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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2010

OR

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from           to

Commission file number: 001-34620

IRONWOOD PHARMACEUTICALS, INC.

(Exact name of registrant as specified in its charter)

(617) 621-7722

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files):   Yes o No o

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

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

As of November 1, 2010, there were 46,560,437 shares of Class A common stock outstanding and 52,274,113 shares of Class B common stock outstanding.

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IRONWOOD PHARMACEUTICALS, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2010

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PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

Ironwood Pharmaceuticals, Inc.

Condensed Consolidated Balance Sheets

(in thousands, except share and per share amounts)

(unaudited)

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

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Ironwood Pharmaceuticals, Inc.

Condensed Consolidated Statements of Operations

(in thousands, except share and per share amounts)

(unaudited)

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

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Ironwood Pharmaceuticals, Inc.

Condensed Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

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

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

1. Nature of Business

Ironwood Pharmaceuticals, Inc. (the “Company”) is an entrepreneurial pharmaceutical company that discovers, develops and intends to commercialize innovative medicines targeting important therapeutic needs. The Company is focused on a portfolio of internally discovered drug candidates that currently includes one Phase 3 drug candidate (linaclotide), one Phase 1/Phase 2 pain drug candidate, and multiple preclinical candidates.

Prior to September 2010, the Company held a majority ownership interest in Microbia, Inc. (formerly known as Microbia Precision Engineering), a subsidiary formed in September 2006.  Microbia, Inc. (“Microbia”) engages in a specialty biochemicals business based on a proprietary strain-development platform.  On September 21, 2010, the Company sold its interest in Microbia to DSM Holding Company USA, Inc. (“DSM”) in exchange for cash proceeds of $9.5 million, the payment of approximately $1.1 million of Microbia debt and interest by DSM and future contingent consideration based on the sale of products incorporating Microbia’s technology.

The Company was incorporated in Delaware on January 5, 1998. On April 7, 2008, the Company changed its name from Microbia, Inc. to Ironwood Pharmaceuticals, Inc. The Company currently operates in one reportable business segment, human therapeutics.  Prior to September 21, 2010, the Company operated in two reportable business segments, human therapeutics and biomanufacturing (Note 12).

The Company has generated an accumulated deficit as of September 30, 2010 of approximately $355.9 million since inception.  In February 2010, the Company completed its initial public offering of Class A common stock and raised a total of approximately $203.2 million in net proceeds (Note 3). At September 30, 2010, the Company believes that based on its current business plan, its unrestricted cash, cash equivalents and available-for-sale securities totaling approximately $250.8 million are sufficient to fund operations through the anticipated commercialization of linaclotide in the U.S.

2. Summary of Significant Accounting Policies

Unaudited Interim Financial Statements

The accompanying condensed consolidated financial statements and the related disclosures as of September 30, 2010 and for the three and nine months ended September 30, 2010 and 2009 are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) and the applicable rules and regulations of the Securities and Exchange Commission (‘‘SEC’’) for interim financial information. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements.  These interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K filed with the SEC on March 30, 2010.  The December 31, 2009 condensed consolidated balance sheet included herein was derived from the audited financial statements as of that date, but does not include all disclosures including notes required by GAAP for complete financial statements.

The unaudited interim condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements and, in the opinion of management, reflect all adjustments of a normal recurring nature considered necessary to present fairly the Company’s financial position as of September 30, 2010 and results of its operations for the three and nine months ended September 30, 2010 and 2009, and its cash flows for the nine months ended September 30, 2010 and 2009. The interim results for the three and nine months ended September 30, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, 2010.

Basis of Presentation

In June 2009, the Financial Accounting Standards Board (“FASB”) issued the FASB Accounting Standards Codification (“Codification”). The Codification became the single source for all authoritative GAAP recognized by the FASB and is required to be applied to financial statements issued for interim and annual periods ending after September 15, 2009. The Codification does not change GAAP and did not impact the Company’s financial position or results of operations.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Principles of Consolidation

During 2006, the Company formed Microbia as a 100% wholly owned subsidiary of the Company. In September 2006, Microbia sold additional equity interests to a third party, which reduced the Company’s ownership interest in Microbia to 85% (Note 13). The accompanying condensed consolidated financial statements of Ironwood Pharmaceuticals, Inc. include the assets, liabilities, revenue, and expenses of Microbia, over which the Company exercised control until September 21, 2010, when the Company sold its interest in Microbia to DSM. The Company recorded noncontrolling interest in its condensed consolidated statements of operations for the ownership interest of the minority owners of Microbia. All intercompany transactions and balances are eliminated in consolidation.

Sale of Subsidiary and Discontinued Operations

As a result of the sale of its interest in Microbia, the Company ceased to have any financial interest in Microbia.  The Company maintains no further investment in Microbia and has recorded a gain on the sale of Microbia (deconsolidation) in its statements of operations based on current accounting guidance as the difference between the sum of the fair value of the consideration received, the carrying value of the noncontrolling interest in the subsidiary at the date of sale, the fair value of the retained noncontrolling interest (which was zero) and the carrying amount of Microbia’s assets and liabilities.  The consideration received includes $9.5 million in cash as well as DSM’s payment of Microbia’s approximately $1.1 million in debt and interest immediately prior to the sale.  The gain on sale of Microbia (deconsolidation) is included in income from discontinued operations in the Company’s statements of operations.

The calculation of the gain on the sale of Microbia (deconsolidation) is calculated as follows (in thousands):

The net liabilities of Microbia on September 21, 2010, prior to the sale, consisted of the following (in thousands):

Additionally, in accordance with the applicable accounting standards, the Company considered if the operations and cash flows of Microbia have been eliminated from the ongoing operations of the Company and if the Company will have any significant continuing involvement in the operations of Microbia after the sale in order to determine whether or not to present Microbia as discontinued operations in the financial statements.  As part of this evaluation, the Company considered the impact of the cash flows from the future contingent consideration, a royalty on future sales of products incorporating Microbia’s technology, that was included in the agreement with DSM.  In accordance with the applicable accounting standards, the cash flows from the future contingent

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

consideration are indirect cash flows, as Ironwood has no continuing involvement with Microbia after the sale, and as such, they represent a passive royalty interest, and therefore the cash flows are considered to be eliminated from the ongoing operations. As a result, Microbia meets the requirements for presentation as discontinued operations and accordingly, the Company has classified the assets, liabilities, operations, and cash flows of Microbia as discontinued operations for all periods presented prior to the sale.  The Company has elected as its accounting policy to account for the future contingent consideration, if any, as a gain contingency as the proceeds have not been received and the receipt of royalty income is uncertain.  As a result, proceeds will only be recorded in future earnings as they are earned.  As of September 30, 2010, no amounts have been recorded for the contingent consideration in the Company’s financial statements.

Use of Estimates

The preparation of consolidated financial statements in accordance with GAAP requires the Company’s management to make estimates and judgments that may affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company’s management evaluates its estimates, including those related to revenue recognition, available-for-sale securities, impairment of long-lived assets, income taxes including the valuation allowance for deferred tax assets, valuation of forward purchase contracts, research and development, contingencies, and share-based compensation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions. Changes in estimates are reflected in reported results in the period in which they become known.

