to treat schizophrenia and bipolar disorder. We submitted an NDA for iloperidone for the treatment of schizophrenia to the FDA on September 27, 2007 and on November 27, 2007 the FDA accepted our NDA. The application included data from 35 clinical trials and more than 3,000 patients treated with iloperidone and also contained pharmacogenetic data aimed to further improve the benefit/risk profile of iloperidone in the treatment of patients with schizophrenia. In July 2008, we announced that the FDA had determined that our NDA was not approvable, which will require us, among other things, to conduct additional studies and submit that data before the FDA will approve iloperidone for commercial sale for the treatment of schizophrenia. Performance and completion of these additional studies will require years of testing and, even if positive results are achieved, may not result in the FDA’s approval of iloperidone. In September 2008, we met with the FDA to discuss the FDA’s determination. The FDA asked us to provide a complete response to the not-approvable letter, which we submitted on November 6, 2008. The timing or outcome of any FDA review of the response is uncertain at this time. As a result, we have suspended all iloperidone-related activities pending further review.

 

From inception to September 30, 2008 we incurred approximately $71.5 million in research and development costs directly attributable to our development of iloperidone, including a $5.0 million milestone license fee paid to Novartis in 2007 upon the acceptance of our NDA.

 

We are also developing a 4-week injectable formulation for iloperidone, for which we already have early Phase II data from a study previously conducted by Novartis. We have completed essential manufacturing activities and intend to conduct additional clinical trials if and when, we receive FDA approval of the oral dose formulation for iloperidone.

 

Tasimelteon.  Tasimelteon is our product candidate under development to treat sleep and mood disorders. Tasimelteon is a melatonin receptor agonist that works by adjusting the human “body clock” of circadian rhythm. Tasimelteon has successfully completed a Phase III trial for the treatment of transient insomnia in November 2006. In June 2008 we announced positive top-line results from the Phase III trial of tasimelteon in chronic primary insomnia. The trial was a randomized, double-blind, and placebo-controlled study with 324 patients. The trial measured time to fall asleep and sleep maintenance, as well as next-day performance. We will have to conduct additional trials prior to our filing of an NDA for tasimelteon to treat sleep disorders. Tasimelteon is also ready for Phase II trials for the treatment of depression.

 

From inception to September 30, 2008, we incurred approximately $51.2 million in direct research and development costs directly attributable to our development of tasimelteon, including a $1.0 million milestone license fee paid to BMS in 2006 upon the initiation of our Phase III program.

 

VSF-173.  On November 3, 2008, we received written notice from Novartis that our license agreement with respect to VSF-173 had terminated in accordance with its terms as a result of our failure to satisfy a specific development milestone within the time period specified in the license agreement. As a result, we no longer have any rights with respect to VSF-173 and Novartis has a non-exclusive worldwide license to all information and intellectual property generated by us or on our behalf related to our development of VSF-173. We are currently evaluating any options that we may have with respect to VSF-173, which may include the possibility of entering into a new license agreement or other arrangement with Novartis to allow us to resume our development of VSF-173; however, there can be no assurance that we will be able to enter into such an agreement or arrangement on acceptable terms, or at all.

 

From inception to September 30, 2008, we incurred approximately $6.7 million in research and development costs directly attributable to our development of VSF-173, including a milestone license fee of $1.0 million paid to Novartis upon the initiation of our first Phase II clinical trial in March of 2007.

 

Research and development expenses

 

Our research and development expenses consist primarily of fees paid to third-party professional service providers in connection with the services they provide for our clinical trials, costs of contract manufacturing services, costs of materials used in clinical trials and research and development, costs for regulatory consultants and filings, depreciation of capital resources used to develop our products, all related facilities

costs, and salaries, benefits and stock-based compensation expenses related to our research and development personnel. We expense research and development costs as incurred, including payments made to date under our license agreements. We believe that significant investment in product development is a competitive necessity and plan to continue these investments in order to realize the potential of our product candidates and pharmacogenetics and pharmacogenomics expertise. From inception through September 30, 2008 we incurred research and development expenses in the aggregate of approximately $146.0 million, including stock-based compensation expenses of approximately $8.1 million. We expect our research and development expenses to increase as we continue to develop our product candidates. We also expect to incur licensing costs in the future that could be substantial, as we continue our efforts to develop our product candidates and to evaluate potential in-license product candidates.

 

The following table summarizes our product development initiatives for the three and nine months ended September 30, 2008 and 2007 and for the period from March 13, 2003 (inception) to September 30, 2008. Included in this table are the research and development expenses recognized in connection with our product candidates in clinical development. Included in “Other product candidates” are the costs directly related to research initiatives for all other product candidates.

