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EX-23.1 - CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM - PROMETHEUS LABORATORIES INCdex231.htm
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As filed with the Securities and Exchange Commission on November 10, 2009

Registration No. 333-148151

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Amendment No. 10

to

FORM S-1

REGISTRATION STATEMENT

Under

The Securities Act of 1933

 

 

PROMETHEUS LABORATORIES INC.

(Exact name of Registrant as

specified in its charter)

 

 

 

California   2834   33-0685754

(State or other jurisdiction of

incorporation or organization)

 

(Primary Standard Industrial

Classification Code Number)

 

(I.R.S. Employer

Identification Number)

9410 Carroll Park Drive

San Diego, CA 92121

(858) 824-0895

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

 

 

Joseph M. Limber

President and Chief Executive Officer

Prometheus Laboratories Inc.

9410 Carroll Park Drive San Diego, CA 92121

(858) 824-0895

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 

 

Copies to:

 

Michael W. Hall, Esq.

Cheston J. Larson, Esq.

Michael E. Sullivan, Esq.

Latham & Watkins LLP

12636 High Bluff Drive, Suite 400

San Diego, CA 92130

(858) 523-5400

 

William Franzblau, Esq.

Vice President, Legal Affairs

Prometheus Laboratories Inc.

9410 Carroll Park Drive

San Diego, CA 92121

(858) 824-0895

 

Mark K. Hyland, Esq.

Shearman & Sterling LLP

525 Market Street

San Francisco, CA 94105

(415) 616-1100

 

 

Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this Registration Statement.

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.  ¨

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

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.

 

Large accelerated filer ¨    Accelerated filer ¨
Non-accelerated filer x (Do not check if a smaller reporting company)    Smaller reporting company ¨

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.

 

 

 


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The information in this preliminary prospectus is not complete and may be changed. These securities may not be sold until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell nor does it seek an offer to buy these securities in any jurisdiction where the offer or sale is not permitted.

 

Subject to Completion. Dated November 10, 2009.

            Shares

LOGO

Prometheus Laboratories Inc.

Common Stock

 

 

This is an initial public offering of shares of common stock of Prometheus Laboratories Inc.

Prometheus is offering              shares to be sold in the offering. [The selling shareholders identified in this prospectus are offering an additional              shares. Prometheus will not receive any of the proceeds from the sale of the shares being sold by the selling stockholders.]

Prior to this offering, there has been no public market for the common stock. It is currently estimated that the initial public offering price per share will be between $              and $            . Application has been made for the listing of the common stock on the Nasdaq Global Select Market under the symbol “RXDX.”

See “Risk Factors” on page 12 to read about factors you should consider before buying shares of the common stock.

 

 

Neither the Securities and Exchange Commission nor any other regulatory body has approved or disapproved of these securities or passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense.

 

 

 

     Per Share    Total  

Initial public offering price

   $                 $                

Underwriting discount

   $                 $                

Proceeds, before expenses, to Prometheus

   $                 $                

[Proceeds, before expenses, to the selling stockholders

   $                 $             

To the extent that the underwriters sell more than              shares of common stock, the underwriters have the option to purchase up to an additional              shares from Prometheus at the initial public offering price less the underwriting discount.

 

 

The underwriters expect to deliver the shares against payment in New York, New York on                     , 2009.

 

Goldman, Sachs & Co.    Credit Suisse

 

BofA Merrill Lynch    Cowen and Company    Wedbush PacGrow Life Sciences

 

 

Prospectus dated                     , 2009.


Table of Contents

TABLE OF CONTENTS

Prospectus

 

     Page

Prospectus Summary

   1

The Offering

   8

Summary Financial Data

   10

Risk Factors

   12

Special Note Regarding Forward-Looking Statements

   50

Use of Proceeds

   52

Dividend Policy

   52

Capitalization

   53

Dilution

   55

Selected Financial Data

   57

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   59

Business

   84

Management

   122

Compensation Discussion and Analysis

   129

Executive Compensation

   140

Principal [and Selling] Shareholders

   155

Certain Relationships and Related Party Transactions

   159

Description of Capital Stock

   161

Shares Eligible for Future Sale

   166

Material U.S. Federal Tax Considerations to Non-U.S. Holders

   169

Underwriting

   172

Notice to Canadian Residents

   180

Legal Matters

   181

Experts

   181

Where You Can Find Additional Information

   181

Index to Consolidated Financial Statements

   F-1

 

 

Through and including                     , 2010 (the 25th day after the date of this prospectus), all dealers effecting transactions in these securities, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to a dealer’s obligation to deliver a prospectus when acting as an underwriter and with respect to an unsold allotment or subscription.

 

 

No dealer, salesperson or other person is authorized to give any information or to represent anything not contained in this prospectus. You must not rely on any unauthorized information or representations. This prospectus is an offer to sell only the shares offered hereby, but only under circumstances and in jurisdictions where it is lawful to do so. The information contained in this prospectus is current only as of its date.

 

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PROSPECTUS SUMMARY

This summary does not contain all of the information you should consider before buying shares of our common stock. You should carefully read the entire prospectus, including our consolidated financial statements and the related notes included in this prospectus and the information set forth under the headings “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” before deciding to invest in shares of our common stock. Unless the context requires otherwise, references in this prospectus to “Prometheus,” “we,” “us” and “our” refer to Prometheus Laboratories Inc. and references to “diagnostic tests” or “diagnostic testing” refer to laboratory tests developed by us and laboratory tests developed by third parties and purchased by us that have either been cleared for use by the U.S. Food and Drug Administration, or FDA, or that we have validated for such use.

Prometheus Laboratories Inc.

Overview

Prometheus is a specialty pharmaceutical and diagnostic company committed to developing and commercializing novel pharmaceutical and diagnostic products to help physicians individualize patient care. We are primarily focused on the detection, diagnosis and treatment of gastrointestinal diseases and disorders in the United States. Our strategy includes the marketing and delivery of proprietary, highly complex diagnostic testing services complemented by the marketing and promotion of pharmaceutical products. By integrating pharmaceutical products and diagnostic testing services, we believe we can address the full continuum of care, thereby providing physicians with a comprehensive solution to treat chronic diseases.

We believe our business model of offering pharmaceuticals combined with our diagnostic testing services differentiates us from other pharmaceutical, specialty pharmaceutical and diagnostic companies, and provides our sales force greater access to physicians. Our approximately 150 person sales force, including sales representatives, sales management and national account managers, has significant experience and technical knowledge of the gastroenterology market. Currently, we principally market our pharmaceutical and diagnostic products and services to the approximately 12,000 gastroenterologists in the United States, of whom approximately 81% prescribed our ENTOCORT® EC (budesonide) Capsules, LOTRONEX® (alosetron hydrochloride) Tablets or at least one of our diagnostic products during 2008. We believe our sales success, access to physicians and proprietary diagnostic testing services may also provide us with an advantage in gaining access to or acquiring additional pharmaceutical and diagnostic products.

We currently operate under two business segments: (1) the pharmaceutical products segment that markets and sells prescription drugs, and (2) the diagnostic testing services segment that offers diagnostic testing services. Our aggregate net sales have grown from $89.6 million in 2004 to $278.1 million in 2008, representing a compounded annual growth rate, or CAGR, of 32.7%. During this same period, our aggregate net sales of pharmaceutical products grew from $38.9 million to $196.0 million, representing a CAGR of 49.8%, and our aggregate net sales of diagnostic testing services grew from $50.7 million to $82.1 million, representing a CAGR of 12.8%. Our aggregate net sales for the first nine months of the year have grown from $204.8 million for the nine months ended September 30, 2008 to $257.8 million for the nine months ended September 30, 2009, with aggregate net sales of pharmaceutical products growing from $144.1 million to $193.1 million and aggregate net sales of diagnostic testing services growing from $60.8 million to $64.7 million across the same periods. Growth in our pharmaceutical and diagnostics segments is due principally to the addition of Entocort EC in 2005, the addition of Lotronex beginning November 2007 and the introduction of new or improved diagnostic testing services. For the year ended 2004 we experienced a net loss of $41.2 million, which included a write-down of $51.9 million related to the carrying value of product rights and termination of a license agreement. Excluding this write-down, our net income for 2004 was $16.2 million and grew to a net income of $37.2 million for the year ended 2008. Growth in this net income is due primarily to the growth in aggregate net sales as well as management of our overall operating expenditures. Our year to date net income decreased from $33.6 million for the nine months ended September 30, 2008 to $28.3 million for the nine months ended September 30, 2009. This

 

 

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decrease is primarily due to a reversal of interest expense of $5.6 million related to a reduction in the fair value of our redeemable warrants which expired in April 2008.

In January 2008, we acquired exclusive rights to Lotronex in the United States from GlaxoSmithKline. Lotronex is the only prescription drug approved by the FDA for use in female patients with severe diarrhea-predominant irritable bowel syndrome, or IBS, who have chronic IBS symptoms, have had abnormalities of the gastrointestinal tract excluded and have not responded to conventional therapy. Prior to our acquisition of Lotronex, GlaxoSmithKline voluntarily withdrew Lotronex from the market in 2000. The FDA approved a supplemental New Drug Application for Lotronex in 2002 with a more limited indication and it was subsequently re-introduced to the market. In order to reduce the potential for harmful side effects of Lotronex, the drug is subject to a special prescribing program designed to ensure that only doctors who have enrolled in the Prescribing Program for Lotronex™ write prescriptions for the drug. In connection with their enrollment into the prescribing program, the physicians must have an understanding of IBS and be familiar with the side effects and risks of Lotronex.

In November 2007, we entered into an exclusive license agreement to develop and commercialize COLAL-PRED® (prednisolone metasulfobenzoate sodium), a development-stage product for the treatment of gastrointestinal diseases or other applications, in North America from a subsidiary of Alizyme plc. Colal-Pred has not been approved by the FDA, and we will not be able to commercialize Colal-Pred in the United States until we receive approval from the FDA. We began a Phase 2 clinical trial to evaluate Colal-Pred for the treatment of patients with ulcerative colitis in May 2008.

We expect to continue to grow through the development, licensing and acquisition of additional pharmaceuticals and diagnostic testing services. As we grow, we also expect to expand into additional areas, such as oncology, that are consistent with our business model of offering pharmaceuticals complemented by proprietary diagnostics. In April 2009, we acquired the rights to sell three oncology diagnostic tests in the United States from Rosetta Genomics Ltd. We began selling these tests as ProOnc TumorSourceDX™, ProOnc SquamousDX™ and ProOnc MesotheliomaDX™ in the United States, in October 2009.

The Gastrointestinal Industry

Inflammatory bowel disease, or IBD, represents a group of chronic, progressive, recurring and debilitating inflammatory disorders of the gastrointestinal tract. According to the Crohn’s & Colitis Foundation of America, an estimated 1.4 million Americans suffer from IBD. Crohn’s disease and ulcerative colitis are the two main types of IBD diseases. The main difference between Crohn’s disease and ulcerative colitis is the location and nature of the inflammation. Because the symptoms of Crohn’s disease and ulcerative colitis are so similar, it is sometimes difficult to establish a definite diagnosis. However, differentiating between the two diseases is extremely important as treatment may be very different. Historically, accurate diagnosis could only be done invasively by endoscopy with biopsy of lesions. In the past ten years, non-invasive diagnostic tests have been introduced that provide information to aid physicians in diagnosing IBD and differentiating Crohn’s disease from ulcerative colitis.

Irritable bowel syndrome is a disorder characterized most commonly by cramping, abdominal pain, bloating, constipation and diarrhea. IBS causes substantial discomfort and distress, but it is not characterized by intestinal inflammation or permanent intestinal damage unlike IBD. For severe cases however, IBS can be disabling. According to the National Institute of Diabetes and Digestive and Kidney Diseases, or NIDDK, in 2007, almost 60 million, or 20%, of the U.S. population had symptoms of IBS, making it one of the most common disorders diagnosed by physicians. Of these patients, less than 5% meet the criteria for prescribing Lotronex. IBS occurs more often in women than in men, and it generally begins in late adolescence or early adult life and rarely appears for the first time after the age of 50 years. Unfortunately, many people suffer from IBS for a long time before seeking medical treatment. Up to 75% of people suffering from IBS are believed not to be receiving medical care for their symptoms, due in part to the current difficulties of diagnosing IBS.

 

 

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Celiac disease is an autoimmune digestive disease that damages the small intestine, interfering with the absorption of nutrients from food. People with celiac disease cannot tolerate a protein called gluten which is found in wheat, barley and rye. Symptoms of celiac disease will vary significantly from person to person and include, but are not limited to, diarrhea, abdominal pain, skin rash, and weight loss. According to a study published in the Archives of Internal Medicine in 2003, the largest multi-center study on the prevalence of celiac disease in the United States found that one in 133 people live with celiac disease and the disease is greatly undiagnosed. The average time between the onset of symptoms and the time celiac disease is confirmed is estimated to be 11 years, according to a study published in the American Journal of Gastroenterology in 2001. The number of diagnosed patients is expected to increase significantly over the next several years, driven by broad-based educational campaigns, National Institutes of Health research funding and widely-available genetic and blood tests for highly-specific antibodies.

Pharmaceutical Products

We market and promote Entocort EC, a glucocorticosteroid, which is currently the only FDA-approved drug indicated for the induction and maintenance of clinical remission in mild to moderate active Crohn’s disease involving the ileum and/or the ascending colon. In January 2005, our sales force began promoting Entocort EC in the United States under an exclusive, six-year distribution agreement with AstraZeneca LP, or AstraZeneca. Entocort EC is designed to release primarily in the ileum and/or the ascending colon, so that as little as 10% of the drug enters systemic circulation. Entocort EC can benefit patients by reducing the frequency of glucocorticosteroid-related side effects, such as acne and puffiness of the face, as compared to those patients taking prednisolone. Entocort EC prescriptions have increased approximately 88% in 2008 over 2004, the year before we began selling the product. In 2008, net sales from Entocort EC were $145.0 million, an increase of approximately 70.4% from 2006 net sales of $85.1 million and 30.9% from 2007 net sales of $110.8 million. For the nine-month period ended September 30, 2009, net sales from Entocort EC were $154.3 million, an increase of approximately 45.7% from net sales of $105.9 million for the nine-month period ended September 30, 2008.

In January 2008, we acquired exclusive rights to Lotronex in the United States from GlaxoSmithKline. Lotronex is the only prescription drug approved by the FDA for use in female patients with severe diarrhea-predominant irritable bowel syndrome who meet the conditions stated in the label. Net sales of Lotronex for 2008 were $25.2 million. Net sales of Lotronex for the nine-month period ended September 30, 2009 were $22.3 million, an increase of approximately 22.8% from net sales of $18.2 million for the nine-month period ended September 30, 2008.

We also sell but do not promote a number of other branded drugs, including Imuran® for use as an adjunct for the prevention of rejection in kidney transplantation and the management of active rheumatoid arthritis, Helidac® Therapy for use together with an H2 antagonist for the eradication of Helicobacter pylori bacteria, the leading cause of peptic ulcers, and Ridaura® for the management of rheumatoid arthritis for patients who have not responded adequately to one or more non-steroidal anti-inflammatory drugs. Through a third-party distributor, we also sell a generic formulation of mercaptopurine, which is approved as a maintenance therapy for acute lymphatic leukemia as part of a combination regimen. Although not approved or promoted for gastrointestinal diseases, Imuran and mercaptopurine are often prescribed by physicians for such use. Our aggregate net sales from our non-promoted pharmaceutical products were $25.8 million in 2008, a decrease from net sales of $34.0 million and $30.3 million in 2006 and 2007, respectively. Our aggregate net sales from our non-promoted pharmaceutical products were $16.6 million for the nine-month period ended September 30, 2009, a decrease of approximately 17.3% from net sales of $20.0 million for the nine-month period ended September 30, 2008.

In November 2007, we entered into an exclusive license agreement with a subsidiary of Alizyme plc to develop and commercialize Colal-Pred in North America. Colal-Pred is based on a drug delivery technology designed to release an anti-inflammatory steroid in the colon to provide the efficacy of steroids while limiting their undesirable systemic side effects. We began a Phase 2 clinical trial with Colal-Pred for the treatment of patients

 

 

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with ulcerative colitis in May 2008. In July 2008, Alizyme released the results of the European Phase 3 clinical trial of Colal-Pred in patients with moderate to severe ulcerative colitis. A total of 799 patients were randomized to either one of three doses of Colal-Pred or a standard regimen of prednisolone. The results showed that the trial failed to meet one of the two co-primary endpoints. Colal-Pred demonstrated superior safety to prednisolone. However, non-inferiority to prednisolone in efficacy response was not shown (i.e., prednisolone demonstrated a better response rate than Colal-Pred). On July 21, 2009 we filed a complaint against Alizyme in the U.S. District Court for the Southern District of California alleging breach by Alizyme of its exclusive license agreement with us, as a result of its failure to conduct certain pre-clinical studies which are necessary in order to obtain regulatory approval for the sale of Colal-Pred in the U.S. and its alleged improper assignment of certain rights under this agreement. On July 24, 2009 Alizyme, and its parent company, Alizyme plc, entered administration in England, in each case on the grounds that it was or was likely to become unable to pay its debts. The administration of Alizyme means that Alizyme, acting through the agency of its administrators, might refuse or decline to perform its outstanding and continuing obligations under the license agreement. While in administration, our contract with Alizyme may not be modified or terminated without our consent. Furthermore, the administration may transition to a liquidation, in which case the liquidator may seek to disclaim the license agreement and Alizyme’s obligations under it, on the grounds that it is an unprofitable contract.

Diagnostic Testing Services

Our diagnostic testing services include specific immunoassays to detect and differentiate diseases, pharmacogenetic testing and drug metabolite monitoring. Our tests can help physicians to detect and differentiate IBD from other bowel disorders and to differentiate Crohn’s disease from ulcerative colitis. In addition, we offer tests that assist physicians in using and monitoring thiopurine drugs and the detection, diagnosis or treatment of celiac disease, lactose intolerance and other related disorders. We currently perform all our gastroenterology diagnostic testing services in our laboratory located in San Diego, California, which is certified for highly-complex testing under the Clinical Laboratory Improvement Amendments of 1988. All of our commercial oncology diagnostic testing services are currently performed by Rosetta Genomics in its Philadelphia, Pennsylvania laboratory.

We believe our PROMETHEUS® IBD Serology 7 is the most comprehensive IBD diagnostic testing service available to help physicians detect and differentiate IBD from other disorders that have similar symptoms such as IBS, celiac disease and lactose intolerance. In addition, this product helps physicians differentiate Crohn’s disease from ulcerative colitis with an overall predictive accuracy of 76% based on validation studies. IBD Serology 7 includes seven tests, three of which are proprietary, and a proprietary algorithm. While there are other laboratories offering IBD tests, we do not believe they are as comprehensive as our IBD Serology 7 product. We provide a diagnostic prediction on every test and prognostic information that may help guide treatment decisions.

Our tests for thiopurine management provide information that helps physicians better manage therapeutic treatment, achieve better clinical outcomes and lower the potential for toxicity when prescribing thiopurine drugs. As with many drugs, the effectiveness and side effects associated with thiopurines vary from person to person due to each person’s ability to metabolize or process thiopurines. Most people have no problem metabolizing thiopurines; however, a very small percentage of patients, approximately 0.3%, have almost no ability to metabolize these drugs. Failure to metabolize thiopurines can result in liver toxicity and potentially death.

We offer three celiac tests to physicians, including antibody tests, a celiac genetics test and a panel that combines both the antibody and genetic tests. We believe our Celiac Serology, a panel of celiac antibody tests, is one of the few five-analyte serology panels currently being offered. It is designed to help physicians make a more accurate diagnosis. Celiac Genetics, our genetics test, has almost a 100% accuracy to aid in lifelong celiac disease rule-out. Both the serology and genetics tests are also offered together in our Celiac PLUS test panel. In June 2009, we began offering MyCeliacID, a saliva-based, do it yourself genetic test based on the same science as our Celiac Genetics test. MyCeliacID is available online.

 

 

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In 2008, we launched PROMETHEUS® IBS Diagnostic, the first blood-based biomarker test to help physicians diagnose IBS. This test incorporates ten biomarkers, two of which are proprietary, and a proprietary algorithm to help physicians clarify or validate other clinical findings. We believe our IBS diagnostic test will help differentiate between IBS and other conditions with similar symptoms.

In October 2009, we began selling three microRNA-based oncology diagnostic tests which we in-licensed from Rosetta Genomics. ProOnc TumorSourceDx identifies the tissue-of-origin of a metastatic tumor. The test identifies 25 different tumor types, including colon, liver, brain, breast, kidney, lung, ovary, pancreas, prostate and testis. ProOnc SquamousDx classifies non-small cell lung carcinoma tumors into two histological groups: cancers of squamous histology and non-squamous cancers. ProOnc MesotheliomaDx uses microRNA to differentiate malignant pleural mesothelioma from peripheral adenocarcinoma of the lung and metastatic carcinomas involving the lung and pleura. In collaboration with Rosetta Genomics, we also plan to begin development of two new microRNA-based gastroenterology diagnostic tests in the future.

We develop new diagnostic testing services, enhance our existing diagnostics and scale up, validate and commercialize technologies through our internal research and development capabilities. As illustrated above, we also acquire or license intellectual property covering our diagnostic testing products from third parties, which we generally further develop and validate for commercialization. In addition to our collaborative development of microRNA-based gastroenterology diagnostic tests with Rosetta Genomics, we are in the early stages of development for additional diagnostic tests that may be used in conjunction with certain cancer therapies; however, there can be no assurance that we will be successful in developing or commercializing any of these products.

Our Competitive Strengths

We believe that we bring the following competitive advantages or strengths to the markets and customers we serve:

 

   

Differentiated, Physician-Focused Business Model - Our business model of offering pharmaceuticals combined with complementary diagnostic testing services differentiates us from most other pharmaceutical, specialty pharmaceutical and diagnostic companies. We believe it creates value for the physician and a different dynamic as compared to a traditional pharmaceutical sales call.

 

   

A Leader in Commercializing Diagnostic Technologies - We believe we are a technological leader in helping to develop and commercialize diagnostic testing services for gastrointestinal diseases. We have developed and commercialized a number of new diagnostics designed to help gastroenterologists and believe we are well positioned to maintain a leading position in developing or acquiring access to new technologies related to gastroenterology.

 

   

Highly-Trained and Effective Sales Force - Unlike many pharmaceutical sales forces that are trained only to understand the mechanism of action, side effects and comparative benefits of their pharmaceuticals, our sales representatives are also trained to understand how our diagnostics relate to diseases. We believe this creates a more collaborative and science-based interaction with physicians resulting in longer sales calls with, and greater access to, physicians.

 

   

Applying the Principles of Personalized Medicine - Personalized medicine recognizes that individual patients respond differently to medications and that the same disease can vary significantly from patient to patient. While being discussed widely in medicine, there have only been limited applications of personalized medicine in the United States to date. By integrating our non-invasive diagnostics with our pharmaceuticals to facilitate a rapid and accurate diagnosis and an efficacious treatment, we believe we can help physicians resolve clinical complexity and begin to fulfill the promise of “personalized medicine.”

 

   

Management Team with Proven Track Record - Our senior management has an average of over 20 years experience in the healthcare industry. Under our current management, we have built a strong financial foundation. We believe our strong financial condition, coupled with the experience and proven track

 

 

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record of our senior management team, positions us well to capitalize on additional opportunities. In addition, our team has executed our product acquisition and in-licensing strategy by acquiring rights to Entocort EC, Lotronex, Colal-Pred and certain oncology diagnostics within the last five years.

Our Strategy for Growth

Our strategy for growth is focused on leveraging our differentiated business model to acquire, develop and commercialize proprietary pharmaceutical products and complementary highly complex diagnostic testing services in the United States. We intend to leverage our sales force and the relationships our sales force has created with physicians to market and sell these additional products and services. In addition to capitalizing on our current strengths, we intend to pursue growth by:

 

   

expanding our access to marketed proprietary pharmaceutical products or products in later-stage development through acquisitions, licensing or distribution agreements, co-promotion or co-marketing agreements or strategic mergers or acquisitions;

 

   

adding diagnostic testing services and new technologies through collaborations, internal development programs, in-licensing or acquisitions that complement our products and sales strategy;

 

   

increasing the market penetration of our existing products and services through product enhancements, targeted promotion and by educating physicians and payors as to the clinical and cost benefits of our products and services; and

 

   

carefully expanding into additional therapeutic areas that are consistent with our business model.

While our focus has been on gastroenterology products and diagnostic services in the United States, we are looking to carefully expand into other therapeutic areas such as oncology and have recently acquired the United States rights to three oncology diagnostics. In June 2009, we began offering MyCeliacID in the United States, Mexico and Canada. We may also consider expanding outside the United States in the future for our other products.

Risk Factors

Our business and our ability to execute on our business strategy are subject to a number of risks that you should be aware of before you decide to buy our common stock. In particular, you should consider the following risks, which are discussed more fully in “Risk Factors” beginning on page 12:

 

   

Our revenues and financial results depend significantly on a limited product line, including our leading pharmaceutical product, Entocort EC, and our three leading diagnostic product groups, IBD Serology 7 and our thiopurine management and celiac tests, and factors adversely affecting the pricing of, or demand for, these products would have a material adverse effect on our business.

 

   

Our exclusive right to promote Entocort EC in the United States expires at the end of 2010, and we cannot assure you that our rights to promote Entocort EC will be extended beyond the end of 2010 or that the distribution agreement pursuant to which we have the exclusive right to promote Entocort EC will not terminate earlier due to a change in control or otherwise.

 

   

In the first half of 2008, Barr Laboratories, Inc. and Barr Pharmaceuticals, Inc., or Barr, which was acquired by Teva Pharmaceutical Industries Ltd. in December 2008, and Mylan Pharmaceuticals Inc., or Mylan, each submitted an Abbreviated New Drug Application, or ANDA, to the FDA containing a Paragraph IV patent certification for Entocort EC. These ANDA filings indicate that Barr and Mylan intend to market a “generic equivalent” of Entocort EC prior to the expiration of one or both of the patents covering the product. If a generic version of Entocort EC is launched while we have the right to distribute and market Entocort EC, it could adversely affect our ability to successfully execute our business strategy to maximize the value of Entocort EC and would likely negatively impact our financial condition and results of operations.

 

 

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We may be unable to successfully commercialize Lotronex as planned and we may be unable to secure an adequate long-term supply of Lotronex to meet market demand.

 

   

We cannot be certain that our planned clinical development program for Colal-Pred will be sufficient to obtain regulatory approval, that we will obtain regulatory approval within a specific time-frame or that we will be able to successfully commercialize the product candidate.

 

   

We cannot be certain that Alizyme will not enter into liquidation or that, if it does so, its liquidator will not seek to have our license agreement with Alizyme modified or terminated;

 

   

We may be unable to successfully commercialize our three recently acquired oncology diagnostics as planned.

 

   

The inability to expand our business through strategic product, technology or company acquisitions or licenses, or the inability to integrate new products or technologies, may cause our competitive position in the specialty pharmaceutical and diagnostic industries to suffer.

 

   

Our future growth depends, in part, on our ability to develop proprietary diagnostic products and our ability to commercialize any of the products we develop, and these development or commercialization efforts may fail.

 

   

Continuing and increased regulation by the Department of Health and Human Services, including the FDA and the Centers for Medicare and Medicaid Services, or other government regulatory bodies regulating drugs and laboratory-developed tests, analyte-specific reagents or genetic testing could lead to increased costs and delays in introducing new products and may subject our currently available products to increased regulatory scrutiny, which may result in increased costs or withdrawal from the market.

 

   

If we lose or are unable to secure collaborators or partners, or if our collaborators or partners do not apply adequate resources to their relationships with us, our product development and potential for profitability will suffer.

Corporate Information

We were incorporated in California in December 1995. Our principal executive offices are located at 9410 Carroll Park Drive, San Diego, California 92121, and our telephone number is (858) 824-0895. Our website address is http://www.prometheuslabs.com. The information on, or accessible through, our website is not part of this prospectus.

Trademarks and Trade Names

We own or have rights to use certain trademarks or trade names in conjunction with the operation of our business including, without limitation, ENTOCORT®, LOTRONEX®, the Lotronex design mark, the Prescribing Program for Lotronex™, COLAL-PRED®, COLALPRED®, COLAL®, Helidac®, Imuran®, PROMETHEUS®, Ridaura®, Trandate®, Zyloprim®, LactoTYPE®, FIBROSpect®, BreathTek™, MyCeliacIDTM, ProOnc TumorSourceDX, ProOnc SquamousDX, ProOnc MesotheliomaDX, ProOnc, TumorSource, “for the person in every patient®,” “practice to practice® ,” “get help going where you want to go with Lotronex™,” “help your patients get where they want to go with Lotronex™,” “From information to insightSM,” the MyCeliacID design mark and our interlink logo design.

 

 

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THE OFFERING

Common stock offered by us

            shares (or            shares, if the underwriters exercise their option to purchase additional shares in full)

 

[Common stock offered by the selling shareholders

            shares]

 

Total offering

            shares (or            shares, if the underwriters exercise their option to purchase additional shares in full)

 

Common stock to be outstanding after the offering

            shares

 

Proposed Nasdaq Global Select Market symbol

RXDX

 

Use of proceeds

As described in “Use of Proceeds,” we intend to use the net proceeds of this offering for working capital purposes and for other general corporate purposes, including to finance in-licensing and acquisition opportunities, research and development for new products, sales and marketing activities and capital expenditures. [We will not receive any proceeds from the sale of shares by the selling shareholders.]

 

Dividend Policy

Following the consummation of the offering, we do not expect to pay any dividends on our common stock for the foreseeable future.

 

Risk Factors

You should carefully read and consider the information set forth under the heading “Risk Factors” and all other information set forth in this prospectus before deciding to invest in our common stock.

The number of shares of common stock shown to be outstanding after the offering is based on the number of shares of common stock outstanding as of September 30, 2009. This number does not include:

 

   

8,971,778 shares of common stock reserved for future issuance upon the exercise of stock options outstanding under our 1997 and 2000 Equity Incentive Award Plans, at a weighted average exercise price of $4.36 per share;

 

   

2,400,000 shares of common stock initially reserved for future issuance under our 2009 Equity Incentive Award Plan;

 

   

600,000 shares of common stock initially reserved for future issuance under our 2009 Employee Stock Purchase Plan; and

 

   

439,371 shares of common stock reserved for future issuance upon the exercise of outstanding warrants at a weighted average exercise price of $1.75 per share.

Except as otherwise indicated, all information in this prospectus assumes:

 

   

that our shares of common stock will be sold at $             per share, which is the midpoint of the range set forth on the cover of this prospectus;

 

   

no exercise by the underwriters of their option to purchase up to             additional shares from us;

 

   

the filing of our amended and restated articles of incorporation and adoption of our amended and restated bylaws upon completion of this offering;

 

 

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the conversion of all outstanding shares of our preferred stock into 35,415,856 shares of common stock upon the completion of this offering;

 

   

no outstanding options have been exercised since September 30, 2009; and

 

   

no outstanding warrants have been exercised or repurchased since September 30, 2009.

 

 

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SUMMARY FINANCIAL DATA

The following table provides a summary of our consolidated financial data for the periods indicated. The summary historical consolidated financial data for each of the fiscal years ended December 31, 2006, 2007 and 2008 have been derived from our audited consolidated financial statements, which are included elsewhere in this prospectus. The summary historical consolidated financial data as of and for the nine-month periods ended September 30, 2008 and 2009 are derived from our unaudited consolidated financial statements, which are included elsewhere in this prospectus. In our opinion, the unaudited consolidated financial statements have been prepared on the same basis as our audited consolidated financial statements and include all adjustments, consisting of only normal recurring adjustments, necessary for a fair statement of our financial position and operating results for the unaudited periods. The summary consolidated financial and operating data as of and for the nine months ended September 30, 2009 are not necessarily indicative of the results that may be obtained for the full year. You should read this information together with our consolidated financial statements and related notes, “Selected Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus.

 

     Years Ended December 31,     Nine Months Ended September 30,  
     2006     2007     2008          2008               2009       
   

(In thousands, except per share data)

 

Consolidated Statement of Income:

         

Net sales:

         

Pharmaceutical products(1)(2)

  $ 119,150      $ 143,655      $ 195,985      $ 144,060      $ 193,132   

Diagnostic testing services(3)

    68,261        77,285        82,073        60,752        64,668   
                                       

Total net sales

    187,411        220,940        278,058        204,812        257,800   
                                       

Operating expenses:

         

Cost of sales (excludes amortization of acquired product rights)

    66,688        87,306        113,601        82,123        116,812   

Selling, general and administrative

    57,075        60,985        81,626        56,090        63,820   

Research and development

    4,622        13,024        14,628        10,260        15,460   

Amortization of acquired product rights

    3,255        3,255        12,057        8,996        9,984   
                                       

Total operating expenses

    131,640        164,570        221,912        157,469        206,076   
                                       

Income from operations

    55,771        56,370        56,146        47,343        51,724   

Interest income

    2,514        4,316        1,655        1,325        364   

Interest income (expense)—warrants(4)

    (2,015     (31,085     5,602        5,602          

Interest expense—other

    (1,993     (3,120     (3,691     (2,757     (1,815

Other income, net

    236        130        553        545        64   
                                       

Income before income taxes

  $ 54,513      $ 26,611      $ 60,265      $
52,058
  
  $ 50,337   
                                       

Net income

  $ 32,239      $ 4,318      $ 37,225      $ 33,619      $ 28,335   
                                       

Net income per common share(5):

         

Basic

  $ 0.60      $      $ 0.69      $ 0.64      $ 0.55   

Diluted

  $ 0.54      $      $ 0.44      $ 0.41      $ 0.39   

Shares used to compute net income per common share(5):

         

Basic

    9,692        10,004        9,542        9,843        9,023   

Diluted

    10,676        10,004        14,966        15,415        12,634   

Pro forma net income per common share(5):

         

Basic

      $ 0.78      $ 0.70      $ 0.64   

Diluted

      $ 0.70      $ 0.62      $ 0.59   

Shares used to compute pro forma net income per common share(5):

         

Basic

        44,958        45,259        44,439   

Diluted

        50,382        50,831        48,050   

Other Data:

         

Depreciation and amortization

  $ 5,469      $ 5,643      $ 14,209      $ 10,607      $ 11,806   

Capital expenditures

  $ 1,446      $ 1,043      $ 1,432      $ 968      $ 5,079   

 

 

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The following table presents a summary of our balance sheet as of September 30, 2009 on an actual basis and on a pro forma as adjusted basis assuming:

 

   

the conversion of all outstanding shares of our preferred stock into 35,415,856 shares of common stock; and

 

   

the issuance and sale by us of              shares of common stock in this offering and our receipt of the estimated net proceeds from this offering, based on an assumed initial public offering price of $             per share, the midpoint of the range set forth on the cover of this prospectus, after deducting the estimated underwriting discounts and commissions and estimated offering costs payable by us.

The pro forma as adjusted information below, which also gives effect to the filing of our amended and restated articles of incorporation, is illustrative only and our capitalization following the completion of this offering will be adjusted based on the actual initial public offering price and other terms of this offering determined at pricing. You should read this table together with the sections entitled “Capitalization,” “Selected Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes appearing elsewhere in this prospectus.

