UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

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

For The Quarterly Period Ended September 30, 2004

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: 000-50767

Critical Therapeutics, Inc.

Registrant’s telephone number, including area code: (781) 402-5700

     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 is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

     As of November 8, 2004, the registrant had 24,039,366 shares of Common Stock, $0.001 par value per share, outstanding.

CRITICAL THERAPEUTICS, INC.

FORM 10-Q
TABLE OF CONTENTS

PART I. Financial Information

Item 1. Financial Statements

CRITICAL THERAPEUTICS, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED BALANCE SHEETS

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

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CRITICAL THERAPEUTICS, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

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

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CRITICAL THERAPEUTICS, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

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

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CRITICAL THERAPEUTICS, INC. AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(1) Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements include the accounts of Critical Therapeutics, Inc. (“Critical” or the “Company”) and its subsidiary, and have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. The Company believes that all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation, have been included. The information included in this Form 10-Q should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements and footnotes thereto included in the Company’s Registration Statement on Form S-1 dated May 26, 2004.

     Operating results for the three- and nine-month periods ended September 30, 2004 and 2003 are not necessarily indicative of the results for the full year.

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates or assumptions. The more significant estimates reflected in these financial statements include certain judgments regarding accrued expenses and valuation of stock-based compensation.

(2) Initial Public Offering of Common Stock

     On June 2, 2004, the Company sold 6,000,000 shares of its common stock in its initial public offering at a price to the public of $7.00 per share. On June 30, 2004, the Company sold an additional 110,000 shares at a price to the public of $7.00 per share pursuant to the partial exercise of the underwriters’ over-allotment option. The Company received gross proceeds of $42.8 million, of which $3.0 million was paid as an underwriting discount. Expenses related to the offering totaled approximately $2.0 million. The Company has invested the net proceeds in highly liquid, interest-bearing, investment grade securities.

     In connection with the Company’s initial public offering of common stock, all of the issued and outstanding redeemable convertible preferred stock converted to common stock at a ratio of one share of common stock for each 3.75 shares of preferred stock then outstanding. Accordingly, on June 2, 2004 60,410,237 shares of preferred stock converted into 16,109,403 shares of common stock. The par value and additional paid-in capital related to the redeemable convertible preferred stock totaling $81.8 million was reclassified to common stock in the Company’s balance sheet. Under the terms of the preferred stock agreement accrued dividends totaling $5.3 million were forfeited in connection with this conversion to common stock.

     As of September 30, 2004, the Company has authorized capital stock of 90,000,000 shares of common stock with a par value of $0.001 per share and 5,000,000 shares of preferred stock with a par value of $0.001 per share. The rights and preferences of the preferred stock may be established from time to time by the Company’s board of directors.

(3) Reverse Stock Split

     The Company effected a 1-for-3.75 reverse stock split of all outstanding common stock and stock options as of May 20, 2004. All references to the number of common shares and per share amounts have been retroactively restated for all periods presented to reflect this reverse stock split including reclassifying an amount equal to the reduction in par value to additional paid-in capital.

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CRITICAL THERAPEUTICS, INC. AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

(4) Revenue Recognition

     The Company recognizes revenue in accordance with the Securities and Exchange Commission’s (“SEC”) Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” (“SAB 101”), as amended by SEC Staff Accounting Bulletin No. 104 “Revenue Recognition” (“SAB 104”). Specifically, revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed and determinable and collectibility is reasonably assured.

     Revenue under the Company’s collaboration agreement with MedImmune, Inc. is recognized over the estimated performance period based on a proportional performance model. Under the proportional performance model, performance is measured as the percentage of cost incurred to date compared to the total costs estimated for the performance period. The amount of revenue recognized during each period represents the cumulative performance percentage of amounts received and due to the Company under the agreement less amounts previously recognized. The Company periodically reviews the estimated performance period and total costs and, to the extent such estimates change, the impact of such change is recorded in operations at that time. During the three months ended September 30, 2004, the Company revised its estimate of remaining total costs under the collaboration agreement with MedImmune, which resulted in an increase in revenue recognized of $1.1 million. Because the Company’s collaborator has the right to cancel the agreement at any time, the Company does not recognize revenues in excess of cumulative cash collections. Deferred revenue consists of payments received in advance of revenue recognized under the agreement.

(5) Cash Equivalents and Short-Term Investments

     The Company considers all highly-liquid investments with original maturities of three months or less when purchased to be cash equivalents.

