SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

Form 10-K

 

 

Commission file number 0-29993

Ardea Biosciences, Inc.

(Exact name of Registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code:

(760) 602-8422

 

Securities registered under Section 12(b) of the Exchange Act:

None.

 

Securities registered under Section 12(g) of the Exchange Act:

Common Stock, par value $.001 per share

(Title of Class)

 

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

 

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

 

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 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.  o

 

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

Large accelerated filer o     Accelerated filer o     Non-accelerated filer þ

 

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

 

The aggregate market value of the Registrant’s common stock held by non-affiliates of the registrant, based on the closing price at which the Registrant’s common stock was last sold on June 30, 2006 was approximately $21,761,953. The determination of affiliate status for the purposes of this calculation is not necessarily a conclusive determination for other purposes. The calculation excludes approximately 6,044,987 shares held by directors, officers and stockholders whose ownership exceeds five percent of the registrant’s outstanding common stock as of June 30, 2006. Exclusion of these shares should not be construed to indicate that such person controls, is controlled by or is under common control with the Registrant. The number of shares outstanding of the registrant’s common stock, par value $0.001 per share, as of February 15, 2007 was 9,376,799 shares.

 

 

TABLE OF CONTENTS

 

 

Certain statements in this annual report on Form 10-K are forward-looking statements that involve a number of risks and uncertainties. In some cases, you can identify forward-looking statements by terminology such as “may,” “might,” “will,” “should,” “intends,” “expects,” “plans,” “goals,” “projects,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue” or the negative of these terms or other comparable terminology. Such forward-looking statements include statements about our plans for our research and development programs, the potential characteristics of our product candidates, the ability to co-formulate our product candidates with other drugs, our ability to initiate or complete clinical trials for any of our product candidates, our ability to progress product candidates through preclinical and clinical development and commercialization, our ability to select a development candidate from the 900 Series Program, our ability to file a U.S. Investigational New Drug application, or IND, or a similar filing with the applicable regulatory agency in a foreign country, or obtain regulatory approval for marketing of any product candidate, our ability to create a fully-integrated research and development organization, the expected benefits from our new management, the market opportunity for any products we may develop and the ability of those products to meet market needs or participate in such markets, the milestones or royalties payable to Valeant Research & Development, our receipt of payments from Valeant under the research services agreement, our research and development goals for 2007, our near- and long-term financial outlook, our anticipated cash usage and resources, the safety and efficacy of our product candidates and any potential products, our ability to develop and commercialize products, our ability to acquire additional product candidates, our ability to rapidly develop product candidates, our ability to manage the risks involved with drug discovery, our ability to generate internal product candidates, our ability to develop a commercialization capability or partner with other companies for the development or commercialization of product candidates, and other statements about our strategy, technologies, programs, and ability to develop compounds and commercialize drugs.

 

For such statements, we claim the protection of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are only predictions, are uncertain and involve substantial known and unknown risks, uncertainties and other factors which may cause our (or our industry’s) actual results, levels of activity or performance to be materially different from any future results, levels of activity or performance expressed or implied by these forward-looking statements. Factors that could cause actual results to differ materially from those stated or implied by our forward-looking statements are included in “Item 1A — Risk Factors” of this annual report and disclosed in our other filings with the Securities and Exchange Commission. We cannot guarantee future results, level of activity or performance. You should not place undue reliance on these forward-looking statements. These forward-looking statements represent our judgment as of the time of this annual report. We disclaim any intent or obligation to update these forward-looking statements, other than as may be required under applicable law.

 

Unless the context indicates otherwise, as used in this annual report, the terms “Ardea,” “we,” “us” and “our” refer to Ardea Biosciences, Inc., a Delaware corporation. Ardea recently changed its name from IntraBiotics Pharmaceuticals, Inc.

 

History and Overview

 

We were incorporated in the State of Delaware in 1994. From our inception in 1994 through May 5, 2005, we devoted substantially all of our efforts to research and development of anti-microbial drugs and generated no product revenues. From the fourth quarter of 2002 until June 2004, we focused our attention on developing iseganan for the prevention of ventilator-associated pneumonia, or VAP. In June 2004, we discontinued our clinical trial of iseganan for the prevention of VAP following a recommendation of our independent data monitoring committee. Subsequently, we terminated the iseganan development program, reduced our work force and evaluated strategic alternatives, including mergers, acquisitions, in-licensing opportunities and liquidation.

 

On May 5, 2005, after considering a variety of strategic alternatives, none of which was determined by our management and Board of Directors to be in the best interests of us and our stockholders, our Board of Directors decided to reduce operating expenses to a minimum appropriate level. In accordance with these plans, we

terminated all of our remaining regular employees on June 15, 2005, engaged Hickey & Hill, Inc. of Lafayette, California, a firm specializing in managing companies in transition, to assume the responsibilities of our day-to-day administration, and appointed Denis Hickey of Hickey & Hill, Inc. as our Chief Executive Officer and Chief Financial Officer.

 

From June 15, 2005 until December 21, 2006, Denis Hickey handled the administration of our affairs while our Board of Directors and selected consultants searched for and evaluated strategic alternatives for our business. During that period, we evaluated several strategic alternatives in the biotechnology industry with the support of consultants, including Barry D. Quart, Pharm.D., and the active participation of our Board of Directors.

 

Transaction with Valeant

 

On December 21, 2006, we acquired intellectual property and other assets related to three distinct pharmaceutical research and development programs from Valeant Research & Development, Inc., or Valeant, pursuant to an Asset Purchase Agreement, hired a new senior management team, including Barry D. Quart, Pharm.D., who replaced Denis Hickey as Chief Executive Officer, and changed our name from IntraBiotics Pharmaceuticals, Inc. to Ardea Biosciences, Inc. The three research and development programs acquired from Valeant include:

 

 

In consideration for the purchased assets from Valeant, subject to certain conditions, Valeant has the right to receive development-based milestone payments and sales-based royalty payments from us. There is one set of milestones for the 800 and 900 Series Programs and a separate set of milestones for the 100 Series Program. Assuming the successful commercialization of a product incorporating a compound from the 800 Series Program or the 900 Series Program, the milestone payments for these two programs combined could total $25 million. For the 100 Series Program, milestone payments could total $17 million, assuming the successful commercialization of a product from that program. For each program, milestones are paid only once regardless of how many compounds are developed or commercialized. In each program, the first milestone payment would be due after the completion of a proof-of-concept clinical study in patients, and more than half of the total milestone payments would be due after regulatory approval. The royalty rates on all products are in the mid-single digits. We agreed to further develop the programs with the objective of obtaining marketing approval in the United States, the United Kingdom, France, Spain, Italy and Germany.

 

Valeant also has the right to exercise a one-time option to repurchase commercialization rights in territories outside the U.S. and Canada for our first NNRTI derived from the acquired intellectual property to advance to Phase III. If Valeant exercises this option, which it can do following the completion of Phase IIb but prior to the initiation of Phase III, the Company would be responsible for completing the Phase III studies and for the registration of the product in the U.S. and European Union. Valeant would pay us a $10.0 million option fee, up to $21.0 million in milestone payments based on regulatory approvals, and a mid-single digit royalty on product sales in the Valeant territories.

 

We also entered into a research services agreement with Valeant under which we will advance a preclinical program in the field of neuropharmacology on behalf of Valeant. Under the agreement, which has a two-year term, subject to Valeant’s option to terminate the agreement after the first year, Valeant will pay us quarterly payments of up to $3.5 million per year to advance the program, and we are entitled to development-based milestone payments of up to $1.0 million. Valeant will own all intellectual property under this research program.

 

In connection with the acquisition from Valeant, we also entered into an office lease agreement for space formerly held by Valeant.

Business Strategy

 

We are focused on the development of small-molecule drugs that address large pharmaceutical markets. We plan to source these development candidates from both our internal drug discovery programs and our continued in-licensing efforts. Our initial therapeutic areas of focus are HIV, cancer and inflammatory disease. We believe that we are well-positioned to create shareholder value through our development activities given the ability to achieve clinical proof-of-concept relatively quickly and cost-effectively in these disease categories.

 

Financial Outlook

 

As of December 31, 2006, we had a total of $48.7 million in cash, cash equivalents and short-term investments and liabilities of $1.2 million. For 2007, we expect to use approximately $16.0 million to $20.0 million in net cash resources to fund operations and expect to end 2007 with approximately $28.0 million to $32.0 million in cash, cash equivalents and short-term investments. We currently expect that our current cash resources will fund operations through 2008. These projections exclude the potential impact of any future business development activity. For more information on our financial position, see “ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” in this annual report.

 

Development Programs

 

The assets we acquired from Valeant include equipment, intellectual property, contracts, permits, licenses and items necessary for us to pursue three pharmaceutical research and development programs. Our three development programs are:

 

 

Market Opportunity

 

We believe that there is a significant market opportunity for our products, should they be successfully developed, approved and commercialized.

In 2005, the worldwide market for HIV antivirals was estimated at approximately $8.0 billion, according to data from IMS Health Incorporated’s Retail Drug Monitor. While the treatment of HIV has improved dramatically over the past decade, we believe that there remains a need for new treatments that are effective against drug-resistant virus, well-tolerated and convenient to take. We believe that our 800 and 900 Series NNRTIs have the potential to meet this market need.

 

We also believe that there is a growing interest in the potential for targeted therapies, including kinase inhibitors, in the treatment of both cancer and inflammatory disease. In 2005, the worldwide market for targeted therapies for cancer was $7.5 billion, according to Datamonitor plc, and the worldwide market for targeted therapies for inflammatory diseases was more than $8 billion, according to data from IMS Health Incorporated. Given the role that MEK appears to play in cancer and inflammatory diseases and the increasing preference for oral therapies, we believe that RDEA119, if successfully developed, approved and commercialized, could participate in these growing markets.

 

Research and Development Expenses

 

Our research and development expense for the three years ended December 31, 2006, 2005, and 2004 was $0.1 million, $0.3 million, and $11.5 million, respectively. We expect that our research and development expenses will increase substantially as we seek to advance the preclinical programs that we acquired from Valeant into later stages of preclinical development and initial clinical trials.

 

Clinical Supplies and Manufacturing

 

We have no manufacturing capabilities. We expect to rely on third-party contract manufacturers to produce our product candidates to support our development programs. Our clinical trial material, critical to our operations, is purchased from two companies among several other available suppliers.

 

Sales and Marketing

 

We do not currently have sales or marketing capabilities. In order to commercially market any pharmaceutical product that we successfully advance through preclinical and clinical development and for which we obtain regulatory approval, we must either develop a sales and marketing infrastructure or collaborate with third parties with sales and marketing capabilities. Because of the early stage of the pharmaceutical development programs we acquired from Valeant, we have not yet developed a sales and marketing strategy for any pharmaceutical products that we may develop.