 

     September 30, 2009
     Actual    Pro
Forma as
Adjusted
     (In thousands)

Balance Sheet Data:

     

Cash and cash equivalents and marketable securities

   $ 108,256    $                 

Working capital(6)

     112,657   

Total assets

     338,261   

Total long-term debt, less current portion

     58,125   

Total shareholders’ equity

     200,847   

 

(1)

We entered into an exclusive agreement with AstraZeneca for the marketing, sale and distribution of ENTOCORT® EC (budesonide) Capsules in the United States beginning January 1, 2005. Entocort EC sales are included in our results of operations since that date. In November 2007, we began selling LOTRONEX® (alosetron hydrochloride) Tablets in the United States under a distribution agreement with GlaxoSmithKline. In January 2008, we acquired Lotronex from GlaxoSmithKline and paid $80.0 million and issued 1,250,000 shares of our common stock to GlaxoSmithKline. We also launched a generic mercaptopurine product through a third-party distributor in February 2004. See Notes 1 and 2 to our consolidated financial statements included elsewhere in this prospectus.

 

(2) The nine months ended September 30, 2009 reflects a $3.1 million allowance for managed care rebates related to the Department of Defense Tricare Retail Pharmacy program pursuant to a final rule that became effective on May 26, 2009 ($1.8 million relates to sales made during 2008 and $1.3 million relates to sales in the nine-month period ending September 30, 2009). See Note 16A to the consolidated financial statements included elsewhere in this prospectus.

 

(3) The year ended December 31, 2006 includes a $3.6 million increase in net sales of diagnostic testing services as a result of a change in estimate. See Note 1 to the consolidated financial statements included elsewhere in this prospectus.

 

(4) Reflects the accretion or reversal of accretion of the redeemable warrants to their estimated fair value. See Note 9 to our consolidated financial statements included elsewhere in this prospectus.

 

(5) See Note 1 to our consolidated financial statements included elsewhere in this prospectus for an explanation of the net income and shares used in computing net income per share.

 

(6) Working capital is calculated by subtracting total current liabilities from total current assets.

 

 

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RISK FACTORS

Investing in our common stock involves a high degree of risk. You should carefully consider the following risk factors, as well as the other information in this prospectus, before deciding whether to invest in shares of our common stock. The occurrence of any of the following risks could harm our business, financial condition, results of operations or growth prospects. In that case, the trading price of our common stock could decline, and you may lose all or part of your investment.

Risks Related to Our Business and Industry

Our revenues and financial results depend significantly on a highly concentrated product line and a single market.

ENTOCORT® EC (budesonide) Capsules, our leading pharmaceutical product, accounted for approximately 52% and 60% of our net sales in the year ended December 31, 2008 and in the nine months ended September 30, 2009, respectively. In addition, 28% and 23% of our net sales in the year ended December 31, 2008 and in the nine months ended September 30, 2009, respectively, were derived from our three leading diagnostic product groups, PROMETHEUS® IBD Serology 7 for the diagnosis and stratification of inflammatory bowel disease, or IBD, and our thiopurine management and celiac disease testing products. Although we have other products and intend to introduce additional products in the future, we expect sales of these key products to continue to account for a substantial portion of our near-term revenue. Because our business is highly dependent on these products and on the gastrointestinal disease and disorder market, factors adversely affecting the pricing of, or demand for, these products would have a material and adverse effect on our business and could cause the value of our stock to decline substantially. In addition, market acceptance of our products is dependent upon acceptance of our products by gastroenterologists, who comprise a relatively small number of physicians within the medical field. Further, we cannot ensure the continued availability of Entocort EC in commercial quantities at acceptable costs, nor can we assure the availability of our leading diagnostic tests at acceptable costs.

Our exclusive right to promote Entocort EC expires at the end of 2010.

Pursuant to our distribution agreement with AstraZeneca LP, or AstraZeneca, we have the exclusive right to promote, distribute, market and sell Entocort EC, our leading pharmaceutical product, in the United States. Our right to promote Entocort EC under the distribution agreement terminates on December 31, 2010. In addition, upon the occurrence of a change in control of our company or in the event of a material uncured breach of the distribution agreement by us, AstraZeneca has the option to terminate the distribution agreement. Under the distribution agreement, a change in control will be deemed to have occurred if: (1) any person or entity (including persons acting as a partnership, limited partnership, syndicate, or other group for the purpose of acquiring, holding, or disposing of securities of an issuer, such as a syndicate or group), other than one who owned stock as of the effective date of the distribution agreement, becomes the beneficial owner of 50% or more of our outstanding capital stock; (2) we liquidate, dissolve or wind-up our business, or merge, consolidate, reorganize or enter into a similar transaction where our outstanding voting securities prior to the transaction represent after the transaction is less than 50% of our voting power or the voting power of the entity that survives the transaction; or (3) after our initial public offering, any person or entity, other than one who owned stock as of the effective date of the distribution agreement, acquires 19.9% or more of the voting power of our outstanding capital stock. Termination of our right to promote Entocort EC will adversely affect our operating results and would cause our business to suffer.

The development of new drugs is a high risk undertaking which involves a lengthy process, and we cannot assure you that our drug discovery and development activities will result in the successful commercialization of COLAL-PRED® (prednisolone metasulfobenzoate sodium) on the time schedule we have planned, or at all.

Colal-Pred is currently in the development stage of clinical trials and is prone to the risks of failure inherent in drug development. Through a third-party clinical research organization, or CRO, we initiated the clinical development of Colal-Pred in the United States in May 2008 with a Phase 2 clinical trial for the treatment of

 

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patients with ulcerative colitis. We will need to conduct additional third-party clinical trials, and may also need to conduct additional third-party preclinical studies, including carcinogenicity studies, before we can demonstrate that Colal-Pred is safe and effective to the satisfaction of the FDA and other regulatory authorities. Preclinical studies and clinical trials are expensive and uncertain processes that take years to complete. Failure can occur at any stage of the process, and we cannot assure you that Colal-Pred will receive FDA approval, or even if it does, that it will result in a commercially successful product.

In July 2008, Alizyme released the results of the European Phase 3 clinical trial of Colal-Pred in patients with moderate to severe ulcerative colitis. A total of 799 patients were randomized to either one of three doses of Colal-Pred or a standard regimen of prednisolone. The results showed that the trial failed to meet one of the two co-primary endpoints. Colal-Pred demonstrated superior safety to prednisolone. However, non-inferiority to prednisolone in efficacy response was not shown (i.e., prednisolone demonstrated a better response rate than Colal-Pred).

We cannot assure you that our clinical trials for Colal-Pred will be completed on schedule, or at all.

The completion of our clinical trials could be substantially delayed or prevented by a number of factors, including:

 

   

slower than expected rates of patient recruitment and enrollment;

 

   

failure of patients to complete the clinical trials;

 

   

failure of our third-party vendors to timely or adequately perform their contractual obligations relating to the clinical trials;

 

   

unforeseen safety issues;

 

   

failure to demonstrate efficacy during clinical trials or failure to achieve specified endpoints;

 

   

lack of adequate funding to continue the clinical trials;

 

   

termination of the clinical trials by one or more clinical trial sites;

 

   

inability or unwillingness of patients or medical investigators to follow our clinical trial protocols;

 

   

failure to conduct clinical trials in accordance with regulatory requirements or clinical protocols;

 

   

conditions imposed on us by the FDA regarding the scope or design of our clinical trials or the need to conduct additional trials;

 

   

unforeseen delays by the FDA after submission of our results;

 

   

an unfavorable FDA inspection of our contract manufacturers of API or drug product; and

 

   

inspection of the clinical trial operations or trial sites by the FDA or other regulatory authorities resulting in the imposition of a clinical hold.

Even if we obtain FDA or other regulatory approvals, Colal-Pred may not achieve market acceptance among physicians, patients and third-party payors and, ultimately, may not be commercially successful. Any failure or significant delay in completing clinical trials for Colal-Pred and achieving market acceptance would harm the commercial prospects for Colal-Pred and adversely affect our financial results. See “—The regulatory approval process is expensive, time-consuming and uncertain and may prevent us from obtaining approvals for the commercialization of Colal-Pred.”

Additionally, changes in regulatory requirements and guidance may occur and we may need to amend clinical trial protocols to reflect these changes. Amendments may require us to resubmit our clinical trial protocols to IRBs for reexamination, which may impact the costs, timing or successful completion of a clinical trial. If we experience delays in completion of, or if we terminate, any of our planned clinical trials for Colal-Pred, the commercial prospects for Colal-Pred may be harmed and our ability to generate product revenues will

 

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be delayed. In addition, many of the factors that cause, or lead to, a delay in the commencement or completion of clinical trials may also ultimately lead to the denial of regulatory approval of Colal-Pred.

Furthermore, on July 21, 2009 we filed a complaint against Alizyme in the U.S. District Court for the Southern District of California alleging breach by Alizyme of its exclusive license agreement with us, as a result of its failure to conduct certain pre-clinical studies which are necessary in order to obtain regulatory approval for the sale of Colal-Pred in the U.S. and its alleged improper assignment of certain rights under this agreement. On July 24, 2009 Alizyme, and its parent company, Alizyme plc, entered administration in England, in each case on the grounds that it was or was likely to become unable to pay its debts. The administration of Alizyme means that Alizyme, acting through the agency of its administrators, might refuse or decline to perform its outstanding and continuing obligations under the license agreement and our inability to obtain remedies for such breaches could delay or prevent us from commercializing Colal-Pred. While in administration, our contract with Alizyme may not be modified or terminated without our consent. Furthermore, the administration may transition to a liquidation, in which case the liquidator may seek to disclaim the license agreement and Alizyme’s obligations under it, on the grounds that it is an unprofitable contract. In the event that Alizyme enters liquidation and its liquidator seeks to and is successful in having our agreement with Alizyme disclaimed, we may be unable to successfully commercialize Colal-Pred. If we are delayed or unable to successfully commercialize Colal-Pred, this could adversely affect our business, financial condition and results of operations.

If we cannot implement our strategy to expand our business through strategic product, technology or company acquisitions or licenses, our competitive position and our business may suffer.

We have historically increased our sales and net income through strategic acquisitions or licenses of pharmaceutical and diagnostic products and the development of proprietary diagnostic products. Our strategy is, in part, focused on increasing sales and enhancing our competitive standing through the acquisition of products, technologies or companies or in-licensing additional products or technologies in order to complement our business and enable us to promote and sell new products and services. Since we engage in limited proprietary research activity with respect to product development, we rely heavily on purchasing or in-licensing products from other companies.

Other companies, many of which have substantially greater financial, marketing and sales resources than we do, compete with us for the acquisition of products, technologies and companies and the in-license of products and technologies. We may not be able to in-license or acquire rights to additional pharmaceutical products, diagnostic technologies or companies on acceptable terms, or at all, or may not be able to obtain future financing for acquisitions or licenses on acceptable terms, or at all. For example, as a result of recent volatility in the capital markets, the cost and availability of credit has been and may continue to be adversely affected by illiquid credit markets and wider credit spreads. Concern about the stability of the markets generally and the strength of counterparties specifically has led many lenders and institutional investors to reduce, and in some cases, cease to provide funding to borrowers. Continued turbulence in the U.S. and international markets and economies may adversely affect our ability to obtain additional financing on terms acceptable to us, or at all. If these market conditions continue, they may limit our ability to obtain financing for acquisitions or licenses. The inability to effect in-licenses or acquisitions of additional products, technologies or companies could limit the overall growth of our business and adversely affect our business, financial condition and results of operations.

Furthermore, even if we obtain additional rights to pharmaceutical products or diagnostic technologies, or if we acquire a company, we may not be able to generate sales sufficient to create a profit or otherwise avoid a loss. For example, our marketing strategy, distribution channels and levels of competition with respect to acquired products or technologies may be different than those of our current pharmaceutical products or diagnostic technologies, limiting our ability to compete favorably in those product categories.

Our future growth depends, in part, on our ability to develop proprietary diagnostic products and we may be unable to commercialize any of the products we develop internally.

Our future growth will depend, in part, on our ability to develop, obtain regulatory approval for and commercialize proprietary diagnostic products that we develop internally and through collaborations. For

 

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example, we are developing diagnostic tests that may be used in conjunction with certain cancer therapies. We are also collaborating on the development of new gastroenterology tests based on microRNAs. MicroRNAs are recently discovered, naturally occurring, small RNAs that act as master regulators and have the potential to form the basis for a new class of diagnostics and therapeutics. The development process involves a high degree of risk and may take several years. In addition, the scientific evidence to support the feasibility of developing diagnostic tests based on microRNAs is both preliminary and limited and key participants in the diagnostic marketplaces, such as physicians, patients and third-party payors, may not accept a microRNA-based approach. We cannot be sure that we will be successful, especially as we enter into markets beyond gastroenterology. Internally-developed products or technologies may not result in commercial products and we may abandon development of a product candidate at any time. We may have to make significant investments in development, marketing and selling any diagnostic product candidate. Our diagnostic product development or commercialization efforts may fail for many reasons which would affect our results of operations and financial condition.

Risks associated with integrating acquisitions or internally developing products could disrupt our business.

As part of our business strategy, we will consider and, as appropriate, make acquisitions of technologies, products and businesses and, in addition, may internally develop proprietary diagnostic products. As discussed above under the heading “—We may be unable to secure an adequate supply of LOTRONEX® (alosetron hydrochloride) Tablets to meet market demand,” in January 2008, we acquired exclusive rights to Lotronex in the United States from GlaxoSmithKline and we have also recently acquired the rights to sell three oncology diagnostics in the United States. Acquisitions, and to a lesser extent, internally-developed products or technologies, typically entail many risks, and acquisitions could result in difficulties integrating the operations, personnel, technologies and products of the companies acquired, some of which may result in significant charges to earnings. Our ability to manage our acquisitions and internally-developed products or technologies will require us to continue to implement and improve our operational, financial and management information systems and to motivate and effectively manage an increasing number of employees. In connection with acquisitions, we could experience disruption in our business or employee base, or key employees of companies that we acquire may seek employment elsewhere, including with our competitors. Furthermore, the products of companies we acquire or products we develop internally may overlap with our existing products or those of our customers, creating conflicts with existing relationships or with other commitments that are detrimental to the integrated businesses. If we are unable to successfully integrate our acquisitions and internally-developed products or technologies with our existing business, we may not obtain the advantages that the acquisitions or developments were intended to create, which may materially adversely affect our business, results of operations, financial condition and cash flows, our ability to develop and introduce additional new products and the market price of our stock. We have never acquired a company before and therefore have no experience in integrating a company into our business.

If we are unable to achieve the desired revenues from one or more of our acquisitions, we may consider the disposition of one or more product lines. We may not be able to consummate any divestiture at a fair market price. We may also be unable to reinvest the proceeds from any disposition to produce the same level of operating profit as the divested product lines or to generate a commensurate rate of return on the amount of our investment.

Lotronex was temporarily withdrawn from the market and has been the subject of substantial litigation. If additional litigation occurs with respect to Lotronex or if the FDA takes negative regulatory action against Lotronex, our reputation, financial position and results of operations may suffer.

Lotronex has been linked to reports of ischemic colitis and severe constipation. Ischemic colitis is a condition in which reduced blood flow to the intestines usually causes reversible injury to the colon and can lead to hospitalization, and in rare cases, blood transfusions, surgery and death. GlaxoSmithKline voluntarily withdrew Lotronex from the market in 2000 after failing to reach agreement with the FDA on how to best manage risks associated with the product. The FDA approved a supplemental New Drug Application, or NDA, for Lotronex in 2002 with a more limited indication, and Lotronex is now approved to treat only women with severe cases of irritable bowel syndrome, or IBS, involving diarrhea and whose symptoms have not been

 

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improved satisfactorily by other treatments. This approval is subject to limited distribution and the potential for expedited withdrawal by the FDA under Subpart H of the FDA’s NDA regulations. In addition, Lotronex has been the subject of a number of lawsuits against GlaxoSmithKline, principally based on an alleged failure to adequately warn patients of potentially harmful side effects. GlaxoSmithKline has advised us that all of these lawsuits have been resolved with the exception of three which are in the process of being dismissed. Although Lotronex was re-approved in 2002, it still carries the risk of harmful side effects. Although we are only liable for claims relating to Lotronex arising after our acquisition of the product, patients treated with Lotronex who suffer from side effects may resort to litigation against us, which may be costly and time-consuming and may result in damage to our reputation, financial position and results of operations.

We may be unable to secure an adequate supply of LOTRONEX® (alosetron hydrochloride) Tablets to meet market demand.

In January 2008, we acquired exclusive rights to Lotronex in the United States from GlaxoSmithKline. GlaxoSmithKline has agreed to supply us with Lotronex for a period of two years after the completion of the acquisition, subject to our right to renew the term for additional one-year periods upon advance notice given six months prior to the end of the then-current term, although the supply price will increase should we seek to renew the supply agreement for more than one additional one-year period. Notwithstanding our right to renew the supply agreement for additional one-year periods, GlaxoSmithKline may terminate the supply agreement (1) upon notice to us that it no longer possesses enough active pharmaceutical ingredient, or API, to produce a standard batch size of the finished product; (2) upon 90 days prior written notice to us if we commit a material breach of the supply agreement and fail to cure such breach within such 90-day period; provided, however that GlaxoSmithKline will be relieved of its obligations to supply product if we fail to make payment within 30 days of the date when such payment is due (which would be 30 days after receipt of an invoice from GlaxoSmithKline); (3) at the end of the initial two-year term if we fail to submit filings to the U.S. Food and Drug Administration, or FDA, seeking approval of a third-party supplier to manufacture the product within 24 months after the completion of the acquisition; (4) at its discretion at the end of the first one-year renewal term; or (5) upon our filing for bankruptcy.

GlaxoSmithKline has agreed to cooperate with our transition to an alternative supplier. However, we cannot assure you that we will be able to find an alternative source of supply for the product on reasonable terms, or at all.

If we fail to secure an alternative source of supply of Lotronex prior to the termination of our supply agreement with GlaxoSmithKline, we will be unable to supply the product after existing product in our inventory is sold or expires. In order to obtain an alternate supplier, we will be required, among other things, to obtain approval from the FDA through the submission of additional regulatory filings.

Under our supply agreement, GlaxoSmithKline has agreed to manufacture a specific amount of API for Lotronex. While we believe the amount of API that GlaxoSmithKline has agreed to manufacture will be sufficient to meet market demands for Lotronex throughout the original two-year term of the supply agreement, we cannot assure you that the quantity of API will be sufficient. In addition, if the API is later determined to be defective for any reason, or is otherwise damaged, lost or destroyed, we may be unable to secure sufficient replacement API to be used in the manufacture of Lotronex. GlaxoSmithKline has not manufactured the raw materials for Lotronex’s API since 2000 and has not manufactured the API for Lotronex since 2005. As such, despite its commitment to replace defective API, we cannot assure you that GlaxoSmithKline will have the capability to do so.

The risk of a supply failure in the case of Lotronex is especially acute given the length of the order process and the 24-month shelf life for the finished product. Under our supply agreement with GlaxoSmithKline, forecasts for orders are binding for four months in advance and orders of finished product must be placed 120 days prior to delivery. Thus, disruption of the source of supply for any reason could lead to diminished product inventory for a substantial period of time. In addition, we have limited remedies under the supply agreement in the event of a breach of the agreement by GlaxoSmithKline. If GlaxoSmithKline fails to meet its

 

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obligations under the supply agreement, our ability to obtain a sufficient supply of Lotronex will be impaired and we may be unable to meet commercial demand for the product.

Failure to secure an adequate supply of Lotronex for any of the foregoing reasons could adversely affect our business, financial condition and results of operations.

Our ability to expand sales of Lotronex may be limited which may adversely impact our financial position and results of operations.

In addition to the inherent risks associated with integrating any new product, our ability to expand sales of Lotronex is subject to further risks associated with its potential for harmful side effects and related “black box” warnings in the product label containing expanded warning statements. In order to limit the potential for harmful side effects of Lotronex, it is subject to a special prescribing program designed to ensure that only doctors who have enrolled write prescriptions for it. In connection with enrolling in the Prescribing Program for Lotronex™, the physicians must have an understanding of IBS and be familiar with Lotronex and its potential side effects. The prescribing program instructs the prescribing physician to review the medication guide with the patient and ask the patient to sign a patient-physician agreement prior to prescribing Lotronex, which indicates that the patient has been advised of and understands the risks and benefits of Lotronex. The physician then places a blue sticker on the prescription, signifying to the pharmacist that he or she is an enrolled physician. Because the prescribing program for Lotronex restricts the physicians who should prescribe Lotronex to those who have enrolled in the prescribing program, it may limit the number of prescriptions written for Lotronex. As of October 15, 2009 there were approximately 10,810 physicians in the United States enrolled in the prescribing program. Moreover, physicians and patients may avoid Lotronex due to the administrative burdens of the prescribing program or due to concerns over side effects. Limitations on the number of prescriptions written for Lotronex as a result of the prescribing program or concerns over side effects may limit our ability to expand sales of Lotronex and adversely impact our financial position and results of operations.

We operate in a highly competitive business environment.

The pharmaceutical and diagnostic industries are highly competitive and require an ongoing, extensive search for technological innovation. They also require, among other things, the ability to effectively discover, develop, test, commercialize, market and promote products, including communicating the effectiveness, safety and value of products to actual and prospective customers and medical professionals.

Many of our competitors have greater resources than we have. This enables them, among other things, to spread their marketing and promotion costs over a broader revenue base. Other competitive factors in the pharmaceutical and diagnostic industries include quality and price, product technology, reputation, customer service and access to technical information.

Many large, well-capitalized companies offer products in the United States that compete with Entocort EC. Entocort EC currently competes with other therapies including aminosalicylates, such as sulfasalazine or mesalamine, and other corticosteroids, such as hydrocortisone, prednisone or prednisolone, none of which is currently approved for the treatment of Crohn’s disease but which are often prescribed by physicians for such use. To date, other than Lotronex, Zelnorm® (tegaserod maleate) and Amitiza® (lubiprostone) are the only other pharmaceutical products that have been approved to treat IBS. Zelnorm was withdrawn from the U.S. market in 2007 and is currently only available under investigational new drug protocols to patients whose condition is life-threatening and who are so sick they require hospitalization. Amitiza was approved by the FDA in April 2008 for the treatment of IBS with constipation in women 18 years of age and older. In addition, our branded pharmaceutical products Imuran®, Trandate® and Zyloprim® face intense competition from generic products. Imuran also faces competition from newer products that have come to market, and Ridaura® faces competition from newer and more effective pharmaceutical products. Zyloprim also competes with other non-generic anti-gout agents, such as probenecid, sulfinpyrazone and colchicines. In addition, our Helidac® product faces competition from TAP Pharmaceutical’s PREVPAC® and Axcan Pharma Inc.’s three-in-one capsule for the eradication of Helicobacter pylori. Our generic mercaptopurine product competes with other generic

 

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mercaptopurine products, including a generic product launched by Teva Pharmaceuticals in April 2005. In addition to competing with these generic products, mercaptopurine also competes with Imuran and generic azathioprine products.

Our diagnostic testing services compete with several large, national laboratories including Quest Diagnostics Incorporated, or Quest, and Laboratory Corporation of America Holdings and also compete with regional and hospital laboratories. The larger competitors have substantially greater financial and human resources, as well as a much larger infrastructure than we do.

A third party, Specialty Laboratories, has a co-existing license to the intellectual property partly underlying our TPMT Genetics diagnostic test. Quest purchased Specialty Laboratories’ parent company, and its commercialization of the intellectual property may strengthen Quest’s competitive position against us with respect to this product.

It is possible that developments by our competitors could make our products or technologies less competitive or obsolete. Our future growth depends, in part, on our ability to provide products which are more effective than those of our competitors and to keep pace with rapid medical and scientific change. For instance, for Entocort EC to be successful, we must be able to effectively market the product and show a sufficient number of gastroenterologists that Entocort EC can help their patients.

Sales of our existing products may decline rapidly if a new product is introduced by a competitor, particularly if a new product represents a substantial improvement over any of our existing products. In addition, the high level of competition in our industry could force us to reduce the price at which we sell our products or require us to spend more to market our products.

Additionally, we compete to acquire the intellectual property assets that we require to continue to develop and broaden our product range. In addition to our in-house research and development efforts, we seek to acquire rights to new intellectual property through corporate acquisitions, asset acquisitions, licensing and joint venture arrangements. Competitors with greater resources may acquire assets that we seek, and even where we are successful, competition may increase the acquisition price of such assets or prevent us from capitalizing on such acquisitions or licensing opportunities. If we fail to compete successfully, our growth may be limited.

If we lose or are unable to secure collaborators or partners, or if our collaborators or partners do not apply adequate resources to their relationships with us, our product development and potential for profitability will suffer.

We have entered into, or may enter into, distribution, co-promotion, partnership and other arrangements for development, manufacturing, sales, marketing and other commercialization activities relating to our products. For example, we have entered into a distribution agreement with AstraZeneca for the right to promote, distribute, market and sell Entocort EC and have also entered into an agreement with Alizyme Therapeutics Limited, or Alizyme, a wholly-owned subsidiary of Alizyme plc, for the development and commercialization of Colal-Pred. Furthermore, we have entered into agreements with Cedars-Sinai Medical Center and the University of California Los Angeles relating to the development and commercialization of diagnostic discoveries related to IBD and with Rosetta Genomics relating to the development of diagnostic tests in oncology and gastroenterology. The amount and timing of resources applied by these or other potential collaborators are largely outside of our control.

If any of our current or future collaborators breaches or terminates our agreements, or fails to conduct our collaborative activities in a timely manner, our commercialization of products could be diminished or blocked completely. It is possible that collaborators will change their strategic focus, pursue alternative technologies or develop alternative products, either on their own or in collaboration with others. The effectiveness of our partners, if any, in marketing our products will also affect our revenues and earnings.

We desire to enter into new collaborative agreements. However, we may not be able to successfully negotiate any additional collaborative arrangements and, if established, these relationships may not be scientifically or commercially successful. Our success in the future depends in part on our ability to enter into agreements with other highly-regarded organizations. This can be difficult due to internal and external

 

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constraints placed on these organizations. Some organizations may have insufficient administrative and related infrastructure to enable collaborations with many companies at once, which can extend the time it takes to develop, negotiate and implement a collaboration. Once news of discussions regarding possible collaborations are known in the medical community, regardless of whether the news is accurate, failure to announce a collaborative agreement or the entity’s announcement of a collaboration with another entity may result in adverse speculation about us, resulting in harm to our reputation and our business.

Disputes could also arise between us and our existing or future collaborators, as to a variety of matters, including financial and intellectual property matters or other obligations under our agreements. These disputes could be both expensive and time-consuming and may result in delays in the development and commercialization of our products or could damage our relationship with a collaborator. Furthermore, on July 21, 2009 we filed a complaint against Alizyme in the U.S. District Court for the Southern District of California alleging breach by Alizyme of its exclusive license agreement with us, as a result of its failure to conduct certain pre-clinical studies which are necessary in order to obtain regulatory approval for the sale of Colal-Pred in the U.S. and its alleged improper assignment of certain rights under this agreement. On July 24, 2009 Alizyme, and its parent company, Alizyme plc, entered administration in England, in each case on the grounds that it was or was likely to become unable to pay its debts. The administration of Alizyme means that Alizyme, acting through the agency of its administrators, might refuse or decline to perform its outstanding and continuing obligations under the license agreement and our inability to obtain remedies for such breaches could delay or prevent us from commercializing Colal-Pred. While in administration, our contract with Alizyme may not be modified or terminated without our consent. Furthermore, the administration may transition to a liquidation, in which case the liquidator may seek to disclaim the license agreement and Alizyme’s obligations under it, on the grounds that it is an unprofitable contract. In the event that Alizyme enters liquidation and its liquidator seeks to and is successful in having our agreement with Alizyme disclaimed, we may be unable to successfully commercialize Colal-Pred. If we are delayed or unable to successfully commercialize Colal-Pred, this could adversely affect our business, financial condition and results of operations.

Our success also depends, in part, on our branded non-promoted, pharmaceutical products, which face competition from generic products.

In addition to our proprietary pharmaceutical products Entocort EC and Lotronex, we sell a number of branded pharmaceutical products that we do not actively promote, which, in the aggregate, accounted for approximately 13% and 8.6% of our net sales from pharmaceutical products, or 9.3% and 6.4% of our total net sales, in the year ended December 31, 2008 and in the nine months ended September 30, 2009, respectively. Many of our branded pharmaceutical products, including Imuran, Trandate and Zyloprim, face competition from less expensive generic products. Even if physicians prescribe our products, third-party payors and pharmacists can substitute generic products. Government agencies and third-party payors often put pressure on patients to purchase generic products instead of brand-name products as a way to reduce healthcare costs. An increase in the amount of generic competition against our branded products would lower our unit sales and revenues.

We do not currently have any manufacturing facilities and depend on others for the manufacture and supply of all of the pharmaceutical products we offer.

We have no manufacturing facilities, and we rely on third-party manufacturers to provide us with an adequate and reliable supply of our pharmaceutical products on a timely basis. AstraZeneca manufactures Entocort EC and GlaxoSmithKline currently manufactures Lotronex. For the manufacturers and suppliers of our non-promoted pharmaceutical products, see “Business—Manufacturing and Testing—Pharmaceutical Products.” Our manufacturers must comply with U.S. regulations, including current Good Manufacturing Practices, or cGMPs, of the FDA applicable to the manufacture of pharmaceutical products, and their facilities must be inspected by the FDA and other regulatory agencies as part of their business. cGMP requirements relate to the control and organization of personnel, buildings, facilities, equipment, control of components, drug product, containers and closure, production and process controls, packaging and labeling controls, holding and distribution, laboratory controls, records and reports, and returned and salvaged products. Ongoing compliance with cGMPs is monitored through periodic inspections and market surveillance by state and federal agencies,

 

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including the FDA. In addition, because some of our manufacturers are located outside of the United States, they must also comply with applicable foreign laws and regulations.

We have limited control over our third-party manufacturers, including with respect to regulatory compliance and quality assurance matters. Any delay or interruption of supply related to a third-party manufacturer’s failure to comply with regulatory or other requirements could limit our ability to make, or cause us to cease, sales of our pharmaceutical products. Any manufacturing defect or error discovered after products have been produced and distributed could result in even more significant consequences, including costly recall procedures, re-stocking costs, damage to our reputation and potential for product liability claims. In addition, the importation of pharmaceutical products into the United States is subject to regulation by the FDA, and the FDA can refuse to allow an imported product into the United States if it is not satisfied that the product complies with applicable laws or regulations. Moreover, our third-party manufacturers and suppliers may experience difficulties related to their overall business and financial stability.

Each of our pharmaceutical products and many of the raw materials required to manufacture such products are sourced from single manufacturers. Many of our relationships with these suppliers are subject to short-term contracts or contracts that have expired and have not been renewed. We cannot assure you that we will be able to renew any such contracts at all or on terms that would be acceptable to us. We plan to continue outsourcing the manufacture of all of our pharmaceutical products in the foreseeable future. Although alternative sources of supply exist, the number of third-party manufacturers with the manufacturing and regulatory expertise and facilities to manufacture the finished forms of our pharmaceutical products or the raw materials incorporated in our products on a commercial scale is limited, and it could be expensive and take a significant amount of time to arrange for alternative manufacturers, which could have a material adverse effect on our business.

Any new manufacturer of products or active pharmaceutical ingredients would be required to qualify under applicable regulatory requirements and would need to have sufficient rights under applicable intellectual property laws to the method of manufacturing such products or ingredients. Any drug product manufactured by that manufacturer could also require FDA approval for the new manufacturing site. The FDA may require us to conduct additional clinical trials, collect stability data and provide additional information concerning any new supplier in order to obtain such approval. Obtaining the necessary FDA approvals or other qualifications under applicable regulatory requirements and ensuring non-infringement of third-party intellectual property rights could result in a significant interruption of supply and could require the new manufacturer to bear significant additional costs which may be passed on to us.

We rely on third parties to conduct clinical trials for Colal-Pred. If these third parties do not successfully carry out their contractual duties or meet expected deadlines, we may not be able to obtain regulatory approval for or commercialize Colal-Pred within our expected timeframes or at all.

We commenced Phase 2 clinical trials for Colal-Pred in May 2008 for treatment of patients with ulcerative colitis. We depend on CROs and/or independent clinical investigators to conduct our clinical trials. We may also retain third parties to manage data collection for any clinical trials we oversee. Third parties that execute clinical trials play a significant role in the conduct of these trials and the subsequent collection and analysis of data. CROs and investigators are not our employees, and we would have limited ability to control the amount or timing of resources that they devote to our programs. If the CROs, consultants or independent investigators we retain fail to devote sufficient time and resources to our drug development programs, or if their performance is substandard, it could delay or prevent the potential approval of our regulatory applications and the commercialization of Colal-Pred. In addition, the execution of clinical trials, and the subsequent compilation and analysis of the data produced, requires coordination among various parties. In order for these functions to be carried out effectively and efficiently, it is imperative that these parties communicate and coordinate with one another. Moreover, these independent investigators and CROs may also have relationships with other commercial entities, some of which may compete with us. If independent investigators and CROs assist our competitors, it could harm our competitive position.

 

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If advances in technology allow others to perform diagnostic tests which are similar to or better than ours or to perform such services in a more efficient or cost-effective manner than is currently possible, the demand for our diagnostic testing services may decrease.

The diagnostic industry is characterized by advancing technology that may enable clinical laboratories, hospitals, physicians or other medical providers to perform diagnostic testing services similar to or better than ours in a more efficient or cost-effective manner than is currently possible. If these or other advances in technology result in a decreased demand for our diagnostic testing services, our financial condition and results of operations would be harmed. In addition, in order for our business to be successful, we may need to develop new diagnostic tests or improve existing diagnostic tests. There is no assurance, however, that we will be able to develop or improve tests in the future. Even if we successfully develop such tests in a timely manner, these new tests may not be utilized by our customers. If we fail to develop new tests or release new or improved tests on a timely basis, or if such tests do not obtain market acceptance, our financial condition and results of operations could also be harmed.

Failure to accurately disclose performance specifications of our diagnostic tests could result in legal actions as well as damage to our reputation with customers, which could have a material adverse effect upon our business.

Many of our diagnostic tests were developed and validated internally by us. If we fail to properly develop diagnostic tests or if we inaccurately measure the performance specifications of the diagnostic tests we develop due to human error, deficiencies in our quality control process or otherwise, we may become subject to legal action as well as damage to our reputation with customers, which could have a material adverse effect upon our business.

In July 2008, we discovered that there was an overlap due to human error between the training and validation cohorts of our IBD Serology 7 diagnostic test. This overlap resulted in us overstating our performance specifications for adult patients. The difference in pediatric patients was not statistically significant. As a result, whereas we previously reported an overall predictive accuracy of 89%, we discovered that the test in fact exhibits an overall predictive accuracy of 76%. We did not change our diagnostic test, only the validation cohort and therefore there was no impact on previous or future test results. In other words, the actual predictions and test results reported by us using our IBD Serology 7 diagnostic test did not change as a result of the revisions to the validation cohort. We believe that this change was not material to patient care, however third parties could bring legal actions against us for having to restate the performance parameters which could damage our reputation and could have a material adverse effect upon our business.

If we are unable to maintain adequate levels of payment or reimbursement for our pharmaceutical products, their commercial success may be severely hindered.