Cash and Cash Equivalents

The Company considers all highly liquid investment instruments with an original maturity when purchased of three months or less to be cash equivalents. Investments qualifying as cash equivalents primarily consist of money market funds and U.S. government sponsored securities. The carrying amount of cash equivalents approximates fair value. The amount of cash equivalents included in cash and cash equivalents was approximately $45.1 million and $120.6 million at September 30, 2010 and December 31, 2009, respectively.

Available-for-Sale Securities

The Company classifies all short-term investments with an original maturity when purchased of greater than three months as available-for-sale. Available-for-sale securities are carried at fair value, with the unrealized gains and losses reported in other comprehensive income (loss). The amortized cost of debt securities in this category is adjusted for the amortization of premiums and accretion of discounts to maturity. Such amortization is included in interest and investment income. Realized gains and losses, and declines in value judged to be other than temporary on available-for-sale securities, are included in interest and investment income.

The cost of securities sold is based on the specific identification method. Interest and dividends on securities classified as available-for-sale are included in interest and investment income. To determine whether an other-than-temporary impairment exists, the Company considers whether it has the ability and intent to hold the investment until a market price recovery, and whether evidence indicating the recoverability of the cost of the investment outweighs evidence to the contrary. There were no other-than-temporary impairments for the three and nine months ended September 30, 2010.

Concentrations of Credit Risk

Financial instruments that subject the Company to credit risk primarily consist of cash and cash equivalents, restricted cash, available-for-sale securities, and accounts receivable. The Company maintains its cash and cash equivalent balances with high-quality financial institutions and, consequently, the Company believes that such funds are subject to minimal credit risk. The Company’s available-for-sale investments potentially subject the Company to concentrations of credit risk. The Company has adopted an investment policy which limits the amounts the Company may invest in any one type of investment, and requires all investments held by the Company to be A+ rated, thereby reducing credit risk concentration.

Accounts receivable primarily consist of amounts due under the collaboration agreement with Forest Laboratories, Inc. (“Forest”) and license agreements with Almirall, S.A. (“Almirall”) and Astellas Pharma Inc. (“Astellas”) (Note 5) for which the

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Company does not obtain collateral. Effective September 1, 2009, Forest became a related party when the Company sold to Forest 2,083,333 shares of the Company’s Series G convertible preferred stock and effective November 2, 2009, Almirall became a related party when the Company sold to them 681,819 shares of its Series I convertible preferred stock.

Forest accounted for approximately 60% of the Company’s revenue from continuing operations for the three and nine months ended September 30, 2010, and approximately 83% for the three and nine months ended September 30, 2009. Almirall accounted for approximately 29% and 31% of the Company’s revenue from continuing operations for the three and nine months ended September 30, 2010, respectively, and approximately 17% for the three and nine months ended September 30, 2009. Astellas accounted for approximately 11% and 9% of the Company’s revenue from continuing operations for the three and nine months ended September 30, 2010, respectively. Tate & Lyle Investments, Ltd. (“T&L”) accounted for approximately 0% and 98% of the Company’s revenue from discontinued operations for the three and nine months ended September 30, 2010, respectively, and 100% for the three and nine months ended September 30, 2009. For the three and nine months ended September 30, 2010 and 2009, no additional customers accounted for more than 10% of the Company’s revenue from continuing operations.

At September 30, 2010 and December 31, 2009, accounts receivable from Forest, net of any payables due Forest, accounted for approximately 90% and 94%, respectively, of the Company’s total accounts receivable. At September 30, 2010 and December 31, 2009, Almirall accounted for approximately 3% and 6%, respectively, of the Company’s total accounts receivable. At September 30, 2010 and December 31, 2009, Astellas accounted for approximately 7% and 0%, respectively, of the Company’s total accounts receivable.

Revenue Recognition

The Company’s revenue is generated primarily through collaborative research and development and licensing agreements. The terms of these agreements typically include payment to the Company of one or more of the following: nonrefundable, up-front license fees; milestone payments; sale of drug substance to its collaborators; and royalties on product sales. In addition, prior to September 2010, the Company generated services revenue through agreements that generally provided for fees for research and development services rendered.

The Company recognizes revenue when there is persuasive evidence that an arrangement exists, services have been rendered or delivery has occurred, the price is fixed and determinable, and collection is reasonably assured. The Company evaluates revenue from agreements that have multiple elements and accounts for the components as separate elements when the following criteria are met:

·                  the delivered items have value to the customer on a stand-alone basis;

·                  there is objective and reliable evidence of fair value of the undelivered items; and

·                  if there is a general right of return relative to the delivered items, delivery or performance of the undelivered items is considered probable and within the Company’s control.

Collaborative Arrangements Revenue

Up-front License Fees

The Company recognizes revenues from nonrefundable, up-front license fees for which the separation criteria were not met due to continuing involvement in the performance of research and development services on a straight-line basis over the contracted or estimated period of performance, which is typically the research or development term.

Milestones

At the inception of each agreement that includes milestone payments, the Company evaluates whether each milestone is substantive and at risk to both parties on the basis of the contingent nature of the milestone, specifically reviewing factors such as the scientific and other risks that must be overcome to achieve the milestone, as well as the level of effort and investment required.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Milestones that are not considered substantive are accounted for as license payments and recognized on a straight-line basis over the remaining period of performance.

In those circumstances where a substantive milestone is achieved, collection of the related receivable is reasonably assured and the Company has remaining obligations to perform under the collaboration arrangement, the Company recognizes as revenue on the date the milestone is achieved an amount equal to the applicable percentage of the performance period that has elapsed as of the date the milestone is achieved, with the balance being deferred and recognized on a straight-line basis over the remaining period of performance.

Payments received or reasonably assured after performance obligations are fully satisfied are recognized as earned.

Services Revenue

The Company recognized services revenue when there was persuasive evidence that an arrangement existed, services had been rendered or delivery had occurred, the price was fixed and determinable, and collection was reasonably assured. Revenue from research and development services rendered was recognized as services were performed.  As a result of the sale of the Company’s interest in Microbia in September 2010, services revenue is included in net income (loss) from discontinued operations.

The Company receives research and development funding under the Forest collaboration agreement and considers the factors or indicators within this arrangement to determine whether reporting such funding on a gross or net basis is appropriate. The Company records revenue transactions gross in the condensed consolidated statements of operations if it is deemed the principal in the transaction, which includes being the primary obligor and having the risks and rewards of ownership. The Company produces clinical materials for its collaborators and is reimbursed for its costs to produce such clinical materials. The Company recognizes revenue on clinical materials when the materials have passed all quality testing required for collaborator acceptance and title and risk of loss have transferred to the collaborator.

For certain of the Company’s arrangements, particularly the Company’s license agreement with Almirall, it is required that taxes be withheld on payments made to the Company. The Company has adopted a policy to recognize revenue net of these tax withholdings.

Research and Development Costs

The Company expenses research and development costs to operations as incurred. The Company defers and capitalizes nonrefundable advance payments made by the Company for research and development activities until the related goods are received or the related services are performed.

Research and development expenses comprise costs incurred in performing research and development activities, including salaries and benefits, share-based compensation expense, laboratory supplies and other direct expenses, facilities expenses, overhead expenses, contractual services, including clinical trial and related clinical manufacturing expenses, and other outside expenses. As a result of the sale of the Company’s interest in Microbia in September 2010, costs of revenue related to the Microbia services contracts and costs associated with Microbia’s research and development activities are included in net income (loss) from discontinued operations.