     Short-term investments consist primarily of U.S. government treasury and agency notes, corporate debt obligations, municipal debt obligations and money market funds, each of investment-grade quality, which have a maturity date greater than 90 days that can be sold within one year. These securities are held until such time as the Company intends to use them to meet the ongoing liquidity needs to support its operations. These investments are recorded at fair value and accounted for as available-for-sale securities. The unrealized gain (loss) during the period is recorded as an adjustment to stockholders’ equity. During the three- and nine month periods ended September 30, 2004, the Company recorded an unrealized gain (loss) on investments of $125,000 and $(252,000), respectively. There was no unrealized gain or loss in 2003 as all holdings were classified as cash equivalents. The cost of the debt securities is adjusted for amortization of premiums and accretion of discounts to maturity. The amortization or accretion is included in interest income (expense) in the corresponding period.

     On July 1, 2004, the Company adopted EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments” (EITF 03-1) as applicable to debt and equity securities that are within the scope of SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities” and equity securities that are accounted for using the cost method specified in APB Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock,” except for paragraphs 10 – 20 of this Issue regarding how to evaluate and recognize an impairment loss that is other-than-temporary, since application of these paragraphs has been deferred. The Company has determined the unrealized gain (loss) on investments is temporary, therefore no impairment exists during the three-and nine-month periods ended September 30, 2004.

(6) Comprehensive Loss

     Comprehensive loss is the total of net loss and all other non-owner changes in equity. The difference between net loss, as reported in the accompanying condensed consolidated statements of operations for the three- and nine-

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CRITICAL THERAPEUTICS, INC. AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

month periods end September 30, 2004, and comprehensive loss is the unrealized gain (loss) on short-term investments for the period. There were no items affecting comprehensive loss for the three- or nine-month periods ended September 30, 2003. Total comprehensive loss was $6.5 million and $3.5 million for the three-month periods ended September 30, 2004 and 2003, respectively, and $20.1 million and $10.0 million, for the nine-month periods ended September 30, 2004 and 2003, respectively. The unrealized loss on investments is the only component of accumulated other comprehensive loss in the accompanying condensed consolidated balance sheet as of September 30, 2004.

(7) Stock-Based Compensation

     The Company accounts for stock-based awards to employees using the intrinsic-value method as prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, no compensation expense is recorded for options issued to employees in fixed amounts and with fixed exercise prices at least equal to the fair market value of the Company’s common stock at the date of grant. Conversely, when the exercise price for accounting purposes is below fair value of the Company’s common stock on the date of grant, a non-cash charge to compensation expense is recorded ratably over the term of the option vesting period in an amount equal to the difference between the value calculated using the exercise price and the fair value. All stock-based awards to non-employees are accounted for at their fair market value in accordance with Statement of Financial Accounts Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” and Emerging Issues Task Force (“EITF”) No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.”

     Stock option activity for the nine-month period ended September 30, 2004 is as follows:

     Certain of the employee stock options granted to employees during the six-month period ended June 30, 2004 were deemed for accounting purposes to have been granted at exercise prices below fair value and therefore the Company has recorded the $525,000 difference between the exercise price and the fair value as deferred stock-based

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CRITICAL THERAPEUTICS, INC. AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

compensation at the time of the grant. The Company expenses deferred stock-based compensation as charges to operations over the vesting period of the options and has recorded $32,000 and $85,000 as stock-based compensation expense during the three and nine-month period ended September 30, 2004, respectively, relating to these options.

     The remaining number of shares of common stock available for award under the Company’s equity incentive plans totaled 1,788,064 at September 30, 2004.

     Had employee compensation expense been determined based on the fair value at the date of grant consistent with SFAS No. 123, the Company’s pro forma net loss and pro forma net loss per share would have been as follows (in thousands, except loss per share data):

     Option valuation models require the input of highly subjective assumptions. Because changes in subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the calculated fair value may not necessarily be indicative of the actual fair value of the stock options. The Company has computed the pro forma disclosures required under SFAS No. 123 for options granted using the Black-Scholes option-pricing model prescribed by SFAS No. 123. The assumptions used and weighted-average information are as follows:

(8) Basic and Diluted Loss per Share

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CRITICAL THERAPEUTICS, INC. AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

     Basic and diluted net loss per common share is calculated by dividing the net loss available to common stockholders by the weighted-average number of unrestricted common shares outstanding during the period. Diluted net loss per common share is the same as basic net loss per common share, since the effects of potentially dilutive securities are anti-dilutive for all periods presented. Anti-dilutive securities that are not included in the diluted net loss per share calculation aggregated 4,446,067 and 21,669,454 as of September 30, 2004 and 2003, respectively. These anti-dilutive securities consist of outstanding stock options, warrants, and unvested restricted common stock as of September 30, 2004, and outstanding redeemable convertible preferred stock, stock options, warrants, and unvested restricted common stock as of September 30, 2003.