Our ability to sell our pharmaceutical products may depend in large part on the extent to which payment or reimbursement for the costs of our products is available from private health insurers, managed care organizations, government entities and others. Third-party payors are increasingly attempting to contain their costs. We cannot predict actions third-party payors may take, or whether they will limit the coverage and level of payment or reimbursement for our pharmaceutical products or refuse to provide any coverage at all. Reduced or partial payment or reimbursement coverage could make our pharmaceutical products less attractive to patients, suppliers and prescribing physicians and may not be adequate for us to maintain price levels sufficient to realize an appropriate return on our investment in our products or compete on price.

In some cases, insurers and other healthcare payment organizations try to encourage the use of less expensive generic brands through their prescription benefits coverage and payment or reimbursement policies. Insurers and other healthcare payment organizations may make the generic alternatives more attractive to the patient by providing different amounts of coverage or out-of-pocket expenses so that the net cost of the generic product to the patient is less than the net cost of a branded product. The prescription benefit policies of insurers could also have a negative effect on our product revenues and profitability.

 

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Many managed care organizations negotiate the price of medical services and products and develop formularies which establish pricing and reimbursement levels. Exclusion of a product from a formulary can lead to its sharply reduced usage in the managed care organization’s patient population. If our pharmaceutical products are not included within an adequate number of formularies or adequate payment or reimbursement levels are not provided, or if those policies increasingly favor generic products, our market share and gross margins could be negatively affected, which would have a material adverse effect on our overall business and financial condition. In addition, managed care initiatives to control costs may influence primary care physicians to refer fewer patients to gastroenterologists and other specialists. Reductions in these referrals could have a material adverse effect on the size of our potential market and increase costs to effectively promote our pharmaceutical products.

Our account managers contact private health insurers, managed care organizations, government entities and other third-party payors, seeking coverage for our products. The process for obtaining coverage can be lengthy and time-consuming, in some cases taking several months or years before a particular payor initially reviews our pharmaceutical product, and we may ultimately be unsuccessful in obtaining coverage. Our competitors generally have larger account management organizations, as well as existing business relationships with third-party payors relating to their products. If we fail to successfully secure and maintain coverage for our pharmaceutical products or are significantly delayed in doing so, we will have difficulty achieving market acceptance of our pharmaceutical products and our business will be materially adversely affected.

If third-party payors do not pay for or adequately reimburse our customers, market acceptance of our diagnostic testing services may be impaired, which may adversely affect our revenues and our operating results.

Market acceptance of our diagnostic testing services and the majority of our diagnostics sales depend, in large part, on the availability of adequate payment or reimbursement from insurance plans, including government plans such as Medicare, managed care organizations, private insurance plans and other third-party payors. Reimbursement by a third-party payor may depend on a number of factors, including a payor’s determination that a product is not experimental or investigational, and that it is medically necessary, appropriate for a specific patient, cost effective or supported by peer-reviewed publications. Because each third-party payor individually approves payment or reimbursement, obtaining these approvals can be a time-consuming and costly process that requires us to provide scientific and clinical support for the use of each of these products to each third-party payor separately with no assurance that approval will be obtained. This individualized process or any action by the government negatively affecting payment for or reimbursement of our products can delay the market acceptance of new products and may have a negative effect on our revenues and operating results. To date, neither we nor Rosetta have secured policy-level reimbursement approval from any third-party payors for those tests which we in-licensed from Rosetta. We cannot be certain that coverage for any of our microRNA-based diagnostic tests will be provided in the future by any third-party payors or that payment policies will be favorable in the future. In addition, there are strict billing rules with respect to claims for diagnostic tests performed on stored specimens for Medicare beneficiaries who were hospital inpatients or outpatients that require us to bill individual hospitals for tests performed on Medicare beneficiaries during stipulated time frames. Because we generally do not have a written agreement in place with these hospitals, we may not be paid for our tests or may have to pursue payment from the hospital on a case-by-case basis. We believe these billing rules may lead to confusion regarding whether Medicare provides adequate reimbursement for our tests, and could discourage Medicare patients from using our tests. We also cannot ensure that hospitals will agree to arrangements to pay us for tests performed on patients falling under these rules.

We believe third-party payors are increasingly limiting coverage for diagnostic testing services, and in many instances are exerting pressure on product suppliers to reduce their prices. Consequently, third-party payment or reimbursement may not be consistently available or adequate to cover the cost of our products. Additionally, third-party payors who have previously approved a specific level of payment or reimbursement may reduce that level. Under prospective payment systems, in which healthcare providers may be paid or reimbursed a set amount based on the type of diagnostic procedure performed, such as those utilized by Medicare and in many

 

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private managed care systems, the cost of our diagnostic products may not be justified and reimbursed. Any limitations on payment or reimbursement for our services could limit our ability to commercialize and sell new services or to continue to sell our existing services, or may cause the selling prices of our existing services to be reduced, which would adversely affect our revenues and operating results.

Adverse results in material litigation matters could have a material adverse effect upon our business.

We may become subject in the ordinary course of business to material legal action related to, among other things, intellectual property disputes, professional liability, contract disputes, false advertising, shareholder litigation and employee-related matters, as well as inquiries from governmental agencies and Medicare or Medicaid requesting comment on allegations of billing irregularities that are brought to their attention through billing audits or third parties. Legal actions could result in substantial monetary damages as well as damage to our reputation with customers, which could have a material adverse effect upon our business.

In June 2004, we filed a complaint against Mayo Collaborative Services in the U.S. District Court for the Southern District of California for infringement of two patents, both of which relate to our Thiopurine Metabolites diagnostic testing services. We are an exclusive licensee of these patents pursuant to a license agreement with Sainte-Justine Hospital. In December 2005, Mayo Clinic Rochester was added to the case as a defendant. We believe that Mayo Collaborative Services and Mayo Clinic Rochester infringed these patents. Mayo Collaborative Services and Mayo Clinic Rochester answered our complaint and asserted affirmative defenses and counterclaims, including that our patents are invalid, not infringed and unenforceable. We denied these counterclaims and sought a court order that would prevent Mayo Collaborative Services or Mayo Clinic Rochester from commercializing products which infringe either of the two patents.

In November 2005, the court granted our motion for summary judgment of infringement, holding that Mayo Collaborative Services infringed one of the claims of one patent. The court also denied Mayo Collaborative Services’ motion for summary judgment that it had not infringed either patent. A consolidated hearing on a number of other motions for summary judgment, including a motion related to the validity of the patents, was held on May 10, 2007. In March 2008, the court granted the motion for summary judgment of Mayo Collaborative Services and Mayo Clinic Rochester for patent invalidity relating to the two patents mentioned above. We filed an appeal of the court’s decision with the U.S. Court of Appeals for the Federal Circuit. On September 16, 2009, the U.S. Court of Appeals for the Federal Circuit ruled in our favor by overturning the lower court’s ruling and directing the court to deny Mayo Collaborative Services’ summary judgment motion. On October 22, 2009, Mayo filed a petition with the U.S. Supreme Court for a writ of certiorari.

On July 21, 2009 we filed a complaint against Alizyme in the U.S. District Court for the Southern District of California alleging breach by Alizyme of its exclusive license agreement with us, as a result of its failure to conduct certain pre-clinical studies which are necessary in order to obtain regulatory approval for the sale of Colal-Pred in the U.S. and its alleged improper assignment of certain rights under this agreement. On July 24, 2009 Alizyme, and its parent company, Alizyme plc, entered administration in England, in each case on the grounds that it was or was likely to become unable to pay its debts. The administration of Alizyme means that Alizyme, acting through the agency of its administrators, might refuse or decline to perform its outstanding and continuing obligations under the license agreement. While in administration, our contract with Alizyme may not be modified or terminated without our consent. Furthermore, the administration may transition to a liquidation, in which case the liquidator may seek to disclaim the license agreement and Alizyme’s obligations under it, on the grounds that it is an unprofitable contract. In the event that Alizyme enters liquidation and its liquidator seeks to and is successful in having our agreement with Alizyme disclaimed, we may be unable to successfully commercialize Colal-Pred. If we are delayed or unable to successfully commercialize Colal-Pred, this could adversely affect our business, financial condition and results of operations.

Product or professional liability claims and product recalls could limit our ability to sell products.

We may be exposed to product or professional liability claims in the event that the development or use of our pharmaceutical products or diagnostic testing services is alleged to have resulted in adverse effects or

 

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inaccurate diagnosis. Side effects of our pharmaceutical products or marketing or manufacturing problems pertaining to any of our products or services, errors in reporting the results of our diagnostic tests or errors in reporting the performance parameters of our diagnostic tests could harm our business by, among other things, reducing demand for our products, injuring our reputation and creating significant adverse media attention or litigation. Product or professional liability claims could also be expensive or could delay or prevent the completion of our development programs or result in withdrawal of approval to market a product or the recall of a product. These problems often occur with little or no notice in connection with the sale of pharmaceutical products. Such risks will exist even with respect to those pharmaceutical products or diagnostic tests that receive regulatory approval for commercial sale. While we have taken, and will continue to take, what we believe are appropriate precautions, there can be no assurance that we will avoid significant product or professional liability exposure. If we do not have sufficient capital resources to pay a judgment our creditors could levy against our assets, including our intellectual property, which could have a material adverse effect on our business.

We currently maintain both product and professional liability insurance coverage. However, such insurance coverage might not be sufficient to fully cover any potential claims. Such insurance can be expensive and difficult to obtain. Adequate insurance coverage may not be available in the future at an acceptable cost, if at all, or in sufficient amounts to protect us against any such liability. Any product or professional liability claim in excess of insurance coverage would have to be paid out of our cash reserves which would have a detrimental effect on our financial condition. If we do not have sufficient capital resources to pay a judgment our creditors could levy against our assets, including our intellectual property, which could have a material adverse effect on our business.

In addition, the manufacturers of our pharmaceutical products may be exposed to product liability claims in the event that the use of our pharmaceutical products is alleged to have resulted in adverse effects. Product liability claims against any of the manufacturers of our pharmaceutical products could be expensive for the manufacturers and, as a result, they may be unable or unwilling to continue manufacturing our products.

We cannot assure you that a product liability claim or series of claims brought against us would not have an adverse effect on our business, financial condition, and results of operations. If any claim is brought against us, regardless of the success or failure of the claim, we cannot assure you that we will be able to obtain or maintain product liability insurance in the future on acceptable terms or with adequate coverage against potential liabilities or the cost of a recall.

We may not be able to maintain our current insurance policies covering our business, assets, directors and officers and product liability claims and we may not be able to obtain new policies in the future.

We currently maintain property, product liability, business interruption, directors’ and officers’ and general liability insurance. Due to recent concerns over corporate governance in the United States, corporate accounting scandals and product liability lawsuits related to pharmaceuticals, liability and other types of insurance can be more difficult and costly to obtain. Unanticipated additional insurance costs could have a material adverse effect on our results of operations and cash flows. We expect that our insurance costs will increase upon completion of this offering and due to changes that often occur in the insurance markets from time to time. There can be no assurance that we will be able to maintain our existing insurance policies or obtain new policies in meaningful amounts or at a reasonable cost. Any failure to obtain or maintain any necessary insurance coverage could have a material adverse effect on our business, financial condition and results of operations.

All of our gastroenterological diagnostic testing services and all of our oncology diagnostic testing services are each performed at a single laboratory and, in the event either of these facilities was to be affected by man-made or natural disasters, our operations could be severely impaired.

We currently perform all our gastroenterological diagnostic testing services in our laboratory located in San Diego, California. All of our oncology diagnostic testing services are performed by Rosetta Genomics in its Philadelphia, Pennsylvania laboratory until we are able to establish our own laboratory and obtain the necessary permits and licenses to perform these services. Despite precautions taken by us and Rosetta Genomics, any future natural or man-made disaster at either of these laboratories, such as a fire, earthquake or terrorist activity, could cause substantial delays in our operations, damage or destroy our equipment and biological samples or cause us

 

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to incur additional expenses. In the event of an extended shutdown of either of these laboratories, we may be unable to perform our diagnostic testing services in a timely manner or at all and therefore would be unable to operate our business in a commercially competitive manner. Despite carrying business interruption insurance, there is no assurance that we could recover quickly from a serious natural or man-made disaster or that we would not permanently lose customers as a result of any such business interruption. This could harm our operating results and financial condition.

In order to rely on a third party to perform our diagnostic testing services, we could only use another facility with established state licensure and accreditation under The Clinical Laboratory Improvement Amendments of 1988, or CLIA. We cannot assure you that we would be able to find another CLIA-certified facility and comply with applicable procedures, or that any such laboratory would be willing to perform the tests for us on commercially reasonable terms. In order to establish a redundant laboratory facility, we would have to spend considerable time and money securing adequate space, constructing the facility, recruiting and training employees and establishing the infrastructure necessary to support a second facility. Additionally, any new laboratory opened by us would be subject to certification under CLIA and licensure by various states, which would take a significant amount of time and result in delays in our ability to begin operations.

Failure to timely or accurately bill for our diagnostic testing services could have a material adverse effect on our net revenues and bad debt expense.

Billing for diagnostic testing can be extremely complicated. Depending on the billing arrangement and applicable law, we must bill various payors, such as insurance companies, Medicare, Medicaid, physicians, hospitals, employer groups and patients, all of which have different billing requirements. Additionally, compliance with applicable laws and regulations as well as internal compliance policies and procedures adds further complexity to the billing process. Changes in laws and regulations could negatively impact our ability to bill our clients or increase our costs. The Centers for Medicare and Medicaid Services, or CMS, also establishes procedures and continuously evaluates and implements changes to the reimbursement process for billing government programs.

Missing or incorrect information on test requisitions adds complexity to and slows the billing process, creates backlogs of unbilled tests, and generally increases the aging of accounts receivable and bad debt expense. Failure to timely or correctly bill may lead to our not being reimbursed for our services or an increase in the aging of our accounts receivable, which could adversely affect our results of operations and cash flows. Failure to comply with applicable laws relating to billing federal healthcare programs could also lead to various penalties, including:

 

   

exclusion from participation in Medicare/Medicaid programs;

 

   

asset forfeitures;

 

   

civil and criminal fines and penalties; and

 

   

the loss of various licenses, certificates and authorizations necessary to operate our business.

Any of these penalties or sanctions could have a material adverse effect on our results of operations or cash flows.

Failures in our information technology systems could disrupt our operations, which could reduce our customer base and result in lost revenues.

Information technology, or IT, systems are used extensively in virtually all aspects of our business, including laboratory testing, billing, customer service, logistics and management of medical data. Our success depends, in part, on the continued and uninterrupted performance of our IT systems. IT systems are vulnerable to damage from a variety of sources, including telecommunications or network failures, software malfunctions, equipment failures, malicious human acts and natural disasters. Moreover, despite network security measures, some of our servers are potentially vulnerable to physical or electronic break-ins, computer viruses and similar disruptive problems. Despite the precautionary measures we have taken to prevent unanticipated problems that could affect our IT systems, system failures could still occur and sustained or repeated system failures could adversely affect our reputation and result in a loss of customers and net revenues.

 

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In addition, public and private initiatives to create Health Information Technology, or HIT, standards and to mandate standardized clinical coding systems for the electronic exchange of clinical information, including laboratory results, could require costly modifications to our existing IT systems. While we do not expect HIT standards to be adopted or implemented without adequate time to comply, failure or delay in implementing HIT or clinical coding standards, interoperability standards, or in adopting and incorporating standardized clinical coding systems in our IT systems, could result in a loss of customers, a loss of business opportunities, and could adversely affect our reputation and operating results.

If we are unable to attract and retain key personnel, our business will suffer.

As of October 15, 2009, we had 427 employees. Our success depends on our continued ability to attract, retain and motivate highly-qualified management, business development, sales and marketing, laboratory, product development and other personnel. We may not be able to recruit and retain qualified personnel, particularly for senior sales and marketing, laboratory and research and development positions, in the future due to intense competition for personnel among businesses like ours, and the failure to do so could have a significant negative impact on our future product revenues and business results. A loss of key research personnel or their work product could hamper or prevent our ability to market existing or new products, which could severely harm our business.

Our success depends on a number of key management and technical personnel, including Joseph M. Limber, our President and Chief Executive Officer. Although we have entered into an employment agreement with Mr. Limber, this agreement provides for at-will employment and is terminable at any time, with or without notice, subject to severance payments under certain conditions. Therefore, we may not be able to retain his services. In addition, we do not have “key person” insurance policies on any of our executive officers that would compensate us for the loss of their services. If we lose the services of one or more of these individuals, replacement could be difficult and may take an extended period of time, while significantly impeding the achievement of our business objectives.

We have a highly-focused sales force and the acquisition or development of additional products or technologies for fields beyond gastroenterology will require us to hire additional sales representatives, who may be costly and difficult to integrate.

Our sales force is predominately focused on the gastrointestinal disease and disorder market and its over 12,000 gastroenterologists in the United States. As of October 15, 2009, we had an approximately 150 person sales force, including sales representatives, national account managers and sales managers located throughout the United States. Our sales representatives complete a comprehensive, disease-level sales training program and are required to participate in regular, ongoing training activities. This training is in addition to training on the mechanism of action, side effects and comparative benefits of pharmaceuticals typically given to pharmaceutical representatives.

Additional product acquisitions or other developments may require us to expand our sales force. Training of additional sales representatives can be costly and time consuming, particularly given the level of experience and sophistication we seek in our sales force. In addition, as we continue to acquire and develop products outside the field of gastroenterology, the difficulty of integrating and training new sales representatives will increase. For example, as a result of our recent acquisition of three oncology diagnostics, we expanded our sales force to include additional sales representatives focused on this new market. If we are unable to effectively retain, train and integrate additional sales representatives, it may adversely affect our ability to effectively market and sell our products.

We depend on wholesale pharmaceutical distributors for retail distribution of our branded pharmaceutical products, and if we lose any of our significant wholesale pharmaceutical distributors, our business could be harmed.

We sell a majority of our pharmaceutical products to wholesale pharmaceutical distributors who, in turn, sell the products to hospitals, pharmacies and other customers. Three wholesale pharmaceutical distributors,

 

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Cardinal Health, Inc., McKesson Corporation and AmerisourceBergen Corporation, individually comprised 39%, 37% and 19%, respectively, of our branded pharmaceutical product sales for the year ended December 31, 2008 and 41%, 36% and 18%, respectively, of our branded pharmaceutical product sales for the nine months ended September 30, 2009. Cardinal Health, Inc., McKesson Corporation and AmerisourceBergen Corporation collectively comprised 94%, 95%, 95% and 95% of our branded pharmaceutical product sales for the years ended December 31, 2006, 2007 and 2008 and the nine months ended September 30, 2009, respectively. The loss of any of these wholesale pharmaceutical distributors’ accounts or a material reduction in their purchases could harm our business, financial condition or results of operations.

In addition, these wholesale customers comprise a significant part of the distribution network for pharmaceutical products in the United States. This distribution network has undergone, and may continue to undergo, significant consolidation marked by mergers and acquisitions. As a result, a smaller number of large wholesale distributors control a significant share of the market. Consolidation of drug wholesalers has increased, and may continue to increase, competitive and pricing pressures on pharmaceutical products. In addition, at times, wholesaler purchases may exceed customer demand, resulting in reduced wholesaler purchases in later quarters. We cannot assure you that we can manage these pricing pressures or that wholesaler purchases will not decrease as a result of this potential excess buying.

Our sales can be greatly affected by the inventory levels our wholesalers carry. We monitor wholesaler inventory of our products using a combination of methods. Pursuant to distribution service agreements with our two largest wholesale customers, we receive inventory level reports. For most other wholesalers where we do not receive inventory level reports, however, our estimates of wholesaler inventories may differ significantly from actual inventory levels. Significant differences between actual and estimated inventory levels may result in excessive inventory production, inadequate supplies of products in distribution channels, insufficient product available at the retail level, and unexpected increases or decreases in orders from our wholesalers. Forward buying by wholesalers, for example, may result in significant and unexpected changes in customer orders from quarter to quarter. These changes may cause our revenues to fluctuate significantly from quarter to quarter, and in some cases may cause our operating results for a particular quarter to be below our expectations or internal projections. If our financial results are below expectations for a particular period, the market price of our securities may drop significantly.

We rely on third parties to perform many necessary services for our commercial products, including services related to the distribution, storage and transportation of our products.

We have retained third-party service providers to perform a variety of functions related to the sale and distribution of our products as well as certain diagnostic testing, key aspects of which are out of our direct control. For example, we rely on one third-party service provider, Integrated Commercialization Solutions, Inc., or ICS, to provide services related to warehousing and inventory management, distribution, contract administration and chargeback processing, accounts receivable management and call center management, and, as a result, most of our inventory is stored at a single warehouse maintained by ICS. We rely on ICS as well as other third-party providers that perform services for us, including draw site collection and transportation of pharmaceuticals and patient samples. In addition, our micro RNA-based oncology diagnostic testing is performed at the Philadelphia, Pennsylvania laboratory of Rosetta Genomics. If these third-party service providers fail to comply with applicable laws and regulations, fail to meet expected deadlines, or otherwise do not carry out their contractual duties to us, or encounter damage at their facilitates, our ability to deliver products and services to meet commercial demand would be significantly impaired. In addition, we utilize third parties to perform various other services for us relating to the return and destruction of nonsaleable pharmaceutical products. We do not currently have the internal capacity to perform these important commercial functions, and although there are other service providers who can perform these functions, we may not be able to maintain commercial arrangements for these services on reasonable terms.

For example, we expect to qualify and validate a new manufacturer for our non-promoted pharmaceutical product, Imuran. This change will require FDA approval. We anticipate that this process will be complete by mid 2010. The process of qualifying and validating a new manufacturer generally takes between 12 and

 

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24 months but may take significantly longer. During that process, the products for which we are seeking a new manufacturer are not being manufactured, and we instead rely on sales from inventories stockpiled at the time we begin the process. It is possible that our inventories of any of these products could be entirely depleted prior to the completion of qualifying the new manufacturer, which would result in our inability to continue to sell such product pending completion of the qualification process. Our inability to continue our sales of any product would likely permanently damage that product’s market position and our financial condition or results of operations would be harmed.

Risks Related to Regulatory Matters

The regulatory approval process is expensive, time consuming and uncertain and may prevent us from obtaining approvals for the commercialization of Colal-Pred.

The research, testing, manufacturing, labeling, approval, selling, marketing and distribution of pharmaceutical products are subject to extensive regulation by the FDA and other regulatory authorities in the United States. We will not be permitted to market Colal-Pred in the United States until we receive approval of an NDA from the FDA. We have not yet submitted an application for or received marketing approval for Colal-Pred. Obtaining approval of an NDA can be a lengthy, expensive and uncertain process.

Prior to receiving approval to commercialize Colal-Pred in the United States, we must demonstrate with substantial evidence from well-controlled clinical trials, and to the satisfaction of the FDA, that Colal-Pred is safe and effective for its intended use. We may also be required to conduct preclinical studies, including carcinogenicity studies. Results from preclinical studies and clinical trials can be interpreted in different ways. Even if we believe the preclinical or clinical data for Colal-Pred are promising, such data may not be sufficient to support approval by the FDA and other regulatory authorities. Administering Colal-Pred to humans may produce undesirable side effects, which could interrupt, delay or halt clinical trials for Colal-Pred and result in the FDA or other regulatory authorities denying approval of the product.

Regulatory approval of an NDA or NDA supplement is uncertain, and the approval process is expensive and may take several years. The FDA also has substantial discretion in the approval process. Despite the time and expense exerted, failure can occur at any stage, and we could encounter problems that cause us to abandon clinical trials, repeat clinical trials or perform additional preclinical studies and clinical trials. The number of preclinical studies and clinical trials that will be required for FDA approval varies depending on the drug candidate, the disease or condition that the product candidate is designed to address, and the regulations applicable to any particular product candidate. The FDA can delay, limit or deny approval of a product candidate for many reasons, including, but not limited to, the following:

 

   

a drug candidate may not be deemed safe or effective;

 

   

the FDA may not find the data from preclinical studies and clinical trials sufficient;

 

   

the FDA might not approve our or our third-party manufacturers’ processes or facilities; or

 

   

the FDA may change its approval policies or adopt new regulations.

If Colal-Pred fails to demonstrate safety and efficacy in clinical trials or does not gain regulatory approval, our potential for growth will be limited.

We are subject to ongoing regulatory review of our pharmaceutical products, and compliance with applicable regulations can be costly and time-consuming. Failure to comply with applicable regulations may result in fines, penalties, removal of our products from the market or criminal prosecution.

Like all pharmaceutical companies, we are subject to extensive, complex, costly and evolving regulation by the federal government, principally the Department of Health and Human Services, or HHS, which includes the FDA, CMS, and similar state government agencies, as well as by varying regulatory agencies in foreign countries where our products are being manufactured. The Federal Food, Drug, and Cosmetic Act, the Prescription Drug

 

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Marketing Act, the Federal Anti-Kickback Statute, the False Claims Act, the Controlled Substances Act and other federal and state statutes and regulations govern or influence the development, testing, manufacturing, packing, labeling, storing, record keeping, safety, approval, advertising, promotion, sale and distribution of our products and require, among other things, ongoing compliance with the FDA’s cGMP regulations. In addition, Lotronex is subject to the FDA’s Risk Evaluation and Mitigation Strategy, or REMS, and we are subject to additional requirements and the risk of civil penalties for failure to comply with the REMS. Furthermore, under California law we must also comply with the Pharmaceutical Research and Manufacturers of America Code on Interactions with Healthcare Professionals and the Office of the Inspector General, or OIG, Compliance Program Guidance for Pharmaceutical Manufacturers.

Under certain of these regulations, the FDA requires post-marketing testing and surveillance to monitor the effects of approved pharmaceutical products or places conditions on any approvals, which restrict the commercial applications of such products. In addition, the subsequent discovery of previously unknown problems with any pharmaceutical product may result in restrictions on the product, including withdrawal of the product from the market. If we fail to comply with applicable regulatory requirements, we may be subject to warning letters, product recall, restrictions on marketing, product seizure, injunction, civil penalties, and criminal prosecution.

In regard to Entocort EC, AstraZeneca is responsible for a post-marketing pediatric study for the product in accordance with the FDA’s requirements imposed at the time of NDA approval for the product. AstraZeneca is required to consult with us concerning any proposed material changes in the label for Entocort EC. We are entitled to have a representative participate in any substantive meeting with the FDA for the pediatric study accompanying a representative from the AstraZeneca team. AstraZeneca is required to fund any post-marketing obligations required for the product. AstraZeneca has requested that the FDA waive the post-marketing pediatric study requirement as AstraZeneca has been unable to successfully engage an adequate number of patients to perform the study. In addition, we are responsible to continue the conduct of ongoing GlaxoSmithKline initiated post-marketing studies with respect to monitoring the occurrence of serious adverse events associated with Lotronex, compliance with the Prescribing Program for Lotronex, and the effectiveness of such program. Of such studies, all have been completed except a patient survey program. The patient survey program is ongoing and is currently being managed for us by a third party service provider.

In addition to our currently marketed pharmaceutical products, as part of our business strategy, we regularly consider and, as appropriate, make acquisitions of technologies, products and businesses that we believe are complementary to our business or our business strategy. For example, we have acquired licenses to three microRNA-based oncology diagnostic tests and we are collaborating to develop others. These tests are presently considered to be laboratory developed tests and are regulated under CLIA and other state laboratory laws. In connection with any acquisitions of new pharmaceutical products, we may be required to obtain governmental approval to develop, manufacture and market such products. In general, the process for obtaining governmental approval to manufacture and market new pharmaceutical products is rigorous, time-consuming and costly, and we cannot predict the extent to which we may be affected by new or existing legislative and regulatory developments. We are dependent on receiving FDA and other governmental or third-party approvals prior to developing, manufacturing, marketing and distributing our pharmaceutical products. Our microRNA-based diagnostic tests currently are not subject to FDA regulation, but there can be no assurance that these tests and the others that we are collaborating to develop will not fall under FDA regulation in the future. If we do not obtain applicable FDA or other necessary approvals, or if the rate, timing and cost of such approvals are excessive, our product introduction plans, results of operations and stock price will be adversely affected. Despite the time and expense exerted, regulatory approval remains uncertain.

Moreover, as part of the sales and marketing process, pharmaceutical companies frequently provide samples of approved drugs to physicians. This practice is regulated by the FDA and other governmental authorities, including, in particular, requirements concerning record keeping and control procedures. Any failure to comply with the regulations may result in significant criminal and civil penalties as well as damage to our credibility in the marketplace.

 

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We have not obtained all relevant state manufacturer and/or wholesale distributor licenses necessary to ship or sell prescription drugs that we distribute into several states, and our ability to ship or sell prescription drugs in these states may be affected if these states require us to cease further marketing and distribution activities until such licenses are obtained.

To date, we have not obtained all relevant state manufacturer and/or wholesale distributor licenses necessary to ship or sell prescription drugs into several states. Our ability to ship into or sell prescription drugs in these states may be affected if these states require us to cease further marketing and distribution activities until such licenses are obtained. Further, these states may seek monetary penalties for failure to maintain appropriate licenses. Any disciplinary action taken by a state may adversely affect our ability to obtain necessary state licenses in the future.

Our diagnostics business could be harmed from the loss or suspension of a license or imposition of a fine or penalties under, or future changes in, federal or state laws and regulations.

The clinical laboratory testing industry is subject to extensive regulation, and many of these statutes and regulations have not been interpreted by the courts. CLIA, which is implemented and enforced by CMS, extends federal oversight to virtually all clinical laboratories by requiring that they be certified by the federal government or by a federally-approved accreditation agency. CLIA is intended to ensure the quality and reliability of non-research laboratory testing performed on the patient samples collected in the United States and its territories by mandating specific standards in the areas of personnel qualifications, administration, participation in proficiency testing, patient test management, quality and inspections. While our laboratory is currently CLIA certified, the sanction for failure to comply with CLIA requirements may be suspension, revocation or limitation of a laboratory’s CLIA certificate, which is necessary to conduct business, as well as significant fines and/or criminal penalties.

In addition, we are subject to regulation under state law. State laws may require that laboratories and/or laboratory personnel meet certain qualifications, specify certain quality controls or require maintenance of certain records. For example, New York State requires us to obtain approval for any diagnostic test prior to offering it for sale or soliciting patient samples from New York. Rosetta Genomics is currently seeking state licensure for its Philadelphia laboratory in New York. We cannot assure you that these licenses will be obtained. Failure to obtain these licenses could jeopardize our ability to launch and commercialize diagnostic tests in these states. Compliance with such standards is verified by periodic inspections and requires participation in proficiency testing programs. No assurances can be given that our facility will pass all future inspections conducted to ensure compliance with federal or any other applicable licensing or certification laws. Substantial expenditures may be required on an ongoing basis to ensure that we comply with existing regulations and to bring us into compliance with newly-instituted regulations.

We cannot assure you that applicable statutes and regulations will not be interpreted or applied by a prosecutorial, regulatory or judicial authority in a manner that would adversely affect our business. Potential sanctions for violation of these statutes and regulations include significant fines and the suspension or loss of various licenses, certificates and authorizations, which could have a material adverse effect on our business. In addition, compliance with future legislation or regulations could impose additional requirements on us which may be costly and difficult to implement.

Proposed FDA regulation of laboratory-developed tests, analyte specific reagents, or genetic testing could lead to increased costs and delays in introducing new diagnostic tests.

The FDA regulates instruments, test kits, reagents and other devices used to perform diagnostic testing by clinical laboratories. In the past, the FDA also claimed regulatory authority over laboratory-developed tests, but had stated that it was exercising enforcement discretion in not regulating laboratory-developed tests. However, in September 2006, the FDA published two draft guidance documents pertaining to its regulation of laboratory-developed tests. In addition, bills proposing various regulatory schemes may be introduced in Congress which, if passed into law, could also materially change the regulation of laboratory-developed tests.

 

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The first draft guidance document described various manufacturer practices and products that the FDA believes would take certain reagent products out of the Class I (exempt) Analyte Specific Reagent, or ASR, category. The FDA issued the final ASR Guidance Document in September 2007. The final ASR Guidance Document has restricted laboratory access to certain products because, in response to its adoption, products have been withdrawn from the market. Although we do not believe the impact of the final ASR Guidance Document on our current laboratory-developed tests to be material, the final ASR Guidance Document could limit how we are able to perform or develop new tests in the future should certain reagent products be withdrawn from, or be delayed in getting to, the market.

The other draft guidance document described certain laboratory-developed tests that the FDA intends to regulate as in vitro diagnostic test systems (i.e., as medical devices). The FDA calls this category of laboratory-developed tests “In Vitro Diagnostic Multivariate Index Assays,” or IVDMIAs. The first draft of the guidance pertaining to IVDMIAs was issued by the FDA in September 2006. The FDA issued a revised draft guidance pertaining to IVDMIAs in July 2007. In the document, the FDA defines an IVDMIA as a device that combines the values of multiple variables using an interpretation function to yield a single, patient-specific result that is intended for use in the diagnosis of a disease or other condition, or in the cure, mitigation, treatment, or prevention of disease, and that provides a result that cannot be independently derived or verified by the end user and whose derivation is non-transparent. The IVDMIA draft guidance, if adopted as published, would extend FDA oversight over laboratory-developed tests which meet this definition. We believe that some of our currently marketed tests may be defined as IVDMIAs under the draft guidance, as may the diagnostic tests that we currently have under development and the three oncology diagnostic tests we recently acquired the U.S. rights to. A final IVDMIA Guidance Document may, however, include a different definition of an IVDMIA.

FDA regulation of laboratory-developed tests or increased regulation of the various medical devices used in laboratory-developed testing would lead to an increased regulatory burden and additional costs and delays in introducing new tests, including genetic tests. IVDMIAs would be subject to the regulatory requirements applicable generally to devices. For example, under the IVDMIA draft guidance, the new diagnostic tests that we are currently developing in the United States would require either pre-market notification, also known as 510(k) clearance, or pre-market approval, from the FDA prior to marketing. The overall 510(k) clearance process usually takes from three to 12 months from the time of submission to the time that the manufacturer or laboratory can begin to market a product in the United States, but can take significantly longer and such clearance may never be obtained. The pre-market approval process, often referred to as the PMA process, is much more costly, lengthy and uncertain and generally takes between one and three years from submission to PMA approval, but may take significantly longer and such approval may never be obtained. In addition, generating the clinical data to support a 510(k) or PMA can take six months or longer.

We believe FDA regulation of laboratory-developed tests and the increased regulation of the various reagent products used in laboratory-developed testing will lead to a substantially increased regulatory burden, additional costs and delays in introducing new diagnostic tests. Laboratories under FDA regulation will also have to operate in compliance with the Quality System Regulation and comply with other FDA regulations governing devices. To date, the FDA has held a public hearing and requested public response to the draft IVDMIA guidance documents. Industry representatives and others have communicated their concerns to the FDA. It is not possible to predict when or if the FDA might issue a final IVDMIA guidance, what changes might be made from the draft document, or what the impact of such a final guidance document would be on our currently marketed diagnostic tests or our diagnostic tests currently under development.

Compliance with the HIPAA security regulations and privacy regulations may increase our costs.

We are subject to regulation under the federal Health Insurance Portability and Accountability Act of 1996, or HIPAA. HIPAA privacy and security regulations establish comprehensive federal standards with respect to the uses and disclosures of protected health information by health plans, healthcare providers and healthcare clearinghouses, in addition to setting standards to protect the confidentiality, integrity and availability of protected health information. Generally, protected health information is any individually identifiable information, including demographic information, related to the past, present or future physical or mental health condition, the

 

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provision of healthcare to an individual, or the past, present or future payment for such healthcare, which is created or received by a healthcare entity. The regulations establish a complex regulatory framework on a variety of subjects, including:

 

   

the circumstances under which uses and disclosures of protected health information are permitted or required without a specific authorization by the patient, including but not limited to treatment purposes, activities to obtain payments for services and healthcare operations activities;

 

   

a patient’s rights to access, amend and receive an accounting of certain disclosures of protected health information;

 

   

the content of notices of privacy practices for protected health information; and

 

   

administrative, technical and physical safeguards required of entities that use or receive protected health information.