 

Customers and Distribution

 

We do not currently sell or distribute pharmaceutical products.

 

Competition

 

The biotechnology and pharmaceutical industries are extremely competitive. Our potential competitors in the field are many in number and include major pharmaceutical and specialized biotechnology companies. Many of our potential competitors have significantly more financial, technical and other resources than we do, which may allow them to have a competitive advantage. In addition, they may have substantially more experience in effecting strategic combinations, in-licensing technology, developing drugs, obtaining regulatory approvals and manufacturing and marketing products. We cannot give any assurances that we can effectively compete with these other biotechnology and pharmaceutical companies. However, because we have a small, highly integrated team of experienced medicinal chemists, therapeutic experts, X-ray crystallographers and preclinical development scientists, we can focus on a validated target from a therapeutic area with significant unmet medical need. RDEA806 and RDEA119 are examples of our drug discovery approach. We believe that by carefully setting a target product profile, we can work towards developing best-in-class drug candidates as fast-followers to those approved drugs or advanced clinical candidates with promising therapeutic properties.

Any products that we may develop or discover will compete in highly competitive markets. Many of our potential competitors in these markets have substantially greater financial, technical and personnel resources than we do, and they may succeed in developing products that may render our products and those of our collaborators obsolete or noncompetitive. In addition, many of our competitors have significantly greater experience than we do in their respective fields.

 

Intellectual Property

 

Our success will depend in large part on our ability to:

 

 

We acquired all of the intellectual property related to our three pharmaceutical research and development programs from Valeant. We intend to continue to seek appropriate patent protection for the lead product candidates in our research and development programs and their uses by filing patent applications in the United States and other selected countries. We intend for these patent applications to cover, where possible, claims for composition of matter, medical uses, processes for preparation and formulations.

 

As part of the acquisition of intellectual property assets and other assets from Valeant, completed on December 21, 2006, we acquired and now own a total of three pending United States patent applications, three pending United States provisional applications, and 14 pending foreign patent applications.

 

Although we believe that our rights under the patent applications we acquired from Valeant provide a competitive advantage, the patent positions of pharmaceutical and biotechnology companies are highly uncertain and involve complex legal and factual questions. We may not be able to develop patentable products or processes, and may not be able to obtain patents from pending applications. Even if patent claims are allowed, the claims may not issue, or in the event of issuance, may not be sufficient to protect the technology owned by or licensed to us. Any patents or patent rights that we obtain may be circumvented, challenged or invalidated by our competitors.

 

We also rely on trade secrets, proprietary know-how and continuing innovation to develop and maintain our competitive position, especially when we do not believe that patent protection is appropriate or can be obtained. We seek protection of these trade secrets, proprietary know-how and any continuing innovation, in part, through confidentiality and proprietary information agreements. However, these agreements may not provide meaningful protection for, or adequate remedies to protect, our technology in the event of unauthorized use or disclosure of information. Furthermore, our trade secrets may otherwise become known to, or be independently developed by, our competitors.

 

Government Regulation

 

Pharmaceutical Regulation

 

If and when we market any pharmaceutical products, they would be subject to extensive government regulation in the United States. Additionally, if we seek to market and distribute any such products abroad, they would also be subject to extensive foreign government regulation.

 

In the United States, the United States Food and Drug Administration, or FDA, regulates pharmaceutical products. FDA regulations govern the testing, manufacturing, advertising, promotion, labeling, sale and distribution of pharmaceutical products, and generally require approval of new drugs through a rigorous process. We also may be subject to foreign regulatory requirements governing clinical trials and drug product sales if products are studied or marketed abroad. The approval process outside the United States varies from jurisdiction to jurisdiction and the time required may be longer or shorter than that required for FDA approval.

Regulation in the United States

 

The FDA testing and approval process requires substantial time, effort and money. We cannot assure you that any of our products will ever obtain approval. The FDA approval process for new drugs includes, without limitation:

 

 

The NDA must include comprehensive and complete descriptions of the preclinical testing, clinical trials, and the chemical, manufacturing and control requirements of a drug that enable the FDA to determine the drug’s safety and efficacy. An NDA must be submitted, filed and approved by the FDA before any product that we may successfully develop can be marketed commercially in the United States.

 

Preclinical studies include laboratory evaluation of the product, as well as animal studies to assess the potential safety and effectiveness of the product. Most of these studies must be performed according to good laboratory practices. The results of the preclinical studies, together with manufacturing information and analytical data, are submitted to the FDA as part of the IND. Clinical trials may begin 30 days after the IND is received, unless the FDA raises concerns or questions about the conduct of the clinical trials. If concerns or questions are raised, the IND sponsor and the FDA must resolve any outstanding concerns before clinical trials can proceed. We have not filed an IND for a lead clinical candidate in any of the pharmaceutical development programs that we acquired from Valeant. We will have to file an IND before we can commence any clinical trials for our product candidates in the United States.

 

We cannot assure you that submission of an IND for any of our preclinical product candidates will result in authorization to commence clinical trials. Nor can we assure you that any of our current or future clinical trials will result in marketing approval. Clinical trials involve the administration of the product candidate that is the subject of the trial, to volunteers or patients under the supervision of a qualified principal investigator. Each clinical trial must be reviewed and approved by an independent institutional review board at each institution at which the study will be conducted. The institutional review board will consider, among other things, ethical factors, safety of human subjects and the possible liability of the institution. Also, clinical trials must be performed according to good clinical practices. Good clinical practices are enumerated in FDA regulations and guidance documents.

 

Clinical trials typically are conducted in sequential phases: Phases I, II and III, with Phase IV studies conducted after approval. Drugs for which Phase IV studies are required include those approved under accelerated approval regulations. The phases may overlap.

 

In Phase I clinical trials, a drug is usually tested on a small number of healthy volunteers to determine safety, any adverse effects, proper dosage, absorption, metabolism, distribution, excretion and other drug effects.

 

In Phase II clinical trials, a drug is usually tested on a limited number of subjects (generally up to several hundred subjects) to preliminarily evaluate the efficacy of the drug for specific, targeted indications, determine dosage tolerance and optimal dosage, and identify possible adverse effects and safety risks.

 

In Phase III clinical trials, a drug is usually tested on a larger number of subjects (up to several thousand), in an expanded patient population and at multiple clinical sites. The FDA may require that we suspend clinical trials at any time on various grounds, including if the FDA makes a finding that the subjects are being exposed to an unacceptable health risk.

 

In Phase IV clinical trials or other post-approval commitments, additional studies and patient follow-up are conducted to gain experience from the treatment of patients in the intended therapeutic indication. Additional

studies and follow-up are also conducted to document a clinical benefit where drugs are approved under accelerated approval regulations and based on surrogate endpoints. In clinical trials, surrogate endpoints are alternative measurements of the symptoms of a disease or condition that are substituted for measurements of observable clinical symptoms. Failure to promptly conduct Phase IV clinical trials and follow-up could result in expedited withdrawal of products approved under accelerated approval regulations.

 

The facilities, procedures, and operations for any of our contract manufacturers must be determined to be adequate by the FDA before product approval. Manufacturing facilities are subject to inspections by the FDA for compliance with cGMP, licensing specifications, and other FDA regulations before and after an NDA has been approved. Foreign manufacturing facilities are also subject to periodic FDA inspections or inspections by foreign regulatory authorities. Among other things, the FDA may withhold approval of NDAs or other product applications of a facility if deficiencies are found at the facility. Vendors that may supply us with finished products or components used to manufacture, package and label products are subject to similar regulations and periodic inspections.

 

In addition, the FDA imposes a number of complex regulatory requirements on entities that advertise and promote pharmaceuticals, including, but not limited to, standards and regulations for direct-to-consumer advertising, off-label promotion, industry-sponsored scientific and educational activities, and promotional activities involving the Internet.

 

Failure to comply with FDA and other governmental regulations can result in fines, unanticipated compliance expenditures, recall or seizure of products, total or partial suspension of production and/or distribution, suspension of the FDA’s review of NDAs, injunctions and criminal prosecution. Any of these actions could have a material adverse effect on us.

 

Regulation Outside the United States

 

If we market drugs in foreign countries, we also will be subject to foreign regulatory requirements governing human clinical trials and marketing approval for pharmaceutical products. The requirements governing the conduct of clinical trials, product approval, pricing and reimbursement vary widely from country to country. Whether or not FDA approval has been obtained, approval of a product by the comparable regulatory authorities of foreign countries must be obtained before manufacturing or marketing the product in those countries. The approval process varies from country to country and the time required for such approvals may differ substantially from that required for FDA approval. There is no assurance that any future FDA approval of any of our clinical trials or drugs will result in similar foreign approvals.

 

Additional Regulation

 

Third-Party Reimbursement

 

Reimbursement systems in international markets vary significantly by country and, within some countries, by region. Reimbursement approvals must be obtained on a country-by-country basis. In many foreign markets, including markets in which we hope to sell our products, the pricing of prescription pharmaceuticals is subject to government pricing control. In these markets, once marketing approval is received, pricing negotiations could take significant additional time. As in the United States, the lack of satisfactory reimbursement or inadequate government pricing of any of our products would limit their widespread use and lower potential product revenues.

 

Fraud and Abuse Laws

 

In the United States, physicians, hospitals and other healthcare providers that purchase pharmaceutical products generally rely on third-party payers, principally private health insurance plans, Medicare and, to a lesser extent, Medicaid, to reimburse all or part of the cost of the product and procedure for which the product is being used. Even if a product is approved for marketing by the FDA, there is no assurance that third-party payers will cover the cost of the product and related medical procedures. If they do not, end-users of the drug would not be eligible for any reimbursement of the cost, and our ability to market any such drug would be materially and adversely impacted.

In addition, federal and state anti-kickback and anti-fraud and abuse laws, as well as the federal Civil False Claims Act may apply to certain drug and device research and marketing practices. The Civil False Claims Act prohibits knowingly presenting or causing to be presented a false, fictitious or fraudulent claim for payment to the United States. Actions under the Civil False Claims Act may be brought by the Attorney General or by a private individual acting as an informer or whistleblower in the name of the government. Violations of the Civil False Claims Act can result in significant monetary penalties. The federal government is using the Civil False Claims Act, and the threat of significant liability, in its investigations of healthcare providers, suppliers and drug and device manufacturers throughout the country for a wide variety of drug and device marketing and research practices, and has obtained multi-million dollar settlements. The federal government may continue to devote substantial resources toward investigating healthcare providers’, suppliers’ and drug and device manufacturers’ compliance with the Civil False Claims Act and other fraud and abuse laws.