 

 

 

 

General and administrative expenses

 

General and administrative expenses consist primarily of salaries and other related costs for personnel, including stock-based compensation, serving executive, finance, accounting, information technology, marketing and human resource functions. Other costs include facility costs not otherwise included in research and development expenses and fees for legal, accounting and other professional services. We expect our general and administrative expenses to decrease as we operate under a reduced spending plan. From inception through September 30, 2008, we incurred general and administrative expenses in the aggregate of approximately $81.8 million, including stock-based compensation expenses of approximately $35.3 million.

Critical Accounting Policies

 

The preparation of our condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of our financial statements, as well as the reported revenues and expenses during the reported periods. We base our estimates on historical experience and on various other factors that we believe are 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 apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

Our significant accounting policies are described in the notes to our audited consolidated financial statements for the year ended December 31, 2007 included in our annual report on Form 10-K. However, we believe that the following critical accounting policies relating to accrued expenses and stock-based compensation expense are important to understanding and evaluating our reported financial results, and we have accordingly included them in this quarterly report on Form 10-Q.

 

Accrued expenses

 

As part of the process of preparing financial statements we are required to estimate accrued expenses. The estimation of accrued expenses involves identifying services that have been performed on our behalf, and then estimating the level of service performed and the associated cost incurred for such services as of each balance sheet date in the financial statements. Accrued expenses include professional service fees, such as those for lawyers and accountants, contract service fees, such as those under contracts with clinical monitors, data management organizations and investigators in conjunction with clinical trials, fees to contract manufacturers in conjunction with the production of clinical materials, and fees for marketing and other commercialization activities. Pursuant to our assessment of the services that have been performed on clinical trials and other contracts, we recognize these expenses as the services are provided. Our assessments include, but are not limited to: (1) an evaluation by the project manager of the work that has been completed during the period, (2) measurement of progress prepared internally and/or provided by the third-party service provider, (3) analyses of data that justify the progress, and (4) management’s judgment. In the event that we do not identify certain costs that have begun to be incurred or we under- or over-estimate the level of services performed or the costs of such services, our reported expenses for such period would be too low or too high.

 

Stock-based compensation

 

We adopted Statement of Financial Accounting Standards No. 123(R), Share Based Payment, (SFAS 123(R)) on January 1, 2006 using the modified prospective transition method of implementation and adopted the accelerated attribution method. Prior to January 1, 2006 we followed APB Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and related interpretations, in accounting for our stock-based compensation plans, rather than the alternative fair value accounting method provided for under SFAS No. 123, Accounting for Stock-Based Compensation.

 

We currently use the Black-Scholes-Merton option pricing model to determine the fair value of stock options. The determination of the fair value of stock options on the date of grant using an option pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include the expected stock price volatility over the expected term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends. Expected volatility rates are based on historical volatility of the common stock of comparable entities and other factors due to the lack of historic information of the Company’s publicly traded common stock. The expected term of options granted is based on the transition approach provided by Staff Accounting Bulletin (“SAB”) No. 110 as the options meet the “plain vanilla” criteria required by this method. The risk-free interest rates are based on the U.S. Treasury yield for a period consistent with the expected term of the option in effect at the time of the grant. We have not paid dividends to our stockholders since the inception and do not plan to pay dividends in the foreseeable future. The stock-based compensation expense for a period is also affected by expected forfeiture rate for the respective option grants. If our estimates of the fair value of these

equity instruments or expected forfeitures are too high or too low, it would have the effect of overstating or understating expenses.

 

Total stock-based compensation expense recognized during the three and nine months ending September 30, 2008 and 2007 was comprised of the following:

 

 

Recent accounting pronouncements

 

In October 2008, the FASB issued Staff Position No. FSP FAS 157-3 “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (FSP FAS 157-3) which amends FAS 157 to include guidance on how to determine the fair value of a financial asset in an inactive market and which is effective immediately on issuance, including prior periods for which financial statements have not been issued. The implementation of FSP FAS 157-3 did not have a material impact on our financial position and results of operations.

 

In December 2007, the FASB issued SFAS No. 141 (revised 2007) (SFAS 141R), Business Combinations and SFAS No. 160 (SFAS 160), Noncontrolling Interests in Consolidated Financial Statements, an amendment of Accounting Research Bulletin No. 51. SFAS 141R will change how business acquisitions are accounted for and will impact financial statements both on the acquisition date and in subsequent periods. SFAS 160 will change the accounting and reporting for minority interests, which will be recharacterized as noncontrolling interests and classified as a component of equity. SFAS 141R and SFAS 160 will be applied to acquisitions that close in years beginning after December 15, 2008. Early adoption is not permitted. These pronouncements are not expected to have significant impact on our results of operations and financial condition.