We have implemented policies and procedures related to compliance with the HIPAA privacy and security regulations, as required by law. The privacy regulations establish a “floor” and do not supersede state laws that are more stringent. Therefore, we are required to comply with both federal privacy regulations and varying state privacy laws.

The privacy and security regulations provide for significant fines and other penalties for wrongful use or disclosure of protected health information, including potential civil and criminal fines and penalties. Although the HIPAA statute and regulations do not expressly provide for a private right of damages, we also could incur damages under state laws to private parties for the wrongful use or disclosure of confidential health information or other private personal information.

Regulations requiring the use of “standard transactions” for healthcare services issued under HIPAA may negatively impact our profitability and cash flows.

Pursuant to HIPAA, the Secretary of HHS, has issued final regulations designed to improve the efficiency and effectiveness of the healthcare system by facilitating the electronic exchange of information in certain financial and administrative transactions while protecting the privacy and security of the information exchanged.

The HIPAA transaction standards are complex, and subject to differences in interpretation by third-party payors. For instance, some third-party payors may interpret the standards to require us to provide certain types of information, including demographic information not usually provided to us by physicians. As a result of inconsistent application of transaction standards by third-party payors or our inability to obtain certain billing information not usually provided to us by physicians, we could face increased costs and complexity, a temporary disruption in accounts receivable and ongoing reductions in reimbursements and net revenues. In addition, requirements for additional standard transactions, such as claims attachments or use of a national provider identifier, could prove technically difficult, time-consuming or expensive to implement, all of which could harm our business.

We may incur significant liability if it is determined that we are promoting the “off-label” use of drugs.

Although not approved or promoted for gastrointestinal diseases, several of our non-promoted pharmaceutical products, including Imuran and mercaptopurine are often prescribed by physicians for such use. Companies may not promote drugs for “off-label” uses, which are uses that are not described in the product’s labeling and that differ from those approved by the FDA. Physicians may prescribe drug products for off-label uses, and such off-label uses are common across medical specialties. Although the FDA and other regulatory agencies do not regulate a physician’s choice of treatments, the Federal Food, Drug, and Cosmetic Act and FDA regulations restrict communications on the subject of off-label uses of drug products by pharmaceutical companies. The OIG and FDA both actively enforce laws and regulations prohibiting promotion of off-label uses and the promotion of products for which marketing clearance has not been obtained. A company that is found to have improperly promoted off-label uses may be subject to significant liability, including civil and administrative remedies as well as criminal sanctions.

 

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Although we believe that all of our communications regarding all of our products are in compliance with the relevant legal requirements, the OIG or the FDA may disagree, and we may be subject to significant liability, including civil and administrative remedies, as well as criminal sanctions. In addition, management’s attention could be diverted from our business operations and our reputation could be damaged.

We may incur liability if our continuing medical or health education programs and/or product promotions are determined, or are perceived, to be inconsistent with regulatory guidelines.

The FDA provides guidelines with respect to appropriate promotion and continuing medical and health education activities. Although we endeavor to follow these guidelines, the FDA or OIG may disagree, and we may be subject to significant liability, including civil and administrative remedies as well as criminal sanctions. In addition, management’s attention could be diverted and our reputation could be damaged.

If we fail to comply with healthcare laws and regulations, we could face substantial penalties and our business, operations and financial condition could be adversely affected.

In addition to FDA rules and regulations on marketing of pharmaceutical products, several other types of state and federal laws have been applied to restrict and govern certain marketing practices in the pharmaceutical and clinical laboratory industries in recent years. These laws include anti-kickback, false claims and Stark Act statutes.

The federal healthcare program anti-kickback statute prohibits, among other things, knowingly and willfully offering, paying, soliciting or receiving remuneration to induce or in return for purchasing, leasing, ordering or arranging for the purchase, lease or order of any healthcare item or service reimbursable under Medicare, Medicaid or other federally financed healthcare programs. This statute applies to laboratory services and has also been interpreted to apply to arrangements between pharmaceutical manufacturers on one hand and prescribers, purchasers and formulary managers on the other. Although there are a number of statutory exemptions and regulatory safe harbors protecting certain common activities from prosecution, the exemptions and safe harbors are drawn narrowly, and any remuneration to or from a prescriber or purchaser of healthcare services may be subject to scrutiny if they do not qualify for an exemption or safe harbor. Our practices may not in all cases meet all of the criteria for safe harbor protection from anti-kickback liability.

Federal false claims laws prohibit any person from knowingly presenting or causing to be presented a false claim for payment to the federal government, or knowingly making or causing to be made a false statement to get a false claim paid. Pharmaceutical and other healthcare companies have been prosecuted under these laws for allegedly providing free product to customers with the expectation that the customers would bill federal programs for the product. Other companies have been prosecuted for causing false claims to be submitted because of the company’s marketing of the product for unapproved, and thus non-reimbursable, uses. The majority of states also have statutes or regulations similar to the federal anti-kickback law and false claims laws, which apply to items and services reimbursed under Medicaid and other state programs, or, in several states, apply regardless of the payor. These false claims statutes allow any person to bring suit in the name of the government alleging false and fraudulent claims presented to or paid by the government (or other violations of the statutes) and to share in any amounts paid by the entity to the government in fines or settlement. Such suits, known as qui tam actions, have increased significantly in the healthcare industry in recent years. Sanctions under these federal and state laws may include civil monetary penalties, exclusion of a manufacturer’s products from reimbursement under government programs, criminal fines and imprisonment.

Under another federal statute, known as the Stark Act or “self-referral” prohibition, physicians who have an investment or compensation relationship with an entity may not refer Medicare patients for designated health services, which include clinical laboratory services, regardless of the intent of the parties, unless an exception applies. Similarly, entities may not bill Medicare or any other party for services furnished pursuant to a prohibited referral. Unlike the federal anti-kickback statute, the Stark Act is strict liability, meaning that all of the requirements of a Stark Act exception must be met in order to take advantage of the exception. Many states have their own self-referral laws as well, which in some cases apply to all patient referrals, not just Medicare.

Because of the breadth of these laws and the narrowness of the safe harbors and exceptions, it is possible that some of our business activities could be subject to challenge under one or more of such laws. Such a

 

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challenge, regardless of the outcome, could have a material adverse effect on our business, business relationships, reputation, financial condition and results of operations.

If our operations are found to be in violation of any of the laws described above or any other governmental regulations that apply to us, we may be subject to penalties, including civil and criminal penalties, damages, fines and the curtailment or restructuring of our operations. Any penalties, damages, fines, curtailment or restructuring of our operations could harm our ability to operate our business and our financial results. Any action against us for violation of these laws, even if we successfully defend against it, could cause us to incur significant legal expenses and divert our management’s attention from the operation of our business. Moreover, achieving and sustaining compliance with applicable federal and state privacy, security and fraud laws may prove costly.

Our reporting and payment obligations under the Medicaid rebate program and other governmental purchasing and rebate programs are complex and may involve subjective decisions, and any determination of failure to comply with those obligations could subject us to penalties and sanctions, which could have a material adverse effect on our business.

The regulations regarding reporting and payment obligations with respect to Medicaid reimbursement and rebates and other governmental programs are complex and several pharmaceutical companies are currently defendants in a number of suits filed by state attorneys general and are subject to an investigation by the U.S. Department of Justice with respect to Medicaid reimbursement and rebates. Our calculations and methodologies are subject to review and challenge by the applicable governmental agencies, and it is possible that such reviews could result in material changes. In addition, because our processes for these calculations and the judgments involved in making these calculations involve, and will continue to involve, subjective decisions and complex methodologies, these calculations are subject to the risk of errors.

Any governmental agencies that may commence an investigation of us could impose, based on a claim of violation of fraud and false claims laws or otherwise, civil and/or criminal sanctions, including fines, penalties and possible exclusion from federal healthcare programs (including Medicare and Medicaid). Some of the applicable laws may impose liability even in the absence of specific intent to defraud. Furthermore, should there be ambiguity with regard to how to properly calculate and report payments, and even in the absence of any such ambiguity, a governmental authority may take a position contrary to a position that we have taken, and may impose civil and/or criminal sanctions. Any such penalties or sanctions could have a material adverse effect on our business, financial position and results of operations and could cause the market value of our stock to decline.

Healthcare cost control initiatives could cause us to sell our products at lower prices, resulting in decreased revenues.

Government payors, such as Medicare and Medicaid, as well as insurers, including managed care organizations, have increased their efforts to control the cost, utilization and delivery of healthcare services. From time to time, Congress has considered and implemented changes in the Medicare fee schedules in conjunction with budgetary legislation. Further reductions of reimbursement for Medicare services or changes in policy regarding coverage of tests may be implemented from time to time. Changes in federal, state, local and third-party payor regulations or policies may have a material adverse impact on our business. Actions by agencies regulating insurance or changes in other laws, regulations, or policies may also have a material adverse effect upon our business.

Legislative proposals and enactments to reform healthcare and government insurance programs, including the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, or MMA, and the Deficit Reduction Act of 2005, or DRA, could significantly influence the manner in which pharmaceutical and diagnostic products are prescribed and purchased. For example, effective January 1, 2006, the MMA established a new Medicare outpatient prescription drug benefit under Part D. The MMA also established a competitive acquisition program, or CAP, in which physicians who administer drugs in their offices are offered an option to acquire drugs covered under the Medicare Part B benefit from vendors who are selected in a competitive bidding process. Implementation of CAP began in July 2006. Further, the DRA requires CMS to amend certain formulas

 

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used to calculate pharmacy reimbursement under Medicaid. These changes could lead to reduced payments to pharmacies for certain pharmaceutical products. Such cost containment measures and healthcare reforms could adversely affect our ability to sell our products.

The MMA created a new prescription drug coverage program for people with Medicare through a new system of private market insurance providers; the program began in January 2006. This new benefit may result in an increased use of formularies such that, in the event a Medicare beneficiary’s medications are not listed on the applicable formulary, such Medicare beneficiary may not receive reimbursement for such medications. Moreover, once these formularies are established, Medicare will not be obligated to pay for drugs omitted from a formulary, and the cost of these non-covered drugs will not be counted towards the $3,600 annual out-of-pocket beneficiary deductible established by the MMA. Further, Medicare prescription drug program beneficiaries are not permitted to purchase private insurance policies, known as “Medigap” policies, to cover the cost of off-formulary medications. If our products are excluded from these new formularies, demand for our products may decrease, and we may be forced to lower prices for our products, which may adversely affect our business and our results of operations.

Furthermore, the U.S. Congress is considering a number of legislative and regulatory proposals with an objective of ultimately reducing healthcare costs. Legislative and regulatory actions under consideration in the U.S. include health care reform initiatives that could significantly alter the market for pharmaceuticals and diagnostics (such as private health insurance expansion, the creation of competing public health insurance plans, a variety of proposals that would reduce government expenditures for prescription drugs to help finance healthcare reform, or the eventual transition of the U.S. multiple payer system to a single payer system). Other actions under consideration include proposals for government intervention in pharmaceutical pricing, changes in government reimbursement, an accelerated approval process for “follow-on” biologics, legalization of commercial drug importation into the U.S., and involuntary approval of medicines for over the counter use. Additionally, individual states have become increasingly aggressive in passing legislation and implementing regulations designed to control pharmaceutical and diagnostic product pricing, including price or patient reimbursement constraints, discounts, restrictions on certain product access, and to encourage importation from other countries and bulk purchasing. Legally-mandated price controls on payment amounts by third-party payors or other restrictions could harm our results of operations and financial condition.

We expect there will continue to be federal and state laws and/or regulations, proposed and implemented, that could limit the amounts that federal, state and foreign governments will pay for healthcare products and services. The extent to which future legislation or regulations, if any, relating to the healthcare industry or third-party coverage and reimbursement may be enacted or what effect such legislation or regulation would have on our business remains uncertain. Such measures or other healthcare system reforms that are adopted could have a material adverse effect on our ability to successfully commercialize our products or could limit or eliminate our spending on development projects and affect our ultimate profitability.

In addition, regional healthcare authorities and individual hospitals are increasingly using bidding procedures to determine what pharmaceutical and diagnostic products and which suppliers will be included in their prescription drug and other healthcare programs. This can reduce demand for our products or put pressure on our product pricing, which could negatively affect our revenues and profitability.

Our business involves the use of hazardous materials and we and our third-party manufacturers must comply with environmental laws and regulations, which can be expensive and restrict how we do business.

Our third-party manufacturers’ activities and our own activities involve the controlled storage, use and disposal of hazardous materials, including the components of our pharmaceutical products, test samples and reagents, biological materials and other hazardous compounds. We and our manufacturers are subject to federal, state and local laws and regulations governing the use, manufacture, storage, handling and disposal of these hazardous materials. Although we believe that the safety procedures for handling and disposing of these materials comply with the standards prescribed by these laws and regulations, we cannot eliminate the risk of accidental contamination or injury from these materials. In the event of an accident, state or federal authorities

 

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may curtail our use of these materials and/or interrupt our business operations. In addition, if an accident or environmental discharge occurs, or if we discover contamination caused by prior operations, including by prior owners and operators of properties we acquire, we could be liable for cleanup obligations, damages and fines. Although we maintain hazardous material insurance coverage under our general insurance policy, it is limited in both the scope and amount of coverage. We cannot assure you that our policy would be sufficient to cover any claims. Any substantial unexpected costs we may incur could significantly harm our financial condition and results of operations.

Failure to comply with environmental, health and safety laws and regulations, including the federal Occupational Safety and Health Administration Act and the Needlestick Safety and Prevention Act, may result in fines and penalties and loss of licensure, and have a material adverse effect upon our business.

We are subject to licensing and regulation under federal, state and local laws and regulations relating to the protection of the environment and human health and safety, including laws and regulations relating to the handling, transportation and disposal of medical specimens, infectious and hazardous waste and radioactive materials as well as regulations relating to the safety and health of laboratory employees. Our laboratory is subject to applicable federal and state laws and regulations relating to biohazard disposal of all laboratory specimens, and we utilize outside vendors for disposal of such specimens. In addition, the federal Occupational Safety and Health Administration has established extensive requirements relating to workplace safety for healthcare employers, including clinical laboratories, whose workers may be exposed to blood-borne pathogens such as HIV and the hepatitis B virus. These requirements, among other things, require work practice controls, protective clothing and equipment, training, medical follow-up, vaccinations and other measures designed to minimize exposure to, and transmission of, blood-borne pathogens. In addition, the Needlestick Safety and Prevention Act requires, among other things, that we include in our safety programs the evaluation and use of engineering controls such as safety needles if found to be effective at reducing the risk of needlestick injuries in the workplace.

Failure to comply with federal, state and local laws and regulations could subject us to denial of the right to conduct business, fines, criminal penalties and/or other enforcement actions which would have a material adverse effect on its business. In addition, compliance with future legislation could impose additional requirements on us, which may be costly.

Risks Related to Intellectual Property

Our ability to protect our proprietary technology, which is vital to our business, is uncertain, and if we are unable to obtain or enforce our intellectual property rights, our competitors may develop and market products or services with similar features to ours.

Our commercial success, competitive position and amount of future income will depend in part on obtaining and maintaining patent, trademark and trade secret protection for our branded pharmaceuticals, our diagnostic tests or any other proprietary products, technologies or services that we are developing or may develop, in-license or otherwise acquire in the future. Our success will also depend on whether we are able to successfully assert or use these intellectual property rights against infringing competitors. We will only be able to protect our products, technologies and services from unauthorized use by third parties to the extent that valid and enforceable patents, trademarks or trade secrets cover them.

Our policy is to seek patent protection and enforce the intellectual property rights we own and license. We cannot assure you that patent applications we submit and have submitted will result in patents being issued. If a patent application is made that qualifies as a joint invention, the joint inventor or his or her employer may have rights in the invention. We cannot assure you that a third party will not infringe upon, design around or develop uses not covered by any patent issued or licensed to us or that these patents will provide any measure of commercial exclusivity. Even issued patents may later be modified or revoked by the U.S. Patent and Trademark Office, or the USPTO, or invalidated in legal proceedings.

 

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Moreover, we believe that obtaining foreign patents may be more difficult than obtaining domestic patents because of differences in patent laws and, accordingly, our patent position may be stronger in the United States than abroad. Foreign patents may be more difficult and/or expensive to defend and/or the remedies available may be less extensive than in the United States. Various countries limit the subject matter that can be patented and limit the ability of a patent owner to enforce patents in the medical and other related fields. This may limit our ability to obtain or utilize those patents internationally.

Patent applications in the United States are maintained in secrecy until at least 18 months after the filing of the application with the USPTO and, since publication of discoveries in the scientific or patent literature tends to lag behind actual discoveries, we cannot be certain that we were the first creator of the inventions covered by pending patent applications or the first to file patent applications on those inventions. We cannot assure you that any of the pending patents for which we have filed applications will be issued, or, if issued, whether the scope of the claims allowed will be sufficient to protect our products, technologies and services.

Several pharmaceutical and diagnostic companies and research and academic institutions have developed technologies, filed patent applications or received patents for technologies that may be related to our business. Others may file patent applications and may receive patents that may overlap or conflict with patents or patent applications we have obtained or licensed for our use, either by claiming the same methods or compounds or by claiming methods or compounds that could dominate those owned by or licensed to us. Litigation or other patent office proceedings to establish the validity of patents, to defend against patent infringement claims of others and to assert patent infringement claims against others can be expensive and time-consuming even if the outcome is favorable to us. If the outcome is unfavorable to us, this could have a material adverse effect on our business. Furthermore, we are collaborating to develop new microRNA-based diagnostic tests and the microRNA field is new and developing. Accordingly, there is significant uncertainty about what patents will be issued and what their claims may cover. There may be significant litigation and other proceedings, such as interference proceedings and opposition proceedings relating to patent rights in the microRNA field. We have taken and may, in the future, take steps to enhance our patent protection, but we cannot assure you that these steps will be sufficient or that, if unsuccessful, our patent protection will be adequate.

The patent positions of pharmaceutical and diagnostic companies can be highly uncertain and involve complex legal and factual questions for which important legal principles remain unresolved. Key questions of patent law underlying pharmaceutical and diagnostic patents remain unresolved or in flux in the United States and even more so outside the United States. Changes in either the patent laws or in interpretations of patent laws in the United States and other countries may diminish the value of our intellectual property. Accordingly, we cannot predict the validity or scope of enforceability of claims that may be allowed in our patents or in third-party patents.

The degree of future protection afforded by our proprietary rights is uncertain, because legal means provide only limited protection that may not be adequate to protect our rights or permit us to gain or keep our competitive advantage. For example:

 

   

we, or the parties from whom we have acquired or licensed patent rights, may not have been the first to file the underlying patent applications or the first to make the inventions covered by such patents;

 

   

the named inventors or co-inventors of patents or patent applications that we have licensed or acquired may be incorrect, which may give rise to inventorship disputes or invalidate the patents;

 

   

others may independently develop similar or alternative technologies or duplicate any of our products, technologies or services or design around our patents;

 

   

it is possible that none of the pending patent applications licensed to us will result in issued patents;

 

   

the issued patents covering our products, technologies or services may not provide us with any competitive advantages;

 

   

the issued patents may be challenged, invalidated, circumvented or rendered unenforceable;

 

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issued patents covering our products, technologies or services may ultimately be deemed or adjudicated as obvious, anticipated and/or otherwise invalid;

 

   

the issued patents may be subject to re-examination which could result in a narrowing of the scope of claims or cancellation of claims found unpatentable;

 

   

we may not develop or acquire additional proprietary technologies that are patentable;

 

   

our trademarks may be invalid or subject to a third party’s prior use; or

 

   

our ability to enforce our patent rights will depend on our ability to detect infringement, and litigation to enforce patent rights is costly and time-consuming.

The term of exclusivity for the two U.S. patents covering Entocort EC expire in May 2011 and January 2015, respectively. Therefore, even if we are able to extend our exclusive contractual right with AstraZeneca to promote Entocort EC beyond 2010, Entocort EC may face increased competition from generic products upon the expiration of either of the patents. Additionally, the U.S. patents covering Helidac expire in October 2010, April 2012 and February 2014; and the five U.S. patents covering Lotronex expire in May 2011, January 2013, January 2018, October 2018 and October 2018. We have submitted one of the Lotronex method of use patents, which expire in October 2018, to re-examination in the United States Patent and Trademark Office in view of references that raise a new question of patentability. In the United States, Colal-Pred is covered by one issued patent that expires in March 2011. In addition, a separate pending application exists in the United States, Canada and Mexico which covers Colal-Pred, and if issued, would expire in February 2023.

We also rely on trade secrets to protect our products, technology and services, particularly where we do not believe patent protection is appropriate or obtainable. However, trade secrets can be difficult to protect. While we use commercially reasonable efforts to protect our trade secrets, our licensors, employees, consultants, contractors, outside scientific collaborators and other advisors may unintentionally or willfully disclose such trade secret information to third parties and competitors. We attempt to protect our proprietary technology in large part by entering into confidentiality and non-disclosure agreements with our employees, consultants and other contractors. We cannot assure you, however, that these agreements will not be breached, that we will have adequate remedies for any breach or that competitors will not know of, or independently discover, our trade secrets. We cannot assure you that others will not independently develop substantially equivalent proprietary information or be issued patents that may prevent the sale of our products, technologies, services or know-how or require licensing and the payment of significant fees or royalties by us in order to produce our products, technologies or services. Moreover, we cannot assure you that our technology does not infringe upon any valid claims of patents that other parties own. Enforcing a claim that a third party illegally obtained and is using our trade secrets is expensive and time consuming, and the outcome is unpredictable. In addition, courts outside the United States are sometimes less willing to protect trade secrets. Moreover, our competitors may independently develop or acquire equivalent knowledge, methods or know-how.

If our licensors or we fail to obtain or maintain patent protection or trade secret protection for our products, technologies, services or any other product candidate we may in-license or acquire, third parties could use our proprietary information, which could impair our ability to compete in the market and adversely affect our ability to generate revenues and maintain profitability.

Two companies each submitted an Abbreviated New Drug Application, or ANDA, to the FDA containing a Paragraph IV patent certification for Entocort EC in the first half of 2008, indicating that each company intends to market a generic version of Entocort EC prior to the expiration of one or both patents covering the product.

In the first half of 2008, Barr Laboratories, Inc. and Barr Pharmaceutical, Inc., or Barr, which was acquired by Teva Pharmaceutical Industries Ltd. in December 2008, and Mylan Pharmaceutical, Inc., or Mylan, each submitted an ANDA containing a Paragraph IV patent certification for Entocort EC pursuant to the Hatch-Waxman Act. We have the exclusive right to distribute, market and sell Entocort EC in the United States under an agreement with AstraZeneca which currently runs through December 31, 2010. In the United States,

 

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Entocort EC is protected by two patents, the term of exclusivity for which expires in May 2011 and January 2015, respectively. The submission of the ANDAs containing the Paragraph IV certification indicates that each party intends to market a “generic equivalent” of Entocort EC prior to the expiration of one or both patents covering the product. Under the Hatch-Waxman Act, an ANDA applicant who files a Paragraph IV certification is required to notify the owner of the patent and the holder of the NDA for the listed drug, which notice must include a detailed statement of the factual and legal basis for the ANDA applicant’s opinion that the patent is not valid or will not be infringed by introduction into the market of the proposed generic product. Both of the patents covering Entocort EC are owned by an affiliate of AstraZeneca.

The submission of an ANDA for a drug product claimed in a patent is an act of infringement, and therefore the ANDA applicant may be sued for patent infringement upon the NDA holder or patent holder’s receipt of notification that the ANDA with the Paragraph IV certification has been submitted to the FDA. A lawsuit for patent infringement filed within 45 days of receipt of notice of the Paragraph IV certification automatically triggers a 30-month stay (commencing the date of receipt of notice), during which the FDA may not give final approval of the ANDA application, unless there is a judicial determination or settlement of the patent dispute prior to the expiration of such 30 month period.

Under our agreement with AstraZeneca, AstraZeneca has the exclusive right to determine what action, if any, will be taken in the event of any infringement or threatened infringement on the patents covering Entocort EC. AstraZeneca has received a notification from each ANDA applicant and AstraZeneca has filed separate suits against Barr and Mylan for patent infringement. Subject to receiving an earlier issued judicial determination or settlement of the patent dispute, we believe that the 30-month stay for Barr will expire in October 2010 and the 30-month stay for Mylan will expire in December 2010. Pursuant to FDA rules and regulations, the first ANDA filer will have a 6-month period of exclusivity from the date it launches its generic product during which all other ANDA filers will not be allowed to market or sell their generic product. We believe that Barr was the first ANDA filer but we have not been able to confirm this belief.

If a generic version of Entocort EC is launched while we have the right to distribute and market Entocort EC, it could adversely affect our ability to successfully execute our business strategy to maximize the value of Entocort EC and would likely negatively impact our financial condition and results of operations. In addition, while AstraZeneca has the exclusive right to determine what action, if any, will be taken in the event of an infringement or threatened infringement of the patents, we are required during the term of our agreement with AstraZeneca, upon AstraZeneca’s reasonable request and at AstraZeneca’s cost, to use diligent efforts to assist AstraZeneca in its actions, in which case any litigation may prove to be time-consuming and distracting to management, which could have a material adverse effect on our business. We have limited, if any, control over the amount or timing of resources that AstraZeneca devotes on our behalf or the priority they place on defending and maintaining these patent rights. Our business may suffer if AstraZeneca fails to prevent infringement by the ANDA applicant, or if the subject patents are found to be invalid.

We also rely on our licensors to protect our patent rights, and if our licensors fail to adequately protect and enforce such rights or if we do not have exclusivity for the marketing of our products or services, our ability to gain exclusivity for our products or services could suffer.

Our distribution agreement with AstraZeneca grants us the exclusive right for the promotion and sale in the United States of Entocort EC, our leading pharmaceutical product. In addition, we have licensed a number of patents, including patents related to Colal-Pred and our IBD Serology 7, thiopurine management and oncology diagnostic tests, with respect to which we depend substantially on third parties to protect and enforce the proprietary rights covering these patents and diagnostic tests. With regard to some of these proprietary rights, we have limited, if any, control over the amount or timing of resources that such parties devote on our behalf or the priority they place on obtaining and maintaining these patent rights, prosecuting these patent applications to our advantage and enforcing any issued patents against infringement by third parties. Our business may significantly suffer if one or more of these agreements terminates or expires, if we or any of our licensors fail to abide by the terms of such agreements or fail to prevent infringement by third parties, or if the subject patents are found to be invalid. Without the protection of the intellectual property we license, other companies might be able to offer

 

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substantially identical products for sale, which could adversely affect our competitive business position and harm our business prospects. We license Colal-Pred from Alizyme and our oncology diagnostic tests from Rosetta Genomics, both of which are located outside of the United States, and we may seek agreements in the future with other companies located outside of the United States. In the event of the insolvency of one of these companies, foreign insolvency law may not protect our proprietary rights under these agreements in the same manner as United States law. On July 24, 2009 Alizyme, and its parent company, Alizyme plc, entered administration in England, in each case on the grounds that it was or was likely to become unable to pay its debts. The administration of Alizyme means that Alizyme, acting through the agency of its administrators, might refuse or decline to perform its outstanding and continuing obligations under the license agreement. While in administration, our contract with Alizyme may not be modified or terminated without our consent. Furthermore, the administration may transition to a liquidation, in which case the liquidator may seek to disclaim the license agreement and Alizyme’s obligations under it. In the event that Alizyme enters liquidation and its liquidator seeks to and is successful in having our agreement with Alizyme disclaimed, we may lose our rights to the Colal-Pred patents covered by our license agreement with Alizyme. Failure to take appropriate steps to protect against infringement of intellectual property rights could jeopardize our ongoing efforts to promote them and could adversely affect our ability to generate revenues and maintain profitability.

If our licenses are terminated for any of our products, product candidates or diagnostic testing services, we may not be able to continue developing or offering such products or services. In addition, if we breach the terms of the distribution agreement with AstraZeneca, the license agreement with Alizyme or any of our other licenses, or otherwise lose our rights under these agreements (including as a result of the administration or potential liquidation of Alizyme discussed above), we may be unable to continue developing and selling our products, including, without limitation, Entocort EC and Colal-Pred. AstraZeneca or others may dispute the scope of our rights under the distribution agreement, and our licensors or others may dispute the scope of our rights under our licenses. AstraZeneca may breach the terms of the distribution agreement or, similarly, the licensors under our licenses may breach the terms of their respective licenses. Any such breach could materially and adversely affect our ability to generate revenues and profitability and, if not cured, may result in the termination of the applicable agreement. In addition, under the distribution agreement, AstraZeneca has the right to require us to discontinue promoting Entocort EC in the event of a claim by a third party that the sale of the product infringes a third party’s patents in the United States.

If the use or sale of our technologies or the manufacture or sale of certain products or services infringe the intellectual property rights of third parties, we may incur substantial liabilities and be unable to commercialize products or services based on these technologies in a profitable manner, if at all.

Other companies may have or may acquire patent rights that they could enforce against us. If they do so, we may be required to alter our technologies, pay licensing fees or cease activities. If our products, technologies or services infringe the patent rights of others, they could bring legal action against us or our licensees, suppliers, vendors, resellers, distributors, customers or collaborators, claiming damages and seeking to enjoin manufacturing and marketing of the affected products, technologies or services.

Because patent applications can take many years to issue, there may be currently pending applications unknown to us or reissue applications that may later result in issued patents upon which our products, technologies or services may infringe. There could also be existing patents of which we are unaware that our products, technologies or services may infringe. In addition, if third parties file patent applications or obtain patents claiming products, technologies or services also claimed by us in pending applications or issued patents, we may have to participate in interference proceedings in the U.S. Patent and Trademark Office to determine priority of invention. If third parties file oppositions in foreign countries, we may also have to participate in opposition proceedings in foreign tribunals to defend the patentability of our filed foreign patent applications.

If a third party claims that we infringe its proprietary or intellectual property rights, it could cause our business to suffer in a number of ways, including:

 

   

we may become involved in time-consuming and expensive litigation, even if the claim is without merit, the third party’s patent is ultimately invalid or we are ultimately found to have not infringed;

 

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we may become liable for substantial damages for past infringement if a court decides that our technologies infringe upon a third party’s patent;

 

   

we may be ordered by a court to stop making, selling or licensing our products or services without a license from the patent holder, which may not be available on commercially acceptable terms, if at all, or which may require us to pay substantial royalties or grant cross-licenses to our patents; and

 

   

we may have to redesign our product so that it does not infringe upon others’ patent rights, which may not be possible or could require substantial investment or time.

If any of these events occur, our business could suffer and the market price of our common stock may decline.

Because of the expense and uncertainty of litigation, we may not be in a position to enforce our intellectual property rights against third parties.

Because of the expense and uncertainty of litigation, we may conclude that even if a third party is infringing our patents or other intellectual property rights, the risk-adjusted cost of bringing and enforcing such a claim or action may be too high or not in the best interest of our company or our shareholders. In such cases, we may decide that the more prudent course of action is to simply monitor the situation or initiate or seek some other non-litigious action or solution.

If we are involved in intellectual property claims and litigation, the proceedings may divert and consume our resources and subject us to significant liability for damages, substantial litigation expense and/or the loss of our proprietary rights.

Litigation may be necessary to assert or defend against infringement claims, enforce our issued and licensed patents, protect our trade secrets or know-how or determine the enforceability, scope and validity of the proprietary rights of others. Our involvement in intellectual property claims and litigation could:

 

   

divert and consume existing management, legal, scientific and financial resources;

 

   

subject us to significant liabilities;

 

   

allow our competitors to market competitive products or services without obtaining a license from us;

 

   

cause product shipment delays and lost sales;

 

   

require us to enter into royalty or licensing agreements, which may not be available on terms acceptable to us, if at all; or

 

   

force us to discontinue selling or to modify our products, to discontinue providing services, or to cease developing new products or services.

There can be no assurance that any such litigation will result in a favorable outcome to us. Additionally, at times, other commercial laboratories that are also our customers have used assays that we believe infringe the patents underlying our licenses. When this occurs, commencing litigation, or otherwise accusing our customers of infringement, may cause them to reduce or eliminate the number of assays that they refer to us.

For a description of current litigation involving our intellectual property, see “Business—Legal Proceedings.”

We may be subject to damages resulting from claims that we or our employees have wrongfully used or disclosed alleged trade secrets of their former employers.

Many of our employees or consultants were previously employed at universities or other diagnostic or biotechnology companies, including our current and potential competitors. Although we are not aware of any claims currently pending against us, we may be subject to claims that these employees, consultants or we have inadvertently or otherwise used or disclosed trade secrets or other proprietary information of their former employers. Litigation may be necessary to defend against these claims. Even if we are successful in defending

 

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against these claims, litigation could result in substantial costs and be a distraction to management. If we fail in defending such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights or personnel or both.

If we cannot obtain intellectual property owned by third parties that we desire to use or incorporate into new products we plan to develop, we may not be able to develop or commercialize these future products.

As part of our business strategy, we regularly consider and, as appropriate, may make acquisitions or purchases of technologies, products, assets and businesses that we believe are strategically desirable or complementary to our business. As part of this strategy, we may develop additional diagnostic tests or acquire the rights to additional pharmaceutical products. The technology that we ultimately may use in the development and commercialization of these future products may be protected by patent and other intellectual property rights owned by third parties. If we are unable to obtain rights to use necessary third-party intellectual property under commercially reasonable terms, or at all, we may be unable to develop these products, and this could harm our ability to expand our commercial product offerings and to generate additional revenue from these products.

Under our distribution agreement with AstraZeneca, we do not have the right to determine what action will be taken in the event of any infringement of the ENTOCORT® trademark.

We have the exclusive right to distribute, market and sell Entocort EC in the United States and to use the trademark, ENTOCORT®, under our distribution agreement with AstraZeneca. We believe the protection of the ENTOCORT® trademark is critical to the commercial success of Entocort EC and to our competitive position. Under the distribution agreement, AstraZeneca has the exclusive right to determine what action, if any, will be taken in the event of any infringement or threatened infringement on the above patents or the trademark. We cannot be certain that AstraZeneca will take any action in the event of an infringement or a threatened infringement of the trademark. If AstraZeneca does not adequately protect the ENTOCORT® trademark from infringement, any goodwill that has been developed in that mark may be lost or impaired.

Many of our diagnostic products and services depend upon third-party computer software.

Many of our diagnostic products and services use, are based upon or incorporate third-party or “open source” computer software. If we are unable to maintain or obtain a license to such software or keep any “open source” proprietary or if software is found to contain errors that cannot be fixed, then we may be unable to offer these diagnostic products and services, which could materially and adversely affect our business, financial condition, results of operations and growth prospects.

Risks Related to Our Finances and Capital Requirements

Our quarterly operating results may fluctuate significantly.

We expect our operating results to be subject to quarterly fluctuations. Our operating results will be affected by numerous factors, including:

 

   

acquisitions and sales of new products, technologies or businesses;

 

   

expenditures incurred to acquire and promote additional products, technologies or businesses;

 

   

changes in our relationships with any collaborators;

 

   

competitive pricing pressures and general economic and industry conditions which affect customer demand;

 

   

the introduction of new products by us or our competitors;

 

   

a changing customer base;

 

   

changes in sales and marketing expenditures;

 

   

the mix of products that we sell during any time period;

 

   

changes in treatment practices of physicians that currently prescribe our products;

 

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changes in third-party insurance coverage and reimbursement policies;

 

   

supply interruptions;

 

   

varying levels of research and development expenditures due to the timing of validation studies and clinical trials and related costs, among other factors;

 

   

expenditures as a result of legal actions and the outcome of any such legal action;

 

   

the impairment and write-down of intangibles or other assets;

 

   

federal, state or international regulatory actions;

 

   

additions or departures of key personnel;

 

   

implementation of new or revised accounting or tax rules or policies;

 

   

termination or expiration of, or the outcome of disputes relating to, patents, license agreements, trademarks and other rights;

 

   

the timing and amount of milestone payments by us;

 

   

increases in insurance rates for existing products and the cost of insurance for new products; and

 

   

timing of revenue recognition related to licensing agreements.

If our quarterly operating results fall below the expectations of investors or securities analysts, the price of our common stock could decline substantially. Furthermore, any quarterly fluctuations in our operating results may, in turn, cause the price of our stock to fluctuate substantially. We believe that quarterly comparisons of our financial results are not necessarily meaningful and should not be relied upon as an indication of our future performance.

We may require additional funding, and our future access to capital is uncertain. Insufficient funds could cause us to delay, scale back or choose not to pursue some or all of our potential product acquisitions and licensing opportunities.

We believe that our available cash balances, anticipated cash flows from operations and the proceeds we receive from the exercise of stock options and this offering will be sufficient to support our current operating needs for the foreseeable future. However, our business can change unpredictably due to a variety of factors, including competition, regulation, legal proceedings or other events, which could impact our funding needs or our cash flow from operations. In addition, our estimates of the funds necessary to develop and commercialize new diagnostic tests or therapeutic products may be inaccurate or we may acquire products or other assets in the future, in each case which could require additional funds. Furthermore, we may seek additional capital due to favorable market conditions or strategic considerations even if we believe we have sufficient funds for our current or future operating plans. Accordingly, we could seek additional funding through public or private financing, including equity and debt offerings. Adequate funds, whether through the financial markets or from other sources, may not be available when we need them or on terms acceptable to us. For example, recent concerns over the availability and the cost of credit, the U.S. mortgage market, a declining residential real estate market in the U.S., inflation, energy costs and geopolitical issues have contributed to increased volatility and diminished expectations for the economy and the markets going forward. These factors, combined with volatile oil prices, declining business and consumer confidence and increased unemployment, have precipitated an economic recession and fears of a possible depression. Domestic and international capital markets have also been experiencing heightened volatility and turmoil, making it more difficult to raise capital through the issuance of equity securities. Furthermore, as a result of the recent volatility in the capital markets, the cost and availability of credit has been and may continue to be adversely affected by illiquid credit markets and wider credit spreads. Concern about the stability of the markets generally and the strength of counterparties specifically has led many lenders and institutional investors to reduce, and in some cases, cease to provide funding to borrowers. Insufficient funds could cause us to delay, scale back or choose not to pursue some or all of our potential product acquisitions and licensing opportunities.

 

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Raising additional capital may cause dilution to existing shareholders, restrict our operations or require us to relinquish rights.

We may seek the additional capital necessary to fund our operations through public or private equity offerings, debt financings, and collaborative and licensing arrangements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, your ownership interest may be diluted and the terms may include liquidation or other preferences or rights that adversely affect your rights as a shareholder. Debt financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions such as incurring additional debt, making capital expenditures, or declaring dividends. If we raise additional funds through collaboration and licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies or products, or grant licenses on terms that are not favorable to us.

Our indebtedness could adversely affect our financial health.

As of September 30, 2009, we had $65.6 million of indebtedness. Our existing indebtedness could:

 

   

impair our ability to obtain additional financing in the future for working capital needs, capital expenditures and general corporate purposes;

 

   

increase our vulnerability to general adverse economic and industry conditions;

 

   

make it more difficult for us to satisfy other debt obligations we may incur in the future;

 

   

require us to dedicate a substantial portion of our cash flows from operations to the payment of principal and interest on our indebtedness, thereby reducing the availability of our cash flows to fund working capital needs, capital expenditures and other general corporate purposes;

 

   

limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate;

 

   

place us at a disadvantage compared to our competitors that have less indebtedness; and

 

   

expose us to higher interest expense in the event of increases in interest rates because our indebtedness under our credit agreement bears, and future borrowings may bear, interest at a variable rate.

For a description of our credit agreement, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Contractual Obligations and Commercial Commitments.”

Covenants in our credit agreement may limit our ability to operate our business.

Under the credit agreement we entered into on September 21, 2007, we are subject to certain affirmative and negative covenants, including limitations on our ability: to grant liens; to make investments; to create, incur, assume, guarantee or be liable with respect to certain indebtedness; to merge, dissolve, liquidate or consolidate our business; to convey, sell, transfer, license, lease or otherwise dispose of assets; to pay dividends and make certain other restricted payments; or to enter into any sale lease-back transactions. We are also subject to certain covenants that require us to maintain certain financial ratios.

As a result of these covenants and ratios, we have certain limitations on the manner in which we can conduct our business, and we may be restricted from engaging in favorable business activities or financing future operations or capital needs. In addition, if we default under the credit agreement because of a covenant breach or otherwise, all outstanding amounts could become immediately due and payable, which would negatively impact our liquidity and reduce the availability of our cash flows to fund working capital needs, capital expenditures and other general corporate purposes.

Impairment of our significant long-lived assets may reduce our profitability.

Our long-lived assets consist of property, equipment, acquired and licensed product rights, patents and trademarks. We regularly review the carrying amount of our long-lived assets. Some factors we consider important in assessing whether or not impairment exists include performance relative to expected historical or

 

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projected future operating results, significant changes in the manner of our use of the assets or the strategy for our overall business and significant negative industry or economic trends. If the carrying value of the asset exceeds projected undiscounted cash flows, the asset will be written down to its fair value, which could result in an impairment of our long-lived assets. Any impairment of our long-lived assets in the future may reduce our profitability and have a material adverse effect on our results of operations and financial condition. Our net long-lived assets were $122.3 million at September 30, 2009.

Our results of operations and liquidity needs could be materially affected by market fluctuations and economic downturn.

Our results of operations could be materially affected by economic conditions generally, both in the U.S. and elsewhere around the world. Recently, concerns over the availability and cost of credit, the U.S. mortgage market, a declining residential real estate market in the U.S., inflation, energy costs and geopolitical issues have contributed to increased volatility and diminished expectations for the economy and the markets going forward. These factors, combined with volatile oil prices, declining business and consumer confidence and increased unemployment, have precipitated an economic recession and fears of a possible depression. Domestic and international capital markets have also been experiencing heightened volatility and turmoil. These events and the continuing market upheavals may have an adverse effect on us. In the event of a continuing market downturn, our results of operations could be adversely affected by those factors in many negative ways, including making it more difficult for us to raise funds if necessary, and our stock price may decline. In addition, we maintain significant amounts of cash and cash equivalents at one or more financial institutions that are in excess of federally insured limits. Given the current instability of financial institutions, we cannot be assured that we will not experience losses on these deposits.

In addition, the weakening of the national economy and the recent reduced availability of credit may have decreased the financial stability of our customers. As a result, it may become more difficult for us to collect our accounts receivable or it may take us longer for us to collect our accounts receivable. If these conditions continue, our operating cash flow and results of operations could be adversely affected.

Risks Relating to Securities Markets and Investment in Our Stock

There may not be a viable public market for our common stock.

Prior to this offering, there has been no public market for our common stock, and there can be no assurance that a regular trading market will develop and continue after this offering or that the market price of our common stock will not decline below the initial public offering price. The initial public offering price will be determined through negotiations between us [, the selling shareholders] and the underwriters and may not be indicative of the market price of our common stock following this offering. Among the factors considered in such negotiations are the history and prospects for the industry in which we compete, market valuations of other companies that we and the representative of the underwriters believe to be comparable to us, prospects for our future earnings, the present state of our development and other factors deemed relevant. See “Underwriting” for additional information.

As a new investor, you will experience immediate and substantial dilution in the net tangible book value of your shares.

The initial public offering price of our common stock in this offering is considerably more than the net tangible book value per share of our outstanding common stock. Investors purchasing shares of common stock in this offering will pay a price that substantially exceeds the value of our tangible assets after subtracting liabilities. As a result, investors will:

 

   

incur immediate dilution of $            per share, based on an assumed initial public offering price of $             per share, the midpoint of the price range set forth on the cover page of this prospectus, assuming the conversion of our convertible preferred stock; and

 

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contribute    % of the total amount invested to date to fund our company based on an assumed initial offering price to the public of $            per share, the midpoint of the price range set forth on the cover page of this prospectus, but will own only    % of the shares of common stock outstanding after the offering.

To the extent outstanding stock options or warrants are exercised, there will be further dilution to new investors.

We believe that our existing cash, cash equivalents and marketable securities, together with the borrowing capacity under our credit agreement will be sufficient to meet our projected operating requirements for the foreseeable future. However, because we may need to raise additional capital in the future, we may conduct substantial additional equity offerings. These future equity issuances, together with the exercise of outstanding options or warrants and any additional shares issued in connection with acquisitions, will result in further dilution to investors.

We expect that the price of our common stock will fluctuate substantially.

The initial public offering price for the shares of our common stock sold in this offering has been determined by negotiation between the representative of the underwriters and us. This price may not reflect the market price of our common stock following this offering. The price of our common stock may decline. In addition, the market price of our common stock is likely to be highly volatile and may fluctuate substantially due to many factors, including:

 

   

fluctuations in our operating results;

 

   

acquisitions and sales of new products, technologies or businesses;

 

   

regulatory developments affecting any development-stage product candidates;

 

   

the outcome of legal actions to which we are party;

 

   

additions or departures of key personnel;

 

   

announcements concerning product development results or intellectual property rights of others;

 

   

approvals or disapprovals of regulatory filings we have submitted;

 

   

changes in regulatory laws and regulations in the United States or announcements relating to these matters;

 

   

new legislation in the United States relating to the sale or pricing of pharmaceuticals;

 

   

deviations in our operating results from the estimates of securities analysts or other analyst comments;

 

   

discussion of us or our stock price by the financial and scientific press and in online investor communities; and

 

   

economic and other external factors, including disasters and other crises.

The realization of these or any of the risks described in these “Risk Factors” could have a dramatic and material adverse impact on the market price of our common stock.

Approximately    % of our outstanding common stock has been deposited into a voting trust, which could affect the outcome of shareholder actions.

Before completion of this offering, approximately            shares of our common stock owned by affiliates of Credit Suisse Securities (USA) LLC, representing approximately    % of our common stock then outstanding, will become subject to a voting trust agreement pursuant to which the shares will be voted by an independent voting trustee.

 

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The voting trust agreement requires that the trustee cause the shares subject to the voting trust to be represented at all shareholder meetings for purposes of determining a quorum, but the trustee is not required to vote the shares on any matter. The voting trust agreement does not provide any criteria that the trustee must use in determining whether or not to vote on a matter. If the trustee votes the shares on any matter subject to a shareholder vote, including proposals involving the election of directors, changes of control and other significant corporate transactions, the shares will be voted in the same proportion as votes cast “for” or “against” those proposals by our other shareholders. As long as these shares continue to be held in the voting trust, if the trustee determines to vote the shares on a particular matter, the voting power of all other shareholders will be magnified by the operation of the voting trust. With respect to matters such as the election of directors, California law provides that the requisite shareholder vote is based on the shares actually voted. Accordingly, with respect to these matters, the voting trust will make it possible to control the “majority” vote of our shareholders with only     % of our outstanding common stock. In addition, with respect to other matters, including the approval of a merger or acquisition of us or substantially all of our assets, a majority or other specified percentage of our outstanding shares of common stock must be voted in favor of the matter in order for it to be adopted. If the trustee does not vote the shares subject to the voting trust on these matters, the effect of the non-vote would be equivalent to a vote “against” the matter, making it substantially more difficult to achieve shareholder approval of the matter. See “Description of Capital Stock—Voting Trust Agreement” for more information regarding the voting trust agreement.

Our management team may invest or spend the proceeds of this offering in ways with which you may not agree or in ways which may not yield a return.

The net proceeds from this offering may be used for working capital purposes and for other general corporate purposes, including to finance in-licensing or acquisition opportunities, the research and development of new products, sales and marketing activities and other capital expenditures. Although we may also use a portion of the net proceeds to in-license or acquire complementary products or to acquire or to enter into collaborations with complementary businesses, we have no current binding commitments or agreements to do so. Our management will have considerable discretion in the application of the net proceeds, and you will not have the opportunity, as part of your investment decision, to assess whether the proceeds are being used appropriately. The net proceeds may be used for corporate purposes that do not increase our operating results or market value. Until the net proceeds are used, they may be placed in investments that do not produce significant income or that may lose value.

Future sales of our common stock may depress our stock price.

Sales of a substantial number of shares of our common stock in the public market could occur at any time. These sales, or the perception in the market that the holders of a large number of shares intend to sell shares, could reduce the market price of our common stock. After this offering, we will have            outstanding shares of common stock based on the number of shares outstanding as of September 30, 2009, after giving effect to the conversion of all of the shares of our preferred stock outstanding as of September 30, 2009 into shares of common stock in connection with this offering. This also includes the shares that we are selling in this offering, which may be resold in the public market immediately. Of the remaining shares,            shares are currently restricted as a result of securities laws or lock-up agreements but will be available for resale in the public market as described in the “Shares Eligible for Future Sale” section of this prospectus. As a result of the lock-up agreements between our underwriters and our security holders and the provisions of Rule 144 and Rule 701 under the Securities Act of 1933, as amended, or the Securities Act, the shares of our common stock (excluding the shares sold in this offering) that will be available for sale in the public market are as follows:

 

   

shares are eligible for sale under Rule 144 as of the date of this prospectus;

 

   

shares will be eligible for sale under Rule 701 upon the expiration of the lock-up agreements, beginning as soon as 180 days after the date of this prospectus;

 

   

shares will be eligible for sale under Rule 144 upon the expiration of the lock-up agreements, subject to volume limitations, manner of sale requirements and other restrictions, beginning as soon as 180 days after the date of this prospectus;

 

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shares will be eligible for sale under Rule 144 upon expiration of the lock-up agreements without volume limitations, manner of sale requirements or other restrictions, beginning as soon as 180 days after the date of this prospectus;

 

   

shares will be eligible for sale, upon exercise of vested options, upon the expiration of the lock-up agreements, beginning as soon as 180 days after the date of this prospectus; and

 

   

shares will be eligible for sale upon exercise of outstanding warrants, upon the expiration of the lock-up agreements, beginning as soon as 180 days after the date of this prospectus.

Moreover, after this offering, holders of approximately            shares of common stock will have rights, subject to some conditions, to require us to file registration statements covering their shares or to include their shares in registration statements that we may file for ourselves or other shareholders. These rights will continue following this offering and will terminate on April 30, 2011, or for any particular holder with registration rights who holds less than 1% of our outstanding capital stock and less than 100,000 shares of our capital stock. We also intend to register all shares of common stock that we may issue under our equity compensation plans. Once we register these shares, they can be freely sold in the public market upon issuance, subject to the lock-up agreements described in the “Underwriting” section of this prospectus.

Our executive officers and directors and their affiliates will exercise control over shareholder voting matters in a manner that may not be in the best interests of all of our shareholders.

Immediately following this offering, our executive officers and directors and their affiliates will together control approximately    % of our outstanding common stock. As a result, these shareholders will collectively be able to significantly influence all matters requiring approval of our shareholders, including the election of directors and approval of significant corporate transactions. The concentration of ownership may delay, prevent or deter a change in control of our company even when such a change may be in the best interests of some shareholders, could deprive our shareholders of an opportunity to receive a premium for their common stock as part of a sale of our company or our assets and might affect the prevailing market price of our common stock.

Anti-takeover provisions under our charter documents and California law could delay or prevent a change in control which could limit the market price of our common stock and may prevent or frustrate attempts by our shareholders to replace or remove our current management.

Our amended and restated articles of incorporation and amended and restated bylaws, which are to become effective at the closing of this offering, will contain provisions that could delay or prevent a change in control of our company or changes in our Board of Directors that our shareholders might consider favorable. Some of these provisions will include:

 

   

a Board of Directors divided into three classes serving staggered three-year terms, such that not all members of the Board of Directors will be elected at one time;

 

   

a prohibition on shareholder action through written consent;

 

   

advance notice requirements for shareholder proposals and nominations;

 

   

a requirement of approval of not less than 662/3% of all outstanding shares of our capital stock entitled to vote to amend any bylaws by shareholder action, or to amend specific provisions of our articles of incorporation; and

 

   

the authority of the Board of Directors to issue preferred stock on terms determined by the Board of Directors without shareholder approval.

In addition, we are governed by the provisions of the California Corporations Code, which could discourage a party from acquiring, or make it more difficult for a party to acquire, control of our company without approval of our Board of Directors. In particular, the provisions of Section 1203 of the California Corporations Code require us to provide a fairness opinion to our shareholders in connection with their consideration of any proposed “interested party” reorganization transaction. These and other provisions in our amended and restated

 

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articles of incorporation, amended and restated bylaws and California law could make it more difficult for shareholders or potential acquirers to obtain control of our Board of Directors or initiate actions that are opposed by the then-current Board of Directors, including to delay or impede a merger, tender offer or proxy contest involving our company. Any delay or prevention of a change in control transaction or changes in our Board of Directors could cause the market price of our common stock to decline.

We have never paid dividends on our capital stock, and because we do not anticipate paying any cash dividends in the foreseeable future, capital appreciation, if any, of our common stock will be your sole source of gain on an investment in our stock.

We have paid no cash dividends on any of our classes of capital stock to date and we currently intend to retain our future earnings, if any, to fund the development and growth of our business. We do not anticipate paying any cash dividends on our common stock in the foreseeable future. Furthermore, our credit agreement restricts our ability to pay dividends. As a result, capital appreciation, if any, of our common stock will be your sole source of gain for the foreseeable future.

We may become involved in securities class action litigation that could divert management’s attention and harm our business.

The stock markets have from time to time experienced significant price and volume fluctuations that have affected the market prices for the common stock of pharmaceutical companies. These broad market fluctuations may cause the market price of our common stock to decline. In the past, securities class action litigation has often been brought against a company following a decline in the market price of its securities. This risk is especially relevant for us because pharmaceutical companies have experienced significant stock price volatility in recent years. We may become involved in this type of litigation in the future. Litigation often is expensive and diverts management’s attention and resources, which could adversely affect our business.

 

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This prospectus contains forward-looking statements. These forward-looking statements are contained in the sections entitled “Prospectus Summary,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Business” and elsewhere in this prospectus. These statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that could cause our actual results, levels of activity, performance or achievement to differ materially from those expressed or implied by these forward-looking statements. These risks and uncertainties include, among others:

 

   

our dependence on a highly-concentrated product line and a single market;

 

   

changes in the price of, or demand for, our leading pharmaceutical product, ENTOCORT® EC (budesonide) Capsules, or our leading diagnostic products;

 

   

the expiration of our exclusive right to promote Entocort EC;

 

   

the potential for a change in control event under our distribution agreement with AstraZeneca LP which may result in termination of our exclusive right to promote Entocort EC;

 

   

our ability to achieve expected sales of LOTRONEX® (alosetron hydrochloride) Tablets and maintain a reliable supply of the product;

 

   

our ability to successfully expand our business through increased strategic product or technology in-licensings or acquisitions or through development of proprietary diagnostic products;

 

   

our ability to obtain regulatory approval for the sale and commercialization of COLAL-PRED® (prednisolone metasulfobenzoate sodium);

 

   

the risk that our exclusive license agreement with Alizyme could be modified or terminated if Alizyme enters liquidation;

 

   

the timing or likelihood of regulatory filings and approvals;

 

   

our ability to successfully commercialize Colal-Pred or our recently acquired oncology diagnostics;

 

   

the risk of side effects of Lotronex or any other product candidates;

 

   

the competitive environment in which we operate;

 

   

the effect of government regulations and changes in laws and regulations governing the pharmaceutical and diagnostic industries;

 

   

our ability to continue to secure collaborators or partners;

 

   

competition from generic products for our branded pharmaceutical products;

 

   

our reliance on third parties for the manufacture and supply of all of the pharmaceutical products we offer;

 

   

our ability to secure alternative manufacturers of our pharmaceutical products or active pharmaceutical ingredients in the event that our agreement with any single source manufacturer is terminated;

 

   

our ability to maintain coverage and reimbursement for any of our pharmaceutical or diagnostic products;

 

   

our reliance on a limited number of wholesale pharmaceutical distributors for a majority of our pharmaceutical sales;

 

   

our ability to protect the intellectual property covering our products and the outcome of existing litigation to enforce the intellectual property covering our products; and

 

   

the prospect of acquiring other pharmaceutical product candidates in clinical development.

 

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Forward-looking statements include all statements that are not historical facts. In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “project,” “predict,” “potential,” or the negative of those terms, and similar expressions and comparable terminology intended to identify forward-looking statements. These statements reflect our current views with respect to future events and are based on assumptions and subject to risks and uncertainties. Given these uncertainties, you should not place undue reliance on these forward-looking statements. These forward-looking statements represent our estimates and assumptions only as of the date of this prospectus and, except as required by law, we undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise after the date of this prospectus.

The forward-looking statements contained in this prospectus are excluded from the safe harbor protection provided by the Private Securities Litigation Reform Act of 1995 and Section 27A of the Securities Act.

 

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USE OF PROCEEDS

We estimate that we will receive net proceeds of approximately $            million from the sale of the shares of common stock offered by us in this offering, or appropriately $            million if the option to purchase additional shares is exercised in full, in each case based on an assumed initial public offering price of $            per share, which is the midpoint of the price range set forth on the cover of this prospectus, and after deducting the estimated underwriting discounts and commissions and estimated offering costs payable by us. Each $1.00 increase or decrease in the assumed public offering price of $            per share would increase or decrease the net proceeds to us from this offering by approximately $            million, or appropriately $            million if the option to purchase additional shares is exercised in full, in each case assuming the number of shares offered by us, as set forth on the cover of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering costs payable by us.

The principal purposes for this offering are to create a public market for our common stock and to increase our ability to access the capital markets in the future. Although we believe that our available cash balances before the proceeds from this offering, anticipated cash flows from operations and proceeds from stock option exercises will be sufficient to satisfy our operating needs for the foreseeable future, we may elect to use the net proceeds of this offering for working capital purposes and other general corporate purposes, including to finance in-licensing and acquisition opportunities, the research and development of new products, sales and marketing activities, and capital expenditures. However, the use of net proceeds for such purposes is uncertain at this time, and the amounts and timing of our actual expenditures may vary significantly from our expectations depending on numerous factors, including our results of operations, financial condition and capital requirements. We may find it necessary or advisable to use the net proceeds for other purposes, and we will have broad discretion in the application of the net proceeds. Pending their use, we intend to invest the net proceeds in short-term, interest-bearing, investment-grade securities.

Although we may also use a portion of the net proceeds to in-license or acquire complementary products or to acquire or to enter into collaborations with complementary businesses, we have no current binding commitments or agreements to do so.

[We will not receive any of the proceeds from the sale of shares by the selling shareholders.]

DIVIDEND POLICY

We currently intend to retain all future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. Our credit agreement restricts us from paying any cash dividends to our shareholders. Any future determination related to dividend policy will be made at the discretion of our Board of Directors and will depend upon, among other factors, our results of operations, financial condition, capital requirements, contractual restrictions and such other factors as our Board of Directors deems relevant.

 

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CAPITALIZATION

The following table presents a summary of our capitalization per our balance sheet as of September 30, 2009 on an actual basis and on a pro forma as adjusted basis assuming:

 

   

the conversion of all outstanding shares of our preferred stock into 35,415,856 shares of common stock; and

 

   

the issuance and sale by us of            shares of common stock in this offering and our receipt of the estimated net proceeds from this offering, based on an assumed initial public offering price of $            per share, the midpoint of the range set forth on the cover of this prospectus, after deducting the estimated underwriting discounts and commissions and estimated offering costs payable by us.

The pro forma information below, which also gives effect to the filing of our amended and restated articles of incorporation, is illustrative only and our capitalization following the completion of this offering will be adjusted based on the actual initial public offering price and other terms of this offering determined at pricing. You should read this table together with the sections entitled “Capitalization,” “Selected Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes appearing elsewhere in this prospectus.

 

     As of September 30, 2009
     Actual     Pro Forma
as Adjusted(1)
     (in thousands, except
share amounts and
par values)

Long-term debt(2)

   $ 58,125      $ 58,125

Shareholders’ Equity:

    

Preferred stock, $0.001 par value: 36,000,000 shares authorized, 35,415,856 convertible preferred shares issued and outstanding;            shares authorized, no shares issued or outstanding, pro forma as adjusted

     35       

Common stock, $0.001 par value; 60,000,000 shares authorized, 9,072,408 shares issued and outstanding;            shares authorized, shares issued and outstanding, pro forma as adjusted

     9     

Additional paid-in capital

     114,040     

Accumulated other comprehensive income

     (1,721  

Retained earnings

     88,484     

Total shareholders’ equity

     200,847     
              

Total capitalization

   $ 258,972     
              

 

(1) Each $1.00 increase or decrease in the assumed public offering price of $            per share, the midpoint of the range set forth on the cover of this prospectus, would increase or decrease, respectively, the amount of cash and cash equivalents, additional paid-in capital and total shareholders’ equity by approximately $            million, $            million and $            million, respectively, assuming the number of shares offered by us, as set forth on the cover of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering costs payable by us.

 

(2) We have $25.0 million in revolving loans available to us under a credit agreement. No revolving loans were outstanding as of September 30, 2009.

The number of shares of common stock shown in the table above to be outstanding after the offering is based on the number of shares of common and preferred stock outstanding as of September 30, 2009. This number does not include:

 

   

8,971,778 shares of common stock reserved for future issuance upon the exercise of stock options outstanding under our 1997 and 2000 Equity Incentive Award Plans at a weighted average exercise price of $4.36 per share;

 

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2,400,000 shares of common stock reserved for future issuance under our 2009 Equity Incentive Award Plan;

 

   

600,000 shares of common stock initially reserved for future issuance under our 2009 Employee Stock Purchase Plan; and

 

   

439,371 shares of common stock reserved for future issuance upon the exercise of outstanding warrants at a weighted average exercise price of $1.75 per share.

 

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DILUTION

If you invest in our common stock, your interest will be diluted to the extent the initial public offering price per share of our common stock exceeds the historical net tangible book value per share of our common stock. As of September 30, 2009, our historical net tangible book value was $88.4 million, or $1.99 per share of common stock, based on 9,072,408 shares of our common stock outstanding and the assumed conversion of all outstanding shares of our preferred stock into 35,415,856 shares of common stock. Our historical net tangible book value represents the amount of our total tangible assets reduced by the amount of our total liabilities.

After giving pro forma effect to our sale in this offering of shares of our common stock at an assumed initial public offering price of $            per share, which is the midpoint of the price range set forth on the cover of this prospectus, and after deducting the estimated underwriting discounts and commissions and estimated offering costs payable by us, our pro forma, as adjusted, net tangible book value as of September 30, 2009 would have been $            million, or $            per share of our common stock. This represents an immediate increase of net tangible book value of $            per share to our existing shareholders and an immediate dilution of $            per share to investors purchasing shares in this offering. The following table illustrates this per share dilution:

 

Assumed initial public offering price per share

      $             

Historical net tangible book value per share as of September 30, 2009

   $ 1.99   

Increase per share attributable to investors purchasing shares in this offering

     
         

Pro forma net tangible book value per share, as adjusted to give effect to this offering

     
         

Dilution to investors in this offering

      $  
         

Each $1.00 increase or decrease in the assumed public offering price of $            per share would increase or decrease our pro forma as adjusted, net tangible book value by approximately $            , our pro forma as adjusted net tangible book value per share by approximately $            per share and the dilution to investors in this offering by approximately $            per share, assuming the number of shares offered by us, as set forth on the cover of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering costs payable by us.

If the underwriters exercise their option to purchase additional shares in full, the pro forma as adjusted, net tangible book value per share after giving effect to this offering would be $            per share, and the dilution to investors in this offering would be $            per share.

The following table summarizes, as of September 30, 2009, on a pro forma as adjusted basis assuming the differences between the number of shares of common stock purchased from us, the total effective cash consideration paid to us, and the average price per share paid by our existing shareholders and by our new investors purchasing stock in this offering at an assumed initial public offering price of $            per share, which is the midpoint of the price range set forth on the cover of this prospectus, before deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us. The following table is illustrative only and the total consideration paid and the average price per share are subject to adjustment based on the actual initial public offering price and other terms of this offering determined at pricing. [The following table does not reflect the impact of the sale of shares by the selling shareholders.]

 

     Shares Purchased    Total Consideration    Average Price
Per Share
     Number    Percent    Amount    Percent   
     (In thousands)     

Existing shareholders before this offering

   44,489        %    $ 90,893        %    $ 2.04

New investors participating in this offering[(1)]

              
                        

Total

      100.0%    $      100.0%   
                        

 

[(1) Excludes            shares to be sold by the selling shareholders to the new investors in this offering and for which we will not receive any proceeds.]

 

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[Taking into account the sales by the selling shareholders of            shares, the number of shares held by existing shareholders, upon completion of this offering, will be            , or approximately    % of the total shares of common stock outstanding, and the number of shares held by new investors participating in this offering, upon completion of this offering, will be            , or approximately    % of the total shares of common stock outstanding.]

Each $1.00 increase or decrease in the assumed public offering price of $             per share would increase or decrease total gross consideration paid by new investors, total gross consideration paid by all shareholders and the average price per share paid by all shareholders by $             million, $             million and $             per share, respectively, assuming the number of shares offered by us, as set forth on the cover of this prospectus exclusive of the additional shares subject to the underwriters’ option to purchase, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering costs payable by us.

If the underwriters exercise their option to purchase additional shares in full, our existing shareholders would own     % and our new investors would own    % of the total number of shares of our common stock outstanding after this offering.

The discussions and tables above assume no exercise of the outstanding options or warrants with exercise prices that are below the assumed initial public offering price. To the extent any of these options or warrants are exercised, there will be further dilution to investors in the offering.

 

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SELECTED FINANCIAL DATA

The following table summarizes certain of our selected consolidated financial data. The selected consolidated financial data as of and for each of the fiscal years ended December 31, 2004, 2005, 2006, 2007 and 2008 have been derived from our audited consolidated financial statements. The summary historical consolidated financial data as of and for the nine-month periods ended September 30, 2008 and 2009 are derived from our unaudited consolidated financial statements, which are included elsewhere in this prospectus. In our opinion, the unaudited consolidated financial statements have been prepared on the same basis as our audited consolidated financial statements and include all adjustments, consisting of only normal recurring adjustments, necessary for a fair statement of our financial position and operating results for the unaudited periods. The summary consolidated financial and operating data as of and for the nine months ended September 30, 2009 are not necessarily indicative of the results that may be obtained for the full year. The selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this prospectus.

 

     Years Ended December 31,     Nine Months
Ended September 30,
 
     2004     2005     2006     2007     2008     2008     2009  
     (In thousands except per share amounts)              
              

Consolidated Statement of Operations:

              

Net sales:

              

Pharmaceutical products(1)(2)

   $ 38,874      $ 83,965      $ 119,150      $ 143,655      $ 195,985      $ 144,060      $ 193,132   

Diagnostic testing services(3)

     50,727        54,978        68,261        77,285        82,073        60,752        64,668   
                                                        

Total net sales

     89,601        138,943        187,411        220,940        278,058        204,812        257,800   
                                                        

Operating expenses:

              

Cost of sales (excludes amortization of acquired product rights)

     18,876        43,555        66,688        87,306        113,601        82,123        116,812   

Selling, general and administrative

     35,421        49,216        57,075        60,985        81,626        56,090        63,820   

Research and development

     5,275        3,712        4,622        13,024        14,628        10,260        15,460   

Amortization of acquired product rights

     4,335        3,255        3,255        3,255        12,057        8,996        9,984   

Write-down in carrying value of product rights and termination of license agreement(4)

     51,935                                             
                                                        

Total operating expenses

     115,842        99,738        131,640        164,570        221,912        157,469        206,076   
                                                        

Income (loss) from operations

     (26,241     39,205        55,771        56,370        56,146        47,343        51,724   

Interest income

     428        1,072        2,514        4,316        1,655        1,325        364   

Interest income (expense)—warrants(5)

            25        (2,015     (31,085     5,602        5,602          

Interest expense—other(6)

     (9,958     (5,850     (1,993     (3,120     (3,691     (2,757     (1,815

Other income, net

     63        50        236        130        553        545        64   
                                                        

Income (loss) before income taxes

     (35,708     34,502        54,513        26,611        60,265        52,058        50,337   

Provision (benefit) for income taxes

     29        (2,055     22,274        22,293        23,040        18,439        22,002   
                                                        

Income (loss) before cumulative effect of a change in accounting principle

     (35,737     36,557        32,239        4,318        37,225        33,619        28,335   

Cumulative effect of a change in accounting principle(7)

            (7,613                                   
                                                        

Net income (loss)

     (35,737     28,944        32,239        4,318        37,225        33,619        28,335   

(Accretion to) reversal of redemption value of redeemable convertible preferred stock

     (5,458     (5,458     (5,161     35,176                        
                                                        

Net income (loss) attributable to common shareholders

   $ (41,195   $ 23,486      $ 27,078      $ 39,494      $ 37,225      $ 33,619      $ 28,335   
                                                        

Net income (loss) per common share(8)

              

Basic

   $ (3.87   $ 0.24      $ 0.60      $      $ 0.69      $ 0.64      $ 0.55   

Diluted

   $ (3.87   $ 0.19      $ 0.54      $      $ 0.44      $ 0.41      $ 0.39   

Shares used to compute net income (loss) per common share(8)

              

Basic

     9,243        9,348        9,692        10,004        9,542        9,843        9,023   

Diluted

     9,243        11,626        10,676        10,004        14,966        15,415        12,634   

 

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     Years Ended December 31,    Nine Months
Ended September 30,
     2004    2005     2006     2007     2008    2008   2009
     (In thousands except per share amounts)         

Pro forma net income per common share (unaudited)(8):

                

Basic

            $ 0.78    $ 0.70   $ 0.64

Diluted

            $ 0.70    $ 0.62   $ 0.59

Shares used to compute pro forma net income (loss) per common share (unaudited)(8):

                

Basic

              44,958      45,259     44,439

Diluted

              50,382      50,831     48,050
          As of December 31,   As of
September 30, 2009
          2004     2005     2006     2007    2008  
          (In thousands)    

Balance Sheet Data:

                

Cash, cash equivalents and marketable securities

      $ 34,906      $ 44,270      $ 78,291      $ 81,915    $ 96,686   $ 108,256

Working capital(9)

        47,125        50,023        72,751        51,186      107,746     112,657

Total assets

        97,995        130,570        167,331        261,025      284,837     338,261

Total long-term debt, less current portion

        44,008        24,700        22,700        71,250      63,750     58,125

Redeemable preferred stock(10)

        91,786        97,244        102,405                

Total shareholders’ equity (deficit)(10)

        (53,307     (34,648     (6,987     104,970      170,928     200,847

 

(1)

We entered into an exclusive agreement with AstraZeneca LP for the marketing, sale and distribution of ENTOCORT® EC (budesonide) Capsules in the United States beginning January 1, 2005. Entocort EC sales are included in our operations since that date. In November 2007, we began selling LOTRONEX® (alosetron hydrochloride) Tablets in the United States under a distribution agreement with GlaxoSmithKline. In January 2008, we acquired Lotronex from GlaxoSmithKline and paid $80.0 million and issued 1,250,000 shares of our common stock to GlaxoSmithKline. We also launched a generic mercaptopurine product through a third-party distributor in February 2004. See Notes 1 and 2 to our consolidated financial statements included elsewhere in this prospectus.

 

(2) The nine months ended September 30, 2009 reflects a $3.1 million allowance for managed care rebates related to the Department of Defense Tricare Retail Pharmacy program pursuant to a final rule that became effective on May 26, 2009 ($1.8 million relates to sales made during 2008 and $1.3 million relates to sales in the nine-month period ending September 30, 2009). See Note 16A to the consolidated financial statements included elsewhere in this prospectus.

 

(3) The year ended December 31, 2006 includes a $3.6 million increase in net sales as a result of a change in estimate. See Note 1 to the consolidated financial statements included elsewhere in this prospectus.

 

(4) We determined that an impairment in the carrying value of certain pharmaceutical product rights had occurred during 2004 and, as a result, wrote down the carrying value of these assets by approximately $47.0 million. Also in 2004, we terminated an exclusive license agreement and recorded a charge of $5.0 million to write-off the balance of our investment in the licensing agreement.

 

(5) Reflects the accretion or reversal of accretion of the redeemable warrants to their estimated fair value. See Note 9 to our consolidated financial statements included elsewhere in this prospectus.

 

(6) Interest expense includes a prepayment penalty and the accelerated amortization of debt discount of $1.2 million and $1.0 million for the early repayment of debt in the years ended December 31, 2004 and 2005, respectively.

 

(7) On the adoption of the FASB guidance for Distinguishing Liabilities from Equity, we reclassified the fair value of our redeemable warrants as of July 1, 2005 as determined by our Board of Directors from shareholders’ equity to liabilities and the change in the fair value of the warrants since the date of issuance to June 30, 2005 was reported as a cumulative effect of a change in accounting principle in the statement of income. See Note 1 to our consolidated financial statements included elsewhere in this prospectus. Pro forma net income (loss) assuming this change in accounting principle was applied retroactively would have been $4.0 million, $(37.9) million and $36.3 million for 2003, 2004 and 2005, respectively.

 

(8) See Note 1 to our consolidated financial statements included elsewhere in this prospectus for an explanation of the net income and shares used in computing net income per share.

 

(9) Working capital is calculated by subtracting total current liabilities from total current assets.

 

(10) Prior to April 10, 2007, the holders of each series of the Series C, Series D and Series E Preferred Stock could have also elected to have their shares redeemed by us for the applicable liquidation value. However, the holders of the Series C, Series D and Series E Preferred Stock did not exercise the redemption right during the election period which ended on April 10, 2007 and, as a result, there are no further redemption rights with respect to the Series C, Series D and Series E Preferred Stock. Accordingly, the Series C, Series D and Series E Preferred Stock were reclassified to shareholders’ equity as of that date.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with “Selected Financial Data” and our consolidated financial statements and related notes appearing elsewhere in this prospectus. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including but not limited to those set forth under “Risk Factors” and elsewhere in this prospectus.

Overview

We are a specialty pharmaceutical and diagnostic company committed to developing and commercializing novel pharmaceutical and diagnostic products to help physicians individualize patient care. We sell both pharmaceutical products and complementary diagnostic testing services. Historically, our products and services have focused on the detection, diagnosis and treatment of gastrointestinal diseases and disorders in the United States. We have experienced significant sales growth in both our pharmaceutical products and diagnostic testing services segments in 2006, 2007 and 2008 and in the nine months ended September 30, 2009, through the addition of new or improved products and services and through the growth of existing products and services. We expanded our sales force and began selling ENTOCORT® EC (budesonide) Capsules in 2005 under a distribution agreement with AstraZeneca LP, significantly increasing our sales and selling, general and administrative costs to support the product. We also began selling LOTRONEX® (alosetron hydrochloride) Tablets in the United States in November 2007 under a distribution agreement with GlaxoSmithKline. Prior to 2005, our sales force principally promoted our diagnostic testing services.

Growth in our pharmaceuticals segment reflects the addition of Entocort EC in January 2005 and Lotronex in 2007. Our other pharmaceutical products principally consist of branded products that we do not promote as they no longer have any patent protection. Consistent with our expectations, sales of these products have and are expected to continue to decline as market share is lost to generics and competitive products. We also launched a generic pharmaceutical product, mercaptopurine, in February 2004 through a third-party distributor. As with other generic products, sales of mercaptopurine have declined each year since its introduction as additional generics have entered the market.

Since 2005, growth in our diagnostics segment has been principally driven by product improvements and the growth of our existing products. Our fastest growing testing services over the last three calendar years have been for inflammatory bowel disease, or IBD, and celiac disease. We introduced improvements to our testing services for both IBD and celiac disease in 2006.

In January 2008, we acquired exclusive rights to Lotronex in the United States from GlaxoSmithKline. Lotronex is a pharmaceutical product for the treatment of severe diarrhea-predominant irritable bowel syndrome, or IBS, in female patients who meet the conditions stated in the label. We sold Lotronex under an exclusive distribution agreement from November 1, 2007 until the acquisition was completed on January 4, 2008. As a result of the acquisition and the launch in May 2008 of PROMETHEUS® IBS Diagnostic, a diagnostic test to help physicians diagnose IBS, we have expanded our sales force and will incur significantly higher costs for marketing and other supporting costs.

In November 2007, we entered into an exclusive license agreement with a subsidiary of Alizyme plc to develop and commercialize COLAL-PRED® (prednisolone metasulfobenzoate sodium) in North America. Colal-Pred is based on a drug delivery technology designed to release an anti-inflammatory steroid in the colon to provide the efficacy of steroids while limiting their undesirable systemic side effects. Colal-Pred has not been approved by the U.S Food and Drug Administration, or FDA, and we will not be able to commercialize Colal-Pred in the United States until we receive approval from the FDA. We began a Phase 2 clinical trial to evaluate Colal-Pred for the treatment of patients with ulcerative colitis in May 2008. We expect to incur substantial and increased costs over the next several years in conjunction with the clinical development of Colal-Pred. In July 2008, Alizyme released the results of the European Phase 3 clinical trial of Colal-Pred in patients with

 

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moderate to severe ulcerative colitis. A total of 799 patients were randomized to either one of three doses of Colal-Pred or a standard regimen of prednisolone. The results showed that the trial failed to meet one of the two co-primary endpoints. Colal-Pred demonstrated superior safety to prednisolone. However, non-inferiority to prednisolone in efficacy response was not shown (i.e., prednisolone demonstrated a better response rate than Colal-Pred).

On July 21, 2009 we filed a complaint against Alizyme in the U.S. District Court for the Southern District of California alleging breach by Alizyme of its exclusive license agreement with us, as a result of its failure to conduct certain pre-clinical studies which are necessary in order to obtain regulatory approval for the sale of Colal-Pred in the U.S. and its alleged improper assignment of certain rights under this agreement. On July 24, 2009 Alizyme, and its parent company, Alizyme plc, entered administration in England, in each case on the grounds that it was or was likely to become unable to pay its debts. The administration of Alizyme means that Alizyme, acting through the agency of its administrators, might refuse or decline to perform its outstanding and continuing obligations under the license agreement. While in administration, our contract with Alizyme may not be modified or terminated without our consent. Furthermore, the administration may transition to a liquidation, in which case the liquidator may seek to disclaim the license agreement and Alizyme’s obligations under it, on the grounds that it is an unprofitable contract.

In addition, in April 2009, we acquired exclusive rights to three microRNA-based oncology diagnostic tests in the United States from Rosetta Genomics. We expanded our sales force and expect to incur additional costs for marketing and other supporting costs as a result of these acquisitions.

Our results of operations could be materially affected by economic conditions generally, both in the U.S. and elsewhere around the world. Issues related to the availability and cost of credit, the U.S. mortgage market, a declining residential real estate market in the U.S., inflation, energy costs and geopolitical issues have contributed to declining business and consumer activity and increased unemployment. The global economy has experienced a significant economic recession during 2008 and early 2009. Domestic and international capital markets have also been experiencing heightened volatility and turmoil. These events may have an adverse effect on us. In the event of a continuing market downturn, our results of operations could be adversely affected by those factors in many negative ways, including making it more difficult for us to raise funds if necessary, and our stock price may decline. In addition, we maintain significant amounts of cash and cash equivalents at one or more financial institutions that are in excess of federally insured limits. We cannot be assured that we will not experience losses on these deposits.

As a result of volatility in the capital markets, the cost and availability of credit has been and may continue to be adversely affected by tighter credit markets and wider credit spreads. Concern about the stability of the markets generally and the strength of counterparties specifically has led many lenders and institutional investors to reduce, and in some cases, cease to provide funding to borrowers. While improving, such conditions in the U.S. and international markets and economies may adversely affect our ability to obtain additional financing on terms acceptable to us, or at all. If these market conditions continue, they may limit our ability to timely replace maturing liabilities and to access the capital markets to meet liquidity needs.

Critical Accounting Policies, Estimates and Assumptions

The preparation and presentation of financial statements in conformity with U.S. generally accepted accounting principles, or GAAP, requires us to establish policies and to make estimates and assumptions that affect the amounts reported in our consolidated financial statements. Accounting assumptions and estimates are inherently uncertain and actual results may differ materially from our estimates. Our significant accounting policies are more fully described in Note 1 to the consolidated financial statements included elsewhere in this prospectus.

 

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Revenue Recognition—Pharmaceutical Products

Revenues from pharmaceutical product sales are generally recognized upon delivery and passage of title to customers and are presented net of amounts estimated for cash discounts, returns, rebates, chargebacks and other allowances. These reductions are estimated based on contractual requirements, historical experience, trends in physicians’ prescribing patterns, analysis of the estimated inventory levels in the distribution channel and product lot expiration dates.

We utilize wholesalers as the principal means of distributing our products to healthcare providers such as hospitals and pharmacies. We monitor sales and estimate the inventory levels held by the wholesalers using data obtained from wholesalers who currently make up over 95% of our pharmaceutical product sales. We have agreements with three of our largest wholesalers which provide us with data on inventory levels and demand. In addition, our two largest wholesalers have agreed to manage their inventory levels within certain limits based on demand in conjunction with inventory management agreements. We regularly review the inventory data as compared to prescription trends, lot expirations and expected market changes in estimating allowances for returns, rebates and chargebacks. We believe wholesaler inventory levels are being maintained at reasonable levels given demand.

Accruals for sales allowances are recorded in the same period that the related sales are recognized as a reduction to product sales. Pharmaceutical product sales are net of the following sales allowances in 2006, 2007 and 2008 and for the nine months ended September 30, 2009:

 

     Years Ended    Nine Months
Ended
September 30,
2009
     2006    2007    2008   
     (In thousands)    (unaudited)

Sales returns

   $ 3,514    $ 4,205    $ 4,808    $ 4,422

Medicaid rebates

     3,120      2,186      5,162      6,811

Chargebacks

     4,388      5,625      7,534      11,758

Discounts and other allowances

     4,006      4,619      7,581      12,577
                           

Total sales allowances

   $ 15,028    $ 16,635    $ 25,085    $ 35,568
                           

% of gross sales

     11%      10%      11%      16%

Pharmaceutical sales allowances were $15.0 million, $16.6 million, $25.1 million and $35.6 million for the years ended December 31, 2006, 2007 and 2008 and the nine months ended September 30, 2009, respectively. For the year ended December 31, 2008, pharmaceutical sales allowances reflect the first full year effect of Lotronex, which we acquired in January 2008. For all periods presented, pharmaceutical sales allowances reflect substantial growth in sales of Entocort EC. Relative to sales, Entocort EC has a proportionately lower level of returns due to its high volume and turnover compared to our other pharmaceutical products. Increases in Medicaid rebates, chargebacks and other discounts and allowances in the nine months ended September 30, 2009 are attributable in part to increases in product pricing and pharmaceutical revenues in the period. In addition, the increase in chargebacks in the period reflects a $3.1 million allowance related to the U.S. Department of Defense, or DOD, Tricare Retail Pharmacy program pursuant to a final rule that became effective on May 26, 2009. The final rule implements the DOD’s revised interpretation of the National Defense Authorization Act of 2008, or NDAA, that was signed into law on January 28, 2008. The final rule changed the process by which managed care rebate obligations for the Tricare Retail Pharmacy program are created such that a contractual agreement is no longer required and the obligation to pay such rebates emanates from the NDAA itself. In consideration of this final rule, an allowance of $3.1 million was recorded in the nine months ended September 30, 2009, of which approximately $1.8 million represents a retroactive rebate assessment for pharmaceutical product sales made during 2008, and approximately $1.3 million represents a rebate assessment for the nine-month period ending September 30, 2009. The Company is in the process of requesting a waiver to appeal the 2008 retroactive rebate assessment, the outcome of which is unknown.

 

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The following table provides a summary of activity with respect to our pharmaceutical allowances:

 

     Sales Returns     Managed
Care,
Medicare
and Medicaid
Rebates
    Chargebacks     Discounts
and Other
Allowances
 
     (in thousands)  

Balance December 31, 2005

   $ 3,381      $ 2,724      $ 1,546      $ 918   

Current Provision(1)

     3,514        3,220        4,488        4,006   

Credits Issued(2)

     (1,215     (3,587     (4,420     (4,066

Changes in Prior Year Estimate(3)

            (100     (100       
                                

Balance December 31, 2006

     5,680        2,257        1,514        858   

Current Provision(1)

     4,205        2,296        5,625        4,619   

Credits Issued(2)

     (2,697     (3,184     (5,777     (5,012

Changes in Prior Year Estimate(3)

            (110              
                                

Balance December 31, 2007

     7,188        1,259        1,362        465   

Current Provision(1)

     4,533        5,162        7,534        7,581   

Credits Issued(2)

     (2,046     (4,495     (7,471     (6,849

Changes in Prior Year Estimate(3)

     275                        
                                

Balance December 31, 2008

     9,950        1,926        1,425        1,197   

Current Provision(1) (unaudited)

     4,097        6,811        10,089        12,577   

Credits Issued(2) (unaudited)

     (2,872     (6,086     (8,467     (10,176

Changes in Prior Year Estimate(3) (unaudited)

     325               1,669          
                                

Balance September 30, 2009

   $ 11,500      $ 2,651      $ 4,716      $ 3,598   
                                

 

(1) Represents increases in the allowances for sales returns, managed care, Medicare and Medicaid rebates, chargebacks, discounts and other allowances related to sales in the applicable year.

 

(2) Credits are reported in the year that they are issued. In general, sales returns are received in years subsequent to the year of sale while credits for the other allowances relate to sales in both the current year and the immediately preceding year.

 

(3) Changes in estimate represent adjustments to allowances related to prior years’ sales.

Sales Returns

Our wholesale and retail customers can return our pharmaceutical products for up to 12 months following the date of expiration. We base our sales returns allowance on our actual returns history, known or expected market events, trend experience, lot expiration dates and estimated inventory levels in the distribution channel. We also consider product demand and the impact of product price increases. In addition, we consider external factors such as competitive pricing pressure, known or expected introductions of new products or possible generic encroachment that may impact our estimates for sales returns. We monitor this activity and re-evaluate returns allowance rates on a periodic basis.

Pharmaceutical products that are returned to us are evaluated on an individual basis to determine eligibility for the issuance of credit, in accordance with the Company’s corresponding wholesaler or retail customer returned goods policy. If eligible, credit is issued at the time of the pharmaceutical product return in the form of a credit memo. No returned product is exchanged for saleable product from inventory in conjunction with any returns transaction.

Accrued sales returns were $5.7 million, $7.2 million and $10.0 million as of December 31, 2006, 2007 and 2008, respectively. The increase in accrued sales returns from 2006 to 2008 principally reflects the addition of Lotronex in 2008 and increased sales of Entocort EC. Returns as a percentage of sales have decreased from 2.6% in 2006 to 2.2% in 2008, due primarily to increased sales of Entocort EC. As Entocort EC sales are growing, product turns over more rapidly reducing the overall returns rate. Products with declining sales generally experience higher returns rates as a percent of sales. As reflected in the table above, we have not experienced significant changes in estimates related to returns over the past three years.

 

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Medicaid Rebates

Medicaid rebates are amounts we are required to rebate to the extent we participate in certain federal and state Medicaid programs. These allowances are recorded based on historical trends, projected changes in pricing and our level of participation in such programs, as well as any expected changes in product sales into such programs. We monitor our rebate activity and reserve rates on a periodic basis.

Accrued Medicaid rebate allowances were $2.3 million, $1.3 million and $1.9 million as of December 31, 2006, 2007 and 2008, respectively. Medicaid rebates as a percentage of sales remained constant at 2.3% in 2006 and 2008. In 2007, Medicaid rebates as a percentage of sales decreased to 1.4% due to the impact of the Medicare Part D legislation. As a result of this legislation, certain patients who had been eligible for Medicaid coverage in the prior years are now covered under Medicare.

Chargebacks

Chargebacks are generated from contractual agreements with wholesalers or other managed care organizations that we have entered into to sell our pharmaceutical products at the prices specified in such agreements. These customers purchase our products through wholesalers at contracted prices. We are then charged for the incremental difference between the selling price and the contracted price at which the product was sold. These chargebacks are generally processed by the wholesaler, reported to us and netted against amounts due to us from the wholesalers. We base our allowance for chargebacks on historical rates, adjusting for the addition of new or terminated contracts, and changes in buying patterns or pricing. Most of our contracts are for discounts off list price and therefore move in a manner consistent with price increases. We monitor chargeback activity and re-evaluate reserve rates on a periodic basis.

Accrued chargebacks were $1.5 million, $1.4 million and $1.4 million as of December 31, 2006, 2007 and 2008, respectively. The nominal decline in accrued chargebacks from 2006 to 2008 is primarily due to improved managed care contract pricing in 2007 and 2008, offset by an increase in sales over the period.

Discounts and Other Allowances

We record an allowance for prompt payment discounts and other allowances, if any, based on payment and other contractual terms extended to customers. Prompt pay discounts move in tandem with sales.

Revenue Recognition—Diagnostic Testing Services

Revenues from diagnostic testing services are recognized once the services have been performed and the results have been reported to the customer. For diagnostic testing services, we typically invoice laboratories or hospitals with which we have a direct bill agreement, or commercial and governmental insurance providers on behalf of patients, as the primary payors of amounts due for the services we perform. We recognize sales to our direct bill accounts based on their negotiated fee schedule, while sales billed to commercial and governmental insurance providers are invoiced at list price. We provide for estimated contractual allowances as a reduction in gross revenues at the time of sale based upon contracts, past payment experience and consideration of other payor-specific factors such as test-specific coverage policies. Contractual allowances as a percentage of gross diagnostic revenues were approximately 8%, 6% and 7% (exclusive of a change in estimate related to prior years) for 2006, 2007 and 2008, respectively. The overall decrease in contractual allowances from 2006 to 2008 is attributable in part to an increase in overall direct bill arrangements with laboratories and hospitals, as discussed below. In addition, improvements in the commercial payor billing and collections processes, including increased billing frequency and claims appeal follow-up, have contributed to reduced contractual allowances. However, the increase in contractual allowances as a percentage of gross diagnostic revenues from 2007 to 2008 is attributable to an anticipated decrease in contractual payments due to the current economic environment.

We invoice patients for amounts uncollected from third parties, when allowed by law and not restricted by contract, and for those amounts directly owed by patients. A bad debts allowance is also recorded at the time of sale for estimated losses on amounts estimated to be ultimately due from patients. The collection of receivables

 

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due from patients is subject to credit risk and the ability of the patients to pay. Charges for bad debts are charged to general and administrative expense. Bad debts as a percentage of gross diagnostic revenues were approximately 5%, 3% and 4% in 2006, 2007 and 2008, respectively. The overall decrease in bad debt allowances as a percentage of gross diagnostic revenues from 2006 to 2008 is generally attributable to improvements made in the billing and collections process, including increased billing frequency and dispute resolution. However, the increase in bad debt allowances as a percentage of gross diagnostic revenues from 2007 to 2008 is attributable to an anticipated decrease in collectability from patients in consideration of the current economic environment.

We estimate contractual and bad debt allowances based on a number of factors, including our collection history and trends, payor reimbursement levels, and market events. We review our estimates at least quarterly and regularly meet with our billing and trade groups to identify collection issues and contract changes or new pricing agreements which may impact our receivables and allowances. In addition, over the past several years, we have increased the number of “direct bill” accounts. These accounts include hospitals and other commercial laboratories which are billed based on a negotiated fee schedule. Our direct bill accounts pay us directly and then bill and collect from insurance companies and other payors without recourse to us, reducing our exposure to contractual allowances and collection risks.

The majority of direct billings are paid within contractual terms. Any accounts past due will be contacted by collections personnel as needed to resolve any issues. Amounts billed to, but not paid by, commercial insurance providers are billed to patients; however, unpaid insurance claims might not be transferred to patients for several months depending on the reasons for the denial of the claims and the timing of the appeals process, if any. Other receivables due from insurance providers are written-off as uncollectible against the allowance for doubtful accounts after reasonable collection efforts have been exhausted. Patients are invoiced on a monthly basis until collected. Patient accounts that are significantly past due are written-off and transferred to a third-party collection agency, generally no sooner than six months from the date of service. At the end of each calendar year, any remaining diagnostic accounts receivable with a date of service of over 24 months prior to such year end are written-off unless subject to current collection activities or unexpired Medicare statutes.

The following table sets forth our accounts receivable balances for diagnostic testing services outstanding by aging category for each major payor source as of September 30, 2009:

 

     Days Outstanding  
     <60    61-120    >120    Total  
     (In thousands)  

Direct bill

   $ 9,462    $ 1,287    $ 389    $ 11,138   

Commercial payors

     2,098      176      306      2,580   

Patient

     1,886      1,244      1,570      4,700   

Medicare/Medicaid and other

     185           75      260   
                             

Total accounts receivable

   $ 13,631    $ 2,707    $ 2,340    $ 18,678   
                       

Less: Allowances for doubtful accounts

              (2,621
                 

Accounts receivable, net

            $ 16,057   
                 

The following table sets forth our accounts receivable balances for diagnostic testing services outstanding by aging category for each major payor source as of December 31, 2008:

 

     Days Outstanding  
     <60 Days    61-120 Days    >120 Days    Total  

Direct bill

   $ 9,765    $ 1,869    $ 929    $ 12,563   

Commercial payors

     2,385      357      20      2,762   

Patient

     2,009      1,314      1,924      5,247   

Medicare/Medicaid and other

     281      10      24      315   
                             

Total accounts receivable

   $ 14,440    $ 3,550    $ 2,897      20,887   
                       

Less: Allowances for doubtful accounts

              (2,326
                 

Accounts receivable, net

            $ 18,561   
                 

 

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Our day’s sales outstanding, which is computed on net accounts receivable, was 83 days and 68 days as of December 31, 2008 and September 30, 2009, respectively. The reduction in days sales outstanding for the nine months ended September 30, 2009 is primarily attributable to increased cash collections, due to improved collections processes for direct bill and contracted payors. The allowance for doubtful accounts as a percentage of accounts receivable related to our diagnostic testing services was 11% and 14% as of December 31, 2008 and September 30, 2009, respectively.

Change in Accounting Estimate

In 2006, we recognized a reduction in contractual allowances resulting in an increase in the recognition of net sales of diagnostic testing services and in net income of approximately $3.6 million and $2.2 million, respectively. The $3.6 million reduction in contractual allowances was related to the years ended December 31, 2003, 2004 and 2005 in the amounts of $1.5 million, $1.2 million and $0.9 million, respectively, or 3.6%, 2.0% and 1.5% of the respective year’s gross diagnostic sales. The change in contractual allowances reflects improvements in the collections process and collections from third-party commercial payors, including payments received from a certain payor that had previously disputed prior payments and had issued a coverage policy stating it would not provide payment for certain of our diagnostic testing services. This change in accounting estimate was recorded as a cumulative adjustment in the period of change. If we were to experience a change in estimate of between 1.5% and 3.6% based on the gross diagnostic sales for the nine months ended September 30, 2009, it would result in a change to our net diagnostic revenues and to our net diagnostic receivables of $1.0 million to $2.5 million for the period.

Intangibles and Long-Lived Assets

Intangibles and long-lived assets, including fixed assets, are continually monitored and are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of any such asset may not be recoverable. The determination of recoverability is based on an estimate of undiscounted cash flows expected to result from the use of an asset and its eventual disposition. The estimate of cash flows is based upon, among other things, certain assumptions about expected future operating performance, growth rates and other factors. Our estimates of undiscounted cash flows may differ from actual cash flows due to, among other things, technological changes, economic conditions, changes to our business model or changes in our operating performance. If the sum of the undiscounted cash flows is less than the carrying value of the asset, we recognize an impairment charge, measured as the amount by which the carrying value exceeds the fair value of the asset. We estimate fair value by discounting the projected cash flows expected to be generated by the applicable asset over their remaining useful life.

We believe the fair values and the useful lives of our intangible and long-lived assets are appropriate based upon the current and future cash flows expected from such assets and our estimates and assumptions used in projecting such cash flows to be reasonable given available facts and circumstances as of December 31, 2007, 2008 and September 30, 2009.

Stock-Based Compensation

Effective January 1, 2006, we adopted the revised authoritative guidance for Stock Compensation, which requires the measurement and recognition of compensation expense for all share-based payments made to employees and directors. The guidance establishes that the fair value of share-based awards is estimated at the grant date using an option-pricing model, and the portion that is ultimately expected to vest is recognized as compensation expense over the requisite service period. We adopted this guidance using the prospective transition method, under which prior periods are not restated.

Prior to January 1, 2006, we accounted for share-based awards using the intrinsic value method. Under the intrinsic value method, no share-based compensation was recognized for employees or directors if the exercise price of the award was equal to or above the fair market value of the underlying stock on the date of grant. In accordance with the revised guidance, we will continue to account for non-vested employee awards outstanding at the date of adoption using the intrinsic method.

 

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We did not make and have not made any significant changes to our stock-based compensation programs or the securities granted under such programs in anticipation of, or in consideration of, the revised authoritative guidance. We recognized stock-based compensation expense of approximately $0.2 million, $2.1 million and $2.9 million for the years ended December 31, 2006, 2007 and 2008, respectively. Due to the prospective method of adoption, such stock-based compensation expense will increase over the average vesting period of our stock awards even assuming similar levels of stock grants and fair values in future years. Stock-based compensation may also fluctuate significantly based on changes in fair market value due to changes in stock prices, volatility, exercise patterns and the other factors as discussed below used to value stock-based compensation.

The process of estimating the fair value of share-based compensation awards and recognizing share-based compensation expense over the related requisite service period involves significant estimates and assumptions. We estimate the fair value of share-based awards on the date of grant using a Black-Scholes option-pricing model, which requires management to make certain assumptions including (1) the expected volatility in the market price of our common stock; (2) a risk-free rate of interest; (3) an estimated dividend yield; (4) the period of time employees are expected to hold the award prior to exercise; (5) a rate of forfeiture, including option expiration and cancellations, that will occur prior to or during the vesting term; and (6) the fair value of the underlying common stock.

To estimate the expected volatility under the Black-Scholes option pricing model, we utilized the disclosed stock price volatility of industry peers of a similar size whose shares are publicly-traded, due to our lack of a trading history, and calculated an even blend of their historical and implied volatility. The risk-free interest rate assumption was based on zero coupon U.S. Treasury instruments whose term was consistent with the expected term of our share-based grants. There is no assumed dividend yield as we do not expect to pay dividends for the foreseeable future. We estimated the expected term of the options using the “simplified” method. Under this method, the expected term is calculated as the average of the time-to-vesting and the contractual life of the option. The FASB revised authoritative guidance for Stock Compensation also requires us to estimate the expected impact of forfeited awards and to recognize stock-based compensation expense only for those awards expected to vest. We used historical experience to estimate our projected rate of forfeitures. If actual forfeiture rates are materially different from our estimates, stock-based compensation expense could be significantly different from what we have recorded. We periodically review actual forfeiture rates and revise our estimates as considered necessary. The cumulative effect on current and prior periods of a change in the estimated forfeiture rate will be recognized as compensation expense in the period of the revision.

 

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The following table summarizes by grant date the number of shares of common stock subject to options granted in 2006, 2007 and 2008 and in the nine months ended September 30, 2009, the associated per share exercise price and the per share estimated fair value of the common stock. The exercise prices were set by our Board of Directors at prices believed to equal or exceed the fair value of our common stock at each of the grant dates. The estimated per share fair values are based on the contemporaneous valuations as described below.

 

Grant Date

   Number of
Options Granted
   Per Share
Exercise Price
   Estimated
Per Share
Fair Value

March 8, 2006

   187,500    $ 2.75    $ 1.38

June 8, 2006

   601,715    $ 2.75    $ 1.38

July 3, 2006

   125,000    $ 2.75    $ 1.38

November 15, 2006

   498,700    $ 2.75    $ 2.50

December 8, 2006

   25,000    $ 3.00    $ 2.50

March 8, 2007

   92,200    $ 3.87    $ 3.87

June 14, 2007

   490,040    $ 5.23    $ 5.23

July 1, 2007

   125,000    $ 5.23    $ 5.23

July 17, 2007

   700,000    $ 5.23    $ 5.23

September 13, 2007

   90,200    $ 7.80    $ 7.80

November 8, 2007

   151,100    $ 10.34    $ 10.34

March 20, 2008

   433,800    $ 9.08    $ 9.08

July 10, 2008

   789,000    $ 8.28    $ 8.28

September 11, 2008

   362,400    $ 8.88    $ 8.88

November 13, 2008

   115,250    $ 6.97    $ 6.97

March 12, 2009

   172,250    $ 5.86    $ 5.86

June 18, 2009

   802,250    $ 5.98    $ 5.98

July 1, 2009

   125,000    $ 5.98    $ 5.98

September 17, 2009

   127,000    $ 5.42    $ 5.42

From January 2004 through December 2006, stock option exercise prices ranging from $2.25 per share to $3.00 per share as set by our Board of Directors exceeded the estimated fair value of our common stock. As shown in the table above, beginning in March 2007, our Board of Directors set stock option exercise prices at estimated fair value. Prior to 2006, fair values were determined on market multiples of historical and projected revenues and earnings prepared by management and the other qualitative and quantitative factors set forth below. Beginning in March 2006, our Board of Directors also considered contemporaneous valuations provided by management in determining the fair value of our common stock. Such valuations were prepared in March and October 2006, January, May, August and November 2007, March, June, August and October 2008 and February, May and August 2009, and valued the common stock at $1.38, $2.50, $3.87, $5.23, $7.80, $10.34, $9.08, $8.28, $8.88, $6.97, $5.86, $5.98 and $5.42 per share, respectively.

The contemporaneous valuations were prepared consistent with the American Institute of Certified Public Accountants Practice Aid, “Valuation of Privately-Held Company Equity Securities Issued as Compensation,” or the Practice Aid. We used both market approaches, which compare our company to similar publicly-traded companies or transactions, and an income approach, which looks at projected future cash flows, to value our company from among the alternatives discussed in the Practice Aid. In addition, as we have several series of preferred stock outstanding, it was also necessary to allocate our company’s value to the various classes of stock, including warrants and stock options. As provided in the Practice Aid, there are several approaches for allocating enterprise value of a privately-held company among the securities held in a complex capital structure. The possible methodologies include the probability-weighted expected return method, the option-pricing method and the current value method. The current value method is more applicable to an early stage company and was therefore not used.

The option-pricing method was used for the stock valuations for October 2006, January 2007 and May 2007 and is considered appropriate when the range of possible future outcomes is difficult to predict. Under the option-pricing method, our company’s value is allocated first to the preferred stock by determining a series of call options with exercise prices based on the liquidation preferences and the conversion rights for each series

 

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preferred stock, with the balance of the value allocated to the common stock. The common stock valuations for August and November 2007 and March, June, August, October 2008, February, May and August 2009 used the probability-weighted expected return method. Under the probability-weighted expected return method, shares are valued based upon the probability-weighted present value of expected future returns, considering various future outcomes available to the company, as well as the rights of each share class. The valuations also reflect a marketability discount ranging from 10% to 22% for the differences in market value of a publicly-traded stock versus privately-held stock, which has additional risk related to a lack of liquidity. The market discounts were calculated using a Black-Scholes option pricing model.

The option-pricing method was believed to be the most appropriate allocation method from March 2006 until August 2007 considering the participating rights and preferences of the preferred stock, and considering that the preferred shareholders hold a controlling voting interest in our company. As a result of the participation rights and preferences, the preferred shareholders will receive substantially more of our company’s value in the event of the dissolution or liquidation of our company, such as in a buy-out or sale of our company, or on the payment of the dividends. For example, on a buy-out or sale of our company, the preferred shareholders were entitled to receive average liquidation preferences of $2.96, $2.99 and $3.05 per share in October 2006, January 2007 and May 2007, respectively, before then participating equally with the common shareholders in the remaining value of our company. Further, across this period and at the direction of the Board of Directors (which includes three directors representing a majority of our preferred shareholders), we were evaluating several liquidity alternatives that would have resulted in significant preference payments to the preferred shareholders. However, during this period we agreed not to pursue an initial public offering until another substantial pharmaceutical product could be acquired, which did not occur until October 2007.

We began using the probability-weighted expected return method in August 2007, when the Board of Directors and management determined it was probable that an acquisition of a substantial pharmaceutical product would be completed before the end of 2007 and, therefore, an initial public offering or sale of our company was substantially more likely to be pursued and completed in 2008 or 2009. Due to the distressed market conditions during 2008 and to date in 2009, neither of these events have occurred. Under the probability-weighted expected return method, the common shares were valued by weighting the estimated enterprise values of likely future outcomes, including an initial public offering or the sale of our company.

The table below summarizes discounted per share value of our company (assuming conversion of the preferred stock to common and the exercise of vested, in the money warrants and options), the discounted average per share value allocated to our preferred stock, the discounted per share value allocated to our common stock and the marketability discount applied at each valuation date from October 2006 to August 2009.

 

Valuation Date

   As Converted
Stock Value(1)
   Average
Preferred
Stock Value
   Estimated
Fair Value of
Common Stock
   Marketability
Discount

Option Pricing Method:

           

October 2006

   $ 4.53    $ 5.23    $ 2.50    14%

January 2007

   $ 5.72    $ 6.50    $ 3.87    14%

May 2007

   $ 7.09    $ 7.88    $ 5.23    10%

Probability-Weighted Expected Return Method:

           

August 2007

   $ 7.80    $ 7.80    $ 7.80    11%

November 2007

   $ 10.34    $ 10.34    $ 10.34    13%

March 2008

   $ 9.08    $ 9.08    $ 9.08    13%

June 2008

   $ 8.28    $ 8.28    $ 8.28    12%

August 2008

   $ 8.88    $ 8.88    $ 8.88    11%

October 2008

   $ 6.97    $ 6.97    $ 6.97    14%

February 2009

   $ 5.86    $ 5.86    $ 5.86    22%

May 2009

   $ 5.98    $ 5.98    $ 5.98    19%

August 2009

   $ 5.42    $ 5.42    $ 5.42    18%

 

(1) Represents the estimated enterprise values divided by the total common shares outstanding, assuming conversion of the preferred stock to common shares and the exercise of vested, in-the-money warrants and options.