     The following table reconciles the weighted-average common shares outstanding to the shares used in the computation of basic and diluted weighted-average common shares outstanding:

Accretion of Dividends and Offering Costs on Preferred Stock

     Prior to the Company’s initial public offering, holders of preferred stock had a right to receive dividends at a stated rate per share. The Company recorded accretion of these dividends as well as offering costs in order to arrive at the net loss available to common stockholders in the periods prior to the initial public offering. Upon conversion of the preferred stock into common stock, the holders of preferred stock, pursuant to the terms of the preferred stock, forgave all cumulative accrued dividends. As of May 26, 2004, cumulative accrued dividends on the Company’s preferred stock totaled $5.3 million.

(9) Long-Term Debt

     Effective June 30, 2004, the Company entered into a modification to its existing loan and security agreement. The modification gives the Company the ability to borrow up to an additional $3.0 million under a credit agreement from July 1, 2004 to December 31, 2004. From January 1, 2005 to December 31, 2005, the Company has additional borrowing capacity up to an amount equal to the lesser of (i) $3.0 million minus the principal amount of advances made in 2004 or (ii) $1.3 million. Advances made during 2004 and 2005 accrue interest at a rate equal to the prime rate plus 2% per year and are required to be repaid in equal monthly installments of principal plus interest accrued through the date of repayment. The repayment term for advances made in 2004 and 2005 are 42 and 36 months, respectively. In connection with the original loan and security agreement, the Company granted the lender a first priority security interest in substantially all of the Company’s assets, excluding intellectual property, to secure the Company’s obligations under the credit agreement. During the three-months ended September 30, 2004, the Company borrowed $1.4 million under modified the credit agreement.

(10) Commitments and Contingencies

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CRITICAL THERAPEUTICS, INC. AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

     The Company has entered into various agreements with third parties and certain related parties in connection with the research and development activities of its existing product candidates as well as discovery efforts on potential new product candidates. These agreements include costs for research and license agreements represent the Company’s fixed obligations payable to sponsor research and minimum royalty payments for licensed patents. These amounts do not include any additional amounts that the Company may be required to pay under its license agreements upon the achievement of scientific, regulatory and commercial milestones that may become payable depending on the progress of scientific development and regulatory approvals, including milestones such as the submission of an investigational new drug application to the FDA, similar submissions to foreign regulatory authorities and the first commercial sale of the Company’s products in various countries. These agreements include costs related to manufacturing, clinical trials and pre-clinical studies performed by third parties. The estimated amount that may be incurred in the future under these agreements totals approximately $14.8 million as of September 30, 2004. The amount and timing of these commitments may change, as they are largely dependent on the rate of enrollment in and timing of the development of the Company’s product candidates.

     The Company is party to a number of agreements that require it to make milestone payments, royalties on net sales of the Company’s products and payments on sublicense income received by the Company.

     From time to time, the Company may have certain contingent liabilities that arise in the ordinary course of business. The Company accrues for liabilities when it is probable that future expenditures will be made and such expenditures can be reasonably estimated. For all periods presented, the Company is not a party to any pending material litigation or other material legal proceedings.

(11) Relocation of Headquarters

     During the three-months ended June 30, 2004, the Company relocated its headquarters to Lexington, Massachusetts and consolidated its research facilities from two to one. Under SFAS No. 146, “Costs Associated with an Exit or Disposal Activity,” the Company recorded a liability of $441,000 in the three-month period ended June 30, 2004 related to the remaining obligations under an operating lease that expires in October 2005 at its previous headquarters. During the three months ended September 30, 2004, the Company reduced the liability by $48,000 to adjust for the known effect of rental income expected to be realized under a sublease agreement signed by the Company in September 2004, partially offset by certain other estimated costs associated with the lease termination.

     The following table summarizes the activity related to the remaining lease obligation recorded under SFAS No. 146 (in thousands):

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion together with our financial statements and accompanying notes included in this quarterly report and our audited financial statements included in our Registration Statement on Form S-1 (No. 333-113727) which is on file with the SEC. In addition to historical information, the following discussion contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results could differ materially from those anticipated by the forward-looking statements due to important factors including, but not limited to, those set forth under “Factors That May Affect Future Results” below.

Nature of Business

          We are a biopharmaceutical company focused on the discovery, development and commercialization of products designed to treat respiratory, inflammatory and critical care diseases through the regulation of the body’s inflammatory response. The inflammatory response occurs within the body’s immune system following a stimulus such as infection or trauma. Our most advanced product is ZYFLO®, a tablet formulation of zileuton, which the U.S. Food and Drug Administration, or FDA, approved in 1996 for the prevention and chronic treatment of asthma. We licensed from Abbott Laboratories exclusive worldwide rights to ZYFLO and other formulations of zileuton for multiple diseases and conditions. We are currently in the process of changing manufacturing sites for ZYFLO, and subject to FDA approval of these sites, we expect to begin selling ZYFLO in the United States in the second half of 2005.

          We are also developing products to regulate the excessive inflammatory response that can damage vital internal organs and, in the most severe cases, result in multiple organ failure and death.