 

HIPAA

 

The Health Insurance Portability and Accountability Act of 1996, or HIPAA, requires the use of standard transactions, privacy and security standards and other administrative simplification provisions by covered entities, which include many healthcare providers, health plans and healthcare clearinghouses. HIPAA instructs the Secretary of the Department of Health and Human Services to promulgate regulations implementing these standards in the United States.

 

Other Laws

 

Other federal, state and local laws of general applicability, such as laws regulating working conditions, also govern us. In addition, we are subject to various federal, state and local environmental protection laws and regulations, including those governing the discharge of material into the environment.

 

Employees

 

As of December 31, 2006, we had three employees. In early January, 2007, we hired 52 additional employees, most of whom formerly worked on the research and development programs we acquired from Valeant. There is no guarantee that we will be able to retain such employees.

 

Company Information

 

Our corporate offices are located at 2131 Palomar Airport Rd., Suite 300, Carlsbad, California 92011, and our telephone number at that office is (760) 602-8422. Our research facilities are located at 3300 Hyland Avenue, Costa Mesa, California 92626 and our telephone number at that office is (714) 729-5555.

 

You should carefully consider the following information about risks and uncertainties that may affect us or our business, together with the other information appearing elsewhere in this annual report. If any of the following events, described as risks, actually occur, our business, financial condition, results of operations and future growth prospects would likely be materially and adversely affected. In these circumstances, the market price of our common stock could decline, and you may lose all or part of your investment in our securities. An investment in our securities is speculative and involves a high degree of risk. You should not invest in our securities if you cannot bear the economic risk of your investment for an indefinite period of time and cannot afford to lose your entire investment.

 

Risks Related to Our Business

 

Development of our products will take years; we may never attain product sales; and we expect to continue to incur net operating losses.

 

Our accumulated deficit as of December 31, 2006 was $236.2 million, and we expect to incur substantial operating losses for the foreseeable future. We expect that most of our resources for the foreseeable future will be

dedicated to research and development and preclinical and clinical testing of compounds. We expect to use approximately $16.0 million to $20.0 million in cash through the end of 2007 to advance the preclinical and clinical development of the product candidates we acquired from Valeant, including to further develop RDEA806 and RDEA119. Any compounds we advance through preclinical and clinical development will require extensive and costly development, preclinical testing and clinical trials prior to seeking regulatory approval for commercial sales. Our most advanced product candidates, RDEA806 and RDEA119, and any other compounds we advance into further development, may never be approved for commercial sales. The time required to attain product sales and profitability is lengthy and highly uncertain and we cannot assure you that we will be able to achieve or maintain product sales.

 

We are not currently profitable and may never become profitable.

 

To date we have generated limited revenues and we do not anticipate generating significant revenues for at least several years, if ever. We expect to increase our operating expenses over at least the next several years as we plan to advance the product candidates we acquired from Valeant, including RDEA806 and RDEA119, into further preclinical testing and clinical trials, expand our research and development activities and acquire or license new technologies and product candidates. As a result, we expect to continue to incur significant and increasing operating losses for the foreseeable future. Because of the numerous risks and uncertainties associated with our research and product development efforts, we are unable to predict the extent of any future losses or when we will become profitable, if ever. Even if we do achieve profitability, we may not be able to sustain or increase profitability on an ongoing basis.

 

Because the results of preclinical studies are not necessarily predictive of future results, we can provide no assurances that, even if our product candidates are successful in preclinical studies, such product candidates will have favorable results in clinical trials or receive regulatory approval.

 

Positive results from preclinical studies should not be relied upon as evidence that clinical trials will succeed. Even if our product candidates achieve positive results in clinical studies, we will be required to demonstrate through clinical trials that these product candidates are safe and effective for use in a diverse population before we can seek regulatory approvals for their commercial sale. There is typically an extremely high rate of attrition from the failure of drug candidates proceeding through clinical trials. If any product candidate fails to demonstrate sufficient safety and efficacy in any clinical trial we would experience potentially significant delays in, or be required to abandon, development of that product candidate. If we delay or abandon our development efforts of any of our product candidates, we may not be able to generate sufficient revenues to become profitable, and our reputation in the industry and in the investment community would likely be significantly damaged, each of which would cause our stock price to decrease significantly.

 

Delays in the commencement of clinical testing of our current and potential product candidates could result in increased costs to us and delay our ability to generate revenues.

 

Our product candidates will require preclinical testing and extensive clinical trials prior to submission of any regulatory application for commercial sales. Delays in the commencement of clinical testing of our product candidates could significantly increase our product development costs and delay product commercialization. In addition, many of the factors that may cause, or lead to, a delay in the commencement of clinical trials may also ultimately lead to denial of regulatory approval of a product candidate.

 

The commencement of clinical trials can be delayed for a variety of reasons, including delays in:

 

 

In addition, the commencement of clinical trials may be delayed due to insufficient patient enrollment, which is a function of many factors, including the size of the patient population, the nature of the protocol, the proximity of patients to clinical sites, the availability of effective treatments for the relevant disease, and the eligibility criteria for the clinical trial.

 

Delays in the completion of, or the termination of, clinical testing of our current and potential product candidates could result in increased costs to us and delay or prevent us from generating revenues.

 

Once a clinical trial for any current or potential product candidate has begun, it may be delayed, suspended or terminated by us or the FDA, or other regulatory authorities due to a number of factors, including:

 

 

Many of these factors that may lead to a delay, suspension or termination of clinical testing of a current or potential product candidate may also ultimately lead to denial of regulatory approval of a current or potential product candidate. If we experience delays in the completion of, or termination of, clinical testing, our financial results and the commercial prospects for our product candidates will be harmed, and our ability to generate product revenues will be delayed.

 

If our internal discovery and development efforts are unsuccessful, we will be required to obtain rights to new products or product candidates from third parties, which we may not be able to do.

 

Our long term ability to earn product revenue depends on our ability to successfully advance our product candidates that we acquired from Valeant through clinical development and regulatory approval and to identify and obtain new products or product candidates through internal development or licenses from third parties. If the development programs we acquired from Valeant and our internal development programs are not successful, we will need to obtain rights to new products or product candidates from third parties. We may be unable to obtain suitable product candidates or products from third parties for a number of reasons, including:

 

 

If we are unable to obtain rights to new products or product candidates from third parties, our ability to generate product revenues and achieve profitability may suffer.

Even if we successfully initiate and complete clinical trials for any product candidate, there are no assurances that we will be able to submit, or obtain FDA approval of, a new drug application.

 

There can be no assurance that if our clinical trials of any potential product candidate are successfully initiated and completed, we will be able to submit a new drug application, or NDA, to the FDA or that any NDA we submit will be approved by the FDA in a timely manner, if at all. If we are unable to submit an NDA with respect to any future product candidate, or if any NDA we submit is not approved by the FDA, we will be unable to commercialize that product. The FDA can and does reject NDAs and requires additional clinical trials, even when drug candidates performed well or achieved favorable results in clinical trials. If we fail to commercialize any future product candidate in clinical trials, we may be unable to generate sufficient revenues to attain profitability and our reputation in the industry and in the investment community would likely be damaged, each of which would cause our stock price to decrease.

 

If we successfully develop products but those products do not achieve and maintain market acceptance, our business will not be profitable.

 

Even if any of our product candidates are approved for commercial sale by the FDA or other regulatory authorities, the degree of market acceptance of any approved product candidate by physicians, healthcare professionals and third-party payors and our profitability and growth will depend on a number of factors, including:

 

 

In addition, even if any of our potential products achieve market acceptance, we may not be able to maintain that market acceptance over time if:

 

 

We will need substantial additional funding and may be unable to raise capital when needed, or at all, which would force us to delay, reduce or eliminate our research and development programs or commercialization efforts.

 

We believe that our existing cash and cash equivalents will be adequate to fund our anticipated levels of operations through 2008. However, our business and operations may change in a manner that would consume available resources at a greater rate than anticipated. In particular, because most of our resources for the foreseeable future will be used to advance the product candidates acquired from Valeant that we only recently acquired, we may not be able to accurately anticipate our future research and development funding needs. We will need to raise substantial additional capital at least within the next two years to, among other things:

 

 

Our future funding requirements will depend on, and could increase significantly as a result of, many factors, including:

 

 

We do not anticipate that we will generate significant continuing revenues for at least several years, if ever. Until we can generate significant continuing revenues, we expect to satisfy our future cash needs through public or private equity offerings, debt financings and corporate collaboration and licensing arrangements, as well as through interest income earned on cash balances. We cannot be certain that additional funding will be available to us on acceptable terms, or at all. If funds are not available, we may be required to delay, reduce the scope of or eliminate one or more of our research or development programs or our commercialization efforts.

 

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

 

We may raise additional funds through public or private equity offerings, debt financings or corporate collaborations and licensing arrangements. We cannot be certain that additional funding will be available on acceptable terms, or at all. To the extent that we raise additional capital by issuing equity securities, our stockholders’ ownership will be diluted. Any debt financing we enter into may involve covenants that restrict our operations. These restrictive covenants would likely include, among other things, limitations on borrowing, specific restrictions on the use of our assets as well as prohibitions on our ability to create liens, pay dividends, redeem capital stocks or make investments. In addition, if we raise additional funds through collaboration and licensing arrangements, it may be necessary to relinquish potentially valuable rights to our potential products or proprietary technologies, or grant licenses on terms that are not favorable to us. For example, we might be forced to relinquish all or a portion of our sales and marketing rights with respect to potential products or license intellectual property that enables licensees to develop competing products.

 

If we fail to establish additional research and development capability internally or through collaborations, we may not generate sufficient revenue to attain profitability.

 

We do not currently possess the resources necessary to independently conduct research and development activities for all of the product candidates we are pursuing. We will either have to establish additional research and development resources, enter into agreements with collaboration partners. The establishment of additional research and development capability would be expensive and time consuming and may not be successful. Establishing strategic collaborations is also difficult and time-consuming and any collaboration we develop may not be on favorable terms. Potential collaborators may reject collaborations based upon their assessment of our financial, regulatory or intellectual property position. If we fail to establish internal research and development capability or adequate collaborations, we will have to forego product development opportunities and may not generate sufficient revenue to attain profitability.

We do not have internal manufacturing capabilities, and if we fail to develop and maintain internal capabilities or supply relationships with collaborators or other outside manufacturers, we may be unable to develop or commercialize any products.

 

Our ability to develop and commercialize any products we may develop will depend in part on our ability to manufacture, or arrange for collaborators or other parties to manufacture, our products at a competitive cost, in accordance with regulatory requirements and in sufficient quantities for clinical testing and eventual commercialization. We currently do not have any significant manufacturing arrangements or agreements, as our current product candidates will not require commercial-scale manufacturing for at least several years, if ever. Our inability to enter into or maintain manufacturing agreements with collaborators or capable contract manufacturers on acceptable terms could delay or prevent the development and commercialization of our products, which would adversely affect our ability to generate revenues and would increase our expenses.

 

If we are unable to establish sales and marketing capabilities or enter into agreements with third parties to sell and market any products we may develop, we may be able to generate product revenue.

 

We do not currently have a sales organization for the sales, marketing and distribution of pharmaceutical products. In order to commercialize any products, we must build our sales, marketing, distribution, managerial and other non-technical capabilities or make arrangements with third parties to perform these services. We have not definitively determined whether we will attempt to establish internal sales and marketing capabilities or enter into agreements with third parties to sell and market any products we may develop. The establishment and development of our own sales force to market any products we may develop will be expensive and time consuming and could delay any product launch, and we cannot be certain that we would be able to successfully develop this capacity. If we are unable to establish our sales and marketing capability or any other non-technical capabilities necessary to commercialize any product we may develop, we will need to contract with third parties to market and sell any products we may develop. If we are unable to establish adequate sales, marketing and distribution capabilities, whether independently or with third parties, we may not be able to generate product revenue and may not become profitable.

 

We will need to increase the size of our organization, and we may encounter difficulties managing our growth, which could adversely affect our results of operations.

 

We will need to expand and effectively manage our managerial, operational, financial and other resources in order to successfully pursue our research, development and commercialization efforts and secure collaborations to market and distribute our products. If we continue to grow, it is possible that our management, accounting and scientific personnel, systems and facilities currently in place may not be adequate to support this future growth. To manage any growth, we will be required to continue to improve our operational, financial and management controls, reporting systems and procedures and to attract and retain sufficient numbers of talented employees. We may be unable to successfully manage the expansion of our operations or operate on a larger scale and, accordingly, may not achieve our research, development and commercialization goals.

 

If we are unable to attract and retain key management and scientific staff, we may be unable to successfully develop or commercialize our product candidates.

 

We are a small company, and our success depends on our continued ability to attract, retain and motivate highly qualified management and scientific personnel. In particular, our research and drug discovery programs depend on our ability to attract and retain highly skilled chemists, biologists, and preclinical personnel, especially in the fields of HIV, cancer and inflammatory diseases. If we are unable to hire or retain these employees, we may not be able to advance our research and development programs at the pace we anticipate, and we may not be able to perform our obligations under our Services Agreement with Valeant. We may not be able to attract or retain qualified management and scientific personnel in the future due to the intense competition for qualified personnel among biotechnology and pharmaceutical businesses, particularly in the San Diego and Costa Mesa, California areas. If we are not able to attract and retain the necessary personnel to accomplish our business objectives, we may experience constraints that will impede significantly the achievement of our research and development objectives. In addition, all of our employees are “at will” employees, which means that any employee may quit at any time and we may

terminate any employee at any time. Currently we do not have employment agreements with any employees or members of senior management that provide us any guarantee of their continued employment. If we lose members of our senior management team, we may not be able to find suitable replacements and our business may be harmed as a result.

 

Our quarterly results and stock price may fluctuate significantly.

 

We expect our results of operations and future stock price to be subject to quarterly fluctuations. The level of our revenues, if any, our results of operations and our stock price at any given time will be based primarily on the following factors:

 

 

These factors, some of which are not within our control, may cause the price of our stock to fluctuate substantially. In particular, if our quarterly operating results fail to meet or exceed the expectations of securities analysts or investors, our stock price could drop suddenly and significantly. We believe that quarterly comparisons of our financial results are not necessarily meaningful and should not be relied upon as an indication of our future performance.

 

If we engage in any acquisition, we will incur a variety of costs, and we may never realize the anticipated benefits of the acquisition.

 

We recently completed the acquisition of our pharmaceutical research and development programs including our product candidates from Valeant and there is no guarantee that we will be able to successfully develop the acquired product candidates. We may attempt to acquire businesses, technologies, services or other products or in-license technologies that we believe are a strategic fit with the development programs we acquired from Valeant, at the appropriate time and as resources permit. In any acquisition, the process of integrating the acquired business, technology, service or product may result in unforeseen operating difficulties and expenditures and may divert significant management attention from our ongoing business operations. These operational and financial risks include:

 

 

 

We may fail to realize the anticipated benefits of any acquisition or devote resources to potential acquisitions that are never completed. If we fail to successfully identify strategic opportunities, complete strategic transactions or integrate acquired businesses, technologies, services or products, we may not be able to successfully expand our product candidate portfolio to provide adequate revenue to attain and maintain profitability.

 

Earthquake damage to our facilities could delay our research and development efforts and adversely affect our business.

 

Our research and development facility in Costa Mesa, California, is located in a seismic zone, and there is the possibility of an earthquake, which could be disruptive to our operations and result in delays in our research and development efforts. In the event of an earthquake, if our facilities or the equipment in our facilities are significantly damaged or destroyed for any reason, we may not be able to rebuild or relocate our facility or replace any damaged equipment in a timely manner and our business, financial condition and results of operations could be materially and adversely affected.

 

Valeant’s exercise of its option to repurchase commercialization rights in territories outside the United States and Canada could limit the market for our products and adversely affect our business.

 

Under the Asset Purchase Agreement that we entered into with Valeant on December 21, 2006, Valeant retains a one-time option to repurchase commercialization rights in territories outside the U.S. and Canada for our first NNRTI derived from the acquired intellectual property to advance to Phase III clinical trials. If Valeant exercises this option, which it can do following the completion of Phase IIb clinical trials but prior to the initiation of Phase III clinical trials, Valeant would pay us a $10.0 million option fee, up to $21.0 million in milestone payments based on regulatory approvals, and a mid-single-digit royalty on product sales in the Valeant territories. However, Valeant would then own all commercialization rights in those territories, which may adversely impact the amount of aggregate revenue we may be able to generate from sales of our products and may negatively impact our potential for long-term growth.

 

Failure to comply with our minimum commitments under the Asset Purchase Agreement with Valeant could expose us to potential liability or otherwise adversely affect our business.

 

We agreed to use reasonable efforts to develop the product candidates in the pharmaceutical research and development programs we acquired from Valeant, with the objective of obtaining marketing approval for the lead product candidates from the 800 Series Program and the 100 Series Program in the United States, the United Kingdom, France, Spain, Italy and Germany. Our efforts will be designed to consistently advance the program with the goal of achieving the first milestone event within 24 months of the closing of the transaction with Valeant. If we fail to make sufficient effort to develop the product candidates we may be subject to a potential lawsuit or lawsuits from Valeant under the Asset Purchase Agreement. If such a lawsuit were filed, our reputation within the pharmaceutical research and development community may be negatively impacted and our business may suffer.

 

Failure to achieve and maintain effective internal controls in accordance with Section 404 of the Sarbanes-Oxley Act could have a material adverse effect on our business and stock price.

 

We have not yet started the process of documenting and testing our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act, which, beginning with our fiscal year ending December 31, 2007, will require annual management assessments of the effectiveness of our internal controls over financial reporting and, beginning with our fiscal year ending December 31, 2008, a report by our independent

auditors that both addresses management’s assessments and provides for the independent auditor’s assessment of the effectiveness of our internal controls. During the course of our testing, we may identify deficiencies which we may not be able to remediate in time to meet the deadline for compliance with Section 404. Testing and maintaining internal controls also involves significant costs and can divert our management’s attention from other matters that are important to our business. We may not be able to conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404, and our independent auditors may not be able or willing to issue a favorable assessment of our conclusions. Failure to achieve and maintain an effective internal control environment could harm our operating results and could cause us to fail to meet our reporting obligations. Inferior internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our stock.

 

Risks Related to Our Industry

 

Because our product candidates and development and collaboration efforts depend on our intellectual property rights, adverse events affecting our intellectual property rights will harm our ability to commercialize products.

 

Our commercial success depends on obtaining and maintaining patent protection and trade secret protection of our product candidates and their uses, as well as successfully defending these patents against third-party challenges. We will only be able to protect our product candidates and their uses from unauthorized use by third parties to the extent that valid and enforceable patents or effectively-protected trade secrets cover them.

 

Due to evolving legal standards relating to the patentability, validity and enforceability of patents covering pharmaceutical inventions and the scope of claims made under these patents, our ability to obtain and enforce patents is uncertain and involves complex legal and factual questions. Accordingly, rights under any issued patents may not provide us with sufficient protection for our drug candidates or provide sufficient protection to afford us a commercial advantage against competitive products or processes. In addition, we cannot guarantee that any patents will issue from any pending or future patent applications owned by or licensed to us. Even with respect to patents that have issued or will issue, we cannot guarantee that the claims of these patents are, or will be valid, enforceable or will provide us with any significant protection against competitive products or otherwise be commercially valuable to us. For example:

 

 

Patent applications in the U.S. are maintained in confidence for at least 18 months after their filing. Consequently, we cannot be certain that the patent applications we acquired from Valeant will lead to the issuance of any patent or be free from infringement or other claims from third parties. In the event that a third party has also filed a U.S. patent application relating to the product candidates we acquired from Valeant or a similar invention, we may have to participate in interference proceedings declared by the U.S. Patent Office to determine priority of invention in the United States. The costs of these proceedings could be substantial and it is possible that our efforts would be unsuccessful, resulting in a material adverse effect on our U.S. patent position. Furthermore, we may not have identified all U.S. and foreign patents or published applications that affect our business either by blocking our ability to commercialize our drugs or by covering similar technologies that affect our drug market.

In addition, some countries, including many in Europe, do not grant patent claims directed to methods of treating humans, and in these countries patent protection may not be available at all to protect our drug candidates. Even if patents issue, we cannot guarantee that the claims of those patents will be valid and enforceable or provide us with any significant protection against competitive products, or otherwise be commercially valuable to us.

 

Other companies may obtain patents and/or regulatory approvals to use the same drugs to treat diseases other than HIV, cancer and inflammatory diseases. As a result, we may not be able to enforce our patents effectively because we may not be able to prevent healthcare providers from prescribing, administering or using another company’s product that contains the same active substance as our products when treating patients infected with HIV, cancer or inflammatory diseases.

 

Our business depends upon not infringing the rights of others.

 

If we are sued for infringing intellectual property rights of others, it will be costly and time consuming, and an unfavorable outcome in that litigation would have a material adverse effect on our business. Our commercial success depends upon our ability to develop, manufacture, market and sell our product candidates without infringing the proprietary rights of third parties. We may be exposed to future litigation by third parties based on claims that our product candidates or activities infringe the intellectual property rights of others. Numerous U.S. and foreign issued patents and pending patent applications owned by others exist in HIV, cancer, inflammatory diseases and the other fields in which we are developing products. We cannot assure you that third parties holding any of these patents or patent applications will not assert infringement claims against us for damages or seeking to enjoin our activities. We also cannot assure you that, in the event of litigation, we will be able to successfully assert any belief we may have as to non-infringement, invalidity or immateriality, or that any infringement claims will be resolved in our favor.

 

There is a substantial amount of litigation involving patent and other intellectual property rights in the biotechnology and biopharmaceutical industries generally. Any litigation or claims against us, with or without merit, may cause us to incur substantial costs, could place a significant strain on our financial resources, divert the attention of management from our core business and harm our reputation. In addition, intellectual property litigation or claims could result in substantial damages and force us to do one or more of the following if a court decides that we infringe on another party’s patent or other intellectual property rights:

 

 

If we find during clinical evaluation that our drug candidates for the treatment of HIV, cancer or inflammatory diseases should be used in combination with a product covered by a patent held by another company or institution, and that a labeling instruction is required in product packaging recommending that combination, we could be accused of, or held liable for, infringement of the third-party patents covering the product recommended for co-administration with our product. In that case, we may be required to obtain a license from the other company or institution to use the required or desired package labeling, which may not be available on reasonable terms, or at all.

 

If we fail to obtain any required licenses or make any necessary changes to our technologies, we may be unable to develop or commercialize some or all of our product candidates.

 

Confidentiality agreements with employees and others may not adequately prevent disclosure of trade secrets and other proprietary information and may not adequately protect our intellectual property.

 

We also rely on trade secrets to protect our technology, especially where we do not believe patent protection is appropriate or obtainable. However, trade secrets are difficult to protect. In order to protect our proprietary technology and processes, we also rely in part on confidentiality and intellectual property assignment agreements

with our employees, consultants and other advisors. These agreements may not effectively prevent disclosure of confidential information or result in the effective assignment to us of intellectual property, and may not provide an adequate remedy in the event of unauthorized disclosure of confidential information or other breaches of the agreements. In addition, others may independently discover our trade secrets and proprietary information, and in such case we could not assert any trade secret rights against such party. Enforcing a claim that a party illegally obtained and is using our trade secrets is difficult, expensive and time consuming, and the outcome is unpredictable. In addition, courts outside the United States may be less willing to protect trade secrets. Costly and time-consuming litigation could be necessary to seek to enforce and determine the scope of our proprietary rights, and failure to obtain or maintain trade secret protection could adversely affect our competitive business position.

 

Many competitors have significantly more resources and experience, which may harm our commercial opportunity.

 

The biotechnology and pharmaceutical industries are subject to intense competition and rapid and significant technological change. We have many potential competitors, including major drug and chemical companies, specialized biotechnology firms, academic institutions, government agencies and private and public research institutions. Many of our competitors have significantly greater financial resources, experience and expertise in:

 

 

Smaller or early-stage companies and research institutions may also prove to be significant competitors, particularly through collaborative arrangements with large and established pharmaceutical or other companies. We will also face competition from these parties in recruiting and retaining qualified scientific and management personnel, establishing clinical trial sites and patient registration for clinical trials, and acquiring and in-licensing technologies and products complementary to our programs or potentially advantageous to our business. If any of our competitors succeed in obtaining approval from the FDA or other regulatory authorities for their products sooner than we do or for products that are more effective or less costly than ours, our commercial opportunity could be significantly reduced.

 

If our competitors develop treatments for HIV, cancer or inflammatory diseases that are approved faster, marketed better or demonstrated to be more effective than any products that we may develop, our commercial opportunity will be reduced or eliminated.

 

We believe that a significant number of drugs are currently under development and may become available in the future for the treatment of HIV, cancer and inflammatory diseases. Potential competitors may develop treatments for HIV, cancer or inflammatory diseases or other technologies and products that are more effective or less costly than our product candidates or that would make our technology and product candidates obsolete or non-competitive. Some of these products may use therapeutic approaches that compete directly with our most advanced product candidates.

 

If we cannot establish pricing of our product candidates acceptable to the government, insurance companies, managed care organizations and other payors, or arrange for favorable reimbursement policies, any product sales will be severely hindered.

 

The continuing efforts of the government, insurance companies, managed care organizations and other payors of health care costs to contain or reduce costs of health care may adversely affect our ability to set a price we believe is fair for any products we may develop and our ability to generate adequate revenues and gross margins. Our ability to commercialize any product candidates successfully will depend in part on the extent to which governmental

authorities, private health insurers and other organizations establish appropriate reimbursement levels for the cost of any products and related treatments.

 

In certain foreign markets, the pricing of prescription pharmaceuticals is subject to government control. In the United States, given recent federal and state government initiatives directed at lowering the total cost of health care, the U.S. Congress and state legislatures will likely continue to focus on health care reform, the cost of prescription pharmaceuticals and on the reform of the Medicare and Medicaid systems. The trend toward managed health care in the United States, which could significantly influence the purchase of health care services and products, as well as legislative proposals to reform health care, control pharmaceutical prices or reduce government insurance programs, may result in lower prices for our product candidates. While we cannot predict whether any legislative or regulatory proposals affecting our business will be adopted, the announcement or adoption of these proposals could have a material and adverse effect on our potential revenues and gross margins.

 

Product liability claims may damage our reputation and, if insurance proves inadequate, the product liability claims may harm our results of operations.

 

We will face an inherent risk of product liability exposure if we begin testing our product candidates in human clinical trials, and we will face an even greater risk if we sell our product candidates commercially. If we cannot successfully defend ourselves against product liability claims, we will incur substantial liabilities, our reputation may be harmed and we may be unable to commercialize our product candidates.

 

Any claims relating to our improper handling, storage or disposal of biological, hazardous and radioactive materials could be time-consuming and costly.

 

Our research and development involves the controlled use of hazardous materials, including chemicals that cause cancer, volatile solvents, radioactive materials and biological materials that have the potential to transmit disease. Our operations also produce hazardous waste products. We are subject to federal, state and local laws and regulations governing the use, manufacture, storage, handling and disposal of these materials and waste products. If we fail to comply with these laws and regulations or with the conditions attached to our operating licenses, the licenses could be revoked, and we could be subjected to criminal sanctions and substantial liability or required to suspend or modify our operations. Although we believe that our safety procedures for handling and disposing of these materials comply with legally prescribed standards, we cannot completely eliminate the risk of accidental contamination or injury from these materials. In the event of contamination or injury, we could be held liable for damages or penalized with fines in an amount exceeding our resources. In addition, we may have to incur significant costs to comply with future environmental laws and regulations. We do not currently have a pollution and remediation insurance policy.

 

Our business and operations would suffer in the event of system failures.

 

Despite the implementation of security measures, our internal computer systems are vulnerable to damage from computer viruses, unauthorized access, natural disasters, terrorism, war and telecommunication and electrical failures. Any system failure, accident or security breach that causes interruptions in our operations could result in a material disruption of our drug discovery programs. To the extent that any disruption or security breach results in a loss or damage to our data or applications, or inappropriate disclosure of confidential or proprietary information, we may incur liability as a result, our drug discovery programs may be adversely affected and the further development of our product candidates may be delayed. In addition, we may incur additional costs to remedy the damages caused by these disruptions or security breaches.

 

Risks Related to Our Common Stock

 

The delisting of our common stock in October 2005 may be adversely affecting the price and liquidity of our common stock.

 

On October 14, 2005, our common stock was delisted from The Nasdaq Global Market (formerly known as the Nasdaq National Market). The delisting decision was made by the Nasdaq Listings Qualifications Panel, following our appeal of a prior determination by the staff of the Nasdaq Stock Market, LLC that we were a “public shell,”

raising public interest concerns pursuant to Marketplace Rule 4300. Our quotation for our common stock currently appears in the “pink sheets” under the trading symbol “ARDC”. The delisting of our common stock may be adversely affecting and may continue to adversely affect the price and liquidity of our common stock. We cannot assure you that we will be able to meet the listing standards of any stock exchange, or that we will be able to maintain any such listing. Until our common stock is listed on an exchange, we expect that it would be continue to be eligible to be quoted in the “pink sheets.” In this venue, however, an investor may find it difficult to obtain accurate quotations as to the market value of our common stock. In addition, if we failed to meet the criteria set forth in SEC regulations, various requirements would be imposed by law on broker-dealers who sell our securities to persons other than established customers and accredited investors. Consequently, such regulations may deter broker-dealers from recommending or selling our common stock, which may further affect its liquidity. This would also make it more difficult for us to raise additional capital.

 

Directors, executive officers principal stockholders and affiliated entities beneficially own or control at least 58% of our outstanding voting common and preferred stock and may be able to exert control over our activities, and the results of our operations and financial condition may suffer.

 

As of December 31, 2006, our directors, executive officers principal stockholders and affiliated entities beneficially owned or controlled securities representing, in the aggregate, approximately 58% of our common equivalent shares, including approximately 2.9 million shares underlying outstanding convertible preferred stock and options or warrants exercisable within 60 days of December 31, 2006. These stockholders, if they determine to vote in the same manner, may be able to control the outcome of any matter requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions or terms of any liquidation.

 

Future sales of our common stock may cause our stock price to decline.

 

Our current stockholders hold a substantial number of shares of our common stock that they will be able to sell in the public market in the near future. In addition, our Series A Preferred Stock is convertible as of December 31, 2006, into 1,578,346 shares of common stock, and outstanding warrants are exercisable as of December 31, 2006. Significant portions of these shares are held by a small number of stockholders. The conversion of Series A Preferred Stock, exercise of warrants, or sales by our current stockholders of a substantial number of shares, or the expectation that such sales may occur, could significantly reduce the market price of our common stock.

 

The holders of our Series A preferred stock have a liquidation preference and other rights that are adverse to the interests of our common stockholders and could be detrimental to our business.

 

The holders of our Series A preferred stock have rights to designate two members of our Board of Directors. In addition, upon our liquidation or dissolution (including by way of a merger or acquisition), the holders of our Series A preferred stock are entitled to receive a liquidation preference in an amount equal to the greater of (i) $10,000 per share of Series A preferred stock plus any declared but unpaid dividends thereon or (ii) the amount that would have been paid had each such share of Series A preferred stock been converted to common stock immediately prior to such liquidation or dissolution. As of December 31, 2006, this liquidation preference was $3.0 million. The holders of Series A preferred stock also have a right of first refusal to purchase their pro rata portion of any equity securities we propose to offer to any person. Such right of first refusal is subject to certain customary exclusions, including shares issued pursuant to any options or other stock awards granted to our employees, directors or consultants, equipment leasing arrangements, debt financings, strategic financings and public offerings that have been approved by our Board of Directors. The holders of Series A preferred stock are also entitled to receive cumulative dividends at the rate of 8% per annum of the original per share price of the Series A preferred stock, prior to and in preference to any declaration or payment of a dividend to the holders of common stock. The dividends on the currently outstanding 300 shares of Series A preferred stock are cumulating at a total of $240,000 per year and are payable in common stock. Additionally, each share of Series A preferred stock automatically converts into shares of common stock on the tenth day after the day that the closing sale price of our common stock on the Nasdaq Global Market (formerly the Nasdaq National Market) has reached at least $8.28 and

has remained at such level for 20 consecutive trading days. If any of the rights and preferences listed above become available to the holders of Series A preferred stock, our common stockholders will be adversely affected.

 

The holders of our Series A preferred stock also have the right at any time to request that we register for resale the shares of our common stock that they acquire upon conversion of their Series A preferred stock or upon exercise of their warrants to purchase our common stock, subject to certain limitations. A registration statement has been filed with the Securities and Exchange Commission and is currently effective for the resale of the shares of common stock issuable upon conversion of our Series A preferred stock and upon the exercise of their warrants to purchase our common stock. In addition, the holders of our Series A preferred stock may convert their Series A preferred stock into common stock and sell the shares of the common stock acquired upon such conversion in the public market in reliance upon Rule 144, subject in certain cases to volume and other limitations. Future sales in the public market of such common stock, or the perception that such sales might occur, could adversely affect the market price of our common stock.

 

For so long as at least 100 shares of Series A preferred stock remain outstanding, we are required to get the consent of at least a majority of the then outstanding Series A preferred stock for any action that amends our certificate of incorporation (including the filing of a certificate of designation) so as to adversely affect the rights, preferences or privileges of the Series A preferred stock and any authorization or designation of a new class or series of stock which ranks senior to the Series A preferred stock in right of liquidation preference, voting or dividends. The Series A preferred stockholders’ right to block the issuance of additional shares of senior preferred stock could impact our ability to raise necessary capital and adversely affect our business.

 

Anti-takeover provisions in our charter documents and under Delaware law may make it more difficult to acquire us.

 

Provisions in our certificate of incorporation and bylaws could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. These provisions:

 

 

In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which may prohibit large stockholders from consummating a merger with, or acquisition of us. These provisions may prevent a merger or acquisition that would be attractive to stockholders and could limit the price that investors would be willing to pay in the future for our common stock.

 

We have never paid cash dividends on our capital stock and we do not anticipate paying dividends in the foreseeable future.

 

We have paid no cash dividends on any of our classes of capital stock to date, and we currently intend to retain our future earnings, if any, to fund the development and growth of our business. In addition, the terms of any future debt or credit facility may preclude us from paying any dividends. As a result, capital appreciation, if any, of our common stock will be your sole source of potential gain for the foreseeable future.

 

None

 

In December 2006, we entered into a lease for our Costa Mesa, California research facility. This property, which is located at 3300 Hyland Avenue, Costa Mesa, California 92626, is being used in connection with our research and development activities. The facility occupies approximately 64,000 square feet of laboratory and office space. The monthly base rent is approximately $90,000, and monthly operating expenses are between $50,000 and $90,000. The lease expires in March of 2008.

 

We also recently entered into a 6-month lease for 2,900 square feet of space in Carlsbad, California, at a monthly rent of approximately $3,000 after sublease income. This facility houses our corporate offices.

 

Currently, we are not a party to any pending legal proceedings, and are not aware of any proceeding against us contemplated by any governmental authority.

 

No matters were submitted to a vote of our stockholders through the solicitation of proxies or otherwise during 2006.

 

Market for Common Equity

 

Our common stock began trading on the Nasdaq Global Market (formerly known as the Nasdaq National Market) on March 28, 2000, under the symbol “IBPI.” On October 14, 2005 our stock was delisted from the Nasdaq Global Market and currently trades in the “pink sheets”. This symbol was changed in January of 2007 to “ARDC.” Information regarding the market prices of our common stock may be found in Note 13 of the notes to the financial statements included in this annual report on Form 10-K.

 

Holders

 

As of February 12, 2007, there were 103 holders of record of our common stock. We estimate that, included within the holders of record, there are approximately 1,550 beneficial owners of our common stock. As of February 15, 2007, the closing price for our common stock was $6.35.

 

Securities Authorized for Issuance Under Equity Compensation Plans

 

The following table sets forth certain information with respect to all of our equity compensation plans in effect as of December 31, 2006:

 

Equity Compensation Plan Information

 

 

Dividend Policy

 

We have never paid dividends on our common stock. We currently intend to retain any future earnings to support the development of our business. The holders of our Series A preferred stock are entitled to receive cumulative dividends at the rate of 8% per annum of the original purchase price of $10,000 per share of Series A preferred stock, prior to and in preference to any declaration or payment of a dividend to the holders of our common stock. The dividends are payable quarterly in shares of our common stock. The number of shares payable is determined based on the average closing sale price of our common stock for each of the five trading days immediately preceding the applicable dividend payment date. Until accrued and unpaid dividends on the Series A preferred stock are paid and set apart, no dividends or other distributions in respect of any other shares of our capital stock shall be declared. We do not currently anticipate paying any cash dividends in the foreseeable future.

 

On December 21, 2006, we acquired certain intellectual property and assets from Valeant related to three research and development programs. See “ITEM 7 — MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — RECENT DEVELOPMENTS” and the notes to the financial statements included in this annual report on Form 10-K for a description of the financial effect of that acquisition on the selected financial information set forth below. The following selected financial data should be read in conjunction with our financial statements and “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” included in Items 7 and 8 of this annual report on Form 10-K. The financial data for periods prior to the financial statements presented in Item 8 of this Form 10-K are derived from audited financial statements not included in this Form 10-K.

 

 

The following discussion and analysis of our financial condition and results of operations should be read together with our financial statements and related notes appearing elsewhere in this Form 10-K. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. The actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including but not limited to those set forth under “Risk Factors.” All forward-looking statements included in this document are based on information available to us on the date of this document and we assume no obligation to update any forward-looking statements contained in this Form 10-K.

 

Overview

 

We were incorporated in the State of Delaware in 1994. From our inception in 1994 through May 5, 2005, we devoted substantially all of our efforts to research and development of anti-microbial drugs and generated no product revenues. From the fourth quarter of 2002 until June 2004, we focused our attention on developing iseganan for the prevention of ventilator-associated pneumonia, or VAP. In June 2004, we discontinued our clinical trial of iseganan for the prevention of VAP following a recommendation of our independent data monitoring committee. Subsequently, we terminated the iseganan development program, reduced our work force and evaluated strategic alternatives, including mergers, acquisitions, in-licensing opportunities and liquidation.

 

On May 5, 2005, after considering a variety of strategic alternatives, none of which was determined by our management and Board of Directors to be in the best interests of us and our stockholders, our Board of Directors decided to reduce operating expenses to a minimum appropriate level. In accordance with these plans, we terminated all of our remaining regular employees on June 15, 2005, engaged Hickey & Hill, Inc. of Lafayette, California, a firm specializing in managing companies in transition, to assume the responsibilities of our day-to-day administration, and appointed Denis Hickey of Hickey & Hill, Inc. as our Chief Executive Officer and Chief Financial Officer.

 

From June 15, 2005 until December 21, 2006, Denis Hickey handled the administration of our affairs while our Board of Directors and selected consultants searched for and evaluated strategic alternatives for our business. During that period, we evaluated several strategic alternatives in the biotechnology industry with the support of consultants, including Barry D. Quart, Pharm.D., and the active participation of our Board of Directors.

 

Recent Developments

 

On December 21, 2006, we acquired intellectual property and other assets related to three distinct pharmaceutical research and development programs from Valeant, hired a new senior management team, including Barry D. Quart, Pharm.D., who replaced Denis Hickey as Chief Executive Officer, and changed our name from IntraBiotics Pharmaceuticals, Inc. to Ardea Biosciences, Inc. With these developments, we currently plan to pursue pharmaceutical research and development focused on novel treatments for HIV, cancer and inflammatory diseases. We will also be providing research services to Valeant in connection with a preclinical program in the field of neuropharmacology pursuant to a services agreement with Valeant. This agreement, which has a two-year term, subject to Valeant’s option to terminate the agreement after the first year, provides that we will receive quarterly payments of up to $3.5 million per year and up to $1.0 million in milestone payments. In connection with our acquisition of the three development programs from Valeant, we entered into an office lease agreement for space formerly held by Valeant.

 

As part of the purchase of assets from Valeant, we received fixed assets valued at approximately $4.3 million and goodwill and intangible assets valued at approximately $800,000. For these assets, we paid no upfront consideration and assumed no liabilities except for liabilities under certain contracts related to the assets. Our costs for professional fees in connection with the transaction were approximately $500,000. These assets were acquired without upfront consideration and, therefore, the fair value of the assets acquired exceeded the cost of the upfront consideration paid. We initially recorded the excess of $4.6 million (net of transaction costs) as negative goodwill and then subsequently allocated this amount in its entirety to reduce the amounts initially assigned to the acquired non-current assets pursuant to paragraph 44 of Statement of Financial Accounting Standards No. 141 (SFAS 141).

As a result, $500,000 of fixed assets associated with the transaction remains on our records. We also have a contingent liability of up to $42 million related to our obligations to make milestone payments for the 800, 900 and 100 Series Programs, to be recorded if and when the milestones become payable.

 

Capitalization

 

Common Stock

 

We are authorized to issue 70,000,000 shares of common stock, of $0.001 par value, of which, as of December 31, 2006, 9,362,191 shares were issued and outstanding.

 

Preferred Stock

 

We are authorized to issue 5,000,000 shares of preferred stock, of $0.001 par value. As of December 31, 2006, 350 shares of preferred stock were designated as Series A preferred stock, of which 300 shares were issued and outstanding.

 

Each share of Series A preferred stock is convertible into approximately 5,261.15 shares of common stock at any time, which represents a conversion price of $1.90 per share. As of December 31, 2006, the 300 shares of Series A preferred stock outstanding were convertible into 1,578,346 shares of common stock. This conversion may occur at any time. In addition, each share of Series A preferred stock automatically converts into shares of common stock on the tenth day after the day that the closing sale price of our common stock on the Nasdaq Global Market (formerly the Nasdaq National Market) has reached at least $8.28 and has remained at such level for 20 consecutive trading days.

 

The holders of Series A preferred stock are also entitled to receive quarterly dividends at the annual rate of $800 per share of Series A preferred stock. The dividend is be paid in common stock based on the average of the closing sales prices of the common stock for the five trading days immediately preceding and ending on the last trading day prior to the date the dividends are payable.

 

Warrants

 

As of December 31, 2006, the following warrants were outstanding:

 

 

Common Stock Reserved for Future Issuance

 

As of December 31, 2006, in addition to the 9,362,191 shares of common stock issued and outstanding, we had reserved additional 6,355,905 shares of common stock for issuance under the following arrangements:

 

 

Critical Accounting Policies and Estimates

 

An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur

periodically, could materially impact the financial statements. Management believes the following critical accounting policies reflect its more significant estimates and assumptions used in the preparation of the financial statements. We review the accounting policies used in our financial statements on a regular basis. In addition, management has reviewed these critical accounting policies and related disclosures with the Audit Committee of our Board of directors.

 

Our discussion and analysis of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses, and related disclosures. On an ongoing basis, we evaluate these estimates, including those related to clinical trial accruals, income taxes, and stock-based compensation. Estimates are based on historical experience, information received from third parties and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could therefore differ materially from those estimates under different assumptions or conditions.

 

Stock-Based Compensation

 

In February 2003, our Board of Directors approved a cancellation and re-grant of 308,835 unexercised stock options held by our then-existing employees and directors in a one-for-one exchange and 12,500 options that were re-granted in connection with the cancellation of 54,166 unexercised stock options held by one of our directors. The re-granted options have an exercise price equal to the closing price of our common stock on the Nasdaq Global Market (formerly known as the Nasdaq National Market) on February 5, 2003, or $2.76 per share. The options generally vest over a four-year period and will expire in February 2008 if not previously exercised. As of December 31, 2006, 203,334 of these options remain outstanding.

 

In 2006, 2005 and 2004 the non-cash stock compensation in connection with variable accounting for these re-granted stock options were recoveries of $9,000, $38,000 and $638,000, respectively. In addition, we recorded non-cash stock compensation expense related to the amortization of deferred stock compensation of $0, $50,000 and $61,000 during the years ended December 31, 2006, 2005, and 2004, respectively, primarily in connection with the grant of certain stock options to employees and officers on, or prior to, our initial public offering on March 20, 2000. In addition, we have granted stock options to consultants, which resulted in non-cash stock compensation expense of $2,000, $150,000 and $472,000 during the years ended December 31, 2006, 2005, and 2004, respectively. For additional details and a tabular summary of stock compensation expense see Note 10 of the notes to the financial statements included in Item 8 of this Form 10-K.

 

As permitted by SFAS No. 123, “Accounting for Stock-Based Compensation”, as amended by Statement of Financial Standards No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” we elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”, or APB 25, and related interpretations in accounting for stock-based employee compensation through December 31, 2005. Under APB 25, if the exercise price of an employee or director stock option is set equal or in excess of the fair market value of the underlying stock on the date of grant, no compensation expense is recognized. In February 2003, certain employee and director stock options for which the exercise prices had originally been set at less than the fair market value of the underlying stock on the grant date, were cancelled and re-granted in a one-for-one exchange. We recorded deferred compensation for the difference between the original exercise price and the fair market value of the underlying stock on the grant date as a component of stockholders’ equity, and the total was being amortized on a straight-line basis over the vesting period of the original awards, ranging from four to six years. The related re-granted options all vest over a four-year period, and the remaining unamortized deferred compensation as of the re-grant date is now being amortized over the new four-year vesting schedule, commencing at the date of re-grant. The amount of deferred stock compensation expense to be recorded in future periods could decrease if options, for which accrued but unvested compensation has been recognized, are forfeited prior to vesting. No adjustments for material changes in estimates have been recognized in any period presented.

Effective January 1, 2006, we adopted “SFAS” 123(R) — “Share-Based Payment”, a revision of SFAS 123, “Accounting for Stock-Based Compensation” which superseded “APB” Opinion No. 25, “Accounting for Stock Issued to Employees,” and its related implementation guidance on August 1, 2005. SFAS 123(R) establishes standards for the accounting for transactions where an entity exchanges its equity instruments for goods or services. The principal focus of SFAS 123(R) is the accounting for transactions in which an entity obtains employee services in share-based payment transactions, and where the measurement of the cost of employee (or member of the Board of Directors) received in exchange for an award of equity instruments is based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee (or director) is required to provide service in exchange for the award — the requisite service period — and unless observable market prices for the same or similar instruments are available, will be estimated using option-pricing models adjusted for the unique characteristics of the instruments. If an equity award is modified after the grant date, incremental compensation cost will be recognized in an amount equal to the excess of the fair value of the modified award over the fair value of the original award immediately before the modification.

 

Under SFAS 123(R), we determined the appropriate fair value model to be used for valuing share-based payments and the amortization method for compensation cost. We adopted SFAS 123(R) using the Black-Scholes modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006. Our Consolidated Financial Statements as of and for the twelve months ended December 31, 2006 reflects the impact of SFAS 123(R). During the twelve months ended December 31, 2006, we recognized $558,000 in compensation expense related to options granted to employees and directors. In accordance with the modified prospective transition method, our Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). If we had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation for the twelve months ended December 31, 2005 and 2004, we would have recorded an expense of $1.8 million and $7.6 million, respectively. The difference between the years is primarily due to the decreased volatility of the stock and option exercises and cancellations resulting from the discontinuance or Iseganan and subsequent termination of all employees.

 

Options or stock awards issued to non-employees are recorded at their fair value as determined in accordance with SFAS 123 and the FASB’s Emerging Issues Task Force issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services”, and are recognized over the related service period. The fair values are estimated using the Black-Scholes option pricing model, and are periodically re-measured as the underlying options vest. The option pricing model is dependent on a number of inputs, which may change over time. Other option pricing models may produce fair values that are substantially different from the Black-Scholes model. No adjustments for material changes in estimates have been recognized in any period presented.

 

Clinical Trial Accruals

 

We accrued costs for clinical trial activities are based upon estimates of the services received and related expenses incurred that have yet to be invoiced by the contract research organizations (CROs) or other clinical trial service providers that perform the activities. Related contracts vary significantly in length, and may be for a fixed amount, a variable amount based on actual costs incurred, capped at a certain limit, or for a combination of these elements. All estimates may differ significantly from the actual amount subsequently invoiced. No adjustments for material changes in estimates have been recognized in any period presented. As of December 31, 2006 amounts accrued related to clinical trials were insignificant

 

Results of Operations

 

Comparison of Years Ended December 31, 2006, 2005, and 2004

 

Revenues

 

We had no product sales or contract revenue for the years ended December 31, 2006, 2005, or 2004.

Expenses

 

Research and Development

 

 

Research and development expenses primarily include clinical trial expenses, research and development payroll expense, drug substance expense, allocated facilities costs and non-cash stock compensation charges. Research and development expenses decreased 72% in 2006 compared to 2005 because of the cessation of activities due to the termination of our Iseganan development project in June 2004. Except for the adjustment of certain payables and facilities costs related to our restart, research and development costs in 2006 ceased as a result of our decision to discontinue the Iseganan program and reduce operating expenses to a minimum appropriate level.

 

Research and development expenses decreased in 2005 by $11.3 million from 2004 as a result of cessation of activities due to the termination of our Iseganan development project in June 2004.

 

Non-cash stock compensation was $0.0 in 2006 compared to charges of $8,000, and $26,000 for the years ended December 31, 2005, and 2004, respectively. The decrease from 2005 to 2006 was due to the decrease in stock options outstanding. The decrease from 2004 to 2005 was due to lower amortization of deferred stock compensation expense during 2005 and a recovery related to stock compensation for variable options awards during 2004. These decreases were offset, in part, by an increase in the stock compensation expense for consultant services.

 

General and Administrative

 

 

General and administrative costs primarily include administrative payroll expense, outside contractors, legal and accounting fees, insurance, non-cash stock compensation charges, facilities, travel and other general administrative expenses. General and administrative expenses decreased by $0.3 million from 2005 to 2006 as a result of expenses associated with decreased headcount and facilities of $1.1 million, offset by $400,000 in signing bonuses in December 2006 for our new management team and an increase in stock compensation expense of $0.4 million to be in compliance with SFAS 123(R), which required all share-based payments to employees, related to 2006, to be recognized in the financial statements. Stock compensation expense was $0.6 million during the year ended 2006 as compared to $153,000 during the year ended 2005.

 

General and administrative expenses decreased by $1.8 million from 2004 to 2005 as a result of expenses associated with decreased headcount and facilities of $0.9 million, and outside contractors and services of $0.8 million. This decrease was offset by an increase in stock compensation expense of $0.3 million related to deferred compensation and variable accounting for stock options for employees and stock compensation for consultants. Stock compensation expense was $153,000 during the year ended 2005 as compared to a stock compensation recovery of $131,000 during the year ended 2004.

 

Non-cash stock compensation charges were $0.6 million in 2006, as compared to $0.2 million in 2005 and a recovery in the year ended December 31, 2004 of $0.1 million. The increase in 2006 was primarily due to implementation of SFAS 123R which, effective January of 2006, required us to record stock compensation expenses for employees.

 

Restructuring and Other Charges

 

 

On May 5, 2005, after considering a variety of strategic alternatives, none of which was determined by management and our Board of Directors to be in the best interests of us and our shareholders, our Board of Directors

decided to reduce operating expenses to a minimum appropriate level (we refer to these activities as the 2005 Restructuring). In accordance with these plans, we terminated all of our remaining employees on June 15, 2005. All restructuring charges are accounted for in accordance with Statement of Financial Accounting Standards No. 146, or SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities.” We recorded a restructuring charge of $648,000 during the twelve months ended December 31, 2005, all of which related to employee termination benefits.

 

In June 2004, we discontinued our clinical trial of iseganan for the prevention of VAP, following a recommendation of the independent data monitoring committee. We terminated the iseganan development program, and focused efforts on evaluating various strategic options, including mergers, acquisitions, in-licensing opportunities, and our liquidation. As a result, in August 2004, we implemented a restructuring plan, which included the termination of nine employees and various operating lease commitments. We recorded a restructuring charge of $858,000 during the year ended December 31, 2004, of which $748,000 related to involuntary employee termination benefits and $110,000 related to the termination of facility operating leases and the write-off of certain property and equipment. The $748,000 of involuntary employee benefits were comprised primarily of $700,000 of lump sum severance payments and related employer taxes and health and other benefits payable.

 

Interest Income and Expense

 

 

Interest income in 2006 increased from 2005 because of the substantially higher average interest-earning investment balances. Interest Income in 2005 increased from 2004 because of substantially higher average interest earning investment balances due to a public stock offering in May 2004, which raised net proceeds of $41.5 million. For additional information on the public stock offering in May 2004 please see Liquidity and Capital Resources, below.

 

Other Income/(Expense), net

 

 

In September 2004 the Company recorded an expense of $175,000 included in other income/(expense) related to the write-down of the carrying value of 350,000 shares of Series A redeemable preferred stock of Micrologix Biotechnology Inc., (“Micrologix”).

 

We issued warrants to purchase shares of our common stock in connection with its Series A convertible preferred stock offering on May 1, 2003 which provide that if our common stock is delisted from the Nasdaq Global Market, the purchase price for the stock upon exercise of the warrants will be reduced by 50% without any associated increase in the number of shares of common stock for which the warrants are then exercisable. This provision was triggered by our October 2005 delisting from The Nasdaq Global Market. As of September 30, 2005, we had warrants to purchase 789,171 shares of our common stock outstanding with an exercise price of $2.066 per share. As a result of the October 14, 2005 delisting, the exercise price dropped from $2.066 to $1.033 per share, and we recorded a non-cash charge of $789,000 to “other expense” and an offsetting increase in “paid-in-capital” in December of 2005 to reflect the fair market value of these warrants.

 

Income Taxes

 

Since inception, we have incurred operating losses and accordingly have not recorded a provision for income taxes for any of the periods presented. As of December 31, 2006, we had net operating loss carry forwards for federal and state income tax purposes of approximately $42.0 million and $31.0 million, respectively. We also had federal and state research and development tax credits each of approximately $3.4 million. If not utilized, the net operating losses and credits will expire in the years 2007 through 2026. Utilization of net operating losses and

credits are subject to a substantial annual limitation due to ownership change limitations provided by the Internal Revenue Code of 1986, as amended. The annual limitation could result in the expiration of our net operating losses and credit carryforwards before they can be used. Please read Note 11 of the notes to the financial statements included in Item 8 of this Form 10-K for further information.

 

Liquidity and Capital Resources

 

 

At December 31, 2006, we had cash and cash equivalents of $14.8 million, representing an increase of $12 million from December 31, 2005. Short-term investments were $33.9 million at December 31, 2006 as compared to $46 million at December 31, 2005. We had no debt outstanding as of December 31, 2006. We invest excess funds in short-term money market funds and securities pursuant to our investment policy guidelines as more fully described in “ITEM 7A — QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.” The following is an analysis of changes in our cash and cash equivalents in each respective year.

 

 

The net cash provided by operating activities in 2006 compared with net cash used in 2005 was primarily the result of terminating all remaining employees in June of 2005 combined with reducing operating expenses thereafter to a minimum appropriate level, and the increase of interest rates on the Company’s cash and cash equivalents. The operating cash outflow during 2005 was primarily due to the net loss of $3.2 million. The net cash used in operating activities decreased in 2005 from 2004. The operating cash outflow during 2004 was primarily due to the net loss of $16.7 million. We expect cash outflows from operating activities for the foreseeable future.

 

The net cash provided by investing activities in 2006 relates to the maturity of short-term investments of $212 million, off-set by the purchase of $200 million of short-term investments. The net cash provided by investing activities in 2005 relates to the maturity of short-term investments of $196 million, off-set by the purchase of $193 million of short-term investments. The net cash used in investing activities in 2004 relates to the purchase of $65.2 million of short-term investments, partially offset by the maturity of short-term investments of $28.2 million.

 

Historically we have relied upon cash flows from interest income and financing activities to fund our operations. Details of our financing activities during the last three years are as follows:

 

 

The primary objective of our investment activities is to preserve our capital until it is required to fund operations while at the same time maximizing the income we receive from our investments without significantly increasing risk. To minimize this risk and to avoid classification as an investment company under the Investment Company Act of 1940, we have limited our investments to cash and securities of the Government of the United States of America and its federal agencies.

 

Most of our resources for the foreseeable future will be dedicated to research and development and preclinical and clinical testing of compounds. The Company expects to use approximately $16.0 million to $20.0 million in

cash through the end of 2007 to advance the preclinical and clinical development of the product candidates we acquired from Valeant, including to further develop RDEA806 and RDEA119. Any compounds we advance through preclinical and clinical development will require extensive and costly development, preclinical testing and clinical trials prior to seeking regulatory approval for commercial sales. Our most advanced product candidates, RDEA806 and RDEA119, and any other compounds we advance into further development, may never be approved for commercial sales. The time required to attain product sales and profitability is lengthy and highly uncertain and we cannot assure you that we will be able to achieve or maintain product sales. Based on current projections, the Company expects cash, cash equivalents and short-term investments at December 31, 2007 to be in the range of $28 million to $32 million. We currently anticipate our cash, cash equivalents and short-term investments to be sufficient to fund the foregoing efforts through 2008. These projections exclude any potential impact of any future business development activity. There can be no assurance that such a range will be achieved, as actual expenditures and interest income may differ significantly from projected levels. This forecast is a forward-looking statement that involves risks and uncertainties, and actual results could vary.

 

Contractual Obligations

 

The following summarizes our contractual obligations as of December 31, 2006:

 

 

 

 

As of December 31, 2006, we had no long-term debt obligations and no capital lease obligations.

 

The contractual obligations in the table above represent future cash commitments and liabilities under agreements with third parties and exclude contingent liabilities for which we cannot reasonably predict future payments. Accordingly, the table above excludes contractual obligations relating to milestone and royalty payments due to third parties, all of which are contingent upon certain future events. The expected timing of payment of the obligations presented above is estimated based on current information. We also enter into agreements with clinical sites and contract research organizations for the conduct of our clinical trials. We will make payments to these sites and organizations based upon the number of patients enrolled and the length of their participation in the clinical trials. In addition, under certain agreements, we may be subject to penalties in the event we prematurely discontinue performance under these agreements. At this time, due to the variability associated with these agreements, we are unable to estimate with certainty the future costs we will incur.

 

Off-Balance Sheet Arrangements

 

We do not have any off-balance sheet arrangements (as that term is defined in Rule 303 of Regulation S-K) that are reasonably likely to have a current or future material effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources.

 

Indemnifications

 

In the ordinary course of business, we enter into contractual arrangements under which we may agree to indemnify the third party to such arrangement from any losses incurred relating to the services they perform on behalf of Ardea or for losses arising from certain events as defined within the particular contract, which may include, for example, litigation or claims relating to past performance. Such indemnification obligations may not be

subject to maximum loss clauses. Historically, payments made related to these indemnifications have been immaterial. In addition, we have entered into indemnity agreements with each of our directors and executive officers. Such indemnity agreements contain provisions, which are in some respects broader than the specific indemnification provisions contained in Delaware law. We also maintain an insurance policy for our directors and executive officers insuring against certain liabilities arising in their capacities as such.

 

Future Capital Requirements

 

We expect to continue to incur operating losses, partially offset by interest income, and will not receive any product revenues. Based on current projections, we expect cash, cash equivalents and short-term investments at December 31, 2007 to be in the range of $28 million to $32 million. We currently expect our current cash resources to fund operations through 2008. There can be no assurance that such a range will be achieved, as actual expenditures and interest income may differ significantly from projected levels.

 

This forecast is a forward-looking statement that involves risks and uncertainties, and actual results could vary.

 

Recent Accounting Pronouncements

 

In December 2004, the FASB issued SFAS 123(R), which replaced SFAS No. 123 and superseded APB 25. SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values, beginning with the first interim or annual period after January 1, 2006, with early adoption encouraged. The pro forma disclosures previously permitted under SFAS 123, no longer will be an alternative to financial statement recognition. We were required to adopt SFAS 123(R) beginning January 1, 2006. Under SFAS 123(R), we determined the appropriate fair value model to be used for valuing share-based payments and the amortization method for compensation cost. We adopted SFAS 123(R) using the Black-Scholes modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006. Our Consolidated Financial Statements as of and for the twelve months ended December 31, 2006 reflects the impact of SFAS 123(R). During the twelve months ended December 31, 2006, we recognized $558,000 in compensation expense related to options granted employees and directors. In accordance with the modified prospective transition method, our Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). If we had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation for the twelve months ended December 31, 2005 and 2004, it would have recorded an expense of $1.8 million and $7.6 million, respectively. The difference between the years is primarily due to the decreased volatility of the stock and option exercises and cancellations resulting from the discontinuance of iseganan and subsequent termination of all non-essential employees.

 

The primary objective of our investment activities is to preserve our capital until it is required to fund operations while at the same time maximizing the income we receive from our investments without significantly increasing risk. As of December 31, 2006, we own financial instruments that are sensitive to market risk as part of our investment portfolio. To minimize this risk and to avoid classification as an investment company under the Investment Company Act of 1940, we have limited our investments to cash and securities of the Government of the United States of America and its federal agencies. The average duration of our investment portfolio as of December 31, 2006 was less than six months. Due to the short-term nature of these investments, a 50 basis point movement in market interest rates would not have a material impact on the fair value of our portfolio as of December 31, 2006. We have no investments denominated in foreign currencies and therefore our investments are not subject to foreign currency exchange risk.

The following table summarizes the average interest rate and estimated fair value of the short-term investments held by us as of December 31, 2006, and 2005 (in thousands).

 

 

The following is a summary of our available-for-sale investments as of December 31, 2006 and 2005 (in thousands):

 

 

 

None of the investments held as of December 31, 2006 or 2005 had been in a continuous unrealized loss position for more than 12 months. The aggregate fair value of our US government agency investments held at December 31, 2006 and December 31, 2005 was $31.9 million and $30.6 million, respectively. The unrealized loss positions continue until either the investment matures, or, until interest rates drop below the rate in effect on the date the various securities were purchased. As a result, we have concluded that any impairment is temporary.

 

The following is a summary of amortized cost and estimated fair value of available-for-sale investments by contract maturity (in thousands):

 

 

ARDEA PHARMACEUTICALS, INC.

 

INDEX TO FINANCIAL STATEMENTS

 

 

TO THE STOCKHOLDERS AND BOARD OF DIRECTORS OF
ARDEA BIOSCIENCES, INC. (Formerly IntraBiotics Pharmaceuticals, Inc.)

 

We have audited the accompanying balance sheets of Ardea Biosciences, Inc. (formerly IntraBiotics Pharmaceuticals, Inc.) as of December 31, 2006 and 2005, and the related statements of operations, stockholders’ equity, and cash flows for each of the two years in the period ended December 31, 2006. 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 audit 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, as well as 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 Ardea Biosciences, Inc. (formerly IntraBiotics Pharmaceuticals, Inc.) as of December 31, 2006 and 2005, and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America.

 

As discussed in Note 10 to the financial statements, in 2006 the Company adopted Statement of Financial Accounting Standards No. 123R (Revised 2004), Share-Based Payments.

 

/s/ Stonefield Josephson, Inc.

 

San Francisco, California

March 30, 2007

ARDEA BIOSCIENCES, INC.
(formerly IntraBiotics Pharmaceuticals, Inc.)

 

 

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

ARDEA BIOSCIENCES, INC.
(formerly IntraBiotics Pharmaceuticals, Inc.)

 

 

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

ARDEA BIOSCIENCES, INC.
(formerly IntraBiotics Pharmaceuticals, Inc.)