 

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The increases in estimated fair value from March 2006 through November 2007 primarily reflect increasing historical and projected sales and earnings, a reduction in the expected time to liquidity and the termination of the preferred shareholder redemption rights in April 2007. In addition, from May to November 2007, the valuations reflect progress in developing a new diagnostic test expected to be launched in mid-2008. Based on progress in developing and acquiring products, the August and November 2007 valuations considered an initial public offering as the most probable route to liquidity for investors and, accordingly, such valuations did not give effect to any preferred stock preferences and assumed the conversion of the preferred stock to common stock. The November 2007 valuation also reflected the expected effect of an agreement signed in October 2007 to acquire exclusive rights to Lotronex, a marketed drug for the treatment of female patients with severe diarrhea-predominant IBS who meet the conditions stated in the label, in the United States.

The decrease in estimated fair value from November 2007 to June 2008 reflects a downturn in general financial market conditions and was determined by an analysis of changes in the market multiples of publicly-held specialty pharmaceutical and diagnostic companies. The increase in estimated fair value from June 2008 to August 2008 reflects a minor increase in these same market multiples during the period. In addition, $9.08 was the price at which we repurchased redeemable warrants which were put to us in April 2008. See Note 9 to our consolidated financial statements located elsewhere in this prospectus. The decrease in estimated market value from August 2008 to February 2009 in part reflects a downturn in general financial market conditions and also reflects the impact of valuing separately the estimated future cash flows from Entocort EC through the end of the distribution agreement on December 31, 2010. The slight increase in estimated fair value from February 2009 to May 2009 primarily reflects changes in the market multiples of publicly-held specialty pharmaceutical and diagnostic companies. The decrease from May 2009 to August 2009 primarily reflects decreases in these same multiples as well as a decrease in the indicated fair value of the Entocort EC business. The value of the Entocort EC business continues to decline as the expiration of the distribution agreement on December 31, 2010 becomes closer.

The other quantitative and qualitative factors considered by our Board of Directors in determining the fair value of our common stock have included:

 

   

the rights, preferences and privileges of our convertible preferred stock relative to those of our common stock (including Series C, Series D and Series E redemption rights, preferences held by the preferred stock with respect to dividend payments, and preference payments and participation of the preferred stock with the common stock on a voluntary or involuntary dissolution, liquidation or winding up of the affairs of our company, including a sale of our company, which factors were particularly significant until such time as our Board of Directors approved proceeding with an initial public offering concurrent with our entering into the agreements to distribute and acquire Lotronex);

 

   

our current and projected operating and financial performance which was impacted by increasing sales of Entocort EC in 2005, 2006 and 2007, from expected and realized sales of Lotronex beginning in November 2007 and the launch of our diagnostic test for IBS in May 2008;

 

   

the status of new product development or acquisitions;

 

   

general financial market conditions and the market prices of similar publicly-held specialty pharmaceutical and diagnostic companies;

 

   

the fact that the option grants involved illiquid securities in a private company; and

 

   

the likelihood of achieving a liquidity event, such as an initial public offering or the sale of our company, given our performance, the need for additional capital or liquidity for investors and prevailing market conditions.

There are significant judgments and estimates inherent in the determination of these valuations. These judgments and estimates include assumptions regarding our future performance, the time to completing an initial public offering or other liquidity event, and the timing of and probability of launching additional products as well as determinations of the appropriate valuation methods. If we had made different assumptions, our deferred stock-based compensation amount, our stock-based compensation expense, net income and net income per share could have been significantly different.

 

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We have also granted performance-based stock options with terms that allow the recipients to vest in a specific number of shares based upon the achievement of performance goals as specified in the awards. Share-based compensation expense associated with these performance-based stock options is recognized using management’s best estimates of the time to vesting for the achievement of the performance milestones. If the actual achievement of the performance milestones varies from our estimates, share-based compensation expense could be materially different than what is recorded in the period. The cumulative effect on current and prior periods of a change in the estimated time to vesting for performance-based stock options will be recognized as compensation cost in the period of the revision, and recorded as a change in estimate.

While the assumptions used to calculate and account for share-based compensation awards represents management’s best estimates, these estimates involve inherent uncertainties and the application of management’s judgment. As a result, if revisions are made to our underlying assumptions and estimates, our share-based compensation expense could vary significantly from period to period.

The total estimated compensation cost related to non-vested awards not yet recognized was $5.1 million and $8.3 million as of December 31, 2007 and 2008, respectively. The weighted-average period over which this expense in expected to be recognized is approximately 2.0 years. See Notes 1, 9 and 16 to the consolidated financial statements located in this prospectus for further discussion of share-based compensation.

Results of Operations

We have two reportable business segments: pharmaceutical products and diagnostic testing services. The pharmaceutical products segment includes Entocort EC for the treatment of mild to moderate active Crohn’s disease involving the ileum and/or ascending colon, Lotronex for the treatment of severe diarrhea-predominant IBS in women and non-promoted pharmaceutical products including, but not limited to, Imuran® for use as an adjunct for the prevention of rejection in kidney transplantation and the management of active rheumatoid arthritis, Helidac® Therapy, or Helidac, for the eradication of Helicobacter pylori, the leading cause of peptic ulcers, and Ridaura® for the management of rheumatoid arthritis for patients who have not responded adequately to one or more non-steroidal anti-inflammatory drugs. The diagnostics segment includes specialized diagnostic tests including specific immunoassays to detect and differentiate certain diseases, drug metabolite monitoring and pharmacogenetic testing. We have no inter-segment revenues.

As both pharmaceutical products and diagnostics testing services are sold through the same sales force and managed by the same personnel, we report, manage and evaluate our business segment performance on net revenues and gross margin. We do not allocate selling, general and administrative, research and development, or other indirect costs to our business segments for performance assessment. Accordingly, our segment discussion and analysis for the years ended December 31, 2006, 2007 and 2008 and the nine months ended September 30, 2008 and 2009 only addresses net sales and the related gross margin.

Comparison of the Nine Months Ended September 30, 2008 and 2009

Net Sales

The following table sets forth the net sales of our pharmaceutical products and diagnostic testing services segments for the nine months ended September 30, 2008 and 2009 and the changes between these periods.

 

     Nine Months Ended
September 30,
   Increase/
(Decrease)
    % Increase/
(Decrease)
     2008    2009     
     (Unaudited; in
thousands)
          

Pharmaceutical products:

          

Entocort EC

   $ 105,869    $ 154,275    $ 48,406      46%

Lotronex

     18,172      22,307      4,135      23%

Non-promoted

     20,019      16,550      (3,469   (17)%
                        

Total

     144,060      193,132      49,072      34%

Diagnostic testing services

     60,752      64,668      3,916      6%
                        

Net sales

   $ 204,812    $ 257,800    $ 52,988      26%
                        

 

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Net sales increased to $257.8 million for the nine months ended September 30, 2009 from $204.8 million for the nine months ended September 30, 2008. The increase was the result of increased pharmaceutical product sales due to higher unit volume of Entocort EC and Lotronex and overall price increases, in addition to increased diagnostic testing services due to higher sales volume from existing products, offset by a decrease in non-promoted pharmaceutical product sales due to continued generic encroachment.

Pharmaceutical Products

Pharmaceutical product sales increased to $193.1 million for the nine months ended September 30, 2009 from $144.1 million for the nine months ended September 30, 2008. The increase of approximately $49.1 million, or 34%, was due primarily to increases in Entocort EC pricing and unit volume, which increased sales by $45.5 million and $2.9 million, respectively. Additionally, sales of Lotronex increased by $4.1 million for the nine months ended September 30, 2009 to $22.3 million, from $18.2 million for the nine months ended September 30, 2008. Lotronex pricing and unit volume increased net sales by $3.6 million and $0.5 million, respectively, over the same period in 2008. Sales of our non-promoted pharmaceutical products decreased by $3.5 million for the nine months ended September 30, 2009 compared to the same period in 2008 due to continued volume erosion caused by generic competition.

For the nine months ended September 30, 2009, the growth of our pharmaceutical products sales was offset by a $3.1 million allowance for rebates related to the DOD’s TriCare Retail Pharmacy program, of which $1.8 million related to a retroactive rebate assessment for sales made during 2008. See Note 16A to the consolidated financial statements located elsewhere in this prospectus.

Diagnostic Testing Services

Net sales of diagnostic testing services increased to $64.7 million for the nine months ended September 30, 2009 from $60.8 million for the nine months ended September 30, 2008. Increased volume of our celiac, IBS diagnostic and IBD Serology 7 diagnostic testing services resulted in increased net sales of $2.3 million, $1.1 million and $0.4 million, respectively. Additionally, we recognized $0.3 million in diagnostic license revenue from the achievement of a commercial milestone. This license revenue related to an out-licensing arrangement for certain patented diagnostic technologies, entered into in 2007. These increases were offset by decreases in sales of other diagnostic services of $0.2 million.

Gross Margin

The following table sets forth the gross margin on sales for our pharmaceutical products and diagnostic testing services segments for the nine months ended September 30, 2008 and 2009 and the changes between these periods.

 

     Nine Months Ended
September 30,
   Increase    % Increase
     2008    2009      
     (Unaudited; in
thousands)
         

Pharmaceutical products

   $ 64,130    $ 79,812    $ 15,682    24%

Diagnostic testing services

     49,563      51,192      1,629    3%
                       

Gross margin

   $ 113,693    $ 131,004    $ 17,311   
                       

Gross margin percentage

     56%      51%      

Our gross margin increased to $131.0 million for the nine months ended September 30, 2009 from $113.7 million for the nine months ended September 30, 2008. The increase of $17.3 million was primarily a result of an overall increase in pharmaceutical product and diagnostic testing services sales, partially offset by a change in the pharmaceutical product mix as discussed below. The overall gross margin percentage declined to 51% for the nine months ended September 30, 2009 from 56% for the nine months ended September 30, 2008, reflecting the increased proportion of the lower overall gross margin in our pharmaceuticals segment.

 

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Additionally, overall gross margin was reduced by approximately $1.7 million, net of the impact of royalties and certain other contractual payments, or 1%, as a result of a $3.1 million allowance for rebates related to the DOD TriCare Retail Pharmacy program recorded in the nine-month period ended September 30, 2009. See Note 16A to the consolidated financial statements located elsewhere in this prospectus. Pharmaceutical gross profit includes the amortization of acquired product rights of $10.0 million and $9.0 million for the nine-month periods ended September 30, 2009 and 2008, respectively.

Pharmaceutical Products

Pharmaceutical product gross margin increased to $79.8 million for the nine months ended September 30, 2009 from $64.1 million for the nine months ended September 30, 2008. The increase in gross margin was primarily a result of increased pharmaceutical net sales of $49.1 million for the nine months ended September 30, 2009 over the same period in 2008. Our pharmaceutical product gross margin percentage decreased to 41% for the nine months ended September 30, 2009 from 45% for the nine months ended September 30, 2008 due primarily to sales of Entocort EC, which were proportionately larger in 2009 compared to 2008. Due to the product cost and royalty structure under the distribution agreement with AstraZeneca, Entocort EC has a significantly lower gross margin than most of our other pharmaceutical products. In addition, pharmaceutical product gross margin was reduced by approximately $1.7 million, net of the impact of royalties and certain other contractual payments, or 1%, as a result of a $3.1 million allowance for rebates related to the DOD TriCare Retail Pharmacy program, recorded in the nine-month period ended September 30, 2009. See Note 16A to the consolidated financial statements located elsewhere in this prospectus.

Diagnostic Testing Services

Diagnostic testing services gross margin increased to $51.2 million for the nine months ended September 30, 2009 from $49.6 million for the nine months ended September 30, 2008. The increase was primarily a result of increased net sales for diagnostic testing services of $3.9 million. Diagnostic testing services gross margin percentage was 79% and 82% for the nine months periods ended September 30, 2009 and 2008, respectively. The decrease in the gross margin percentage is due to general increases in labor and direct supply costs related to these testing services.

Operating Expenses

The following table sets forth our operating expenses for the nine months ended September 30, 2008 and 2009.

 

     Nine Months Ended September 30,           
     2008    2009           
     Operating
Expense
   % of Net
Sales
   Operating
Expense
   % of Net
Sales
   Increase/
(Decrease)
    % Increase/
(Decrease)
     (Unaudited; in thousands)

Sales and marketing

   $ 39,660    19%    $ 38,956    15%    $ (704   (2)%

General and administrative

     16,429    8%      24,864    10%      8,435      51%

Research and development

     10,260    5%      15,460    6%      5,200      51%

Sales and Marketing

Sales and marketing expense decreased to $39.0 million for the nine months ended September 30, 2009 from $39.7 million for the nine months ended September 30, 2008. The decrease of $0.7 million was a result of decreased sales force and employee related expenses of approximately $1.5 million, offset by an increase in promotion, consulting and other commercial operating costs of $0.8 million. Sales and marketing expenses as a percentage of net sales decreased to 15% for the nine months ended September 30, 2009 from 19% for the same period in 2008 as a result of the 2% decrease in total sales and marketing expenses and the 26% increase in net sales for the nine months ended September 30, 2009 compared to September 30, 2008.

 

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General and Administrative

General and administrative expense increased to $24.9 million for the nine months ended September 30, 2009 from $16.4 million for the nine months ended September 30, 2008. The increase was primarily a result of increases in employee related expenses of $3.8 million due to increased compensation and headcount, $1.8 million in legal expenses relating to general legal, business development and ongoing patent litigation matters and $1.8 million in other general operating expenses. Additionally, declines in estimated diagnostic accounts receivable collectability resulted in incremental bad debt expense of $1.1 million over the same period in 2008. General and administrative expense as a percentage of net sales increased to 10% for the nine months ended September 30, 2009 from 8% over the same period in 2008 as a result of the 51% increase in total general and administrative expenses compared to the 26% increase in net sales for the nine months ended September 30, 2009 compared to September 30, 2008.

Research and Development

Research and development expense increased to $15.5 million for the nine months ended September 30, 2009 from $10.3 million for the nine months ended September 30, 2008. The increase was primarily a result of a $2.4 million increase in salaries, benefits, travel and other employee expenses due to an increase in headcount and $2.8 million in increased costs for the development and validation of new diagnostic products. Research and development expense as a percentage of net sales increased to 6% for the nine months ended September 30, 2009 from 5% over the same period in 2008 as a result of the 51% increase in research and development expense compared to the 26% increase in net sales for the nine months ended September 30, 2009 compared to the same period in 2008. We expect to incur significant research and development expenses related to diagnostic development activities in both the gastrointestinal and oncology areas. In addition, we also expect to incur significant expenses due to our clinical trials to evaluate Colal-Pred for the treatment of patients with ulcerative colitis. However, these development activities involve a high degree of risk and uncertainty, and we may abandon development of any product candidate at any time.

Interest Expense

Interest expense related to the bank credit agreement decreased to $1.8 million for the nine months ended September 30, 2009 from $2.8 million for the same period in 2008. The decrease was primarily a result of a decrease in interest rates as well as a lower principal balance outstanding during the nine months ended September 30, 2009 compared to the same period in 2008.

In conjunction with a loan agreement entered into in June 2000 and the issuance of our senior notes in April 2001, we issued warrants to purchase Series D Redeemable Preferred Stock and common stock, respectively, collectively referred to as the redeemable warrants. As the holders of the redeemable warrants had certain rights that could have required us to repurchase the warrants or the related shares, subsequent to June 20, 2005, increases or decreases in the fair value of the redeemable warrants were recorded as interest expense in the statement of income through April 30, 2008. Redemption rights related to the warrants to purchase the Series D Redeemable Preferred Stock expired in April 2007. Redemption rights with respect to the warrants to purchase common stock issued in connection with our senior notes expired in April 2008. Interest expense for the nine months ended September 30, 2008 included the reversal of interest expense of $5.6 million related to a reduction in the fair value of the redeemable warrants.

Interest and Other Income

Net interest and other income decreased to $0.4 million for the nine months ended September 30, 2009 from $1.9 million for the nine months ended September 30, 2008. The decrease of $1.5 million was in part related to a substantial reduction in yield on investments of $1.0 million realized in 2009. This decrease in yield was due to a conservative cash management strategy to protect and conserve our cash, cash equivalent and marketable securities balances in the current economic environment. In addition, the nine month period ended September 30, 2008 included proceeds related to the sale of equity obtained through the license of patented diagnostic technologies of $0.5 million.

 

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Provision for Income Taxes

Income tax expense increased to $22.0 million, or 43.7% of pre-tax income, for the nine month period ended September 30, 2009, compared to $18.4 million or 35.4% of pretax income, for the nine-month period ended September 30, 2008. The higher tax rate for the nine month period ended September 30, 2009 compared to the nine months ended September 30, 2008 was primarily due to a $5.6 million non-taxable reversal of accretion to the fair value of the redeemable warrants in March 2008 (see Note 9 to our consolidated financial statements located elsewhere in this prospectus). In February 2009, the California Legislature enacted 2009-2010 budget legislation containing various California tax law changes including an election to apply a single sales factor apportionment formula for taxable years beginning on or after January 1, 2011. Such a change in apportionment will reduce the Company’s California effective tax rate. We anticipate making the election and as a result, the state and federal deferred tax assets have been adjusted to reflect a reduction in the future tax rate. The impact of the adjustment was an increase to the provision for income taxes of $1.0 million. The adjustment was recorded as a discrete item in the nine-month period ended September 30, 2009 and increased the effective tax rate for the nine months ended September 30, 2009 by approximately 1.8%.

During the quarter ending September 30, 2009, the Company had an increase in unrecognized tax benefits of $0.7 million. The $0.7 million relates to the timing of tax deductions and as such, none of the amount, if recognized, would affect the Company’s effective tax rate. The Company is currently in the appeals phase of an IRS audit of its returns for the 2005 through 2007 tax years. The Company expects the appeals process will be completed during the 12-month period following the quarter ended September 30, 2009. The Company expects any currently unrecognized tax benefits to be paid within 12 months following the quarter ended September 30, 2009.

Comparison of the Years Ended December 31, 2007 and 2008

Net Sales

The following table sets forth the net sales of our pharmaceutical products and diagnostic testing services segments for the years ended December 31, 2007 and 2008 and the changes between these periods.

 

     2007    2008    Increase/
(Decrease)
   % Increase/
(Decrease)
 

Pharmaceutical Products:

           

Entocort EC

   $ 110,848    $ 145,028    $ 34,180    31

Lotronex

     2,471      25,154      22,683    918

Non-Promoted

     30,336      25,803      (4,533)    (15)
                       

Total

     143,655      195,985      52,330    36

Diagnostic Testing Services

     77,285      82,073      4,788    6
                       

Net Sales

   $ 220,940    $ 278,058    $ 57,118   
                       

Net sales increased to $278.1 million in 2008 from $220.9 million in 2007. The increase was the result of increased pharmaceutical product sales due to higher volume and price increases, the first full year of Lotronex sales and increased diagnostic testing services due to higher volume from existing products, offset by a decrease in non-promoted pharmaceutical products due to continued generic encroachment.

Pharmaceutical Products

Pharmaceutical product sales increased to $196.0 million in 2008 from $143.7 million in 2007. The increase of $52.3 million, or 36%, was in part due to increases in Entocort EC unit volumes and pricing, which increased Entocort sales $13.8 million and $20.4 million, respectively. Beginning November 1, 2007, we also began selling Lotronex under an exclusive distribution agreement. Sales of Lotronex under the distribution agreement were approximately $2.5 million in 2007, compared to sales of $25.2 million in 2008. Sales of our non-promoted pharmaceutical products decreased due to continued volume erosion caused by generic competition. Sales of Helidac, Imuran and other non-promoted pharmaceutical products decreased by $2.5 million, $1.3 million and $0.7 million, respectively, due primarily to volume decreases in 2008 compared to the same period in 2007 due to continued volume erosion caused by generic competition. We expect sales of non-promoted pharmaceutical products to continue to decrease due to continued volume erosion caused by generic competition.

 

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Diagnostic Testing Services

Net sales of diagnostic testing services increased to $82.1 million in 2008 from $77.3 million in 2007. Increased volume of our celiac and IBD Serology 7 diagnostic testing services resulted in increased net sales of $3.5 million and $1.4 million, respectively. Beginning in April 2008, we began selling our IBS diagnostic test. Sales of our IBS diagnostic testing services were $0.8 million in 2008. These increases were offset by decreases in sales of thiopurine management and other diagnostic services of $0.9 million.

Gross Margin

The following table sets forth the gross margin on sales for our pharmaceutical products and diagnostic testing services segments for the years ended December 31, 2007 and 2008 and the changes between these periods.

 

     2007    2008    Increase/
(Decrease)
   % Increase/
(Decrease)

Pharmaceutical Products

   $ 67,940    $ 86,339    $ 18,399    27%

Diagnostic Testing Services

     62,439      66,061      3,622    6%
                       

Gross Margin

   $ 130,379    $ 152,400    $ 22,021   
                       

Gross Margin Percentage

     59%      55%      

Our gross margin increased to $152.4 million in 2008 from $130.4 million in 2007. The increase of $22.0 million was primarily a result of an increase in sales, partially offset by a change in the pharmaceutical product mix as discussed below. The overall gross margin percentage declined to 55% in 2008 from 59% in 2007, reflecting the increased proportion of the lower overall gross margin in our pharmaceuticals segment. Pharmaceutical gross profit includes the amortization of acquired product rights and intangibles of $12.1 million and $3.3 million for 2008 and 2007, respectively.

Pharmaceutical Products

Pharmaceutical product gross margin increased to $86.3 million in 2008 from $67.9 million in 2007. The increase in gross margin was primarily a result of increased pharmaceutical net sales of $52.3 million in 2008 over 2007. Our pharmaceutical product gross margin percentage decreased to 44% in 2008 from 47% in 2007 as sales of Entocort EC were proportionately larger in 2008 as compared to 2007. Due to the product cost and royalty structure under the distribution agreement with AstraZeneca, Entocort EC has a significantly lower gross margin than most of our other pharmaceutical products. Additionally, the decrease in pharmaceutical gross margin was impacted by the amortization of acquired product rights and intangibles increasing to $12.1 million in 2008 compared to $3.3 million in 2007. The increase of $8.8 million was due to the amortization of product rights and intangible assets relating to the acquisition of Lotronex in January 2008.

Diagnostic Testing Services

Diagnostic testing services gross margin increased to $66.1 million in 2008 from $62.4 million in 2007. The increase was primarily a result of increased net sales for diagnostic testing services of $4.8 million. Diagnostic testing services gross margin percentage was 80% and 81% in 2008 and 2007, respectively.

Operating Expenses

The following table sets forth our operating expenses for the years ended December 31, 2007 and 2008.

 

     2007    2008    Increase/
(Decrease)
   % Increase/
(Decrease)
     Operating
Expense
   % of Net
Sales
   Operating
Expense
   % of Net
Sales
     

Sales and Marketing

   $ 37,350    17%    $ 54,932    20%    $ 17,582    47%

General and Administrative

     23,635    11%      26,694    10%      3,059    13%

Research and Development

     13,024    6%      14,628    5%      1,604    12%

 

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Sales and Marketing

Sales and marketing expense increased to $54.9 million in 2008 from $37.4 million in 2007. The increase was primarily a result of increases in salaries, benefits, travel expenditures and other employee expenses of $11.7 million related to the sales force expansion associated with the Lotronex acquisition and the launch of our IBS diagnostic test in 2008. Additionally, market research and other promotional activities increased by approximately $5.9 million over 2007 due primarily to product launch activities for Lotronex and our IBS diagnostic test. Sales and marketing expenses as a percentage of net sales increased to 20% in 2008 from 17% in 2007 as a result of the 47% increase in total sales and marketing expenses exceeding the 26% increase in net sales in 2008 over 2007.

General and Administrative

General and administrative expense increased to $26.7 million in 2008 from $23.6 million in 2007. The increase is primarily due to the write-off of previously deferred initial public offering, or IPO, costs of $3.4 million in 2008. These costs were expensed as of December 31, 2008 due to the continued delay of the IPO caused by sustained unfavorable market conditions. These costs included accounting, legal and printer fees of $1.6 million, $1.6 million and $0.2 million, respectively. Additionally, increases in headcount resulted in incremental salaries and related benefits and other operating expenses of $1.4 million and $0.3 million in 2008 from 2007, offset by a decrease in non-IPO related legal fees of $2.0 million relating to general legal and ongoing patent litigation matters. General and administrative expense as a percentage of net sales decreased to 10% in 2008 from 11% in 2007 as a result of the 13% increase in total general and administrative expenses compared to the 26% increase in net sales in 2008 over 2007.

Research and Development

Research and development expense increased to $14.6 million in 2008 from $13.0 million in 2007. The increase was primarily a result of increases in costs for the development and validation of new diagnostic products of $2.4 million and salaries, benefits, and other employee expenses of $2.2 million due to an increase in headcount, offset by approximately $0.5 million in reduced miscellaneous operating expenses in 2008. In 2007, research and development expenses included a $2.5 million upfront payment for the licensing of Colal-Pred, which did not recur in 2008. Research and development expense as a percentage of net sales decreased to 5% in 2008 compared to 6% in 2007 as a result of the 12% increase in research and development expense compared to the 26% increase in net sales. We expect research and development expenses to continue to increase due to increased diagnostic development activities, including but not limited to development and clinical validation costs related to further development of our gastrointestinal diagnostic testing services and potential oncology diagnostic products as well as continued development of Colal-Pred. However, these development activities involve a high degree of risk and uncertainty, and we may abandon development of any product candidate at any time.

Interest Expense

In conjunction with a loan agreement entered into in June 2000 and the issuance of our senior notes in April 2001, we issued warrants to purchase Series D Redeemable Preferred Stock and common stock, respectively, collectively referred to as the redeemable warrants. As the holders of the redeemable warrants had certain rights that could have required us to repurchase the warrants or the related shares, subsequent to June 20, 2005, increases or decreases in the fair value of the redeemable warrants were recorded as interest expense in the statement of income through April 30, 2008. Redemption rights related to the warrants to purchase the Series D Redeemable Preferred Stock expired in April 2007. Redemption rights with respect to the warrants to purchase common stock issued in connection with our senior notes expired in April 2008. Interest expense in 2008 included the reduction of $5.6 million in the fair value of the redeemable warrants compared to interest expense of $31.1 million in 2007 related to the increase in the fair value of the redeemable warrants discussed above.

Interest expense related to the bank credit agreement increased to $3.7 million in 2008 from $3.1 million in 2007. The increase was primarily a result of the interest incurred from a new term loan entered into in September 2007 (see Note 8 to our consolidated financial statements located elsewhere in this prospectus). The term loan provided for total gross proceeds of $75.0 million.

 

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Interest and Other Income

Net interest and other income decreased to $2.2 million in 2008 from $4.4 million in 2007. The decrease of $2.2 million was primarily related to a substantial reduction in yield on investments of $2.7 million realized in 2008, offset by the sale of equity obtained through the license of patented technologies of $0.5 million. This decrease in yield was due to a conservative cash management strategy to protect and conserve our principal cash and cash equivalent balances in the current economic environment as well as an overall decrease in interest rates.

Provision for Income Taxes

Income tax expense increased to $23.0 million, or 38.2% of pre-tax income, in 2008 from $22.3 million or 83.8% of pretax income, in 2007. The lower tax rate for 2008 compared to 2007 was primarily due to $31.1 million in non-deductible interest expense incurred in 2007 associated with the increase in the fair value of the redeemable warrants (see Notes 1 and 10 to our consolidated financial statements located elsewhere in this prospectus).

Comparison of the Years Ended December 31, 2006 and 2007

Net Sales

The following table sets forth the net sales of our pharmaceutical products and diagnostic testing services segments for the years ended December 31, 2006 and 2007 and the increase or decrease between these periods.

 

     2006    2007    Increase/
(Decrease)
   % Increase/
(Decrease)
     (In thousands)     

Pharmaceutical products:

           

Entocort EC

   $ 85,123    $ 110,848    $ 25,725    30%

Lotronex

          2,471      2,471   

Non-promoted

     34,027      30,336      (3,691)    (11)%
                       

Total

     119,150      143,655      24,505    21%

Diagnostic testing services

     68,261      77,285      9,024    13%
                       

Net sales

   $ 187,411    $ 220,940    $ 33,529    18%
                       

Net sales increased to $220.9 million in 2007 from $187.4 million in 2006. The increase was the result of increased pharmaceutical product sales due to higher volume and price increases, the addition of Lotronex in November 2007, and increased diagnostic testing services due to higher volume from existing products, offset by a decrease in non-promoted pharmaceutical products due to continued generic encroachment.

Pharmaceutical Products

Pharmaceutical product sales increased to $143.7 million in 2007 from $119.2 million in 2006. The increase of $24.5 million, or 21%, in 2007 was the result of an increase in Entocort EC unit volume and a price increase, which resulted in increased product sales of approximately $15.4 million and $10.3 million, respectively. Beginning November 1, 2007, we also began selling Lotronex under an exclusive distribution agreement. Sales of Lotronex under the distribution agreement were approximately $2.5 million in 2007. Sales of our non-promoted pharmaceutical products decreased due to continued volume erosion caused by generic competition. Among our non-promoted pharmaceutical products, sales of mercaptopurine dropped by $2.5 million across the same period as pricing and volume fell due to competitive pressure from generic products.

Diagnostic Testing Services

Net sales of diagnostic testing services increased to $77.3 million in 2007 from $68.3 million in 2006. The increase of $9.0 million, or 13%, was primarily due to an increase in the number of tests performed, led by IBD Serology 7, a diagnostic test to aid physicians in detecting and diagnosing inflammatory bowel disease. Sales of

 

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IBD Serology 7, when combined with and compared to its predecessor tests, resulted in a net sales increase of $7.8 million in 2007 as compared to 2006. Increased volume of our celiac and other testing services contributed to the increase by $4.5 million and $0.3 million in 2007 over 2006, respectively.

Additionally, in 2006, we recognized a reduction in contractual allowances resulting in an increase in net sales of diagnostics testing services of approximately $3.6 million. The reduction in contractual allowances reflected improvements in our collections process and collections from third-party commercial payors, including payments received from a certain payor that had previously disputed prior payments and had issued a coverage policy that stated it would not provide payment for certain of our diagnostic testing services. This change in estimate was recorded as a cumulative adjustment in 2006.

Gross Margin

The following table sets forth the gross margin on sales for our pharmaceutical products and diagnostic testing services segments for the years ended December 31, 2006 and 2007 and the increase between the years.

 

     2006    2007    Increase    % Increase
     (In thousands)     

Pharmaceutical products

   $ 61,111    $ 67,940    $ 6,829    11%

Diagnostic testing services

     56,357      62,439      6,082    11%
                       

Gross margin

   $ 117,468    $ 130,379    $ 12,911    11%
                       

Gross margin percentage

     63%      59%      

Our gross margin increased to $130.4 million in 2007 from $117.5 million in 2006. The increase of $12.9 million was primarily a result of an increase in sales, partially offset by a change in the pharmaceutical product mix discussed below. The overall gross margin percentage declined to 59% in 2007 from 63% in 2006, reflecting a lower overall gross margin in our pharmaceutical products segment. Gross margin includes the amortization of acquired product rights and intangibles of $3.3 million in each of 2006 and 2007.

Pharmaceutical Products

Pharmaceutical product gross margin increased to $67.9 million in 2007 from $61.1 million in 2006. The increase in gross margin was primarily a result of increased net sales of $24.5 million in 2007 over the same period in 2006. Our pharmaceutical product gross margin percentage decreased to 47% in 2007 from 51% in 2006 as sales of Entocort EC were proportionately larger in 2007 as compared to 2006. Due to the royalty structure under the distribution agreement with AstraZeneca, Entocort EC has a significantly lower gross margin than most of our other pharmaceutical products. In addition, the royalty rates for Entocort EC were higher in 2007 than in 2006.

Diagnostic Testing Services

The gross margin on diagnostic testing services increased to $62.4 million in 2007 from $56.4 million in 2006. The increase was primarily a result of increased net revenues of $9.0 million. The gross margin percentage on diagnostic testing services was 81% in 2007 and 82% (exclusive of the change in estimate discussed above) in 2006.

Operating Expenses

The following table sets forth our operating expenses for the years ended December 31, 2006 and 2007.

 

     2006    2007          
     Operating
Expense
   % of Net
Sales
   Operating
Expense
   % of Net
Sales
   Increase    % Increase
     (Dollars in thousands)

Sales and marketing

   $ 37,233    20%    $ 37,350    17%    $ 117    —%

General and administrative

     19,842    11%      23,635    11%      3,793    19%

Research and development

     4,622    2%      13,024    6%      8,402    182%

 

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Sales and Marketing

Sales and marketing expense slightly increased to $37.3 million in 2007 from $37.2 million in 2006. The increase was due to additional headcount in 2007 resulting in an increase of $1.1 million of salary and related benefits, and increases of $0.3 million and $0.4 million relating to consulting and travel expenses, respectively. These increases are offset by decreases of $1.7 million in promotional and market research expenditures. Sales and marketing expenses as a percentage of net sales decreased to 17% in 2007 from 20% in 2006 as a result of the increase in net sales for 2007 as compared to 2006.

General and Administrative

General and administrative expense increased to $23.6 million in 2007 from $19.8 million in 2006. The increase is primarily due to an increase in headcount, resulting in additional salaries and wages of $1.0 million, incentive and other employee compensation of $1.7 million, and an increase in stock based compensation of $1.4 million, offset by a net decrease in other general operating expenses of $0.3 million. General and administrative expense as a percentage of net sales remained flat at 11% in 2007 from 2006. As a public company, we expect to incur additional legal, accounting and other expenses that we did not incur as a private company. For example, we expect to incur significant expense and devote substantial management effort toward ensuring compliance with Section 404 of the Sarbanes-Oxley Act which relates to our internal controls over financial reporting. In addition, we have hired and expect to hire additional accounting and investor relations personnel.

Research and Development

Research and development expenses increased to $13.0 million in 2007 from $4.6 million in 2006. The increase was primarily a result of increases in salaries, benefits, and other employee expenses of $1.7 million from an increase in headcount, costs for the development and validation of new diagnostic products of $2.9 million, upfront payments for the licensing of Colal-Pred of $2.5 million and $1.3 million for other general research and development operating expenses. Research and development expense as a percentage of net sales increased to 6% in 2007 as compared to 2% in 2006 as a result of the increase in research and development costs, offset by the increase in sales. We expect to continue to incur significant research and development expenses in 2009 related to diagnostic development activities. In addition, we also expect to incur significant expenses due to our commencement of a Phase 2 clinical trial to evaluate Colal-Pred for the treatment of patients with ulcerative colitis in May 2008. However, these development activities involve a high degree of risk and uncertainty, and we may abandon development of any product candidate at any time.

Interest Expense

Interest expense increased to $34.2 million in 2007 from $4.0 million in 2006. Interest expense in 2007 included $3.1 million related to bank credit agreements and $31.1 million related to increases in the fair value of the redeemable warrants as discussed above. Interest expense in 2006 included interest expense of $2.0 million related to our bank credit agreements and $2.0 million for the accretion to fair value of the redeemable warrants.

Interest and Other Income

Net interest and other income increased to $4.4 million in 2007 from $2.8 million in 2006. The increase of $1.6 million was principally related to interest income on higher levels of invested cash. Cash, cash equivalents and marketable securities grew to $161.9 million (which includes a net increase in borrowings of $51.3 million in September 2007 and restricted cash of $80.0 million) as of December 31, 2007 from $78.3 million as of December 31, 2006.

Provision for Income Taxes

Income tax expense remained flat at $22.3 million, or 83.8% of pretax income, in 2007 from $22.3 million, or 40.9% of pretax income, in 2006. The significant increase in the effective tax rate for 2007 was primarily the result of $31.1 million in non-deductible interest expense associated with the increase in the fair value of the redeemable warrants (see Note 9 to our consolidated financial statements located elsewhere in this prospectus).

 

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Liquidity and Capital Resources

Since our inception, we have financed our operations primarily through private placements of our preferred stock, debt financings and sales of our pharmaceutical products and diagnostic testing services. At September 30, 2009, we had $108.3 million in cash, cash equivalents and marketable securities, compared to $96.7 million at December 31, 2008 and $81.9 million at December 31, 2007. At December 31, 2007 we also had $80.0 million in restricted cash that was used in January 2008 for an upfront payment to acquire Lotronex. We believe that our existing funds, cash expected to be generated from operations and our access to financing should be adequate to satisfy the working capital, capital expenditure and debt repayment requirements of our present business for the foreseeable future.

Cash Flows

The following table summarizes our cash flow activity for the periods indicated:

 

     For the Years Ended December 31,     Nine Months Ended
September 30,
 
     2006     2007     2008         2008             2009      
     (In thousands)              

Net cash provided by operating activities

   $ 40,076      $ 38,003      $ 45,311      $ 33,166      $ 44,323   

Net cash provided by (used in) investing activities

     (24,672     (75,603     33,009        33,652        (31,313

Net cash provided by (used in) financing activities

     (3,767     48,339        (26,429     (27,387     (5,795

Operating Activities

Cash provided by operating activities has been and is expected to continue to be our primary recurring source of funds. Cash flows from operations was materially consistent from 2006 to 2007, providing $40.1 million and $38.0 million, respectively. Operating cash flows increased to $45.3 million in 2008 primarily as a result of an increase in net income, offset by a net cash outflow from the increase in accounts receivable. Net accounts receivable increased in 2008 due to the increase in revenues from pharmaceutical products and diagnostic testing services, in addition to an increase in diagnostic accounts receivable days sales outstanding from 75 days in 2007 to 83 days in 2008, as discussed above. In 2008, net income included $3.4 million in pretax expenses incurred associated with the IPO. Of these costs, $1.9 million and $1.5 million were deferred in 2007 and 2008, respectively, but charged to the Statement of Income as of December 31, 2008 due to the continued delay of our initial public offering, caused by sustained unfavorable market conditions. Cash from operations in 2007 is net of $2.7 million paid to the holders of senior note warrants for the purchase of 521,059 shares of common stock that were put to us and repurchased by us in July 2007. Cash generated from operations increased from $33.2 million for the nine months ended September 30, 2008 to $44.3 million for the nine months ended September 30, 2009. The increase is primarily due to increases in accounts payable and accrued liabilities, offset primarily by increases in accounts receivable and inventory, attributable to the growth of our pharmaceuticals product segment.

Investing Activities

Cash provided by investing activities was $33.0 million in 2008 compared with $75.6 million and $24.7 million of cash used in investing activities in 2007 and 2006, respectively. Investing activities included the net sales of marketable securities of $37.1 million and $7.1 million in 2008 and 2007, respectively. Investing activities included the net investment of cash and cash equivalents in excess of our operating requirements of $22.4 million in 2006. In 2008, we liquidated our position in variable rate demand notes and invested all excess funds in money market accounts backed by government securities for protection of principal during the economic downturn. In addition, our investing activities have included purchases of product rights, investment to protect intellectual property and capital expenditures to support the growth of our business. As discussed above, $80.0 million in cash was invested in a restricted account during 2007 and was used in January 2008 for an upfront payment to acquire Lotronex. No restricted cash was held at September 30, 2009. Deferred acquisition costs incurred for this acquisition were $1.0 million in 2007. Cash provided by investing activities was

 

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$33.7 million compared to cash used in investing activities of $31.3 million for the nine months ended September 30, 2008 and 2009, respectively. As previously discussed, all marketable securities were liquidated into cash and cash equivalents in the nine-month period ended September 30, 2008. As the global economy has deteriorated over the past 18 months, significant decreases in interest yield have also been realized. To partially offset this decrease in yield, we have invested $14.8 million in pre-refunded municipal bond securities, offset by $10.4 million in maturities of those investments, in the nine months ended September 30, 2009.

Purchases of product rights and intangible assets were $82.7 million, $0.7 million and $0.8 million in 2008, 2007 and 2006 and $82.5 million and $21.9 million for the nine months ended September 30, 2008 and 2009, respectively. Such investing activities primarily relate to the Lotronex asset purchase as discussed above. We are continuing to pursue the acquisition of pharmaceutical products and diagnostic technologies and expect to continue to invest in acquiring access to such products and technologies in the future. Such investments could be substantial.

Capital expenditures were $1.4 million, $1.0 million and $1.4 million in 2008, 2007 and 2006, respectively, principally reflecting equipment for our laboratory operations and leasehold improvements to support our growth. Capital expenditures were $1.0 million and $5.1 million for the nine months ended September 30, 2008 and 2009, respectively. Approximately $3.1 million of these expenditures relate to the expansion of our current facility.

Financing Activities

Cash used in financing activities increased to $26.4 million in 2008 from $3.8 million in 2006. Cash provided by financing activities was $48.3 million in 2007. Cash used in financing activities was $27.4 million and $5.8 million for the nine months ended September 30, 2008 and 2009, respectively.

Most of our financing activities have related to borrowings and the repayment of debt. Payments of debt include principal payments under a bank credit agreement of $5.6 million and $2.8 million for the nine months ended September 30, 2009 and 2008, respectively, and $3.8 million, $24.7 million and $4.1 million in the years ended 2008, 2007, and 2006, respectively. In September 2007, we repaid the $23.7 million balance outstanding and terminated our then-existing credit agreement. Concurrently, we borrowed $75.0 million ($73.7 million net of fees and costs) pursuant to a new term loan entered into under a new bank credit agreement.

Net cash outflows for financing activities in 2008, 2007 and 2006 were offset by proceeds from the exercise of stock options by $0.3 million, $0.8 million and $0.3 million, respectively. There were no material proceeds from the exercise of stock options in the nine months ended September 30, 2008 or 2009. Net cash inflows for financing activities in 2008 and 2007 each included an excess tax benefit from the exercise of non-qualified stock options of $0.4 million.

In April 2008, holders of our senior note warrants to purchase 2,568,079 shares of our common stock put their warrants to us for an aggregate purchase price of $23.3 million in cash and we issued a net of 1,375,568 shares of common stock pursuant to the automatic cashless exercise of the remaining senior note warrants to purchase 1,377,086 shares of our common stock.

Future Financing Requirements

We believe that our available cash balances and anticipated cash flows from operations will be sufficient to satisfy our operating needs for the foreseeable future. However, our business and its financing needs can change unpredictably due to a variety of factors including product acquisition opportunities, competition, regulation, legal proceedings and other events.

In January 2008, we acquired exclusive rights to Lotronex in the United States from GlaxoSmithKline for $80.0 million in cash and 1,250,000 shares of our common stock. In addition to the upfront fee, we will pay royalties to GlaxoSmithKline based on net sales of Lotronex and may also make payments of up to $100.0 million on the achievement of certain sales-based milestones. In April 2009, we attained the first such sales-based milestone upon the achievement of $35.0 million in cumulative net sales of Lotronex since the

 

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completion of the asset acquisition in January 2008. This achievement resulted in a milestone payment of $20.0 million, which occurred in May 2009. In November 2007, we made a $2.5 million payment in conjunction with entering into the exclusive license agreement for Colal-Pred. Under the license agreement, we are responsible for the clinical development and commercialization of Colal-Pred in North America, and for the payment of up to $15.0 million on the successful achievement of development milestones and, assuming the successful completion of clinical trials and regulatory approval, royalties based on net sales of Colal-Pred. We are selectively pursuing further acquisitions, licenses or other collaborations to obtain access to proprietary pharmaceutical products and diagnostic technologies which could require additional funding.

In April 2009, we entered into a license and collaboration agreement with Rosetta Genomics Ltd. under which Rosetta granted us exclusive U.S. rights to three microRNA-based oncology diagnostic tests. Under the terms of a related stock purchase agreement, we made an equity investment of $8.0 million for 2,000,000 ordinary shares.

 

As a result of the above, in the future we could need additional funds to support our existing operations, to acquire new products or technologies, to commercialize new products and services, to develop and perform clinical trials related to these technologies or to expand our infrastructure. Accordingly, we may need to raise additional funds through the sale of equity or debt securities or from credit facilities; however, additional funds, if needed, may not be available on satisfactory terms, if at all.

For example, recent concerns over the availability and cost of credit, the U.S. mortgage market, a declining residential real estate market in the U.S., inflation, energy costs and geopolitical issues have contributed to increased volatility and diminished expectations for the economy and the markets going forward. These factors, combined with volatile oil prices, declining business and consumer confidence and increased unemployment, have precipitated an economic recession and fears of a possible depression. Domestic and international capital markets have also been experiencing heightened volatility and turmoil, potentially making it more difficult to raise capital through the issuance of equity securities. Furthermore, as a result of the recent volatility in the capital markets, the cost and availability of credit has been and may continue to be adversely affected by illiquid credit markets and wider credit spreads. Concern about the stability of the markets generally and the strength of counterparties specifically has led many lenders and institutional investors to reduce, and in some cases, cease to provide funding to borrowers.

Contractual Obligations and Commercial Commitments

Contractual obligations and commercial commitments represent future cash commitments and liabilities under agreements with third parties, and exclude contingent liabilities for which we cannot reasonably predict future payment.

Bank Credit Agreement

In September 2007, we entered into an amended and restated credit agreement which provides for a term loan of $75.0 million and, subject to meeting certain requirements at the time of the borrowing, revolving loans of up to $25.0 million. As of September 30, 2009, we had $65.6 million of borrowings outstanding under the term loan and no outstanding borrowings under the revolving loans. The loans mature and the credit agreement terminates in September 2012. Under the credit agreement, we pay a commitment fee of 0.20% to 0.50% per annum on amounts available under the revolving loans, based upon our consolidated leverage ratio. The term loan and any borrowings under revolving loans bear interest, at our election, either at (1) LIBOR plus an increment of 1.25% to 2.00% or (2) the bank’s prime rate (or the federal funds rate plus 0.5%, whichever is higher) plus an increment of 0.25% to 1.00%, such increments being based on our consolidated leverage ratio. In entering into the credit agreement, we incurred loan fees of $1.3 million, which are included in other assets and are being amortized as a component of interest expense over the term of the credit agreement. The credit agreement requires us to comply with various financial and restrictive covenants. As of September 30, 2009, we were in compliance with all covenants.

 

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Commercial Commitments

The following table summarizes our contractual obligations as of December 31, 2008. The expected timing of payment of the obligations presented below is estimated based upon current information or contractual terms. Timing of payments and actual amounts paid may be different depending on the timing of receipt of goods or services or changes to agreed-upon terms or amounts for some obligations. The table does not include any milestone, royalty or other contingent payments. There are no contractual obligations due after 2012.

 

     Total    2009
<1 year
   2010-2011
2-3 years
   2012-2013
4-5 years

Term loan principal payments

   71,250    7,500    18,750    45,000

Term loan interest payments(1)

   7,969    2,198    4,719    1,052

Credit agreement commitment fees(2)

   301    63    127    111

Operating lease obligations(3)

   5,158    1,236    2,579    1,343

Licensing obligations(4)

   12,410    4,000    8,410   

Purchasing and other obligations

   609    609      
                   

Total

   97,697    15,606    34,585    47,506
                   

 

(1) Assumes the December 31, 2008 interest rate of approximately 4.12% for all periods, scheduled debt payments and no borrowings under revolving loans.

 

(2) Assumes a 0.25% commitment fee on $25.0 million in revolving loans for all periods. Assumes there are no borrowings during the term of the credit agreement.

 

(3) Reflects the future minimum lease payments due under the operating lease for our laboratory, research and administrative facility.

 

(4) Amounts represent the estimated minimum levels of promotional spending required in each period under the marketing, sale and distribution agreement for Entocort EC.

Off-Balance Sheet Arrangements

Since inception, we have not engaged in any off-balance sheet arrangements, including the use of structured finance, special purpose entities or variable interest entities.

Quantitative and Qualitative Disclosures about Market Risk

We are exposed to changes in interest rates, primarily from our variable-rate term and revolving loans, if any.

Our term and revolving loans bear interest, at our election, at LIBOR, or the applicable bank’s prime rate (or the federal funds rate plus 0.5%, whichever is higher), plus an increment based on our consolidated leverage ratio. We do not believe that the interest rate risk represented by our floating rate debt is material as of September 30, 2009.

Under our current policies, we do not use interest rate derivatives instruments to manage our exposure to interest rate changes. A hypothetical 1.0% adverse move in interest rates would not materially affect the fair value of our financial instruments or variable rate debt that is exposed to changes in interest rates.

Recently, there has been concern in the credit markets regarding the value of a variety of mortgage-backed and auction rate securities and the resultant effect on various securities markets. We do not currently have any auction rate securities. We do not believe our cash, cash equivalents and marketable securities have significant risk of default or illiquidity. While we believe our cash, cash equivalents and marketable securities are well diversified and do not contain excessive risk, we cannot provide absolute assurance that in the future our investments will not be subject to adverse changes in market value. In addition, we maintain significant amounts of cash and cash equivalents at one or more financial institutions that are in excess of federally insured limits. Given the current instability of financial institutions, we cannot be assured that we will not experience losses on these deposits.

We have no operations outside the United States and do not have any foreign currency or other derivative financial instruments.

 

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BUSINESS

Overview

Prometheus is a specialty pharmaceutical and diagnostic company committed to developing and commercializing novel pharmaceutical and diagnostic products to help physicians individualize patient care. We are currently focusing on the detection, diagnosis and treatment of gastrointestinal diseases and disorders in the United States. Our strategy includes the marketing and delivery of proprietary, highly complex diagnostic testing services complemented by the marketing and promotion of pharmaceutical products. By integrating pharmaceutical products and diagnostic testing services, we believe we can address the full continuum of care, thereby providing physicians with a comprehensive solution to treat chronic diseases. We believe Prometheus is a leader in applying the principles of personalized medicine to the diagnosis and treatment of gastrointestinal diseases. Personalized medicine recognizes that individual patients respond differently to medications and that the same disease can vary significantly from patient to patient.

We believe our business model of offering pharmaceuticals combined with our diagnostic testing services differentiates us from other pharmaceutical, specialty pharmaceutical and diagnostic companies, and provides our sales force greater access to physicians. Our approximately 150 person sales force has significant experience and technical knowledge of the gastroenterology market. Our average sales time with physicians was approximately 11 minutes in 2008, which we believe to be longer than the industry average. Currently, we principally market our pharmaceutical and diagnostic products and services to the over 12,000 gastroenterologists in the United States, of whom approximately 81% prescribed ENTOCORT® EC (budesonide) Capsules, LOTRONEX® (alosetron hydrochloride) Tablets or at least one of our diagnostic products during 2008. We believe our sales success, access to physicians and proprietary diagnostic testing services may also provide us an advantage in gaining access to or acquiring additional pharmaceutical and diagnostic products.

Our portfolio of branded pharmaceutical products includes Entocort EC, which is indicated for the treatment of mild to moderate active Crohn’s disease involving the ileum and/or the ascending colon. In January 2005, our sales force began promoting Entocort EC in the United States under an exclusive, six-year distribution agreement with AstraZeneca LP, or AstraZeneca. In addition, in January 2008, we acquired exclusive rights to Lotronex in the United States from GlaxoSmithKline. Lotronex is the only prescription drug approved for use in female patients with severe diarrhea-predominant irritable bowel syndrome, or IBS, who have chronic IBS symptoms, have had abnormalities of the gastrointestinal tract excluded and have not responded to conventional therapy. From November 1, 2007 through the completion of the acquisition, we marketed and sold Lotronex under an exclusive distribution agreement. We also sell but do not promote a number of branded drugs, including Imuran® for use as an adjunct for the prevention of rejection in kidney transplantation and the management of active rheumatoid arthritis, Helidac® Therapy for use together with an H2 antagonist for the eradication of Helicobacter pylori bacteria, the leading cause of peptic ulcers and Ridaura® for the management of rheumatoid arthritis for patients who have not responded adequately to one or more non-steroidal anti-inflammatory drugs. In February 2004, we also introduced the first generic mercaptopurine product through a third-party distributor. Mercaptopurine is approved as a maintenance therapy for acute lymphatic leukemia as part of a combination regimen. Although not approved or promoted for gastrointestinal diseases, Imuran and mercaptopurine are often prescribed by physicians for such use.

In November 2007, we entered into an exclusive license agreement with a subsidiary of Alizyme plc to develop and commercialize COLAL-PRED® (prednisolone metasulfobenzoate sodium) in North America. Colal-Pred is based on a drug delivery technology designed to release an anti-inflammatory steroid in the colon to provide the efficacy of steroids while limiting their undesirable systemic side effects. Colal-Pred has not been approved by the U.S. Food and Drug Administration, or FDA, and we will not be able to commercialize Colal-Pred in the United States until we receive approval from the FDA. We began a Phase 2 clinical trial to evaluate Colal-Pred for the treatment of patients with ulcerative colitis in May 2008. Subject to successful completion of all necessary clinical trials, we would anticipate submitting a new drug application, or NDA, for Colal-Pred to the FDA in 2012. In July 2008, Alizyme released the results of the European Phase 3 clinical trial of Colal-Pred in patients with moderate to severe ulcerative colitis. A total of 799 patients were randomized to either one of

 

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three doses of Colal-Pred or a standard regimen of prednisolone. The results showed that the trial failed to meet one of the two co-primary endpoints. Colal-Pred demonstrated superior safety to prednisolone. However, non-inferiority to prednisolone in efficacy response was not shown (i.e., prednisolone demonstrated a better response rate than Colal-Pred). On July 21, 2009 we filed a complaint against Alizyme in the U.S. District Court for the Southern District of California alleging breach by Alizyme of its exclusive license agreement with us, as a result of its failure to conduct certain pre-clinical studies which are necessary in order to obtain regulatory approval for the sale of Colal-Pred in the U.S. and its alleged improper assignment of certain rights under this agreement. On July 24, 2009 Alizyme, and its parent company, Alizyme plc, entered administration in England, in each case on the grounds that it was or was likely to become unable to pay its debts. The administration of Alizyme means that Alizyme, acting through the agency of its administrators, might refuse or decline to perform its outstanding and continuing obligations under the license agreement. While in administration, our contract with Alizyme may not be modified or terminated without our consent. Furthermore, the administration may transition to a liquidation, in which case the liquidator may seek to disclaim the license agreement and Alizyme’s obligations under it, on the grounds that it is an unprofitable contract.

In addition, in April 2009, we acquired exclusive rights to three microRNA-based oncology diagnostic tests in the United States from Rosetta Genomics. We expanded our sales force began selling these tests as ProOnc TumorSourceDX, ProOnc SquamousDX and ProOnc MesotheliomaDX in the United States in October 2009 and expect to incur additional costs for marketing and other supporting costs as a result of these acquisitions.

In conjunction with university and academic research collaborators, we have identified a number of unmet needs in the chronic gastrointestinal disease market and have developed or in-licensed diagnostic tests targeting these diseases and disorders. Our diagnostic testing services include specific immunoassays to detect and differentiate diseases, pharmacogenetic testing and drug metabolite monitoring. Our highly specific tests can help physicians to detect and differentiate inflammatory bowel disease from other bowel disorders and to differentiate Crohn’s disease from ulcerative colitis. In addition, we offer tests that assist physicians in the detection, diagnosis or treatment of celiac disease, lactose intolerance and other related disorders. We currently perform all our gastroenterology diagnostic testing services in our laboratory located in San Diego, California, which is certified for highly-complex testing under the Clinical Laboratory Improvement Amendments of 1988, or CLIA, and accredited by the College of American Pathologists, or CAP. All of our oncology diagnostic testing services are currently performed by Rosetta Genomics in its Philadelphia, Pennsylvania laboratory.

We currently operate under two business segments: (1) the pharmaceutical products segment that markets and sells prescription drugs, and (2) the diagnostic testing services segment that offers diagnostic testing services. Our aggregate net sales have grown from $89.6 million in 2004 to $278.1 million in 2008 (a compound annual growth rate of 32.7%), with aggregate net sales of pharmaceutical products growing from $38.9 million to $196.0 million (a compounded annual growth 49.8%) and aggregate net sales of diagnostic testing services growing from $50.7 million to $82.1 million (a compounded annual growth rate of 12.8%) across the same period. Our aggregate net sales for the first nine months of the year have grown from $204.8 million for the nine months ended September 30, 2008 to $257.8 million for the nine months ended September 30, 2009, with aggregate net sales of pharmaceutical products growing from $144.1 million to $193.1 million and aggregate net sales of diagnostic testing services growing from $60.8 million to $64.7 million across the same periods. These tests were developed by us in prior years but were not being marketed.

Prometheus was founded and incorporated in California in December 1995 to license, develop and commercialize diagnostic discoveries related to inflammatory bowel disease originally made by Cedars-Sinai Medical Center, or Cedars-Sinai, and the University of California at Los Angeles, or UCLA. We have grown, and expect to continue to grow, through the development, licensing and acquisition of pharmaceuticals and diagnostic technologies. We also expect to expand into additional therapeutic areas that are consistent with our business model of offering proprietary pharmaceuticals complemented by proprietary diagnostics. As discussed above, in April 2009 we acquired the rights to sell three oncology diagnostics in the United States from Rosetta Genomics.

 

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Gastrointestinal Diseases

In 2006, gastrointestinal anti-inflammatory prescription drugs accounted for sales of over $3.0 billion in the United States, according to IMS Health. Despite the relatively high number of patients suffering from gastrointestinal diseases and disorders, there are only approximately 12,000 gastroenterologists in the United States. Historically, our products focus primarily on the diagnosis and treatment of inflammatory bowel disease and celiac disease. However, in addition to selling Lotronex, we launched PROMETHEUS® IBS Diagnostic, the first blood-based biomarker test to help physicians diagnose IBS in May 2008.

Inflammatory Bowel Disease

Inflammatory bowel disease, or IBD, represents a group of chronic, progressive, recurring and debilitating inflammatory disorders of the gastrointestinal tract. The immune system normally protects the body from infection. In people with IBD, however, the immune system reacts inappropriately by launching an attack on the body’s own tissues. In the process, the body sends white blood cells into the lining of the intestines, where they produce chronic inflammation. These cells then generate harmful products that ultimately lead to ulcerations and bowel injury. IBD typically has an onset before 30 years of age and is a lifelong illness that can be potentially life-threatening. Although IBD has no known cause, there is a presumed genetic component to susceptibility. IBD may be triggered by environmental factors and although IBD is not thought to be caused by dietary factors, dietary modification may reduce discomfort.

Crohn’s disease and ulcerative colitis are the two main types of IBD diseases. The main difference between Crohn’s disease and ulcerative colitis is the location and nature of the inflammation. According to the Crohn’s & Colitis Foundation of America, an estimated 1.4 million Americans suffer from IBD. Because the symptoms of Crohn’s disease and ulcerative colitis are so similar, it is sometimes difficult to establish a definite diagnosis. However, differentiating between the two diseases is extremely important as treatment may be very different. Historically, accurate diagnosis could only be done invasively by endoscopy with biopsy of lesions. In the past ten years, non-invasive diagnostic tests have been introduced that provide information to aid physicians in diagnosing IBD.

Crohn’s Disease

Crohn’s disease is a chronic disorder that causes inflammation of the digestive or gastrointestinal tract. Crohn’s disease most commonly affects the end of the small intestine, or the ileum, and the beginning of the large intestine, or the colon, although it may involve any part of the gastrointestinal tract. Crohn’s disease may involve all layers of the intestine, and there can be normal healthy bowel in between patches of diseased bowel. The inflammation extends deep into the lining of the affected area and primarily causes ulcerations, or breaks in the lining, of the small and large intestines. Flare-ups of the disease can range from mild to severe and typically involve symptoms such as diarrhea, abdominal pain, fever and sometimes rectal bleeding.

Treatment for Crohn’s disease depends on the location and severity of the disease, complications and response to previous treatment. Mild symptoms may be treated with an antidiarrhea medication. For mild to moderate symptoms, the only FDA-approved medication is Entocort EC; however, although not approved for such use, physicians also prescribe aminosalicylates, such as sulfasalazine or mesalamine. Corticosteroids, such as hydrocortisone or prednisone, are also given orally to control inflammation. However, corticosteroids are not generally used for prolonged treatment due to serious side effects including acne and puffiness of the face, among others.

Depending on the severity of the disease, patients may also take medications that suppress the immune system, such as azathioprine, mercaptopurine or methotrexate. Moderate to severe disease may be treated with biologics, such as infliximab and adalimumab, which inhibit the action of certain factors that lead to inflammation. When medical treatment does not control the disease, or when the side effects of steroids or other drugs threaten a person’s health, surgery may be required. However, inflammation may return next to the area of the bowel that was removed.

 

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Crohn’s disease is often expensive to treat because many patients may require long-term medical care, including multiple hospitalizations, surgeries and expensive therapeutics. The condition can be difficult to manage clinically and consumes a substantial amount of healthcare resources in terms of physician time, procedures and medications. More than 600,000 Americans had Crohn’s disease in 2007, according to Datamonitor.

Ulcerative Colitis

Ulcerative colitis is a chronic disease of the colon and rectum. The disease is marked by inflammation and ulceration of the innermost lining of the colon, whereas Crohn’s disease can affect all layers of the intestine. Ulcerative colitis involves inflammation of the entire rectum and extends up the colon in a continuous manner. There are no areas of normal intestine between the areas of diseased intestine. Because the inflammation makes the colon empty frequently, symptoms typically include diarrhea (sometimes bloody) and often crampy abdominal pain. Ulcerative colitis may, however, also affect parts of the body outside the intestine, producing symptoms resembling arthritis in other parts of the body.

Ulcerative colitis can be painful and debilitating, and at times it can lead to life-threatening complications. The goal of medical treatment is to reduce the inflammation and to induce remission initially with medication, followed by the administration of maintenance medication to prevent a relapse of the disease. Treatment for ulcerative colitis depends on the severity of the disease, complications and response to previous treatment. Most patients with mild to moderate ulcerative colitis will first be treated with aminosalicylates, such as sulfasalazine or mesalamine, which are used to help control inflammation. Patients with moderate to severe disease who do not respond to aminosalicylates may take corticosteroids such as prednisone, methylprednisone and hydrocortisone, which are also used to reduce inflammation. These drugs are not recommended for long-term use due to their side effects, but they can be very effective for short-term use. Depending on the severity of the disease, patients may also take medications that suppress the immune system, such as azathioprine and mercaptopurine. These drugs are used for patients who have not responded to aminosalicylates or corticosteroids or who are dependent on corticosteroids.

Severe symptoms can often result in hospitalization and surgery. In the best cases, treatment may lead not only to symptom relief, but also to long-term remission. More than 700,000 Americans had ulcerative colitis in 2007, according to Datamonitor.

Irritable Bowel Syndrome

IBS is a disorder characterized most commonly by cramping, abdominal pain, bloating, constipation and diarrhea. Patients diagnosed with IBS are commonly classified as having one of three forms: IBS with constipation, IBS with diarrhea, or mixed-pattern IBS alternating between constipation and diarrhea. IBS causes substantial discomfort and distress, but it is not characterized by intestinal inflammation or permanent intestinal damage unlike IBD. Researchers have yet to discover any specific cause for IBS. No cure has been found for IBS, but symptoms can often be controlled with diet, stress management and prescribed and over-the-counter medications, including fiber supplements, laxatives, anti-diarrhea medication, antispasmodics and antidepressants. For severe cases, however, IBS can be disabling. People suffering from severe cases of IBS may be unable to work, attend social events or even travel short distances. Thus far, only three drugs have been approved for the treatment of IBS. The first, Lotronex (alosetron hydrochloride), is the only prescription drug approved for use in female patients with severe diarrhea-predominant IBS who meet the conditions stated in the label. The second, Zelnorm® (tegaserod maleate), was withdrawn from the United States market in 2007 and is currently only available under investigational new drug protocols for patients whose condition is life-threatening and who are so sick they require hospitalization. Amitiza® (lubiprostone) was approved by the FDA in April 2008 for the treatment of IBS with constipation in women 18 years of age and older.

According to the NIDDK, in 2007, almost 60 million, or 20%, of the U.S. population had symptoms of IBS, making it one of the most common disorders diagnosed by physicians. Of these patients, less than 5% meet the criteria for prescription of Lotronex. It occurs more often in women than in men, and it generally begins in late adolescence or early adult life and rarely appears for the first time after the age of 50. Unfortunately, many

 

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people suffer from IBS for a long time before seeking medical treatment. Up to 75% of people suffering from IBS are believed not to be receiving medical care for their symptoms, due in part to the current difficulties of diagnosing IBS.

Celiac Disease

Celiac disease is an autoimmune digestive disease that damages the small intestine, interfering with the absorption of nutrients from food. People with celiac disease cannot tolerate a protein called gluten which is found in wheat, barley and rye. With celiac disease, eating foods or using products containing gluten causes an immune response that damages the villi in the small intestine. Villi are small, fingerlike protrusions that line the small intestine and allow nutrients from food to be absorbed into the bloodstream.

Although the cause of celiac disease is unknown, research has shown that it is strongly associated with certain genes involved in the regulation of the body’s immune response to gluten. It is also believed that celiac disease is generally triggered the first time by an environmental factor such as a viral infection or severe stress. The disease can appear at any time during a person’s life. Symptoms of celiac disease will vary significantly from person to person and include, but are not limited to, diarrhea, abdominal pain, skin rash, and weight loss. According to a Columbia University led survey of over 1,600 celiac patients published in the American Journal of Gastroenterology in 2001, the average length of time between the first symptoms and a diagnosis of celiac disease is 11 years. The only treatment for people with celiac disease is lifetime avoidance of gluten. In most cases, a diet avoiding gluten prevents any further damage and allows existing intestinal damage to heal.

According to the NIDDK, as many as three million Americans live with celiac disease but it remains greatly undiagnosed. The number of diagnosed patients is expected to increase significantly over the next several years, driven by broad-based educational campaigns, NIH research funding and widely available genetic and blood tests for highly-specific antibodies.

Our Competitive Strengths

We believe that we bring the following competitive advantages or strengths to the markets and customers we serve.

Differentiated, Physician-Focused Business Model

We believe our business model of offering pharmaceuticals combined with complementary diagnostic testing services differentiates us from most other pharmaceutical, specialty pharmaceutical and diagnostic companies and provides us with several benefits and advantages. We put the focus on specialist physicians and provide them with a continuum of patient-care tools, including those for early disease detection, diagnosis and differentiation; for selecting pharmaceuticals and avoiding therapeutic side effects; and for therapy monitoring.

We also believe selling both proprietary pharmaceuticals and diagnostics in the same sales call creates value for the physician and a different dynamic as compared to a traditional pharmaceutical sales call, resulting in longer sales calls and greater physician access. In addition, as scientists and physicians make additional discoveries in the diagnosis and treatment of gastrointestinal diseases, we believe our business model may provide us with a competitive advantage in acquiring or licensing additional pharmaceutical products and in obtaining, developing and commercializing additional diagnostics.

A Leader in Commercializing Diagnostic Technologies

We believe we are a technological leader in helping to develop and commercialize diagnostic testing services for gastrointestinal diseases. For example, we believe our IBD Serology 7 diagnostic is the most comprehensive IBD test available to help physicians detect and differentiate IBD from other disorders that have similar symptoms. This product also helps physicians diagnose IBD and differentiate Crohn’s disease from ulcerative colitis. Over the past several years, we have developed and commercialized a number of new diagnostic products designed to help gastroenterologists. Our diagnostic development group has successfully developed, scaled up and validated both our own technologies and those discovered and licensed in from

 

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academic institutions and others. We believe we are well positioned to maintain a leading position in developing and acquiring access to new technologies related to gastroenterology based on our experience and past successes in commercializing new technologies and, when combined with the strength of our existing product portfolio, our differentiated business model and our effective sales force.

Highly-Trained and Effective Sales Force

We believe we have a leading gastroenterology-focused sales force. Unlike many pharmaceutical sales forces that are trained only to understand the mechanism of action, side effects and comparative benefits of their pharmaceuticals, our sales representatives are also trained to understand how our diagnostics relate to diseases. We feel this knowledge in conjunction with the marketing of our diagnostic products creates a more collaborative and science-based interaction with physicians in a sales call and, as a result, we believe our sales representatives generally experience longer sales calls with and greater access to physicians than most other pharmaceutical sales representatives. In addition to making our sales force more effective with respect to promoting existing products, we believe the nature of our interactions with physicians can help to build a lasting sales channel through which additional, high-value products and services can be brought to the physician community. As a result of our recent acquisition of three oncology diagnostics, expanded our sales force to include additional sales representatives focused on this new market.

Applying the Principles of Personalized Medicine

Personalized medicine recognizes that individual patients respond differently to medications and that the same disease can vary significantly from patient to patient. By integrating our non-invasive diagnostics with our pharmaceuticals, we believe we can help physicians by facilitating a rapid and accurate diagnosis and an efficacious treatment, to resolve clinical complexity and begin to fulfill the promise of “personalized medicine.” While being discussed widely in medicine and although beginning to grow, there have only been limited applications of personalized medicine in the United States to date. The potential benefits of personalized medicine can be substantial, including improvements in diagnosis, more effective treatment and reductions in side effects, benefiting patients and thereby generating cost savings to the healthcare system.

Our diagnostic tests identify individual patient and disease differences at a molecular or genetic level, including tests for measuring or identifying variations in genes, proteins or metabolites. These diagnostics, in conjunction with a patient’s symptoms, medical history, lifestyle and other health conditions, allow physicians to more effectively tailor treatment to the individual patient. We believe our science-based approach enables more individualized patient care and can help physicians determine the optimal management and treatment of challenging diseases.

Management Team with Proven Track Record

We have an experienced management team that is focused on the daily execution of our business plan and the future growth of our company. Our senior management has an average of over 20 years experience in the healthcare industry. Under our current management, we have built a strong financial foundation. Our net sales have increased from $187.4 million in 2006 to $278.1 million in 2008, representing a compounded annual growth rate of 21.8%. We believe our strong financial condition, coupled with the experience and proven track record of our senior management team, positions us well to capitalize on additional opportunities. In addition, our team has executed our product acquisition and in-licensing strategy by acquiring rights to Entocort EC, Lotronex, Colal-Pred and certain oncology diagnostics within the last five years.

 

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Our Strategy for Growth

Capitalizing on our current strengths, our strategy for growth is focused on leveraging our differentiated business model to acquire, develop and commercialize proprietary pharmaceutical products and complementary, highly complex diagnostic testing services in the United States. We intend to leverage our sales force and the relati