 

In December 2007, the FASB ratified EITF Issue 07-1, Accounting for Collaborative Arrangements (EITF 07-1). The consensus prohibits the equity method of accounting for collaborative arrangements under APB 18, The Equity Method of Accounting for Investments in Common Stock, unless a legal entity exists. Payments between the collaborative partners will be evaluated and reported in the income statement based on applicable GAAP. Absent specific GAAP, the participants to the arrangement will apply other existing GAAP by analogy or apply a reasonable and rational accounting policy consistently. The guidance in Issue EITF 07-1 is effective for periods that begin after December 15, 2008 and will apply to arrangements in existence as of the effective date. The effect of the new consensus will be accounted for as a change in accounting principle through retrospective application. We are currently evaluating the impact of EITF 07-1 on our results of operations and financial condition.

 

Results of Operations

 

We have a limited history of operations. We anticipate that our quarterly results of operations will fluctuate for the foreseeable future due to several factors, including any possible payments made or received pursuant to licensing or collaboration agreements, progress of our research and development efforts, and the timing and outcome of clinical trials and related possible regulatory approvals. Our limited operating history makes predictions of future operations difficult or impossible. Since our inception, we have incurred significant losses. As of September 30, 2008, we had a deficit accumulated during the development stage of approximately $217.5 million. We anticipate incurring additional losses for the foreseeable future.

Three months ended September 30, 2008 compared to three months ended September 30, 2007

 

Research and development expenses.  Research and development expenses decreased by approximately $10.1 million, or 72.7%, to approximately $3.8 million for the three months ended September 30, 2008 compared to approximately $13.9 million for the three months ended September 30, 2007.

 

The following table discloses the components of research and development expenses reflecting all of our project expenses for the three months ended September 30, 2008 and 2007:

 

 

Direct costs decreased approximately $10.2 million for the three months ended September 30, 2008 compared to the three months ended September 30, 2007 as a result of the absence of any milestone license payments in 2008, lower expenses relating to our NDA for iloperidone and lower clinical trial and manufacturing expenses. Clinical trials expense decreased approximately $1.9 million for the three months ended September 30, 2008 compared to the three months ended September 30, 2007 primarily due to lower clinical trial costs relating to tasimelteon and iloperidone. Contract research and development, consulting, materials and other direct costs decreased approximately $2.9 million for the three months ended September 30, 2008 relative to the three months ended September 30, 2007, primarily as a result of decreased iloperidone NDA related expenses and manufacturing costs related to iloperidone and tasimelteon. Salaries, benefits and related costs increased approximately $109,000 for the three months ended September 30, 2008 relative to the three months ended September 30, 2007 primarily due to cost of living adjustments. Stock-based compensation expense decreased by approximately $593,000 compared to the three months ended September 30, 2007 as a result of the lower fair market value of options granted during the 2008.

 

General and administrative expenses.  General and administrative expenses decreased by approximately $2.2 million, or 23.3%, to approximately $7.4 million for the three months ended September 30, 2008 from approximately $9.6 million for the three months ended September 30, 2007.

 

The following table discloses the components of our general and administrative expenses for the three months ended September 30, 2008 and 2007:

 

Salaries, benefits and related costs increased by approximately $546,000 for the three months ended September 30, 2008 compared to the three months ended September 30, 2007 primarily due to an increase in marketing personnel as we added to our marketing capabilities in anticipation of the commercial launch of iloperidone and cost of living adjustments. Stock-based compensation expense decreased by approximately $944,000 for the three months ended September 30, 2008, compared to the three months ended September 30, 2007, as a result of the lower fair market value of options granted during 2008. Marketing and related consulting services expenses decreased by approximately $2.5 million for the three months ended September 30, 2008, relative to the three months ended September 30, 2007, due to the suspension of all iloperidone-related activities. Legal, accounting and other professional costs increased by approximately $764,000 for the three months ended September 30, 2008 compared to the three months ended September 30, 2007 due primarily to higher legal fees incurred in connection with business development activities related to iloperidone.

 

Other income, net.  Interest and other income in the three months ended September 30, 2008 was approximately $323,000 compared to approximately $1.6 million in the three months ended September 30, 2007. Interest income was lower for the three months ended September 30, 2008, compared to the three months ended September 30, 2007, due to lower average cash balances and lower short-term interest rates for the three months ended September 30, 2008. Other income for the three months ended September 30, 2007 includes approximately $71,000 in revenue recognized from a grant from the Economic Development Board in Singapore. We do not expect to receive similar grants in the future.