	•		CTI-01. We are developing a small molecule product candidate, CTI-01, that we believe may be effective in regulating the inflammatory response. Results from preclinical studies suggest that CTI-01 inhibits the release of protein molecules called cytokines that are responsible for communication between cells in the body and are associated with conditions such as post-operative ileus, which is the loss of normal intestine movement following surgery, and the damage to vital organs that can occur in patients after cardiopulmonary bypass, a procedure commonly performed during heart surgery.
	•		HMGB1. We believe that a cytokine called HMGB1, or high mobility group protein B1, may be an important target for the development of products to treat inflammatory diseases because of the timing and the duration of its release from cells into the bloodstream. We are currently collaborating with MedImmune, Inc. on preclinical development of our monoclonal antibodies directed towards HMGB1 in a number of animal models.
	•		Cholinergic Anti-inflammatory Program. We are developing small molecules designed to inhibit the body’s inflammatory response by acting on the nicotinic µ-7 cholinergic target, which is a cell receptor associated with the production of the cytokines that play a fundamental role in the inflammatory response. We believe that successful development of a product candidate targeting the nicotinic µ-7 cholinergic receptor could lead to an oral anti-cytokine therapy for acute and chronic diseases. We are also exploring the development of a medical device, similar to those already marketed for the treatment of epileptic seizures, to stimulate the vagus nerve, which links the brain with the major organs of the body, and induce an anti-inflammatory response by acting on the µ-7 receptor.

Overview

          Since our inception, we have incurred significant losses each year. As of September 30, 2004, we had an accumulated deficit of $47.3 million. We expect to incur significant and growing losses for the foreseeable future. Although the size and timing of our future operating losses are subject to significant uncertainty, we expect our operating losses to continue to increase over the next several years as we continue to fund our development programs and prepare for potential commercial launch of our product candidates. We do not expect to achieve profitability in the foreseeable future, if at all. Since inception, we have funded our operations through the sale of

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common and preferred stock, debt financings, the receipt of interest income and payments from our collaborator MedImmune.

          We expect that research and development expenses relating to our development portfolio will continue to increase for the foreseeable future. In particular, we expect to incur increased expenses over the next several years for clinical trials of our product development candidates, including the controlled-release formulation of zileuton and CTI-01. We also expect manufacturing expenses included in research and development expenses to increase as we complete the technology transfer relating to the manufacturing of ZYFLO and the controlled-release formulation of zileuton and purchase inventory in preparation for the commercial launch of ZYFLO.

          We anticipate that our general and administrative expenses will also increase as we expand our operations, facilities and other activities now that we are operating as a publicly traded company. In addition, we expect to incur significant sales and marketing costs as we commercialize ZYFLO and the controlled-release formulation of zileuton.

Critical Accounting Policies

          The discussion and analysis of our financial condition and results of operations is based on our unaudited consolidated 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 us to make estimates and judgments that affect our reported assets and liabilities, revenues and expenses, and other financial information. Actual results may differ significantly from these estimates under different assumptions and conditions. In addition, our reported financial condition and results of operations could vary due to a change in the application of a particular accounting standard.

          We regard an accounting estimate or assumption underlying our financial statements as a “critical accounting estimate” where:

	•		the nature of the estimate or assumption is material due to the level of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change; and
	•		the impact of the estimates and assumptions on financial condition or operating performance is material.

          Our significant accounting policies are more fully described in Note 2 of the Notes to Consolidated Financial Statements and “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies and Estimates” in our Registration Statement on Form S-1 (File No. 333-113727). Not all of these significant accounting policies, however, fit the definition of “critical accounting estimates.” We have discussed our accounting policies with the audit committee of our board of directors, and we believe that our estimates relating to revenue recognition, accrued expenses, stock-based compensation and income taxes described under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates” in our Registration Statement on Form S-1 (File No. 333-113727), fit the definition of “critical accounting estimates.”

          Revenue Recognition. Under our collaboration agreement with MedImmune, we are entitled to receive non-refundable license fees, milestone payments and other research and development payments. Payments received are initially deferred from revenue and subsequently recognized in our statement of operations when earned. We must make significant estimates in determining the performance period and periodically review these estimates, based on joint management committees and other information shared by our collaborators with us. We recognize these revenues over the estimated performance period as set forth in the contracts based on proportional performance and adjusted from time to time for any delays or acceleration in the development of the product. For example, a delay or acceleration of the performance period by our collaborator may result in further deferral of revenue or the acceleration of revenue previously deferred. Because our collaboration agreement can be canceled by MedImmune, we do not recognize revenues in excess of cumulative cash collections. It is difficult to estimate the impact of the

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adjustments on the results of our operations because, in each case, the amount of cash received would be a limiting factor in determining the adjustment.

          Accrued Expenses. As part of the process of preparing our consolidated financial statements, we are required to estimate certain expenses. This process involves i