The Company has entered into a collaboration agreement in which it shares research and development expenses with a collaborator. The Company records the expenses for such work as research and development expense. Because the collaboration arrangement is a cost-sharing arrangement, the Company concluded that when there is a period during the collaboration arrangement during which the Company receives payments from the collaborator, the Company records the payments by the collaborator for their share of the development effort as a reduction of research and development expense.

Share-Based Compensation

Share-based compensation is recognized as an expense in the financial statements based on the grant date fair value. Compensation expense recognized relates to stock awards, restricted stock and stock options granted, modified, repurchased or cancelled on or after January 1, 2006. Stock options granted to employees prior to that time continue to be accounted for using the

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

intrinsic value method. Under the intrinsic value method, compensation associated with share-based awards to employees was determined as the difference, if any, between the fair value of the underlying common stock on the date compensation was measured, generally the grant date, and the price an employee must pay to exercise the award. For awards that vest based on service conditions, the Company uses the straight-line method to allocate compensation expense to reporting periods. The grant date fair value of options granted is calculated using the Black-Scholes option-pricing model, which requires the use of subjective assumptions including volatility, expected term and the fair value of the underlying common stock, among others.

The Company records the expense for stock option grants subject to performance-based milestone vesting over the remaining service period when management determines that achievement of the milestone is probable. Management evaluates when the achievement of a performance-based milestone is probable based on the relative satisfaction of the performance conditions as of the reporting date.

The Company records the expense of services rendered by non-employees based on the estimated fair value of the stock option using the Black-Scholes option-pricing model. The fair value of unvested non-employee awards are remeasured at each reporting period and expensed over the vesting term of the underlying stock options.

Noncontrolling Interest

Noncontrolling interest represents the noncontrolling stockholder’s proportionate share of equity and net income or net loss of the Company’s former consolidated subsidiary, Microbia.  On September 21, 2010, the Company sold its interest in Microbia, resulting in the deconsolidation of its former subsidiary bringing the noncontrolling interest balance to zero.  Immediately prior to the sale, the Company converted certain intercompany debt and payables into an additional investment in Microbia, which resulted in an approximately $2.9 million decrease in the noncontrolling interest.  The noncontrolling stockholder’s proportionate share of the equity in Microbia of approximately $3.2 million as of December 31, 2009 is reflected as noncontrolling interest in the Company’s condensed consolidated balance sheets as a component of stockholders’ equity (deficit).

The proportionate share of the net loss attributable to noncontrolling interest is reflected in the accompanying condensed consolidated statements of operations. The following table is a roll-forward of the noncontrolling interest (in thousands):

Net Loss Per Share

The Company calculates basic and diluted net loss per common share by dividing the net loss by the weighted average number of common shares outstanding during the period. The Company has excluded all shares that are subject to repurchase by the Company from the weighted average number of common shares outstanding. The Company’s potentially dilutive shares, which include convertible preferred stock, outstanding common stock options and unvested shares of restricted stock, have not been included in the computation of diluted net loss per share for all periods as the result would be antidilutive.  The Company presents the net loss per share attributable to both continued and discontinued operations.  The loss attributable to the noncontrolling interest is included in the net income (loss) per share from discontinued operations.

Income Taxes

The Company provides for income taxes under the liability method. Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates in effect when the differences are expected to reverse. Deferred tax assets are reduced by a valuation allowance to reflect the uncertainty associated with their ultimate realization.  The Company is currently evaluating the impact the sale of Microbia will have on its tax attributes.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Management of the Company has evaluated the positive and negative evidence bearing upon the realizability of its deferred tax assets. Management has considered the Company’s history of operating losses and concluded, in accordance with the applicable accounting standards, that it is more likely than not that the Company will not realize the benefit of its deferred tax assets. Accordingly, the deferred tax assets have been fully reserved at September 30, 2010 and December 31, 2009. Management reevaluates the positive and negative evidence on a quarterly basis.

The Company accounts for uncertain tax positions recognized in the condensed consolidated financial statements by prescribing a more-likely-than-not threshold for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  There were no income tax provisions or benefits for the three and nine months ended September 30, 2010 given the Company’s continued net operating loss position. In the three and nine months ended September 30, 2009, the Company recognized an income tax benefit of approximately $0.2 million related to a refundable research and development tax credit.

The statute of limitations for assessment by the Internal Revenue Service (“IRS”) and state tax authorities is open for tax years ending December 31, 2006, 2007 and 2008, although carryforward attributes that were generated prior to tax year 2006 may still be adjusted upon examination by the IRS or state tax authorities if they either have been or will be used in a future period. The Company does not have any federal or state audits currently in progress.

Impairment of Long-Lived Assets

The Company regularly reviews the carrying amount of its long-lived assets to determine whether indicators of impairment may exist which warrant adjustments to carrying values or estimated useful lives. If indications of impairment exist, projected future undiscounted cash flows associated with the asset are compared to the carrying amount to determine whether the asset’s value is recoverable. If the carrying value of the asset exceeds such projected undiscounted cash flows, the asset will be written down to its estimated fair value. There were no indicators of impairment at September 30, 2010.

Comprehensive Income (Loss)

All components of comprehensive income (loss) are required to be disclosed in the condensed consolidated financial statements. Comprehensive income (loss) is defined as the change in equity of a business enterprise during a period from transactions, and other events and circumstances from non-owner sources and currently consists of net loss and changes in unrealized gains and losses on available-for-sale securities.  Comprehensive loss from operations was calculated as follows (in thousands):

Segment Information

Operating segments are components of an enterprise for which separate financial information is available and is evaluated regularly by the Company’s chief operating decision-maker in deciding how to allocate resources and in assessing performance.

Prior to the sale of its interest in Microbia in September 2010, the Company had two reportable business segments: human therapeutics and biomanufacturing (Note 12). Revenue from the Company’s human therapeutics segment is presented in the condensed consolidated statements of operations as collaborative arrangements revenue. Revenue from the Company’s biomanufacturing segment is presented as a component of the net income (loss) from discontinued operations.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

New Accounting Pronouncements

From time to time, new accounting pronouncements are issued by the FASB or other standard setting bodies that are adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company believes that the impact of recently issued standards that are not yet effective will not have a material impact on its consolidated financial position or results of operations upon adoption.

Recently Issued Accounting Standards

In April 2010, the FASB issued Accounting Standards Update “ASU” No. 2010-17, Revenue Recognition — Milestone Method (“ASU 2010-017”). ASU 2010-017 provides guidance in applying the milestone method of revenue recognition to research or development arrangements. Under this guidance management may recognize revenue contingent upon the achievement of a milestone in its entirety, in the period in which the milestone is achieved, only if the milestone meets all the criteria within the guidance to be considered substantive. This ASU is effective on a prospective basis for research and development milestones achieved in fiscal years, beginning on or after June 15, 2010. Early adoption is permitted; however, adoption of this guidance as of a date other than January 1, 2011 will require the Company to apply this guidance retrospectively effective as of January 1, 2010 and will require disclosure of the effect of this guidance as applied to all previously reported interim periods in the fiscal year of adoption. As the Company plans to implement ASU No. 2010-17 prospectively, the effect of this guidance will be limited to future transactions.

In October 2009, the FASB issued ASU No. 2009-13, Multiple- Deliverable Revenue Arrangements (“ASU 2009-13”). ASU 2009-13, amends existing revenue recognition accounting pronouncements that are currently within the scope of FASB Accounting Standards Codification Subtopic 605-25 (previously included within EITF 00-21, Revenue Arrangements with Multiple Deliverables (“EITF 00-21”). The consensus to ASU 2009-13 provides accounting principles and application guidance on whether multiple deliverables exist, how the arrangement should be separated, and the consideration allocated. This guidance eliminates the requirement to establish the fair value of undelivered products and services and instead provides for separate revenue recognition based upon management’s estimate of the selling price for an undelivered item when there is no other means to determine the fair value of that undelivered item. EITF 00-21 previously required that the fair value of the undelivered item be the price of the item either sold in a separate transaction between unrelated third parties or the price charged for each item when the item is sold separately by the vendor. Under EITF 00-21, if the fair value of all of the elements in the arrangement was not determinable, then revenue was deferred until all of the items were delivered or fair value was determined. This new approach is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 and allows for retrospective application. The Company is currently evaluating the potential impact of this standard on its financial position and results of operations.

3. Initial Public Offering

In February 2010, the Company completed its initial public offering of Class A common stock pursuant to a registration statement that was declared effective on February 2, 2010. The Company sold 19,166,667 shares of its Class A common stock, which included 2,500,000 shares of the Company’s Class A common stock sold pursuant to an over-allotment option granted to the underwriters, at a price to the public of $11.25 per share. As a result of the initial public offering, the Company raised a total of $215.6 million in gross proceeds, and approximately $203.2 million in net proceeds after deducting underwriting discounts and commissions of $10.5 million and offering expenses of $1.9 million. Costs directly associated with the Company’s initial public offering were capitalized and recorded as deferred offering costs prior to the closing of the initial public offering. These costs have been recorded as a reduction of the proceeds received in arriving at the amount to be recorded in additional paid-in capital.

Upon the closing of the initial public offering, 69,904,843 shares outstanding of the Company’s convertible preferred stock automatically converted into 70,391,620 shares of its Class B common stock.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

4. Net Loss Per Share

Basic and diluted net loss per share is calculated as follows (in thousands, except share and per share amounts):

The net loss attributable to noncontrolling interest is reflected in the net loss from discontinued operations for purposes of segregating the earnings per share calculation between continuing and discontinued operations.

The following potentially dilutive securities have been excluded from the computation of diluted weighted average shares outstanding as of September 30, 2010 and 2009, as they would be anti-dilutive:

5. Collaboration and License Agreements

Forest Laboratories, Inc.

In September 2007, the Company entered into a collaboration agreement with Forest to jointly develop and commercialize linaclotide, a drug candidate for the treatment of irritable bowel syndrome with constipation (“IBS-C”), chronic constipation (“CC”) and other lower gastrointestinal conditions, in North America. Under the terms of this collaboration agreement, the Company shares equally with Forest all development costs, as well as potential future profits and losses from the development and sale of linaclotide in the United States. The Company will receive royalties from Forest for sales in Canada and Mexico. The Company retained the rights to commercialize linaclotide outside of North America. Forest made non-refundable, up-front payments totaling $70.0 million to the Company in order to obtain rights to linaclotide in North America. Because of the Company’s continuing involvement in the development program, the Company is recognizing the up-front license fee as revenue on a straight-line basis over five years, which is

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

the Company’s estimate of the period over which linaclotide will be jointly developed under the collaboration. The collaboration agreement also includes contingent milestone payments, as well as a contingent equity investment based on the achievement of specific clinical and commercial milestones. These payments, including the up-front license fee, could total up to $330.0 million, of which $125.0 million has already been received, if certain development and sales milestones are achieved for linaclotide. In September 2008, the Company achieved a clinical milestone which triggered a $10.0 million milestone payment from Forest. At September 30, 2010, approximately $27.4 million and $3.9 million of the up-front license fee and milestone payment, respectively, remain deferred and are being recognized on a straight-line basis over the remaining estimated development period.

The collaboration agreement included a contingent equity investment, in the form of a forward purchase contract, which required Forest to purchase 2,083,333 shares of the Company’s convertible preferred stock, when a specific clinical milestone was met, at a price of $12.00 per share. The Company evaluated this financial instrument and determined that because the Company may be required to settle the instrument by transferring assets to Forest due to “deemed liquidation” provisions of the preferred stock, it should be considered an asset or liability, which is required to be carried at fair value.  The changes in fair value are recorded as other income or expense.

The Company valued the contingent equity investment at September 12, 2007 at $9.0 million, which represented the value of the premium that Forest would pay for shares of the Company’s stock should the milestone be achieved. The $9.0 million was recorded as an asset and incremental deferred revenue at the inception of the arrangement. The $9.0 million of incremental deferred revenue is being recognized as revenue on a straight-line basis over the period of the Company’s continuing involvement, which was estimated to be five years from the inception of the arrangement. At September 30, 2010, approximately $3.5 million of the incremental deferred revenue remains deferred and is being recognized on a straight-line basis over the remaining estimated development period.

For the three and nine months ended September 30, 2009, the Company recorded an increase of approximately $0.4 million and $0.1 million, respectively, in the fair value of the forward purchase contract related to this remeasurement.

On July 22, 2009, the Company achieved the clinical milestone under the Forest collaboration agreement, triggering the equity investment. As a result, the Company remeasured the fair value of the contingent equity investment as of July 22, 2009 using assumptions as of that date. The resulting final fair value of the contingent equity investment was $8.8 million. The increase in the fair value of the contingent equity investment was recorded to other income (expense) at that time and the Company reclassified the forward purchase contract as a reduction to convertible preferred stock. The Company issued the 2,083,333 shares to Forest on September 1, 2009. Additionally, the achievement of the clinical milestone triggered a $20.0 million milestone payment from Forest that was received on August 20, 2009, of which approximately $7.8 million remains deferred at September 30, 2010 and is being recognized on a straight-line basis over the remaining estimated development period.

The Company recognized in revenue from the Forest collaboration agreement approximately $5.5 million and $16.4 million during the three and nine months ended September 30, 2010, respectively, and approximately $12.6 million and $21.5 million during the three and nine months ended September 30, 2009, respectively.

Further, because the Company shares development costs equally with Forest, payments from Forest with respect to research and development costs incurred by the Company are recorded as a reduction to expense, and not as revenue.  As a result of the cost-sharing arrangements under the collaboration, the Company offset approximately $4.5 million and $12.6 million during the three and nine months ended September 30, 2010 and approximately $5.4 million and $10.2 million during the three and nine months ended September 30, 2009, respectively, against research and development expense.

Almirall, S.A.

In April 2009, the Company entered into a license agreement with Almirall for European rights to develop and commercialize linaclotide for the treatment of IBS-C, CC and other lower gastrointestinal conditions. Under the terms of the license agreement, Almirall is responsible for the expenses associated with the development and commercialization of linaclotide in the European territory. The license agreement requires the Company to participate on a joint development committee over linaclotide’s development period. The Company will receive escalating royalties from the sales of linaclotide in the European territory. In May 2009, the Company received a $38.0 million payment from Almirall representing a $40.0 million non-refundable up-front payment net of foreign withholding taxes. The Company elected to record the non-refundable up-front payment on a net basis. Because of the Company’s continuing involvement in the development program, the Company is recognizing the up-front license fee

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

as revenue on a straight-line basis over fifty months, which is the Company’s estimate of the period over which linaclotide will be developed under the license agreement for the European territory. At September 30, 2010, approximately $25.1 million of the up-front license fee remains deferred.  The license agreement also includes contingent milestone payments, as well as a contingent equity investment based on the achievement of specific clinical and sales milestones. These payments could total up to $55.0 million, including the contingent equity investment discussed below, of which $15.0 million has already been received, if certain development and sales milestones are achieved for linaclotide.

The license agreement included a contingent equity investment, in the form of a forward purchase contract, which required Almirall to purchase 681,819 shares of the Company’s convertible preferred stock, when a specific clinical milestone was met, at a price of $22.00 per share. The Company evaluated this financial instrument and determined that because the Company may be required to settle the instrument by transferring assets to Almirall, it should be considered an asset or liability. The contingent equity investment was valued at inception at its fair value. The Company valued the contingent equity investment at April 30, 2009 at $6.0 million, which represented the value of the premium that Almirall would pay for shares of the Company’s stock should the milestone be achieved. The $6.0 million was recorded as an asset and incremental deferred revenue at the inception of the arrangement. The $6.0 million of incremental deferred revenue is being recognized as revenue on a straight-line basis over the period of the Company’s continuing involvement, which is estimated to be fifty months. At September 30, 2010, approximately $4.0 million of the incremental deferred revenue remains deferred.

At September 30, 2009, the Company remeasured the fair value of the contingent equity investment using current assumptions resulting in a fair value of $5.8 million. For the three and nine months ended September 30, 2009, the Company recorded a decrease of approximately $0.4 million and a decrease of approximately $0.2 million, respectively, in the fair value of the forward purchase contract related to this remeasurement.

On November 2, 2009, the Company achieved the clinical milestone under the Almirall license agreement, triggering the equity investment. As a result, the Company remeasured the fair value of the contingent equity investment as of November 2, 2009 using assumptions as of that date. The resulting final fair value of the contingent equity investment was $6.5 million. The increase in the fair value of the contingent equity investment was recorded to other income (expense) at that time, and the Company reclassified the forward purchase contract as a reduction to convertible preferred stock. On November 13, 2009, the Company received $15.0 million from Almirall for the purchase of 681,819 shares of convertible preferred stock.

The Company recognized approximately $2.6 million and $8.3 million in revenue from the Almirall license agreement during the three and nine months ended September 30, 2010, respectively, including approximately $0 and $0.4 million, respectively, from the sale of clinical materials to Almirall. During both the three and nine months ended September 30, 2009 the Company recognized approximately $2.6 million and $4.4 million, respectively, in revenue from the Almirall license agreement.

Astellas Pharma Inc.

On November 9, 2009, the Company entered into a license agreement with Astellas. Astellas has the right to develop and commercialize linaclotide for the treatment of IBS-C, CC and other lower gastrointestinal conditions in Japan, South Korea, Taiwan, Thailand, Philippines, and Indonesia. Under the terms of the agreement, Astellas paid the Company an up-front licensing fee of $30.0 million on November 16, 2009. The license agreement requires the Company to participate on a joint development committee over linaclotide’s development period. The agreement includes additional development milestone payments that could total up to $45.0 million. In addition, the Company will receive escalating royalties on linaclotide sales should Astellas receive approval to market and sell linaclotide in the Asian market. Astellas will be responsible for activities relating to regulatory approval and commercialization.  Because of the Company’s continuing involvement in the development program, the Company is recognizing the up-front license fee as revenue on a straight-line basis over 115 months, which is the Company’s estimate of the period over which linaclotide will be developed under the license agreement for the Asian market. At September 30, 2010, approximately $28.2 million of the up-front license fee remains deferred. During the three and nine months ended September 30, 2010, the Company recognized approximately $1.0 million and $2.4 million, respectively, in revenue from the Astellas license agreement, including approximately $0.2 million and $0.6 million, respectively, from the sale of clinical materials to Astellas.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

6. Fair Value of Financial Instruments

The table below presents information about the Company’s assets that are measured at fair value on a recurring basis as of September 30, 2010 and indicates the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value. In general, fair values determined by Level 1 inputs utilize observable inputs such as quoted prices in active markets for identical assets or liabilities. Fair values determined by Level 2 inputs utilize data points that are either directly or indirectly observable, such as quoted prices, interest rates and yield curves. Fair values determined by Level 3 inputs utilize unobservable data points in which there is little or no market data, which require the Company to develop its own assumptions for the asset or liability.

The Company’s investment portfolio includes many fixed income securities that do not always trade on a daily basis. As a result, the pricing services used by the Company applied other available information as applicable through processes such as benchmark yields, benchmarking of like securities, sector groupings and matrix pricing to prepare evaluations. In addition, model processes were used to assess interest rate impact and develop prepayment scenarios. These models take into consideration relevant credit information, perceived market movements, sector news and economic events. The inputs into these models may include benchmark yields, reported trades, broker-dealer quotes, issuer spreads and other relevant data.

The Company has classified assets measured at fair value on a recurring basis as follows (in thousands):

Cash, cash equivalents, accounts receivable, prepaid expenses and other current assets, restricted cash, accounts payable, accrued expenses and the current portion of capital lease obligations at September 30, 2010 and December 31, 2009, and the current portion of long-term debt at December 31, 2009 are carried at amounts that approximate fair value due to their short-term maturities.

Capital lease obligations at September 30, 2010 and December 31, 2009 and long-term debt at December 31, 2009 approximate fair value as they bear interest at a rate approximating a market interest rate.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

7. Available-for-Sale Investments

The following is a summary of available-for-sale securities at September 30, 2010 (in thousands):

The Company did not have any available-for-sale securities at December 31, 2009.

The contractual maturities of all securities held at September 30, 2010 are one year or less. There were four investments in an unrealized loss position having an aggregate fair value of approximately $15.7 million at September 30, 2010.  The Company reviews its investments for other-than-temporary impairment whenever the fair value of an investment is less than amortized cost and evidence indicates that an investment’s carrying amount is not recoverable within a reasonable period of time. To determine whether an impairment is other-than-temporary, the Company considers whether it has the ability and intent to hold the investment until a market price recovery and considers whether evidence indicating the cost of the investment is recoverable outweighs evidence to the contrary.

The cost of securities sold is determined based on the specific identification method for purposes of recording realized gains and losses. Gross realized gains and losses on the sales of investments have not been material to the Company’s consolidated results of operations.

8. Commitments and Contingencies

The Company leases various facilities and equipment under leases that expire at varying dates through 2016. Certain of these leases contain renewal options, and require the Company to pay operating costs, including property taxes, insurance, and maintenance.

On February 9, 2010, the Company entered into a Second Lease Amendment for its 301 Binney Street facility. Under the amended lease, the Company, effective as of February 9, 2010, leased an additional 50,000-60,000 square feet of the 301 Binney Street facility, comprised of (a) an initial phase of at least 30,000 square feet (the “Initial Phase”), with rent for such space in the Initial Phase commencing July 1, 2010, and (b) a second phase of up to an additional 30,000 square feet (for total additional space of no less than 50,000 square feet and no more than 60,000 square feet) (the “Second Phase”), with rent for such space in the Second Phase commencing no later than July 1, 2011.  The Company signed a Third Lease Amendment, effective as of July 1, 2010, that defines the Initial Phase as 35,444 rentable square feet.  The final square footage of the Second Phase will be mutually agreed upon based on actual constructed space. The rent for the space in the Initial Phase is $42.00 per rentable square foot per year, and the rent for the space in the Second Phase will be $42.50 per rentable square foot per year. The base rent for the additional space in each of the Initial Phase and the Second Phase will increase annually by $0.50 per rentable square foot. Under the terms of the Second Lease Amendment, the landlord will provide the Company with a finish work allowance of $55.00 per rentable square foot of additional space rented in the Initial Phase and the Second Phase. The Amendment does not change the January 31, 2016 expiration date of the original lease. As a result of the Second Amendment, the Company increased its letter of credit by approximately $2.1 million and disposed of leasehold improvements resulting in a loss of approximately $0.2 million. In conjunction with the Second Amendment, the Company elected not to renew its lease of approximately 39,000 square feet of space at its 320 Bent Street facility when the lease expires in December 2010.

On November 3, 2009, Microbia amended its facility lease to include an early termination option. In consideration for an up-front payment of approximately $0.3 million, the landlord gave Microbia an option to terminate the lease, which was exercised on January 18, 2010.  As a result, the lease would have terminated on September 30, 2010 had the Company not sold its interest in Microbia. Under the terms of the amended lease, the landlord agreed to defer the monthly base rent for the seven months beginning March 2010 and ending September 2010.  Additionally, Microbia may have been required to issue a warrant to the landlord, which would have been exercisable into shares of Microbia common stock. The number of shares issuable would have been determined at

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

the time of issuance in accordance with the terms of the warrant and the price per share would have been the fair value of Microbia’s common stock at that time. The Company calculated the fair value of the warrant at September 21, 2010 and December 31, 2009, which was de minimus. As a result of the sale of Microbia, all common stock and warrants of Microbia were cancelled, as such, no warrants will be issued.

As a result of the sale of the Company’s interest in Microbia to DSM, Microbia will not incur approximately $0.8 million of contingent restructuring costs related to its November 2009 restructuring, which would have been incurred if Microbia implemented an additional reduction in force prior to the earlier of November 5, 2010 or the date that Microbia closed on a new round of financing.

In June 2010, the Company entered into a commercial supply agreement with a contract manufacturing organization for the purchase of a portion of the linaclotide active pharmaceutical ingredient (“API”) that will be used to seek regulatory approval of linaclotide in the United States, Canada and/or Mexico, and, pending any such approval, that will be commercialized in such country. The commercial supply agreement contains minimum purchase requirements that commence with the commercial launch of linaclotide and that are dependent upon forecasted commercial requirements. Since, at this time, linaclotide has not yet been approved for commercialization and future commercial demand for linaclotide is unknown, the Company cannot estimate our future minimum purchase requirements under the commercial supply agreement.

In September 2010, the Company repaid all outstanding principal and interest under its loan and security agreement with a financing company which was used to finance the purchase of laboratory and other equipment.  The Company incurred pre-payment fees of approximately $67,000 in conjunction with the repayment of debt of which approximately $31,000 is included in net income (loss) from discontinued operations and the remainder is included in interest expense in the statements of operations.

9. Stockholders’ Equity (Deficit)

Common Stock

At September 30, 2010, the Company is authorized to issue 675,000,000 shares of stock, of which 600,000,000 shares have been authorized for the issuance of common stock, with a par value of $0.001 per share, which consist of Class A common stock and Class B common stock, and 75,000,000 shares have been authorized for the issuance of preferred stock, with a par value of $0.001 per share.

All shares of common stock that were outstanding immediately prior to the initial public offering were shares of Class B common stock and all shares of common stock sold in the initial public offering were shares of Class A common stock.  Prior to the closing of the Company’s initial public offering, the Company had outstanding nine series of convertible preferred stock with various rights and preferences.  In conjunction with the closing of the Company’s initial public offering, all of the Company’s 69,904,843 outstanding convertible preferred shares automatically converted on a one-for-one basis, except for Series C convertible preferred stock, which converted on a one-for-1.076 basis, into 70,391,620 shares of Class B common stock.  At September 30, 2010, the Company had no preferred shares outstanding.

Restricted Stock

In 2009, the Company sold an aggregate of 515,549 shares of common stock to independent members of the Board of Directors under restricted stock agreements in accordance with the terms of the Company’s 2005 Stock Incentive Plan (“2005 Plan”) and the Company’s director compensation program. 115,549 shares of restricted common stock sold in 2009 vested on December 31, 2009 and the remainder vest ratably over four years beginning in January 2010. In the event that a member of the Board of Directors ceases to serve on the Company’s Board prior to December 31, 2013, the member shall forfeit all unvested shares in accordance with the terms of the restricted stock agreement.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

A summary of the unvested shares of restricted stock as of September 30, 2010 is presented below:

10. Stock Option Plans

The Company has several share-based compensation plans. Under the 1998 Amended and Restated Stock Option Plan (“1998 Plan”), options to purchase 3,405,000 shares of common stock were available for grant to employees, directors, and consultants of the Company. The options were granted under the 1998 Plan at fair market value on the grant date, generally vest over a period of four years, and expire ten years from the grant date. There are no shares available for future grant under this plan, as it expired in accordance with its terms in 2008. At September 30, 2010 and December 31, 2009, options for 328,346 and 550,633 shares, respectively, were outstanding under the 1998 Plan.

Under the Company’s 2002 Stock Incentive Plan (“2002 Plan”) and 2005 Plan, stock awards may be granted to employees, officers, directors, consultants, or advisors of the Company. The 2002 Plan and 2005 Plan provide for the granting of stock options, restricted stock, restricted stock units, and other share-based awards. At September 30, 2010, 4,700,000 shares of common stock are reserved for issuance under the 2002 Plan and 12,200,000 shares are reserved under the 2005 Plan. The 2002 Plan allows for the transfer of unused shares from the 1998 Plan.  At September 30, 2010, there were 61,831 shares available for future grant under the 2002 Plan and 23,657 shares available for future grant under the 2005 Plan.

On January 21, 2010, the Company’s stockholders approved the 2010 Employee, Director and Consultant Equity Incentive Plan (“2010 Plan”) (together with the 2002 Plan and 2005 Plan, the “Plans”) which became effective upon the closing of the Company’s initial public offering. Under the 2010 Plan, stock awards may be granted to employees, officers, directors, or consultants of the Company. There were 6,000,000 shares of common stock initially reserved for issuance under the 2010 Plan. The number of shares available for future grant under the 2010 Plan may be increased on the first day of each fiscal year by an amount equal to the lesser of (i) 6,600,000; (ii) 4% of the number of outstanding shares of common stock on the first day of each fiscal year; and (iii) an amount determined by the Board of Directors. Awards that are returned to the Company’s 1998 Plan, 2002 Plan and 2005 Plan as a result of their expiration, cancellation, termination or repurchase are automatically made available for issuance under the 2010 Plan.  At September 30, 2010, there were 5,976,901 shares available for future grant under the 2010 Plan.

On January 21, 2010, the Company’s stockholders approved the 2010 Employee Stock Purchase Plan (“Purchase Plan”) which became effective upon the closing of the Company’s initial public offering. The Purchase Plan allows eligible employees the right to purchase shares of common stock at the lower of 85% of the fair market value of a share of common stock on the first or last day of an offering period. Each offering period is six months. There were 400,000 shares of common stock initially reserved for issuance pursuant to the Purchase Plan. The number of shares available for future grant under the Purchase Plan may be increased on the first day of each fiscal year by an amount equal to the lesser of (i) 1,000,000 shares, (ii) 1% of the shares of common stock outstanding on the last day of the immediately preceding fiscal year, or (iii) such lesser number of shares as is determined by the Board.  At September 30, 2010, there were 400,000 shares available for future grant under the Purchase Plan.  The initial offering period began on July 1, 2010 and runs through December 31, 2010.  During the three and nine months ending September 30, 2010, $0.1 million of stock compensation expense was recognized in relation to the Purchase Plan.

Each plan, other than the Purchase Plan, provides for the granting of stock awards whereby the Company’s Class B common stock is issuable upon exercise of options granted before the closing of the Company’s initial public offering and Class A common stock is issuable upon exercise of options granted after the Company’s initial public offering. At September 30, 2010, options exercisable into 12,346,540 shares of Class B common stock and 2,234,306 shares of Class A common stock were outstanding.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

The option price at the date of grant is determined by the Board of Directors and, in the case of incentive stock options, may not be less than the fair market value of the common stock at the date of grant. Due to the absence of an active market for the Company’s common stock, prior to the pricing of the Company’s initial public offering on February 2, 2010, the Board of Directors was required to determine the fair value of the common stock for consideration in setting exercise prices for the options granted and in valuing the options granted. In determining the fair value, the Board of Directors considered both quantitative and qualitative factors including prices at which the Company sold shares of its convertible preferred stock, the rights, preferences and liquidity of the Company’s convertible preferred and common stock, the Company’s historical operating and financial performance and the status of its research and product development efforts, achievement of enterprise milestones, including the Company entering into collaboration agreements where third parties agree to purchase shares of the Company’s convertible preferred stock at fixed prices sometime in the future, external market conditions affecting the biotechnology industry sector, and financial market conditions and, commencing in 2006, contemporaneous valuations provided by management.

The option exercise period may not extend beyond ten years from the date of grant. The 2002 Plan and 2005 Plan provide that, subject to approval by the Board of Directors, option grantees may have the right to exercise an option prior to vesting. Shares purchased upon the exercise of unvested options will be subject to the same vesting schedule as the underlying options, and are subject to repurchase at the original exercise price by the Company should the employee be terminated or leave the Company prior to becoming fully vested in such shares. At September 30, 2010 and December 31, 2009, there were 19,341 and 34,156 shares, respectively, that had been issued pursuant to the exercise of unvested options that remain unvested and subject to repurchase by the Company. Upon stock option exercise, the Company issues restricted shares and delivers them to the participant. The number of these early-exercised shares is not substantive.  The cash paid for the exercise prices is recorded as a liability and was not material to the consolidated financial statements at September 30, 2010 and December 31, 2009.  At September 30, 2010, the Company does not hold any treasury shares.

The Company, from time to time, issues certain time-accelerated stock options to certain employees under the Plans. The vesting of these time-accelerated stock options accelerates upon the achievement of certain performance-based milestones, such as the filing of a New Drug Application (“NDA”) with the Food and Drug Administration (“FDA”), the first commercial sale of a Company product, the successful completion of an initial public offering, or achieving a specified market capitalization target, among others. If these criteria are not met, such options will vest between six and ten years after the date of grant, and expire at the end of ten years. During the nine months ended September 30, 2010, 52,500 shares vested as a result of milestone or service period achievements, and the Company recorded related share-based compensation of approximately $0.1 million for these options. In the three months ended September 30, 2010, 7,500 shares vested as a result of milestone or service period achievements. At September 30, 2010 and December 31, 2009, there were 2,279,000 and 2,481,500 shares, respectively, issuable under outstanding and unvested time-accelerated options. When achievement of the milestone is not deemed probable, the Company recognizes compensation expense associated with time-accelerated stock options initially over the vesting period of the respective stock option. When deemed probable of achievement, the Company expenses the remaining unrecognized compensation for the respective stock option over the implicit service period.

During 2005, the Company granted to employees options to purchase 97,500 shares of common stock at an exercise price of $0.60 per share, which represented the fair value of the stock at that time. These options are subject to performance-based milestone vesting and expire ten years from the date of grant. The options were deemed to be variable upon grant because the number of shares that will vest were not fixed on the date of grant. The options are therefore remeasured at each reporting period until settlement of the option. During the year ended December 31, 2006, 37,500 shares vested as a result of milestone achievements. In the year ended December 31, 2008, it became probable that the remaining 60,000 unvested options would vest and ultimately vested in February 2009.  In April 2010, 30,000 shares were exercised and therefore will no longer be remeasured.  For the three and nine months ended September 30, 2010, the Company recorded related share-based compensation expense of approximately $(0.1) million for these options and approximately $0.2 million for the three and nine months ending September 30, 2009.

During 2009, the Company granted to employees options to purchase a total of 1,060,000 shares of common stock subject to performance-based milestone vesting. During the nine months ended September 30, 2010, the Company granted additional options to purchase a total of 57,500 shares of common stock subject to performance-based milestone vesting.  The vesting of these stock options will occur upon the achievement of certain performance-based milestones, such as the filing of a second NDA with the FDA, the first commercial sale of a Company product, or achieving a specified sales target.  During the three months ended September 30, 2010, the Company did not grant any additional options to purchase shares of common stock subject to performance-based milestone vesting.  During the nine months ended September 30, 2010, 5,000 shares vested as a result of milestone achievements and the Company

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

recorded related share-based compensation expense of approximately $31,000 for these options.  During the three months ended September 30, 2010, no shares vested as a result of milestone achievements. The Company has concluded that for the remaining shares of common stock subject to performance-based milestone vesting, only one performance-based milestone has become probable of achievement as of September 30, 2010; as such, approximately $77,000 of compensation expense has been recorded related to these options. At September 30, 2010, the unrecognized share-based compensation expense related to these options was approximately $3.9 million.

The Company also grants options to external consultants. No options were granted to external consultants during the three months ended September 30, 2010 or the three months ended September 30, 2009. 25,000 options were granted to external consultants during the nine months ended September 30, 2010.The weighted average grant date fair value per share of these options was $7.22. During the nine months ended September 30, 2009, the Company granted options for the purchase of 37,000 shares to external consultants. The weighted average grant date fair value per share of options granted to external consultants during the nine months ended September 30, 2009 was $2.97. Most grants made to external consultants vest over a period of one year, and the expense related to these options is charged to share-based compensation expense over the vesting period of the options. The amount of share-based compensation expense that may be recognized for outstanding, unvested options as of September 30, 2010 was approximately $0.1 million. The amount of share-based compensation expense that will ultimately be recorded will depend on the remeasurement of the outstanding awards through their vesting date. This remaining compensation expense will be recognized over a weighted average amortization period of 1.4 years at September 30, 2010.

In calculating share-based compensation costs, the Company estimated the fair value of stock options using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of short-lived, exchange-traded options that have no vesting restrictions and are fully transferable. The Company estimates the number of awards that will be forfeited in calculating compensation costs. Such costs are then recognized over the requisite service period of the awards on a straight-line basis.

Determining the fair value of share-based awards using the Black-Scholes option-pricing model requires the use of highly subjective assumptions, including the expected term of the award and expected stock price volatility. The weighted average assumptions used to estimate the fair value of the stock options using the Black-Scholes option-pricing model were as follows for the three and nine months ended September 30, 2010 and 2009:

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

The following table summarizes the expense recognized for these share-based compensation arrangements in the condensed consolidated statements of operations (in thousands):

Share-based compensation is reflected in the condensed consolidated statements of operations as follows for the three and nine months ended September 30, 2010 and 2009 (in thousands):

At September 30, 2010, there were 6,062,389 shares, available for future grant under the Plans.

The following table summarizes stock option activity under the share-based compensation plans, including performance-based options:

(1)                                  All stock options granted under the 1998 Plan, 2002 Plan and 2005 Plan contain provisions allowing for the early exercise of such options into restricted stock. The exercisable shares disclosed above represent those that are vested as of September 30, 2010.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

The weighted average grant date fair value per share of options granted to employees during the three and nine months ended September 30, 2010 was $6.04 and $6.58, respectively, and $3.38 and $3.16 during the three and nine months ended September 30, 2009, respectively. The total intrinsic value of options exercised during the three and nine months ended September 30, 2010 was approximately $5.7 million and $14.1 million, respectively, and approximately $0.6 million and $0.8 million during the three and nine months ended September 30, 2009, respectively. Prior to the closing of the Company’s initial public offering, the intrinsic value was calculated as the difference between the estimated fair value of the Company’s common stock and the exercise price of the option.

The grant date fair value of the options granted to employees during the three and nine months ended September 30, 2010 was approximately $2.2 million and $14.7 million, respectively, and approximately $4.6 million and $9.0 million, respectively during the three and nine months ended September 30, 2009.

As of September 30, 2010, there was approximately $1.5 million and $16.2 million of unrecognized share-based compensation, net of estimated forfeitures, related to restricted stock awards and unvested stock option grants with time-based vesting, respectively, which are expected to be recognized over a weighted average period of 3.45 years. The total unrecognized share-based compensation cost will be adjusted for future changes in estimated forfeitures.

11. Related Party Transactions

The Company has and currently obtains legal services from a law firm that is an investor of the Company. The Company paid approximately $96,000 and $196,000 in legal fees to this investor during the three and nine months ended September 30, 2010, respectively, and approximately $4,000 and $8,000 in legal fees to this investor during the three and nine months ended September 30, 2009, respectively.

In September 2009, Forest became a related party when the Company sold to Forest 2,083,333 shares of the Company’s convertible preferred stock and in November 2009, Almirall became a related party when the Company sold to Almirall 681,819 shares of the Company’s convertible preferred stock (Note 5). Additional related party disclosure related to Microbia and T&L is included in Note 13.

12. Segment Reporting

Prior to the sale of its interest in Microbia in September 2010, the Company had two reportable business segments: human therapeutics and biomanufacturing. The Company has no inter-segment revenues.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

As a result of the sale of the Company’s interest in Microbia the results of the biomanufacturing segment are now presented as discontinued operations in the balance sheets, statements of operations and statements of cash flows. The following table reports revenue and loss from operations for the Company’s reportable segments for the three and nine months ended September 30, 2010 and 2009 (in thousands):

At September 30, 2010 and December 31, 2009, approximately $5.0 million and $5.2 million, respectively, of the Company’s accounts receivable related to the human therapeutics segment. At December 31, 2009, approximately $15,000 of accounts receivable related to the Company’s biomanufacturing segment was included in current assets of discontinued operations.

13. Microbia, Inc.

Sale of Microbia to DSM

On September 21, 2010, the Company sold its interest in Microbia to DSM in exchange for cash proceeds of $9.5 million, the payment of approximately $1.1 million of Microbia debt and interest by DSM and future contingent consideration based on the sale of products incorporating Microbia’s technology.

Tate & Lyle Investments, Ltd.

In September 2006, the Company entered into a collaboration agreement with T&L. The collaboration agreement had a five-year term with a one-year notice of termination. In connection with the execution of the collaboration agreement, the Company also issued T&L 1,823,529 shares of common stock of Microbia, at the aggregate purchase price of approximately $2,000, and issued 7,000,000 shares of convertible preferred stock of Microbia at the aggregate purchase price of $7.0 million. After the sale of stock to T&L, the Company retained an 85% majority ownership interest, and T&L had a 15% noncontrolling interest in Microbia. The Company’s ownership interest in Microbia was entirely comprised of convertible preferred stock with the same preferences to that held by T&L. The ownership of the convertible preferred and common stock by T&L is recorded as noncontrolling interest in the consolidated financial statements.

On June 15, 2010, T&L and Microbia entered into an agreement to terminate their collaboration.  The terms and conditions of the agreement included an exchange of intellectual property and a one-time payment to Microbia of approximately $1.8 million.  All current and future obligations between Microbia and T&L were terminated as a result of this agreement.

Revenue earned from the T&L collaboration agreement totaled approximately $1.9 million during the nine months ended September 30, 2010 and approximately $0.1 million and $1.6 million during the three and nine months ended September 30, 2009, respectively.  No revenue was earned from the T&L collaboration agreement during the three months ended September 30, 2010. This

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

revenue is included in discontinued operations for all periods presented.  Accounts receivable from T&L was approximately $10,000 at December 31, 2009.

Strategic Restructuring Plan

In November 2009, Microbia implemented a strategic restructuring plan that included an immediate reduction of Microbia’s workforce by approximately 40% of its existing workforce, and a reduced workweek for an additional 12% of its existing workforce. Microbia took this action to focus on its proprietary strain-development platform and existing service agreements.

In connection with the strategic restructuring plan, Microbia recorded restructuring charges of approximately $1.2 million in the year ended December 31, 2009, relating primarily to one-time termination benefits and asset impairment charges, which are included in net income (loss) from discontinued operations.  As of September 21, 2010, Microbia had paid in cash all remaining termination benefits. As a result of the sale of the Company’s interest in Microbia to DSM, Microbia will not incur approximately $0.8 million of contingent restructuring costs related to its November 2009 restructuring, which would have been incurred if Microbia implemented an additional reduction in force prior to the earlier of November 5, 2010 or the date that Microbia closed on a new round of financing.

14. Subsequent Events

Milestone

On November 1, 2010, the Company announced positive top-line results in the second confirmatory Phase 3 clinical trial assessing the efficacy and safety of linaclotide in patients with IBS-C.  The Company announced the positive top-line results of the first confirmatory Phase 3 clinical trial in September 2010.  Based on the positive top-line results from these two clinical trials, Almirall will make a one-time $20 million milestone payment, less applicable taxes, to the Company.

Federal Grant

On October 29, 2010, the Company was notified that it was awarded approximately $978,000 in grants under the Qualifying Therapeutic Discovery Project Program which was created in March 2010 as part of the Patient Protection and Affordability Care Act. The total amount awarded is expected to be recognized during the fourth quarter of 2010.

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