 

Our interest and other income for the three months ended September 30, 2008 and 2007 are disclosed on the following table:

 

 

Nine months ended September 30, 2008 compared to nine months ended September 30, 2007

 

Research and development expenses.  Research and development expenses decreased by approximately $14.3 million, or 41.2%, to approximately $20.4 million for the nine months ended September 30, 2008 compared to approximately $34.7 million for the nine months ended September 30, 2007.

 

The following table discloses the components of research and development expenses reflecting all of our project expenses for the nine months ended September 30, 2008 and 2007:

 

Direct costs decreased approximately $14.2 million for the nine months ended September 30, 2008 compared to the nine months ended September 30, 2007 as a result of lower expenses relating to our NDA for iloperidone, the suspension of manufacturing activities pending further review by management and the FDA and the absence of any milestone license fee payments in 2008. Clinical trials expense increased approximately $452,000 for the nine months ended September 30, 2008 compared to the nine months ended September 30, 2007 primarily due to the cost incurred during the nine months ended September 30, 2008 in our Phase III clinical trial of tasimelteon that we initiated during the fourth quarter of 2007. Contract research and development, consulting, materials and other direct costs decreased approximately $8.0 million for the nine months ended September 30, 2008 relative to the nine months ended September 30, 2007, primarily as a result of decreased iloperidone NDA related expenses and lower manufacturing costs. Salaries, benefits and related costs increased approximately $305,000 for the nine months ended September 30, 2008 relative to the nine months ended September 30, 2007 primarily due to cost of living adjustments. Stock-based compensation expense decreased by approximately $936,000 compared to the nine months ended September 30, 2007 as a result of the lower fair market value of options granted during the nine months ended September 30, 2008.

 

General and administrative expenses.  General and administrative expenses increased by approximately $1.5 million, or 6.4% to approximately $24.8 million for the nine months ended September 30, 2008 from approximately $23.3 million for the nine months ended September 30, 2007.

 

The following table discloses the components of our general and administrative expenses for the nine months ended September 30, 2008 and 2007:

 

 

Salaries, benefits and related costs increased by approximately $1.1 million for the nine months ended September 30, 2008 compared to the nine months ended September 30, 2007 due to an increase in marketing personnel as we added to our marketing capabilities in anticipation of the potential commercial launch of iloperidone and cost of living adjustments. Stock-based compensation expense decreased by approximately $660,000 for the nine months ended September 30, 2008, compared to the nine months ended September 30, 2007, as a result of the lower fair market value of options granted during the nine months ended September 30, 2008. Marketing and related consulting services expenses increased by approximately $311,000 for the nine months ended September 30, 2008, relative to the nine months ended September 30, 2007, due to the increase iloperidone-related commercial expenses incurred prior to the issuance by the FDA of the not-approvable letter. Legal, accounting and other professional expenses increased by approximately $817,000 for the nine months ended September 30, 2008 compared to the nine months ended September 30, 2007 due primarily to higher legal fees incurred in connection with business development activities related to iloperidone.

 

Other income, net.  Interest and other income in the nine months ended September 30, 2008 was approximately $1.6 million compared to approximately $4.7 million in the nine months ended September 30, 2007. Interest income was lower for the nine months ended September 30, 2008, compared to the nine months ended September 30, 2007, due to lower average cash balances and lower short-term interest rates for the nine months ended September 30, 2008. Other income for the nine months ended September 30, 2007 includes approximately $71,000 in revenue recognized from a grant from the Economic Development Board in Singapore. We do not expect to receive similar grants in the future.

Our interest income for the nine months ended September 30, 2008 and 2007 are disclosed on the following table:

 

 

Liquidity and Capital Resources

 

We have funded our operations through September 30, 2008 principally with the net proceeds from private preferred stock offerings of approximately $62.0 million, with net proceeds from our April 2006 initial public offering of approximately $53.3 million and with net proceeds from our January 2007 follow-on offering of approximately $111.3 million.

 

As of September 30, 2008, our total cash and cash equivalents and marketable securities were approximately $51.7 million compared to approximately $93.2 million at December 31, 2007. Our cash and cash equivalents are deposits in operating accounts and highly liquid investments with an original maturity of 90 days or less at date of purchase and consist of time deposits, investments in money market funds with commercial banks and financial institutions, and commercial paper of high-quality corporate issuers. As of September 30, 2008 the Company also held a non-current deposit of $430,000 that is used to collateralize a letter of credit issued for its current office lease expiring in 2016.

 

As of September 30, 2008 and December 31, 2007, our liquidity resources are summarized as follows: