UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

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

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

Commission File Number: 000-51665

Somaxon Pharmaceuticals, Inc.

(Exact name of registrant as specified in its charter)

Delaware		20-0161599
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)
10935 Vista Sorrento Parkway, Suite 250, San Diego CA		92130
(Address of principal executive offices)		(Zip Code)

(858) 876-6500
(Registrant’s telephone number, including area code)

(Former name, former address and formal fiscal year, if changed since last report)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No o

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

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

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

The number of outstanding shares of the registrant’s common stock, par value $0.0001 per share, as of October 17, 2011 was 47,984,918.

 

 

SOMAXON PHARMACEUTICALS, INC.

QUARTERLY REPORT ON FORM 10-Q

For the Quarter Ended September 30, 2011

TABLE OF CONTENTS

		Page
PART I — FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Condensed Balance Sheets			F-1
Condensed Statements of Operations			F-2
Condensed Statements of Cash Flows			F-3
Condensed Statements of Stockholders’ Equity and Comprehensive Loss			F-4
Notes to Condensed Financial Statements			F-5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			1
Item 3. Quantitative and Qualitative Disclosures about Market Risk			14
Item 4. Controls and Procedures			15
PART II — OTHER INFORMATION
Item 1. Legal Proceedings			15
Item 1A. Risk Factors			16
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			32
Item 3. Defaults Upon Senior Securities			32
Item 4. (Removed and Reserved)			32
Item 5. Other Information			32
Item 6. Exhibits			34
SIGNATURES			35
Exhibit 10.5
Exhibit 10.6
Exhibit 10.7
Exhibit 10.8
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1
Exhibit 32.2
EX-101 INSTANCE DOCUMENT
EX-101 SCHEMA DOCUMENT
EX-101 CALCULATION LINKBASE DOCUMENT
EX-101 LABELS LINKBASE DOCUMENT
EX-101 PRESENTATION LINKBASE DOCUMENT
EX-101 DEFINITION LINKBASE DOCUMENT

PART I — FINANCIAL INFORMATION

Item 1.		Financial Statements

CONDENSED BALANCE SHEETS

		September 30,				December 31,
		2011				2010
ASSETS
Current assets
Cash and cash equivalents		$	33,981			$	21,008
Short-term investments			—				33,809
Current portion of restricted cash			50				—
Accounts receivable, net			2,121				5,584
Inventory			941				991
Other current assets			2,225				1,882
Total current assets			39,318				63,274
Long-term portion of restricted cash			200				—
Property and equipment, net			965				755
Intangible assets, net			1,140				1,102
Total assets		$	41,623			$	65,131
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable		$	826			$	1,709
Accrued liabilities			9,589				5,699
Current portion of long-term debt			15,000				—
Deferred revenue, current portion			—				3,459
Total current liabilities			25,415				10,867
Deferred revenue, non-current portion			456				—
Commitments and contingencies (see Note 7)
Stockholders’ equity
Preferred stock, $0.0001 par value; 10,000 shares authorized, none issued and outstanding			—				—
Common stock, $0.0001 par value; 100,000 shares authorized; 47,985 and 45,004 shares outstanding at September 30, 2011 and December 31, 2010, respectively			5				5
Additional paid-in capital			281,617				271,112
Accumulated deficit			(265,870	)			(216,852	)
Accumulated other comprehensive income (loss)			—				(1	)
Total stockholders’ equity			15,752				54,264
Total liabilities and stockholders’ equity		$	41,623			$	65,131

The Accompanying Notes are an Integral Part of these Unaudited Condensed Financial Statements

SOMAXON PHARMACEUTICALS, INC.

CONDENSED STATEMENTS OF OPERATIONS

		Three months ended								Nine months ended
		September 30,								September 30,
		2011				2010				2011				2010
Revenue
Net product sales		$	3,676			$	38			$	12,240			$	38
Operating costs and expenses
Cost of sales		$	454			$	3			$	1,478			$	3
Selling, general and administrative			18,101				11,923				56,767				19,877
Research and development			242				1,014				1,118				2,941
Total operating costs and expenses			18,797				12,940				59,363				22,821
Loss from operations			(15,121	)			(12,902	)			(47,123	)			(22,783	)
Interest and other income			15				2				30				10
Interest and other expense			(1,925	)			—				(1,925	)			(13	)
Net loss		$	(17,031	)		$	(12,900	)		$	(49,018	)		$	(22,786	)
Basic and diluted net loss per share		$	(0.36	)		$	(0.37	)		$	(1.06	)		$	(0.71	)
Shares used to calculate net loss per share			47,629				35,217				46,040				31,905

The Accompanying Notes are an Integral Part of these Unaudited Condensed Financial Statements

SOMAXON PHARMACEUTICALS, INC.

CONDENSED STATEMENTS OF CASH FLOWS

		Nine Months Ended September 30,
		2011				2010
Cash flows from operating activities
Net loss		$	(49,018	)		$	(22,786	)
Adjustments to reconcile net loss to net cash used in operating activities:
Share-based compensation expense			4,256				5,294
Depreciation			203				298
Amortization of intangible assets			124				17
Amortization of investment discount			148				39
Accretion of debt discount and issuance costs			950				—
Realized gain on sale of short-term investments			1				—
Loss on disposal of equipment			—				13
Changes in operating assets and liabilities:
Accounts receivable			3,463				(5,152	)
Inventory			(69	)			(1,000	)
Other current and non-current assets			(288	)			(2,920	)
Accounts payable			(883	)			2,184
Accrued liabilities			3,857				1,528
Deferred revenue			(2,971	)			4,437
Net cash used in operating activities			(40,227	)			(18,048	)
Cash flows from investing activities
Purchases of property and equipment			(413	)			(467	)
Payments for intangible assets			(161	)			(1,109	)
Purchases of marketable securities			(3,508	)			(22,265	)
Sales and maturities of marketable securities			37,232				1,000
Restricted cash			(250	)			—
Net cash provided by (used in) investing activities			32,900				(22,841	)
Cash flows from financing activities
Issuance of common stock, net of costs			5,547				52,745
Net proceeds from issuance of debt			14,752				—
Exercise of warrants			—				1,474
Exercise of stock options			1				1,929
Purchase of treasury stock			—				(44	)
Net cash provided by financing activities			20,300				56,104
Increase in cash and cash equivalents			12,973				15,215
Cash and cash equivalents at beginning of the period			21,008				5,165
Cash and cash equivalents at end of the period		$	33,981			$	20,380
Non-cash investing and financing activities
Common stock issued to settle severance obligation		$	—			$	860
Issuance of warrant pursuant to loan agreement			701				—
Supplemental cash flow information
Cash paid for interest			94				—

The Accompanying Notes are an Integral Part of these Unaudited Condensed Financial Statements

SOMAXON PHARMACEUTICALS, INC.

CONDENSED STATEMENT OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE LOSS

																		Accumulated
										Additional								Other
		Common Stock								Paid-in				Accumulated				Comprehensive
		Shares				Amount				Capital				Deficit				Income (Loss)				Total
Balance at December 31, 2010			45,004			$	5			$	271,112			$	(216,852	)		$	(1	)		$	54,264
Net loss			—				—				—				(49,018	)			—				(49,018	)
Unrealized gains in short-term investments			—				—				—				—				1				1
Comprehensive loss			—				—				—				—				—				(49,017	)
Issuance of common stock			2,972				—				5,547				—				—				5,547
Issuance of common stock pursuant to vesting of restricted stock units			8				—				—				—				—				—
Warrants issued pursuant to loan agreement			—				—				701				—				—				701
Exercise of stock options			1				—				1				—				—				1
Share-based compensation expense			—				—				4,256				—				—				4,256
Balance at September 30, 2011			47,985			$	5			$	281,617			$	(265,870	)		$	—			$	15,752

The Accompanying Notes are an Integral Part of these Unaudited Condensed Financial Statements

Note 1. Organization

Business

Somaxon Pharmaceuticals, Inc. (“Somaxon”, “the Company”, “we”, “us” or “our”) is a specialty pharmaceutical company focused on the in-licensing, development and commercialization of proprietary branded products and late-stage product candidates to treat important medical conditions where there is an unmet medical need and/or high-level of patient dissatisfaction, currently in the central nervous system therapeutic area. In March 2010, the U.S. Food and Drug Administration (“FDA”) approved our New Drug Application (“NDA”) for Silenor^® 3 mg and 6 mg tablets for the treatment of insomnia characterized by difficulty with sleep maintenance. Silenor was made commercially available by prescription in the United States in September 2010. We operate in one reportable segment, which is the development and commercialization of pharmaceutical products.

Basis of Presentation

The accompanying condensed balance sheet as of December 31, 2010, which has been derived from our audited financial statements, and the unaudited interim condensed financial statements have been prepared in accordance with U.S. generally accepted accounting principles and the rules and regulations of the Securities and Exchange Commission (“SEC”) related to a quarterly report on Form 10-Q. Certain information and note disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to those rules and regulations, although we believe that the disclosures made are adequate to make the information presented not misleading. The unaudited interim condensed financial statements reflect all adjustments which, in the opinion of our management, are necessary for a fair statement of the results for the periods presented. All such adjustments are of a normal and recurring nature. These unaudited condensed financial statements should be read in conjunction with the financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2010. The operating results presented in these unaudited condensed financial statements are not necessarily indicative of the results that may be expected for any future periods.

Capital Resources

Since inception, our operations have been financed primarily through the sale of equity securities and the proceeds from the exercise of warrants and stock options. We have incurred losses from operations and negative cash flows since the inception of the Company, and we expect to continue to incur substantial losses for the foreseeable future as we continue our commercial activities for Silenor, commercialize any other products to which we obtain rights and potentially pursue the development of other product candidates. Based on our recurring losses, negative cash flows from operations and working capital levels, we will need to raise substantial additional funds to finance our operations. If we are unable to maintain sufficient financial resources, including by raising additional funds when needed, our business, financial condition and results of operations will be materially and adversely affected.

We have received $14.9 million in net proceeds pursuant to a loan and security agreement with Silicon Valley Bank (“SVB”) and Oxford Finance LLC (together with SVB, the “Lenders”). The Lenders have the right to declare the loan immediately due and payable in an event of default under the Loan Agreement, which includes, among other things, a material adverse change in our business, operations or financial condition or a material impairment in the prospect of repayment of the loan. In addition, under the loan agreement, we are required to maintain with SVB our primary cash and investment accounts, which accounts are also covered by control agreements for the benefit of the Lenders. Based on the Lenders’ ability to declare the loan immediately due and payable, we have classified the outstanding debt balance as a current liability as of September 30, 2011.

In August 2011, we entered into an at-the-market equity sales agreement with Citadel Securities LLC (“Citadel”). However, there can be no assurance that Citadel will be successful in consummating such sales based on prevailing market conditions or in the quantities or at the prices that we deem appropriate. Citadel or the Company is permitted to terminate the sales agreement at any time. Sales of shares pursuant to the sales agreement will have a dilutive effective on the holdings of our existing stockholders, and may result in downward pressure on the price of our common stock.

We commercially launched Silenor in September 2010 with sales representatives provided to us on an exclusive basis under our contract sales agreement with Publicis Touchpoint Solutions, Inc. (“Publicis”), and additional sales representatives provided to us under our co-promotion agreement with Procter & Gamble (“P&G”). On September 30, 2011, we provided a notice of termination to Publicis of the contract sales agreement and to P&G of the co-promotion agreement, in each case effective as of December 31, 2011. At the conclusion of the contract term with Publicis, we will assume financial responsibility for the remaining vehicle lease payments associated with our Publicis sales representatives. The remaining obligation under those lease payments was approximately $0.9 million as of September 30, 2011, although we are taking steps to mitigate the obligation that we assume at the end of the contract. We intend to hire 30 sales representatives, most of whom will be hired from the Publicis sales force, to promote Silenor as Somaxon employees effective no later than January 1, 2012. The remainder of the Publicis sales force ceased promoting Silenor as of November 2, 2011. In addition, in order to reduce expenditures, we terminated the employment of 14 employees in November 2011. However, decreases in our operating expenses based on these personnel decisions will be partially offset in 2012 by our plan to allocate marketing resources to direct to consumer advertising for Silenor to a greater extent than we did in 2011.

We will need to obtain additional funds to finance our operations, particularly if we are unable to access adequate or timely funds under our at-the-market equity sales agreement. Until we can generate significant cash from our operations, we intend to obtain any additional funding we require through public or private equity or debt financings, strategic relationships, assigning receivables or royalty rights, or other arrangements and we cannot assure such funding will be available on reasonable terms, or at all. Additional equity financing will be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants.

If our efforts in raising additional funds when needed are unsuccessful, we may be required to delay, scale-back or eliminate plans or programs relating to our business, relinquish some or all rights to Silenor or renegotiate less favorable terms with respect to such rights than we would otherwise choose or cease operating as a going concern. In addition, if we do not meet our payment obligations to third parties as they come due, we may be subject to litigation claims. Even if we were successful in defending against these claims, litigation could result in substantial costs and be a distraction to management, and may result in unfavorable results that could further adversely impact our financial condition.

If we are unable to continue as a going concern, we may have to liquidate our assets and may receive less than the value at which those assets are carried on our financial statements, and it is likely that investors will lose all or a part of their investments. These financial statements do not include any adjustments that might result from the outcome of this uncertainty.

Note 2. Summary of Significant Accounting Policies

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

Cash and Cash Equivalents

All highly liquid investments with maturities of three months or less at the time of purchase are considered to be cash equivalents. Investments with maturities at the date of purchase greater than three months are classified as marketable securities. At September 30, 2011, our cash and cash equivalents consisted primarily of money market funds and other available-for-sale securities that have an original maturity date of three months or less. All of our cash equivalents have liquid markets and high credit ratings.

Marketable Securities

Our investments in marketable securities are classified as available-for-sale securities. Available-for-sale securities are carried at fair market value, with unrealized gains and losses reported as a component of stockholders’ equity in accumulated other comprehensive income/loss. Interest and dividend income is recorded when earned and included in interest income. Premiums and discounts on marketable securities are amortized and accreted, respectively, to maturity and included in interest income. Marketable securities with a maturity date of less than one year as of the balance sheet date are classified as short-term investments. Marketable securities with a maturity of more than one year as of the balance sheet date are classified as long-term investments. We assess the risk of impairment related to securities held in our investment portfolio on a regular basis and noted no impairment during the three and nine months ended September 30, 2011.

Concentration of Credit Risk, Significant Customers and Sources of Supply

Financial instruments that potentially subject us to concentrations of credit risk consist primarily of cash and cash equivalents, short-term investments, and accounts receivable. We maintain accounts in federally insured financial institutions in excess of federally insured limits. We also maintain investments in money market funds and similar short-term investments that are not federally insured. However, management believes we are not exposed to significant credit risk due to the financial positions of the depository institutions in which these deposits are held and of the money market funds and other entities in which these investments are made. Additionally, we have established guidelines regarding the diversification of our investments and their maturities that are designed to maintain safety and liquidity.

We sell our product primarily to established wholesale distributors in the pharmaceutical industry. The following table sets forth customers who represented 10% or more of our product sales for the three and nine months ended September 30, 2011:

		Three Months Ended				Nine Months Ended
		September 30, 2011				September 30, 2011
Cardinal Health			49	%			47	%
McKesson			32	%			35	%
AmerisourceBergen			14	%			12	%

The majority of our accounts receivable balance as of September 30, 2011 represents amounts due from these three wholesale distributors. Credit is extended based on an evaluation of the customer’s financial condition. Based upon the review of these factors, we did not record an allowance for doubtful accounts at September 30, 2011.

We rely on third-party manufacturers for the production of Silenor and single source third-party suppliers to manufacture key components of Silenor. If our third-party manufacturers are unable to continue manufacturing Silenor, or if we lost our single source suppliers used in the manufacturing process, we may not be able to meet market demand for our product.

Inventory

Our inventories are valued at the lower of weighted average cost or net realizable value. We analyze our inventory levels quarterly and write down inventory that has become obsolete or has a cost basis in excess of its expected net realizable value, as well as any inventory quantities in excess of expected requirements. We did not record any write-downs for potentially obsolete or excess inventory during the three or nine months ended September 30, 2011.

Intangible Assets

Our intangible assets consist of the costs incurred to in-license our product and technology development costs relating to our websites. Prior to the FDA approval of our NDA for Silenor, we had expensed all license fees and milestone payments for acquired development and commercialization rights to operations as incurred since the underlying technology associated with these expenditures related to our research and development efforts and had no alternative future use at the time. Costs related to our intellectual property are capitalized once technological feasibility has been established. Capitalized amounts are amortized on a straight line basis over the expected life of the intellectual property. License fees began being amortized upon the first sale of Silenor to our wholesaler in August 2010 and are being amortized over approximately ten years. Costs incurred in the planning stage of a website are expensed, while costs incurred in the development stage are capitalized and will be amortized over the expected life of the product associated with the website once the asset is placed in service. Costs incurred for other intangible assets to be used primarily on our website are capitalized and amortized over the expected useful life, which we estimate to be two years. The carrying values of our intangible assets are periodically reviewed to determine if the facts and circumstances suggest that a potential impairment may have occurred. We had no impairment of our intangible assets for the three and nine months ended September 30, 2011.

Revenue Recognition

Product Sales

We sell Silenor to wholesale pharmaceutical distributors. Our returned goods policy generally permits our customers to return products up to six months before and up to twelve months after the expiration date of the product. We authorize returns for expired products in accordance with our returned goods policy and issue credit to our customers for expired returned product. We do not exchange product from inventory for returned product. As of September 30, 2011, the dollar amount of returns received in 2011 has been negligible.

We recognize product revenue from product sales when it is realized or realizable and earned. Revenue is realized or realizable and earned when all of the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) our price to the buyer is fixed or determinable; and (4) collectability is reasonably assured. Revenue from sales transactions where the buyer has the right to return the product is recognized at the time of sale only if (1) our price to the buyer is substantially fixed or determinable at the date of sale, (2) the buyer has paid us, or the buyer is obligated to pay us and the obligation is not contingent on resale of the product, (3) the buyer’s obligation to us would not be changed in the event of theft or physical destruction or damage of the product, (4) the buyer acquiring the product for resale has economic substance apart from that provided by us, (5) we do not have significant obligations for future performance to directly bring about resale of the product by the buyer, and (6) the amount of future returns can be reasonably estimated.

Prior to the second quarter of 2011, we were unable to reasonably estimate returns. We therefore deferred revenue recognition until the right of return no longer existed, which was the earlier of Silenor being dispensed through patient prescriptions or the expiration of the right of return. We estimated patient prescriptions dispensed using an analysis of third-party information. In order to develop a methodology to reliably estimate product returns and provide a basis for recognizing revenue on sales to customers at the time of product shipment, we analyzed many factors, including, without limitation, industry data regarding product return rates, and tracked the Silenor product return history, taking into account product expiration dating at the time of shipment and levels of inventory in the wholesale channel compared to prescription units dispensed and the sell-down of our launch inventory. During the second quarter of 2011, the sell-down of our launch inventory was completed, which we believe demonstrates sufficient market acceptance of our product for purposes of our revenue recognition analysis. In addition, since product launch, we have sold product to wholesale pharmaceutical distributors at standard commercial terms utilized in the industry. As a result, we believe we can analogize to industry data regarding product return rates. Based on the sell-down of our launch inventory and the industry and internal data gathered, we believe we have the information needed to reasonably estimate product returns. As a result, in the second quarter of 2011, we began recognizing revenue for Silenor sales at the time of delivery of the product to wholesale pharmaceutical distributors and our other customers.

License and Royalty Revenue

In June 2011, we entered into a license agreement with Paladin Labs Inc. (“Paladin”) pursuant to which Paladin will commercialize Silenor in Canada, South America, the Caribbean and Africa subject to the receipt of marketing approval in each such territory. We received an upfront payment of $500,000 in connection with the execution of this agreement. We recorded the upfront payment as deferred revenue and are recognizing the upfront payment as license revenue over the period of our significant involvement under the agreement, which we are estimating to be 15 years. As of September 30, 2011, the deferred revenue balance associated with the license agreement is $489,000, of which $456,000 is recorded as non-current and $33,000 is recorded as current within accrued liabilities. We recognized $8,000 and $11,000 as revenue during each of the three and nine months ended September 30, 2011, respectively, which is recorded in interest and other income.

If Silenor is commercialized in the licensed territories, we would be eligible to receive sales-based milestone payments of up to $128.5 million as well as a tiered double-digit percentage of net sales in the licensed territories. Due to the uncertainty surrounding the achievement of these future sales-based milestones and royalties, these potential payments will not be recognized as revenue until they are realized and earned.

Product Sales Discounts and Allowances

We record product sales discounts and allowances at the time of sale and report revenue net of such amounts in the same period that product sales are recorded. In determining the amount of product sales discounts and allowances, we must make significant judgments and estimates. If actual results vary from our estimates, we may need to adjust these estimates, which could have an effect on product revenue in the period of adjustment. Our product sales discounts and allowances and the specific considerations we use in estimating these amounts include:

Prompt Pay Discounts. As an incentive for prompt payment, we offer a 2% cash discount to customers. We calculate the discount based on the gross amount of each invoice as we expect that all customers will comply with the contractual terms to earn the discount. We record the discount as an allowance against accounts receivable and a corresponding reduction of revenue. At September 30, 2011 and December 31, 2010, the allowance for prompt pay discounts was $44,000 and $114,000, respectively.

Patient Discount Programs. We offer discount programs to patients of Silenor under which the patient receives a discount on his or her prescription. We reimburse pharmacies for these discounts through third-party vendors. We estimate the total amount that will be redeemed based on the dollar amount of the discounts, the timing and quantity of distribution and historical redemption rates. We accrue the discounts and recognize a corresponding reduction of revenue. At September 30, 2011 and December 31, 2010, the accrual for patient discount programs was $379,000 and $182,000, respectively.

Distribution Service Fees. We pay distribution services fees to each wholesaler for distribution and inventory management services. We accrue for these fees based on contractually defined terms with each wholesaler and recognize a corresponding reduction of revenue. At September 30, 2011 and December 31, 2010, the accrual for distribution service fees was $310,000 and $276,000, respectively.

Chargebacks. We provide discounts to federal government qualified entities with whom we have contracted. These federal entities purchase products from the wholesalers at a discounted price, and the wholesalers then charge back to us the difference between the current retail price and the contracted price the federal entity paid for the product. We accrue chargebacks based on contract prices and sell-through sales data obtained from third-party information. At September 30, 2011 and December 31, 2010, the accrual for chargebacks was $18,000 and $9,000, respectively.

Rebates. We participate in certain rebate programs, which provide discounted prescriptions to qualified insured patients. Under these rebate programs, we pay a rebate to the third-party administrator of the program. We accrue rebates based on contract prices, estimated percentages of product sold to qualified patients and estimated levels of inventory in the distribution channel. Our accrual consists of: (1) the amount expected to be incurred based on the current quarter’s product sold, (2) an accrual for unpaid rebates relating to prior quarters; and (3) an accrual for rebates relating to estimated inventory in the distribution channel. Our estimate of utilization is based on partial claims history data received, third-party data, and information about our expected patient population. At September 30, 2011 and December 31, 2010, the accrual for rebates was $1,214,000 and $6,000, respectively.

Product Returns. We estimate future product returns based upon actual returns history, product expiration dating analysis, estimated inventory levels in the distribution channel, and industry data regarding product return rates for similar products. There may be a significant time lag between the date we determine the estimated allowance and when we receive product returns and issue credits to customers. Due to this time lag, we may record adjustments to our estimated allowance over several periods, which would impact our operating results in those periods. At September 30, 2011, the allowance for product returns was $104,000.

Cost of Sales

Cost of sales includes the costs to manufacture, package, and ship Silenor, including personnel costs associated with manufacturing oversight, as well as royalties and amortization of capitalized license fees associated with our license agreement with ProCom One, Inc. (“ProCom”).

Share-Based Compensation Expense

Share-based compensation expense for employees and directors is recognized in the statement of operations based on estimated amounts, including the grant date fair value, the probability of achieving performance conditions and the expected service period for awards with conditional vesting provisions. We estimate the grant date fair value for our stock option awards using the Black-Scholes valuation model which requires the use of multiple subjective inputs including estimated future volatility and the expected terms of the stock option awards. Our stock did not have a readily available market prior to our initial public offering in December 2005, creating a relatively short history from which to obtain data to estimate the volatility of our stock price. Consequently, we estimate expected future volatility based on a combination of both comparable companies and our own stock price volatility to the extent such history is available. The expected term for stock options is estimated using guidance provided by the SEC in Staff Accounting Bulletin (“SAB”) No. 107 and SAB 110. This guidance provides a formula-driven approach for determining the expected term. Share-based compensation is based on awards expected to ultimately vest and has been reduced for estimated forfeitures. The estimated forfeiture rates may differ from actual forfeiture rates which would affect the amount of expense recognized during the period. Estimated forfeitures are adjusted to actual amounts as they become known.

We recognize the value of the portion of the awards that are ultimately expected to vest on a straight-line basis over the award’s requisite service period. The requisite service period is generally the time over which our share-based awards vest. Some of our share-based awards vested upon achieving certain performance conditions, generally pertaining to the commercial performance of Silenor or the achievement of other strategic objectives. Share-based compensation expense for awards with performance conditions is recognized over the period from the date the performance condition is determined to be probable of occurring through the time the applicable condition is met. If the performance condition is not considered probable of being achieved, no expense is recognized until such time the meeting of the performance condition is considered probable.

Income Taxes

Our income tax expense consists of current and deferred income tax expense or benefit. Current income tax expense or benefit is the amount of income taxes expected to be payable or refundable for the current year. A deferred income tax asset or liability is recognized for the future tax consequences attributable to tax credits and loss carryforwards and to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. As of December 31, 2010, we have established a valuation allowance to fully reserve our net deferred tax assets. It is expected that the amount of unrecognized tax benefits may change over the course of the year; however, because our deferred tax assets are fully reserved, we do not expect the change to have a significant impact on our results of operations, cash flows or financial position. Tax rate changes are reflected in income during the period such changes are enacted. Changes in ownership may limit the amount of net operating loss carryforwards that can be utilized in the future to offset taxable income.

Net Loss per Share

Basic earnings per share (“EPS”) excludes the effects of common stock equivalents. EPS is calculated by dividing net income or loss applicable to common stockholders by the weighted average number of common shares outstanding for the period, reduced by the weighted average number of unvested common shares outstanding subject to repurchase. Diluted EPS is computed in the same manner as basic EPS, but includes the effects of common stock equivalents to the extent they are dilutive, using the treasury-stock method. For us, basic and diluted net loss per share are equivalent because we have incurred a net loss in all periods presented, causing any potentially dilutive securities to be anti-dilutive.

Net loss per share was determined as follows (in thousands, except per share amounts):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2011				2010				2011				2010
Numerator:
Net loss		$	(17,031	)		$	(12,900	)		$	(49,018	)		$	(22,786	)
Denominator:
Weighted average common shares outstanding			47,629				35,217				46,040				31,934
Weighted average unvested common shares subject to repurchase			—				—				—				(29	)
Denominator			47,629				35,217				46,040				31,905
Basic and diluted net loss per share		$	(0.36	)		$	(0.37	)		$	(1.06	)		$	(0.71	)
Weighted average anti-dilutive securities not included in diluted net loss per share calculation:
Weighted average stock options outstanding			4,711				3,718				4,377				3,503
Weighted average restricted stock units outstanding			570				733				457				775
Weighted average warrants outstanding			2,791				2,619				2,544				3,232
Weighted average unvested common shares subject to repurchase			—				—				—				29
Total weighted average anti-dilutive securities not included in diluted net loss per share			8,072				7,070				7,378				7,539

Recent Accounting Pronouncements

In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2009-13 “Revenue Recognition,” which provides guidance on recognizing revenue in arrangements with multiple deliverables. This standard impacts the determination of when the individual deliverables included in a multiple element arrangement may be treated as a separate unit of accounting. It also modifies the manner in which the consideration received from the transaction is allocated to the multiple deliverables and no longer permits the use of the residual method of allocating arrangement consideration. This accounting standard was effective for the first year beginning on or after June 15, 2010, with early adoption permitted. The adoption of ASU 2009-13, which occurred on January 1, 2011, did not have a material impact on our financial statements.

In December 2010, the FASB issued ASU No. 2010-27 “Other Expenses: Fees Paid to the Federal Government by Pharmaceutical Manufacturers,” which provides guidance concerning the recognition and classification of the new annual fee payable by branded prescription drug manufacturers and importers on branded prescription drugs which was mandated under the health care reform legislation enacted in the United States in March 2010. Under this new authoritative guidance, the annual fee should be estimated and recognized in full as a liability upon the first qualifying commercial sale with a corresponding deferred cost that is amortized to operating expenses using a straight-line method unless another method better allocates the fee over the calendar year in which it is payable. This new guidance was effective for calendar years beginning on or after December 31, 2010, when the fee initially becomes effective. The adoption of ASU 2010-27, which occurred on January 1, 2011, did not have a material impact on our financial statements.

In May 2011, the FASB issued ASU No. 2011-04 “Fair Value Measurement: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs”. Some of the amendments clarify the FASB’s intent about the application of existing fair value measurement requirements. Other amendments change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. This guidance is effective for interim and annual periods beginning after December 15, 2011. We are still evaluating the potential future effects of this guidance.

In June 2011, the FASB issued ASU No. 2011-05 “Comprehensive Income: Presentation of Comprehensive Income.” Under the new guidance, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. This guidance is effective for interim and annual periods beginning after December 15, 2011. We have evaluated the potential future effects of this guidance and do not expect the adoption of ASU 2011-05 to have a material impact on our financial statements.

Note 3. Fair Value of Financial Instruments

Cash equivalents, accounts receivable, accounts payable and accrued liabilities are presented in the financial statements at their carrying amounts, which are reasonable estimates of fair value due to their short maturities.

The fair value of financial assets and liabilities is measured under a framework that establishes “levels” which are defined as follows: Level 1 fair value is determined from observable, quoted prices in active markets for identical assets or liabilities. Level 2 fair value is determined from quoted prices for similar items in active markets or quoted prices for identical or similar items in markets that are not active. Level 3 fair value is determined using the entity’s own assumptions about the inputs that market participants would use in pricing an asset or liability.

The fair value of our investment holdings at September 30, 2011 and December 31, 2010 is summarized in the following tables (in thousands).

		September 30, 2011
		Total Fair				Fair Value Determined Under:
		Value				(Level 1)				(Level 2)				(Level 3)
Commercial paper		$	250			$	—			$	250			$	—
U.S. government agency securities			421				—				421				—
Money market funds			9,016				9,016				—				—
Total		$	9,687			$	9,016			$	671			$	—

		December 31, 2010
		Total Fair				Fair Value Determined Under:
		Value				(Level 1)				(Level 2)				(Level 3)
Commercial paper		$	18,415			$	—			$	18,415			$	—
U.S. government agency securities			30,628				—				30,628				—
Total		$	49,043			$	—			$	49,043			$	—

Commercial paper and U.S. government agency securities are classified as part of either cash and cash equivalents or short-term investments in the condensed consolidated balance sheets. The carrying value of short-term investments consisted of the following as of September 30, 2011 and December 31, 2010 (in thousands).

		September 30, 2011
		Amortized				Unrealized				Unrealized				Fair Market
		Cost				Gains				Losses				Value
Commercial paper		$	250			$	—			$	—			$	250
U.S. government agency securities			421				—				—				421
Total		$	671			$	—			$	—			$	671

		December 31, 2010
		Amortized				Unrealized				Unrealized				Fair Market
		Cost				Gains				Losses				Value
Commercial paper		$	18,415			$	—			$	—			$	18,415
U.S. government agency securities			30,629				2				(3	)			30,628
Total		$	49,044			$	2			$	(3	)		$	49,043

Available-for-sale marketable securities with maturities of three months or less from date of purchase have been classified as cash equivalents, and amounted to $0.7 million and $15.2 million as of September 30, 2011 and December 31, 2010, respectively.

Note 4. Composition of Certain Balance Sheet Items

Accounts Receivable

Accounts receivable, net consisted of the following (in thousands):

		September 30,				December 31,
		2011				2010
Accounts receivable for product sales, gross		$	2,165			$	5,975
Allowances for discounts			(44	)			(391	)
Total accounts receivable		$	2,121			$	5,584

Inventory

Inventory consisted of the following (in thousands):

		September 30,				December 31,
		2011				2010
Work in process		$	333			$	207
Finished goods inventory held by the Company			608				515
Finished goods inventory held by others			—				269
Total inventory		$	941			$	991

Other Current Assets

Other current assets consisted of the following (in thousands):

		September 30,				December 31,
		2011				2010
Deposits and other prepaid expenses		$	784			$	641
Prepaid sales and marketing expenses			1,431				529
Interest receivable			10				206
Other current assets			—				506
Total other current assets		$	2,225			$	1,882

Property and Equipment

Property and equipment consisted of the following (in thousands):

		September 30,				December 31,
		2011				2010
Tooling		$	867			$	832
Computer equipment			481				354
Furniture and equipment			241				66
Leasehold improvements			76				—
Property and equipment, at cost			1,665				1,252
Less: accumulated depreciation			(700	)			(497	)
Property and equipment, net		$	965			$	755

Intangible Assets

Intangible assets consisted of the following (in thousands):

		September 30,				December 31,
		2011				2010
License fees		$	1,000			$	1,000
Technology development costs relating to websites			147				147
Other intangible assets			161				—
Less: accumulated amortization			(168	)			(45	)
Total intangible assets, net		$	1,140			$	1,102

Accrued Liabilities

Accrued liabilities consisted of the following (in thousands):

		September 30,				December 31,
		2011				2010
Accrued fees and royalties		$	1,863			$	1,566
Other accrued expenses			1,741				1,489
Accrued compensation and benefits			1,660				1,329
Accrued product discounts, allowances and returns			2,025				473
Accrued legal fees			915				—
Accrued interest			731				—
Accrued liability to third party sales organization			654				842
Total accrued liabilities		$	9,589			$	5,699

Accrued interest includes amounts accreted for the $638,000 final payment due to the Lenders upon repayment of the debt.

Note 5. Loan and Security Agreement

In July 2011, we terminated our existing loan agreement with Comerica Bank and in August 2011, we entered into a new loan and security agreement (the “Loan Agreement”) with the Lenders under which we borrowed $15.0 million. The term loan bears interest at 7.5% per annum. We are obligated to pay interest on the loan through December 31, 2011, and to thereafter pay the principal balance of the loan and interest in 24 equal monthly installments through December 31, 2013. At our option, we may prepay all or any part of the outstanding principal balance, subject to a pre-payment fee of $150,000. We will be required to repay the entire outstanding principal balance if a generic version of Silenor enters the market while the loan is outstanding. At the time that the loan is repaid, we are also obligated to make an additional final payment of $638,000.

The loan was recorded at an initial carrying value less the debt discount of $900,000. In connection with this transaction, we also paid the lenders an initial fee of $150,000 and reimbursed them for certain transaction costs.

As part of the financing, the Lenders received warrants to purchase up to an aggregate of 583,152 shares of our common stock at an exercise price equal to $1.5433 per share. The warrants will expire ten years from the date of grant. The value assigned to these warrants of $701,000 was determined using the Black-Scholes valuation method and is reflected in the debt discount and additional paid in capital in our balance sheet.

At September 30, 2011, the future principal payments under the Loan Agreement for the years then ended are as follows (in thousands):

2011 (remaining three months)		$	—
2012			7,220
2013			7,780
Total		$	15,000

In connection with the Loan Agreement, we granted the Lenders a security interest in substantially all of our personal property now owned or hereafter acquired, excluding intellectual property. Under the Loan Agreement, we are subject to certain affirmative and negative covenants, including limitations on our ability to: undergo certain change of control events; convey, sell, lease, license, transfer or otherwise dispose of assets, other than in certain specified circumstances; create, incur, assume, guarantee or be liable with respect to certain indebtedness; grant liens; pay dividends and make certain other restricted payments; and make certain investments. In addition, under the Loan Agreement, subject to certain exceptions, we are required to maintain with SVB our primary cash and investment accounts, which accounts are also covered by control agreements for the benefit of the Lenders. We have currently met all of our obligations under the Loan Agreement.

The Lenders have the right to declare the loan immediately due and payable in an event of default under the Loan Agreement, which includes, among other things, a material adverse change in our business, operations or financial condition or a material impairment in the prospect of repayment of the loan. Based on the Lenders’ right to declare the loan immediately due and payable, we have classified the outstanding debt balance as a current liability as of September 30, 2011. In addition, as of September 30, 2011, we fully accreted to interest expense the debt discount, debt issuance costs, and final payment and have also accrued for the pre-payment fee.

Note 6. License Agreements

Paladin. In June 2011, we entered into a license agreement, a supply agreement and a stock purchase agreement with Paladin. Under the license agreement, Paladin will commercialize Silenor in Canada, South America, the Caribbean and Africa, subject to the receipt of marketing approval in each such territory. We received $500,000 in connection with the execution of the agreements, and Paladin purchased 2,184,769 shares of our common stock for an aggregate purchase price of $5.0 million. If Silenor is commercialized in the licensed territories, we would also be eligible to receive sales-based milestone payments of up to $128.5 million as well as a tiered double-digit percentage of net sales in the licensed territories. Paladin will be responsible for regulatory submissions for Silenor in the licensed territories and will have the exclusive right to commercialize Silenor in the licensed territories. Governance of the collaboration will occur through a joint committee. We have also granted to Paladin a right of first negotiation with respect to additional doxepin products we may develop in the licensed territories and, subject to the rights we have previously granted to P&G, a right of first negotiation relating to rights to develop and market Silenor as an over-the-counter medication in the licensed territories.

The term of the license agreement runs through the longer of the last date on which Silenor is sold by Paladin in the licensed territories or 15 years from the first commercial sale of Silenor in the licensed territories. We may terminate the license agreement on a country-by-country basis in specified key countries upon 60 days’ prior written notice if the first commercial sale has not occurred in such country within 12 months of the date on which marketing approval was obtained in such country. We may also terminate the license agreement upon 60 days’ prior written notice if marketing approval in Canada has not been received by December 7, 2013. Either party may terminate the license agreement upon an uncured material breach by the other party, upon the bankruptcy or insolvency of the other party, or a force majeure event that lasts for at least 120 days. We may also terminate the license agreement upon 60 days’ prior written notice and payment of a termination fee if we are unable to license rights to a third party’s intellectual property and such failure would reasonably be expected to result in a claim from such third party alleging intellectual property infringement or misappropriation. Pursuant to the license agreement, we also entered into the supply agreement, under which we will supply Paladin all of its requirements for Silenor during the term of the license agreement or until Paladin procures its own supply of Silenor. Paladin may terminate the supply agreement upon 10 business days notice if we are materially unable to supply Silenor to Paladin’s requirements as defined in the supply agreement, and at any time if Paladin enters into a direct contractual relationship with our manufacturer of Silenor. We may terminate the supply agreement upon 180 days prior written notice if there is a regulatory change or safety consideration that would have a material adverse effect on the global supply chain and at any time on six months’ prior notice after April 30, 2013.

ProCom. In August 2003, we entered into an exclusive worldwide in-license agreement with ProCom to develop and commercialize Silenor for the treatment of insomnia. This agreement was amended and restated in September 2010. The term of the license extends until the last licensed patent expires, which is expected to occur no earlier than 2020. The license agreement is terminable by us at any time with 30 days notice if we believe that the use of the product poses an unacceptable safety risk or if it fails to achieve a satisfactory level of efficacy. Either party may terminate the agreement with 30 days notice if the other party commits a

material breach of its obligations and fails to remedy the breach within 90 days, or upon the filing of bankruptcy, reorganization, liquidation, or receivership proceedings. Costs related to the licensed intellectual property incurred after approval of the Silenor NDA by the FDA in March 2010 have been capitalized and included in intangibles in our balance sheet as of December 31, 2010. Capitalized amounts are amortized on a straight line basis over approximately ten years. Royalty payments due under the terms of the agreement are recorded in accrued liabilities as of September 30, 2011. The royalty payments are recognized as an expense in cost of sales when the related shipments of product are recognized as revenue.

Other Agreement. In October 2006, we entered into a supply agreement pertaining to a certain ingredient used in the formulation for Silenor. In August 2008, this supply agreement was amended to provide us with the exclusive right to use this ingredient in combination with doxepin. Pursuant to the amendment, we are obligated to pay a royalty on worldwide net sales of Silenor beginning as of the expiration of the statutory exclusivity period for Silenor in each country in which Silenor is marketed. Such royalty is only payable if one or more patents under the license agreement continue to be valid in each such country and a patent relating to our formulation for Silenor has not issued in such country.

Note 7. Commitments and Contingencies

Commitments

Publicis Touchpoint Solutions, Inc. In July 2010, we entered into a professional detailing services agreement with Publicis under which Publicis agreed to provide sales support to promote Silenor in the U.S. through 110 full-time sales representatives, together with management coordination personnel, all of whom will be employees of Publicis. In February 2011, we entered into an amended and restated agreement with Publicis under which Publicis deployed for us an additional 35 sales representatives that are exclusively promoting Silenor, together with management coordination personnel. We recognize the revenue from Silenor product sales generated by the promotional efforts of the sales organization. Under the terms of the agreement, we were required to pay a one-time start up fee, and we are required to pay a fixed monthly fee, which is subject to certain quarterly adjustments based on actual staffing and spending levels. During the term of the agreement, a portion of Publicis’ management fee will be subject to payment by us only to the extent that specified performance targets are achieved. The performance targets relate to initial scale-up activities, turnover and vacancy rates, call attainment and specified sales goals. In addition, we are obligated to reimburse the sales organization for approved pass-through costs, which primarily include bonuses, meeting and travel costs and certain administrative expenses.

On September 30, 2011, we provided notice of termination to Publicis of the services agreement, effective as of December 31, 2011. At the conclusion of the contract term with Publicis, we will assume financial responsibility for the remaining vehicle lease payments associated with our Publicis sales representatives. The remaining obligation under those lease payments was approximately $0.9 million as of September 30, 2011, although we are taking steps to mitigate the obligation that we assume at the end of the contract. We intend to hire 30 sales representatives, most of whom will be hired from the Publicis sales force, to promote Silenor as Somaxon employees effective no later than January 1, 2012. The remainder of the Publicis sales force ceased promoting Silenor as of November 2, 2011.

Procter & Gamble. In August 2010, we entered into a co-promotion agreement with P&G under which P&G provides sales support to promote Silenor in the U.S. through its team of full-time sales representatives. We recognize the revenue from Silenor product sales generated by the promotional efforts of P&G. Under the terms of the agreement, we are required to pay P&G a fixed fee and a royalty fee as a percentage of U.S. net sales, in each case on a quarterly basis during the term of the agreement. The fees are recognized as a sales, general, and administrative expense and are recorded in accrued liabilities as of September 30, 2011. The agreement also provides for financial penalties in the event that either party fails to deliver specified minimum detailing requirements under certain circumstances. Each party will be responsible for the costs of training, maintaining and operating its own sales force, and we are responsible for all other costs pertaining to the commercialization of Silenor.

On September 30, 2011, we provided notice of termination to P&G of the co-promotion agreement, with such termination to be effective as of December 31, 2011. As a result of such termination, P&G will be entitled to a low single digit royalty on net sales of Silenor for the 2012 fiscal year. In addition, on September 30, 2011, we and P&G amended the surviving provision of such agreement relating to over-the-counter rights for Silenor. The amendment provides that if P&G notifies us that it is interested in negotiating for such rights before the end of P&G’s 45-day evaluation period relating to such rights, P&G will have the exclusive right to negotiate with us relating to such rights for 120 days, or such longer period upon which we and P&G mutually agree. On October 11, 2011, we provided notice to P&G to begin P&G’s 45-day evaluation period. See “Note 10. Subsequent Events.”

Comerica Bank (“Comerica”). In February 2011, we entered into a $15.0 million loan agreement with Comerica. This agreement was terminated in July 2011 in connection with our new loan and security agreement with the Lenders as discussed above in “Note 5. Loan and Security Interest.”

Citadel Securities LLC. On August 1, 2011, we entered into an at-the-market equity sales agreement with Citadel (the “Sales Agreement”) pursuant to which we may sell, at our option, up to an aggregate of $30.0 million in shares of our common stock through Citadel, as sales agent. Sales of the common stock made pursuant to the Sales Agreement, if any, will be made on the NASDAQ Stock Market under our currently-effective Registration Statements on Form S-3 by means of ordinary brokers’ transactions at then-prevailing market prices. Additionally, under the terms of the Sales Agreement, we may also sell shares of our common stock through Citadel, on the NASDAQ Stock Market or otherwise, at negotiated prices or at prices related to the prevailing market price. Under the terms of the Sales Agreement, we may also sell shares to Citadel as principal for Citadel’s own account at a price agreed upon at the time of sale pursuant to a separate terms agreement to be entered into with Citadel at such time. We will pay Citadel a commission equal to 3% of the gross proceeds from the sale of shares of our common stock under the Sales Agreement. The offering of common stock pursuant to the Sales Agreement will terminate upon the earlier of (a) the sale of all of the common stock subject to the Sales Agreement or (b) the termination of the Sales Agreement by us or Citadel. Either party may terminate the Sales Agreement in its sole discretion at any time upon written notice to the other party.

Lease. In May 2011, we entered into a new lease arrangement to rent approximately 12,100 square feet of office space, which we use as our new corporate headquarters. The lease commenced on August 25, 2011. The lease will expire on December 24, 2016, and we will have the option to extend the term for an additional five years at the then-current fair market rental rate (as defined in the lease). We have paid the first month’s rent of approximately $30,000 and the monthly rent is approximately $30,000. However, the second through thirteenth month’s rent will be abated by one-half, provided that we are not in default of the lease. After the first year, the monthly rent will increase by 3.5% per year. We also have a letter of credit in the amount of $200,000 in favor of our landlord to secure our obligations under the lease which is recorded as restricted cash in our balance sheet as of September 30, 2011.

Other Commitments. We have contracted with various consultants, drug manufacturers, wholesalers, and other vendors to assist in clinical trial work, data analysis, and commercialization activities for Silenor. The contracts are terminable at any time, but obligate us to reimburse the providers for any time or costs incurred through the date of termination. We have employment agreements with certain of our current employees that provide for severance payments and accelerated vesting for certain share-based awards if their employment is terminated under specified circumstances.

Litigation

We have received notices from each of Actavis Elizabeth LLC and Actavis Inc. (collectively, “Actavis”), Mylan Pharmaceuticals Inc. and Mylan, Inc. (collectively, “Mylan”), Par Pharmaceutical, Inc. and Par Pharmaceutical Companies, Inc. (collectively, “Par”), and Zydus Pharmaceuticals USA, Inc. and Cadila Healthcare Limited (d/b/a Zydus Cadila) (collectively, “Zydus”) that each has filed with the FDA an Abbreviated New Drug Application (“ANDA”) for a generic version of Silenor 3 mg and 6 mg tablets. The notices included “paragraph IV certifications” with respect to eight of the nine patents listed in the FDA’s Approved Drug Products with Therapeutic Equivalence Evaluations, commonly known as the Orange Book, for Silenor. A paragraph IV certification is a certification by a generic applicant that in the opinion of that applicant, the patent(s) listed in the Orange Book for a branded product are invalid, unenforceable, and/or will not be infringed by the manufacture, use or sale of the generic product.

We, together with ProCom, have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus. The lawsuits allege that each of Actavis, Mylan, Par and Zydus have infringed U.S. Patent No. 6,211,229 (the “’229 patent”) by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

In addition, we have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that such parties have infringed U.S. Patent No. 7,915,307 (the “’307 patent”) by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

Pursuant to the provisions of the Hatch-Waxman Act, FDA final approval of the Actavis and Mylan ANDAs can occur no earlier than May 3, 2013, FDA final approval of the Par ANDA can occur no earlier than June 23, 2013 and FDA final approval of the Zydus ANDA can occur no earlier than November 13, 2013, unless in each case there is an earlier court decision that the ’229 patent and the ’307 patent are not infringed and/or invalid or unless any party to the action is found to have failed to cooperate reasonably to expedite the infringement action.

At this time, the other patents included in Orange Book have not been asserted against these parties.

We intend to vigorously enforce our intellectual property rights relating to Silenor, but cannot predict the outcome of these matters.

Note 8. Share-based Compensation and Equity

Share-based Compensation Expense

Somaxon has restricted stock units (“RSUs”) and stock options outstanding under its equity incentive award plans. Share-based expense for employees and directors is based on the grant-date fair value of the award. The following table summarizes non-cash share-based compensation expense (in thousands).

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
Composition of share-based compensation expense:		2011				2010				2011				2010
Included in research and development expense		$	103			$	288			$	397			$	1,047
Included in selling, general and administrative expense			1,565				1,482				3,859				4,247
Total share-based compensation expense		$	1,668			$	1,770			$	4,256			$	5,294

Certain of our share-based awards will vest upon the achievement of performance conditions. Compensation expense for share-based awards granted to employees and directors is recognized based on the grant date fair value for the portion of the awards for which performance conditions are considered probable of being achieved. Such expense is recorded over the period the performance condition is expected to be performed. No expense is recognized for awards with performance conditions that are considered improbable of being achieved.

On March 18, 2010, the FDA notified us that it approved our NDA for Silenor 3 mg and 6 mg tablets. FDA approval of the Silenor NDA caused 105,000 shares of restricted stock to vest, 129,000 RSUs to vest, and 275,000 stock options to vest. The Company recognized an aggregate of $1,384,000 of share-based compensation expense during the first quarter of 2010 from the vesting of these awards.

Included in these tables for 2010 is the effect of a modification of the option agreements with certain terminated employees as a result of an extension of the term of their post-employment consulting agreements. We recognized $233,000 of share-based compensation expense during 2010 as a result of this modification.

Equity

In June 2011, we entered into agreements with Paladin pursuant to which Paladin purchased 2,184,769 shares of our common stock for an aggregate purchase price of $5.0 million (see Note 6, “License Agreements”) in a private placement pursuant to Rule 506 of the Securities Act of 1933, as amended.

During the three months ended September 30, 2011, we sold an aggregate of 786,825 shares of our common stock and received gross proceeds of $0.8 million under our Sales Agreement with Citadel. Our financial statements for the period ended September 30, 2011 reflect the gross proceeds from these transactions, which are reflected in stockholders’ equity net of $0.3 million of legal and accounting fees associated with the execution of the sales agreement and commissions.

Note 9. Related Party Transaction

We have in-licensed certain intellectual property from ProCom (see Note 6, “License Agreements”). In March 2010, we paid $1.0 million to ProCom pursuant to the terms of this agreement. During 2011, we recognized in costs of sales $690,000 of ProCom royalty payments in connection with this arrangement. At September 30, 2011, $219,000 is recorded in accrued liabilities for ProCom royalty payments. As part of the in-license agreement, ProCom has the right to designate one nominee for election to our board of directors (Terrell Cobb, a principal of ProCom).

Note 10. Subsequent Events

Resignation

On October 1, 2011, we accepted the resignation of our Senior Vice President and Chief Commercial Officer. In connection with the resignation, the individual received certain benefits including: (1) a lump sum severance payment of $316,000; (2) a lump sum payment equal to the cost of 12 months of health care benefits continuation at our expense; and (3) a lump sum payment equal to the cost of 12 months of the portion of the monthly premiums for the individual’s life insurance and disability insurance coverage that are borne by us. In addition, on October 1, 2011, the portion of the stock options and restricted stock units which would have vested if the individual had remained employed for an additional 12 months immediately vested.

The individual entered into a consulting agreement with us that will expire on June 30, 2013. We cannot estimate with any certainty the amount that may be paid, if any, for consulting services under such agreement. The remaining outstanding stock awards will continue to vest through the expiration of the consulting agreement, and the individual will be entitled to exercise such stock awards for 180 days following such expiration.

As of September 30, 2011, we have recorded approximately $346,000 in accrued liabilities for severance owed. The accelerated vesting of the share-based awards resulted in $836,000 of additional share-based compensation expense being recorded during the third quarter of 2011.

P&G’s Evaluation Period

On October 11, 2011, we notified P&G that we were beginning P&G’s 45-day evaluation period relating to an over-the-counter pharmaceutical product containing doxepin. Pursuant to the surviving provisions of the co-promotion agreement with P&G, P&G has until November 25, 2011 to notify us of its interest in negotiating to obtain such product rights. If P&G so notifies us, P&G will have the exclusive right to negotiate with us relating to such rights for 120 days from our receipt of the notice, or such longer period as may be mutually agreed by us and P&G.

Amendment to Professional Detailing Services Agreement with Publicis Touchpoint Solutions, Inc.

On November 1, 2011, we entered into an amendment to Supplement No. 1 the Professional Detailing Services Agreement between us and Publicis dated February 7, 2011. The amendment provides for the termination of all but those that will be included in our 30 person sales force as of November 2, 2011 and the pricing adjustments related thereto.

Reduction in Force

On November 2, 2011, we committed to a plan of termination that resulted in a work force reduction of 14 employees in order to reduce operating costs. We commenced notification of employees affected by the workforce reduction on November 2, 2011, and the workforce reduction is expected to be completed by November 4, 2011. Each affected employee will be eligible to receive a severance payment equivalent to two months of their base salary and the amount of the health insurance benefits paid by us for the previous two months. Payment of these severance benefits to each affected employee is contingent on the affected employee entering into a separation agreement with us, which agreement includes a general release of claims against us. The severance payments are expected to be approximately $0.5 million in the aggregate.

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

The interim financial statements and this Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the financial statements and notes thereto for the year ended December 31, 2010, and the related Management’s Discussion and Analysis of Financial Condition and Results of Operations, both of which are contained in our Annual Report on Form 10-K for the year ended December 31, 2010. 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 the caption “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2010 and the caption “Risk Factors” in this Quarterly Report on Form 10-Q for the quarter ended September 30, 2011.

Overview

Background

We are a specialty pharmaceutical company focused on the in-licensing, development and commercialization of proprietary branded products and late-stage product candidates to treat important medical conditions where there is an unmet medical need and/or high-level of patient dissatisfaction, currently in the central nervous system therapeutic area. In March 2010, the U.S. Food and Drug Administration, or FDA, approved our New Drug Application, or NDA, for Silenor 3 mg and 6 mg tablets for the treatment of insomnia characterized by difficulty with sleep maintenance. Silenor was made commercially available by prescription in the United States in September 2010.

Our principal focus is on commercial activities relating to Silenor. We commercially launched Silenor in September 2010 with sales representatives provided to us on an exclusive basis under our contract sales agreement with Publicis Touchpoint Solutions, Inc., or Publicis, and additional sales representatives provided to us under our co-promotion agreement with Procter & Gamble, or P&G. In June 2011, we entered into agreements with Paladin Labs Inc., or Paladin, under which Paladin has the right to commercialize Silenor in Canada, South America, the Caribbean and Africa.

On September 30, 2011, we provided a notice of termination to Publicis of the contract sales agreement and to P&G of the co-promotion agreement, in each case effective as of December 31, 2011. At the conclusion of the contract term with Publicis, we will assume financial responsibility for the remaining vehicle lease payments associated with our Publicis sales representatives. The remaining obligation under those lease payments was approximately $0.9 million as of September 30, 2011, although we are taking steps to mitigate the obligation that we assume at the end of the contract. We intend to hire 30 sales representatives, most of whom will be hired from the Publicis sales force, to promote Silenor as Somaxon employees effective no later than January 1, 2012. The remainder of the Publicis sales force ceased promoting Silenor as of November 2, 2011. In addition, in order to reduce expenditures, we terminated the employment of 14 employees in November 2011.

In 2012, we intend to allocate significantly more marketing resources to direct to consumer, or DTC, advertising for Silenor than we did in 2011. We expect to concentrate our DTC advertising in certain regions where we believe there is the potential for sales growth based on managed care coverage, favorable insomnia demographics, feasible media costs, and where we plan to retain and/or hire sales representatives. The DTC campaign will consist of a mix of TV, print and on-line advertisements in each targeted regional area.

We are increasing our focus on DTC advertising because we believe that the insomnia market has proven to be responsive to this form of advertising and that Silenor’s clinical profile compared to other insomnia products makes Silenor a particularly good candidate for a DTC campaign. According to Med Ad News’ 15th Annual Report from May 2009, the average return on investment, or ROI, for TV advertising for prescription insomnia medications is 2.6, which is the highest ROI for any therapeutic area. This report also indicated that the ROI for print advertising for prescription insomnia medications is 1.9, which places insomnia in the top five therapeutic areas in this medium.

In addition, we believe the competitive DTC market provides us with an opportunity to effectively reach our target consumer audience with DTC Silenor messages with limited competition and at feasible media costs. According to Nielsen Adviews, DTC advertising expenditures by our prescription competitors has decreased markedly in recent years, from a high of approximately $679 million in 2006 to approximately $64 million in 2010.

According to a direct to consumer drug advertising study by the Nielsen Company in 2010, consumers are two to three times more likely to ask their physician for a specific advertised pharmaceutical product when they are exposed to an integrated combination of TV and online advertising, as compared to when they are exposed to either TV or online advertising alone. In addition, consumer response to DTC advertising increases with the frequency and repetition of their exposure to DTC messages. The Silenor DTC plan is specifically designed to provide an integrated mix of TV, online and print advertising, with such frequency and repetition of exposures where it will run.

In addition, our market research indicates that when a patient asks a physician for a specific prescription insomnia product, the physician will write a prescription for that product approximately two-thirds of the time.

We also believe that Silenor is a good candidate for DTC advertising based on its clinical profile. With respect to efficacy, Silenor is the first and only non-scheduled prescription medication approved by the FDA for the treatment of sleep maintenance insomnia, and in our clinical trials Silenor maintained adult and elderly patients’ sleep into the 7^th and 8^th hours of the night.

In addition, Silenor’s safety profile addresses many of the most important and frequently cited reasons why consumers do not pursue prescription treatment for their insomnia. In our market research when patients were asked to list their top five concerns with prescription insomnia medications, among the most cited reasons were risk of dependence and addiction, fear of side effects, next-day grogginess associated with prescription drugs, fear of complex sleep behaviors, such as sleep driving, and the inability to take the medication over long periods of time.

We believe that Silenor’s most significant differentiating characteristic is that it is not a Schedule IV controlled substance, with no abuse potential or evidence of physical dependence or withdrawal. Other relevant aspects of Silenor’s safety profile include the lack of meaningful next-day residual effects, an overall incidence of adverse events comparable to placebo, and no evidence of tolerance, amnesia or complex sleep behaviors.

For 2012, we expect that the decreases in our operating expenses caused by our personnel decisions will be partially offset by this plan to allocate greater marketing resources to direct to consumer advertising for Silenor.

Critical Accounting Policies and Estimates

Management’s discussion and analysis of our financial condition and results of operations is based on our condensed financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, expenses and related disclosures. Actual results could differ from those estimates. We believe the following accounting policies to be critical to the judgments and estimates used in the preparation of our condensed financial statements.

Revenue Recognition

Product Sales

We sell Silenor to wholesale pharmaceutical distributors. Our returned goods policy generally permits our customers to return products up to six months before and up to twelve months after the expiration date of the product. We authorize returns for expired products in accordance with our returned goods policy and issue credit to our customers for expired returned product. We do not exchange product from inventory for returned product. As of September 30, 2011, the dollar amount of returns received in 2011 has been negligible.

We recognize product revenue from product sales when it is realized or realizable and earned. Revenue is realized or realizable and earned when all of the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) our price to the buyer is fixed or determinable; and (4) collectability is reasonably assured. Revenue from sales transactions where the buyer has the right to return the product is recognized at the time of sale only if (1) our price to the buyer is substantially fixed or determinable at the date of sale, (2) the buyer has paid us, or the buyer is obligated to pay us and the obligation is not contingent on resale of the product, (3) the buyer’s obligation to us would not be changed in the event of theft or physical destruction or damage of the product, (4) the buyer acquiring the product for resale has economic substance apart from that provided by us, (5) we do not have significant obligations for future performance to directly bring about resale of the product by the buyer, and (6) the amount of future returns can be reasonably estimated.

Prior to the second quarter of 2011, we were unable to reasonably estimate returns. We therefore deferred revenue recognition until the right of return no longer existed, which was the earlier of Silenor being dispensed through patient prescriptions or the expiration of the right of return. We estimated patient prescriptions dispensed using an analysis of third-party information. In order to develop a methodology to reliably estimate product returns and provide a basis for recognizing revenue on sales to customers at the time of product shipment, we analyzed many factors, including, without limitation, industry data regarding product return rates, and tracked the Silenor product return history, taking into account product expiration dating at the time of shipment and levels of inventory in the wholesale channel compared to prescription units dispensed and the sell-down of our launch inventory. During the second quarter of 2011, the sell-down of our launch inventory was completed, which we believe demonstrates sufficient market acceptance of our product for purposes of our revenue recognition analysis. In addition, since product launch, we have sold product to wholesale pharmaceutical distributors at standard commercial terms utilized in the industry. As a result, we believe we can analogize to industry data regarding product return rates. Based on the sell-down of our launch inventory and the industry and internal data gathered, we believe we have the information needed to reasonably estimate product returns. As a result, in the second quarter of 2011, we began recognizing revenue for Silenor sales at the time of delivery of the product to wholesale pharmaceutical distributors and our other customers.

License and Royalty Revenue

In June 2011, we entered into a license agreement with Paladin, pursuant to which Paladin will commercialize Silenor in Canada, South America, the Caribbean and Africa, subject to the receipt of marketing approval in each such territory. We received an upfront payment of $500,000 in connection with the execution of this agreement. We recorded the upfront payment as deferred revenue and are recognizing the upfront payment as license revenue over the period of our significant involvement under the agreement, which we are estimating to be 15 years. As of September 30, 2011, the deferred revenue balance associated with the license agreement is $489,000, of which $456,000 is recorded as non-current and $33,000 is recorded as current within accrued liabilities. We recognized $8,000 and $11,000 as revenue during each of the three and nine months ended September 30, 2011, respectively, which is recorded in interest and other income.

Once Silenor is commercialized in the licensed territories, we will be eligible to receive sales-based milestone payments of up to $128.5 million as well as a tiered double-digit percentage of net sales in the licensed territories. Due to the uncertainty surrounding the achievement of these future sales-based milestones and royalties, these potential payments will not be recognized as revenue until they are realized and earned.

Product Sales Discounts and Allowances

We record product sales discounts and allowances at the time of sale and report revenue net of such amounts in the same period that product sales are recorded. In determining the amount of product sales discounts and allowances, we must make significant judgments and estimates. If actual results vary from our estimates, we may need to adjust these estimates, which could have an effect on product revenue in the period of adjustment. Our product sales discounts and allowances and the specific considerations we use in estimating these amounts include:

Prompt Pay Discounts. As an incentive for prompt payment, we offer a 2% cash discount to customers. We calculate the discount based on the gross amount of each invoice as we expect that all customers will comply with the contractual terms to earn the discount. We record the discount as an allowance against accounts receivable and a corresponding reduction of revenue. At September 30, 2011 and December 31, 2010, the allowance for prompt pay discounts was $44,000 and $114,000, respectively.

Patient Discount Programs. We offer discount programs to patients of Silenor under which the patient receives a discount on his or her prescription. We reimburse pharmacies for these discounts through third-party vendors. We estimate the total amount that will be redeemed based on the dollar amount of the discounts, the timing and quantity of distribution and historical redemption rates. We accrue the discounts and recognize a corresponding reduction of revenue. At September 30, 2011 and December 31, 2010, the accrual for patient discount programs was $379,000 and $182,000, respectively.

Distribution Service Fees. We pay distribution services fees to each wholesaler for distribution and inventory management services. We accrue for these fees based on contractually defined terms with each wholesaler and recognize a corresponding reduction of revenue. At September 30, 2011 and December 31, 2010, the accrual for distribution service fees was $310,000 and $276,000, respectively. As these fees are recorded based on contractually defined terms, there have been minimal adjustments to these balances.

Chargebacks. We provide discounts to federal government qualified entities with whom we have contracted. These federal entities purchase products from the wholesalers at a discounted price, and the wholesalers then charge back to us the difference between the current retail price and the contracted price the federal entity paid for the product. We accrue chargebacks based on contract prices and sell-through sales data obtained from third party information. At September 30, 2011 and December 31, 2010, the accrual for chargebacks was $18,000 and $9,000, respectively.

Rebates. We participate in certain rebate programs, which provide discounted prescriptions to qualified insured patients. Under these rebate programs, we pay a rebate to the third-party administrator of the program. We accrue rebates based on contract prices, estimated percentages of product sold to qualified patients and estimated levels of inventory in the distribution channel. Our accrual consists of: (1) the amount expected to be incurred for the current quarter’s product sold; (2) an accrual for prior quarters unpaid rebates; and (3) an accrual for estimated inventory in the distribution channel. Our estimate of utilization is based on partial claims history data received, third-party data and information about our expected patient population. At September 30, 2011 and December 31, 2010, the accrual for rebates was $1,214,000 and $6,000, respectively.

Product Returns. We estimate future product returns based upon actual returns history, analysis of product expiration dating, estimated inventory levels in the distribution channel, and industry data regarding product return rates for similar products. There may be a significant time lag between the date we determine the estimated allowance and when we receive product returns and issue credits to customers. Due to this time lag, we may record adjustments to our estimated allowance over several periods, which would impact our operating results in those periods. At September 30, 2011, the allowance for product returns was $104,000. We have not had reason to make any material changes to the assumptions utilized in our returns estimates.

As we expand our managed care rebate programs and discount programs to offset patients’ out of pocket costs, we expect product sales discounts and allowances to increase.

The following table summarizes the activity for the nine months ended September 30, 2011 associated with product sales discounts and allowances, with amounts shown in thousands:

																		Product
		Prompt				Patient								Charge-				Returns &
		Pay				Discount				Distribution				backs and				Other
		Discounts				Fees				Service Fees				Rebates				Discounts				Total
Balance at January 1, 2011		$	114			$	182			$	276			$	15			$	277			$	864
Current period provision			327				865				1,087				1,596				394				4,269
Provision related to previously deferred sales			(82	)			(158	)			(283	)			(14	)			(274	)			(811	)
Payments and other credits			(315	)			(510	)			(770	)			(365	)			(293	)			(2,253	)
Balance at September 30, 2011		$	44			$	379			$	310			$	1,232			$	104			$	2,069

Additional Discounts and Allowances. From the initial launch of Silenor through September 30, 2011, we offered additional discounts to wholesale distributors for product purchased. At December 31, 2010, the allowance for product launch discounts was $277,000. At September 30, 2011, this balance has been settled in full.

Cost of Sales

Cost of sales includes the costs to manufacture, package, and ship Silenor, including personnel costs associated with manufacturing oversight, as well as royalties and amortization of capitalized license fees associated with our license agreement with ProCom One, Inc., or ProCom.

Inventory

Our inventories are valued at the lower of weighted average cost or net realizable value. We analyze our inventory levels quarterly and write down inventory that has become obsolete, or has a cost basis in excess of its expected net realizable value, as well as any inventory quantities in excess of expected requirements. Expired inventory is disposed of and the related costs are written off.

Capitalized License Fees

License fees related to our intellectual property are capitalized once technological feasibility has been established. Determining when technological feasibility has been achieved, and determining the related amortization period for capitalized intellectual property, requires the use of estimates and subjective judgment. Costs incurred to in-license our product candidates subsequent to FDA approval of our NDA for Silenor have been capitalized and recorded as an intangible asset. Capitalized amounts are amortized on a straight line basis over approximately ten years.

Share-based Compensation

Share-based compensation expense for employees and directors is recognized in the statement of operations based on estimated amounts, including the grant date fair value, the probability of achieving performance conditions and the expected service period for awards with conditional vesting provisions. For stock options, we estimate the grant date fair value using the Black-Scholes valuation model which requires the use of multiple subjective inputs including an estimate of future volatility and the expected terms of the awards. Our stock did not have a readily available market prior to our initial public offering in December 2005, creating a relatively short history from which to obtain data to estimate volatility for our stock price. Consequently, we estimate our expected future volatility based on a combination of both comparable companies and our own stock price volatility to the extent such history is available. Our future volatility may differ from our estimated volatility at the grant date. We estimate the expected term of our options using guidance provided by the Securities and Exchange Commission, or SEC, in Staff Accounting Bulletin, or SAB, No. 107 and SAB No. 110. This guidance provides a formula-driven approach for determining the expected term. Share-based compensation recorded in our statement of operations is based on awards expected to ultimately vest and has been reduced for estimated forfeitures. Our estimated forfeiture rates may differ from actual forfeiture rates which would affect the amount of expense recognized during the period. Estimated forfeitures are adjusted to actual amounts as they become known.

We recognize the value of the portion of the awards that are expected to vest on a straight-line basis over the awards’ requisite service periods. The requisite service period is generally the time over which our share-based awards vest. Some of our share-based awards vested upon achieving certain performance conditions, generally pertaining to the commercial performance of Silenor or the achievement of other strategic objectives. Share-based compensation expense for awards with performance conditions is recognized over the period from the date the performance condition is determined to be probable of occurring through the time the applicable condition is met. If the performance condition is not considered probable of being achieved, then no expense is recognized until such time the performance condition is considered probable of being met. At that time, expense is recognized over the period during which the performance condition is likely to be achieved. Determining the likelihood and timing of achieving performance conditions is a subjective judgment made by management which may affect the amount and timing of expense related to these share-based awards. Share-based compensation is adjusted to reflect the value of options which ultimately vest as such amounts become known in future periods. As a result of these subjective and forward-looking estimates, the actual value of our stock options realized upon exercise could differ significantly from those amounts recorded in our financial statements.

Results of Operations

Comparisons of the Three Months Ended September 30, 2011 and 2010

Product Sales. Product sales represent sales of Silenor for which we have recognized revenue. Net product sales for 2011 and 2010 are summarized in the following table (in thousands).

		Three Months Ended
		September 30,
		2011				2010				Change
Gross product sales		$	5,397			$	47			$	5,350
Sales discounts and allowances
Prompt pay discount			(108	)			(1	)			(107	)
Patient discount programs			(272	)			(2	)			(270	)
Distribution service fees			(356	)			(3	)			(353	)
Chargebacks and rebates			(949	)			—				(949	)
Product returns and other discounts			(36	)			(3	)			(33	)
Total discounts and allowances			(1,721	)			(9	)			(1,712	)
Total net product sales		$	3,676			$	38			$	3,638

We recognized net product sales of $3.7 million and $38,000 for the three months ended September 30, 2011 and 2010, respectively. Sales discounts and allowances totaled $1.7 million for the three months ended September 30, 2011, compared to $9,000 in the same period in 2010. As a percentage of gross sales, the discounts and allowances were 31.9% and 19.1% for the three months ended September 30, 2011 and 2010, respectively. The net increases in gross product sales and sales discounts and allowances are due to growth of sales of Silenor since the commencement of Silenor sales in the third quarter of 2010.

Cost of Sales. Cost of sales includes the costs to manufacture, package, and ship Silenor, including personnel costs associated with manufacturing oversight, as well as royalties and amortization of capitalized license fees associated with our license agreement. Cost of sales for 2011 and 2010 are summarized in the following table (in thousands).

		Three Months Ended
		September 30,
		2011				2010				Change
Cost of sales		$	454			$	3			$	451

We recognized cost of sales of $0.5 million and $3,000 for the three months ended September 30, 2011 and 2010, respectively, relating to product with respect to which revenue was recognized. The net increase was due to growth of sales of Silenor since the commencement of Silenor sales in the third quarter of 2010. Gross profit was $3.2 million and $35,000 for the three months ended September 30, 2011 and 2010, respectively. Expressed as a percentage of net product sales, gross margin was 87.6% and 92.1% for the three months ended September 30, 2011 and 2010, respectively.

Selling, General and Administrative Expense. Our selling, general and administrative expenses consist primarily of salaries, benefits, share-based compensation expense, advertising and market research costs, insurance and facility costs, and professional fees related to our marketing, administrative, finance, human resources, legal and internal systems support functions. Selling, general and administrative expense for 2011 and 2010 are summarized in the following tables (in thousands, except percentages).

		Three Months Ended
		September 30,								Change
		2011				2010				Dollar				Percent
Sales and marketing		$	13,936			$	8,619			$	5,317				62	%
General and administrative			4,165				3,304				861				26	%
Total selling, general and administrative expense		$	18,101			$	11,923			$	6,178				52	%

Selling and marketing expenses totaled $13.9 million and $8.6 million for the three months ended September 30, 2011 and 2010, respectively. Of this, share-based compensation expense totaled $1.0 million and $0.3 million for the three months ended September 30, 2011 and the comparable period in 2010, respectively. The net increase of $5.3 million was primarily due to an increase in costs associated with the commercial activities of Silenor as Silenor was initially made commercially available during the third quarter of 2010. These costs included the costs of our sales representatives, royalties paid to our co-promotion partner, personnel costs and other promotional spending and consulting costs. The net increase is also partially due to $0.8 million of additional share-based compensation expense being recorded during the third quarter of 2011 related to the accelerated vesting of share-based awards. We expect sales and marketing expense to decrease in the fourth quarter of 2011 and in 2012 because, while we intend to hire 30 sales representatives to promote Silenor as Somaxon employees effective no later than January 1, 2012, the remainder of the Publicis sales force ceased promoting Silenor as of November 2, 2011. We have also terminated our agreements with P&G and Publicis effective as of December 31, 2011. However, this decrease will be partially offset in 2012 by our plan to allocate marketing resources to direct to consumer advertising for Silenor to a greater extent than we did in 2011.

General and administrative expenses totaled $4.2 million and $3.3 million for the three months ended September 30, 2011 and 2010, respectively. Of this, share-based compensation expense totaled $0.6 million and $1.2 million for the three months ended September 30, 2011 and 2010, respectively. The net increase of $0.9 million was primarily due to an increase in legal expenses related to Silenor paragraph IV litigation during the three months ended September 30, 2011 compared to the comparable period in 2010. This was offset by lower share-based compensation expense during the third quarter of 2011 compared to 2010 due to the vesting of performance based equity awards associated with the execution of the co-promotion agreement with P&G that occurred during 2010.

Research and Development Expense. Our most significant research and development costs during the three months ended September 30, 2011 were salaries, benefits and share-based compensation expense related to our research and development personnel. Research and development expense for 2011 and 2010 are summarized in the following table (in thousands, except percentages).

		Three Months Ended
		September 30,								Change
		2011				2010				Dollar				Percent
Personnel and other costs		$	139			$	726			$	(587	)			(81	)%
Share-based compensation expense			103				288				(185	)			(64	)%
Total research and development expense		$	242			$	1,014			$	(772	)			(76	)%

Research and development expense decreased $0.8 million for the three months ended September 30, 2011 compared to the same period in 2010 primarily due to lower personnel and other costs. Personnel and other costs attributable to research and development personnel decreased primarily due to costs associated with the process validation for the packaging of Silenor which were incurred in 2010.

Comparisons of the Nine Months Ended September 30, 2011 and 2010

Product Sales. Product sales represent sales of Silenor for which we have recognized revenue. Net product sales for 2011 and 2010 are summarized in the following table (in thousands).

		Nine Months Ended
		September 30,
		2011				2010				Change
Gross product sales		$	16,509			$	47			$	16,462
Sales discounts and allowances
Prompt pay discount			(327	)			(1	)			(326	)
Patient discount programs			(865	)			(2	)			(863	)
Distribution service fees			(1,087	)			(3	)			(1,084	)
Chargebacks and rebates			(1,596	)			—				(1,596	)
Product returns and other discounts			(394	)			(3	)			(391	)
Total discounts and allowances			(4,269	)			(9	)			(4,260	)
Total net product sales		$	12,240			$	38			$	12,202

We recognized net product sales of $12.2 million and $38,000 for the nine months ended September 30, 2011 and 2010, respectively. Sales discounts and allowances totaled $4.3 million for the nine months ended September 30, 2011 compared to $9,000 in the same period in 2010. As a percentage of gross sales, the discounts and allowances were 25.9% and 19.1% for the nine months ended September 30, 2011 and 2010, respectively. The net increases in gross product sales and sales discounts and allowances are due to growth of sales of Silenor since the commencement of Silenor sales in the third quarter of 2010. As a result of recognizing revenue upon delivery to our wholesale customers, in the second quarter of 2011 we recognized additional net product sales of Silenor of $3.2 million.

Cost of Sales. Cost of sales includes the costs to manufacture, package, and ship Silenor, including personnel costs associated with manufacturing oversight, as well as royalties and amortization of capitalized license fees associated with our license agreement. Cost of sales for 2011 and 2010 are summarized in the following table (in thousands).

		Nine Months Ended
		September 30,
		2011				2010				Change
Cost of sales		$	1,478			$	3			$	1,475

We recognized cost of sales of $1.5 million and $3,000 for the nine months ended September 30, 2011 and 2010, respectively, relating to product with respect to which revenue was recognized. The net increase was due to growth of sales of Silenor since the commencement of Silenor sales in the third quarter of 2010. Gross profit was $10.8 million and $35,000 for the nine months ended September 30, 2011 and 2010, respectively. Expressed as a percentage of net product sales, gross margin was 87.9% and 92.1% for the nine months ended September 30, 2011 and 2010, respectively.

Selling, General and Administrative Expense. Our selling, general and administrative expenses consist primarily of salaries, benefits, share-based compensation expense, advertising and market research costs, insurance and facility costs, and professional fees related to our marketing, administrative, finance, human resources, legal and internal systems support functions. Selling, general and administrative expense for 2011 and 2010 are summarized in the following tables (in thousands, except percentages).

		Nine Months Ended
		September 30,								Change
		2011				2010				Dollar				Percent
Sales and marketing		$	42,295			$	11,600			$	30,695				265	%
General and administrative			14,472				8,277				6,195				75	%
Total selling, general and administrative expense		$	56,767			$	19,877			$	36,890				186	%

Selling and marketing expenses totaled $42.3 million and $11.6 million for the nine months ended September 30, 2011 and 2010, respectively. Of this, share-based compensation expense totaled $1.7 million and $0.9 million for the nine months ended September 30, 2011 and the comparable period in 2010, respectively. The net increase of $30.7 million was primarily due to an increase in costs associated with the commercial activities of Silenor as Silenor was initially made commercially available during the third quarter of 2010. These costs included the costs of our sales representatives, royalties paid to our co-promotion partner, personnel costs and other promotional spending and consulting costs. The increase is also partially due to $0.8 million of additional share-based compensation expense being recorded during the third quarter of 2011 related to the accelerated vesting of share-based awards.

General and administrative expenses totaled $14.5 million and $8.3 million for the nine months ended September 30, 2011 and 2010, respectively. Of this, share-based compensation expense totaled $2.1 million and $3.3 million for the nine months ended September 30, 2011 and 2010, respectively. The net increase of $6.2 million was primarily due to an increase in salary and benefits expense resulting from an increase in overall headcount during the nine months ended September 30, 2011 compared to the comparable period in 2010, as well as an increase in legal expenses related to Silenor paragraph IV litigation. This was offset by a decrease in share-based compensation expense due to higher share-based compensation expense during the nine months ended September 30, 2010 as a result of vesting of performance-based equity awards upon FDA approval of the NDA for Silenor and the execution of the co-promotion agreement with P&G.

Research and Development Expense. Our most significant research and development costs during the nine months ended September 30, 2011 were salaries, benefits and share-based compensation expense related to our research and development personnel. Research and development expense for 2011 and 2010 are summarized in the following table (in thousands, except percentages).

		Nine Months Ended
		September 30,								Change
		2011				2010				Dollar				Percent
Personnel and other costs		$	721			$	1,894			$	(1,173	)			(62	)%
Share-based compensation expense			397				1,047				(650	)			(62	)%
Total research and development expense		$	1,118			$	2,941			$	(1,823	)			(62	)%

Research and development expense decreased $1.8 million for the nine months ended September 30, 2011 compared to the same period in 2010 primarily due to lower personnel and other costs and share-based compensation expense. Personnel and other costs attributable to research and development personnel decreased primarily due to costs associated with the process validation for the packaging of Silenor which were incurred in 2010. Share-based compensation expense attributable to research and development personnel decreased due to recognition of compensation costs associated with the vesting of performance-based equity awards upon FDA approval of the NDA for Silenor in the first half of 2010 and the execution of the co-promotion agreement with P&G.

Liquidity and Capital Resources

Since inception, our operations have been financed primarily through the sale of equity securities and the proceeds from the exercise of warrants and stock options. We have incurred losses from operations and negative cash flows since our inception, and we expect to continue to incur losses and have negative cash flows from operations in the foreseeable future as we continue our commercial activities for Silenor, commercialize any other products to which we obtain rights and potentially pursue the development of other product candidates. Based on our recurring losses, negative cash flows from operations and working capital levels, we will need to raise substantial additional funds to finance our operations. If we are unable to maintain sufficient financial resources, including by raising additional funds when needed, our business, financial condition and results of operations will be materially and adversely affected.

As of September 30, 2011, we had $34.0 million in cash and cash equivalents. This amount includes our receipt of $14.9 million in net proceeds pursuant to a loan and security agreement with Silicon Valley Bank, or SVB, and Oxford Finance LLC, or together with SVB, the Lenders. The Lenders have the right to declare the loan immediately due and payable in an event of default under the Loan Agreement, which includes, among other things, a material adverse change in our business, operations or financial condition or a material impairment in the prospect of repayment of the loan. In addition, under the loan agreement, we are required to maintain with SVB our primary cash and investment accounts, which accounts are also covered by control agreements for the benefit of the Lenders. Based on the Lenders’ right to declare the loan immediately due and payable, we have classified the outstanding debt balance as a current liability as of September 30, 2011.

In August 2011, we entered into an at-the-market equity sales agreement, or sales agreement, with Citadel Securities LLC, or Citadel. However, there can be no assurance that Citadel will be successful in consummating such sales based on prevailing market conditions or in the quantities or at the prices that we deem appropriate. Citadel or the Company is permitted to terminate the sales agreement at any time. Sales of shares pursuant to the sales agreement will have a dilutive effective on the holdings of our existing stockholders, and may result in downward pressure on the price of our common stock.

We commercially launched Silenor in September 2010 with sales representatives provided to us on an exclusive basis under our contract sales agreement with Publicis, and additional sales representatives provided to us under our co-promotion agreement with P&G. On September 30, 2011, we provided a notice of termination to Publicis of the contract sales agreement and to P&G of the co-promotion agreement, in each case effective as of December 31, 2011. At the conclusion of the contract term with Publicis, we will assume financial responsibility for the remaining vehicle lease payments associated with our Publicis sales representatives. The remaining obligation under those lease payments was approximately $0.9 million as of September 30, 2011, although we are taking steps to mitigate the obligation that we assume at the end of the contract. We intend to hire 30 sales representatives, most of whom will be hired from the Publicis sales force, to promote Silenor as Somaxon employees effective no later than January 1, 2012. The remainder of the Publicis sales force ceased promoting Silenor as of November 2, 2011. In addition, in order to reduce expenditures, we terminated the employment of 14 employees in November 2011. However, decreases in our operating expenses based on these personnel decisions will be partially offset in 2012 by our plan to allocate marketing resources to direct to consumer advertising for Silenor to a greater extent than we did in 2011.

We believe we have access to sufficient financial resources to fund our operations for at least the next twelve months. We will need to obtain additional funds to finance our operations, particularly if we are unable to access adequate or timely funds under our sales agreement with Citadel. Until we can generate significant cash from our operations, we intend to obtain any additional funding we require through public or private equity or debt financings, strategic relationships, assigning receivables or royalty rights, or other arrangements and we cannot assure such funding will be available on reasonable terms, or at all. Additional equity financing will be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants. Actual financial results for the period of time through which our financial resources will be adequate to support our operations could vary based upon many factors, including but not limited to the rate of growth of Silenor sales, the actual cost of commercial activities and any potential litigation expenses we may incur.

Our future capital uses and requirements depend on numerous forward-looking factors. These factors include but are not limited to the following:

•

our success in generating cash flows from the commercialization of Silenor;

•

the costs of establishing or contracting for commercial programs and resources, and the scope of the commercial programs and resources we pursue;

•

the terms and timing of any future collaborative, licensing and other arrangements that we may establish;

•

the costs of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights;

•

the extent to which we acquire or in-license new products, technologies or businesses;

•

the rate of progress and cost of any future non-clinical studies, any future clinical trials and other development activities;

•

the scope, prioritization and number of development programs we pursue; and

•

the effect of competing technological and market developments.

If our efforts in raising additional funds when needed are unsuccessful, we may be required to delay, scale-back or eliminate plans or programs relating to our business, relinquish some or all rights to Silenor or renegotiate less favorable terms with respect to such rights than we would otherwise choose or cease operating as a going concern. In addition, if we do not meet our payment obligations to third parties as they come due, we may be subject to litigation claims. Even if we were successful in defending against these claims, litigation could result in substantial costs and be a distraction to management, and may result in unfavorable results that could further adversely impact our financial condition.

If we are unable to continue as a going concern, we may have to liquidate our assets and may receive less than the value at which those assets are carried on our financial statements, and it is likely that investors will lose all or a part of their investments. Our financial statements do not include any adjustments that might result from the outcome of this uncertainty.

We have invested a substantial portion of our available cash in money market funds and marketable securities. The capital markets remain highly volatile and there has been a lack of liquidity for certain financial instruments. All of our investments in marketable securities and money market funds are highly rated, highly liquid securities with readily determinable fair values. As of September 30, 2011, none of our securities are considered to be impaired.

We have two effective shelf registration statements on Form S-3 filed with the SEC under which we may offer from time to time up to an aggregate of approximately $66.2 million in any combination of debt securities, common and preferred stock and warrants. These registration statements could allow us to seek additional financing, subject to the SEC’s rules and regulations relating to eligibility to use Form S-3. Additional equity financing will be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants.

Cash Flows

Net cash used in operating activities was $40.2 million for the nine months ended September 30, 2011, compared to $18.0 million for the same period in 2010. The increase in net cash used in operating activities was primarily due to an increase in our net loss in 2011 as compared to the prior year.

Net cash provided by investing activities was $32.9 million for the nine months ended September 30, 2011, compared to net cash used in investing activities of $22.8 million for the same period in 2010. Results for 2011 reflect net sales and maturities of marketable securities of $33.7 million and payments for property and equipment of $0.4 million. Results for 2010 reflect a $1.0 million milestone payment to ProCom under our license agreement which became due as a result of the approval by the FDA of our NDA for Silenor and net purchases of marketable securities of $21.3 million.

Net cash provided by financing activities was $20.3 million for the nine months ended September 30, 2011, compared to net cash provided by financing activities of $56.1 million for the same period in 2010. Results for 2011 reflect net proceeds of $14.8 million from the issuance of debt, net proceeds of $5.0 million received from Paladin from the sale by us of 2.2 million shares of our common stock, and net proceeds of $0.5 million from the sale of 786,825 shares of our common stock under our sales agreement,with Citadel. Results for 2010 reflect cash proceeds of $52.7 million from our follow-on offering and proceeds of $3.4 million from the exercise of warrants and stock options.

Loan Agreement

In July 2011, we terminated our existing loan agreement with Comerica Bank and we entered into a new loan and security agreement with the Lenders, pursuant to which the Lenders made us a term loan in the principal amount of $15.0 million. The term loan bears interest at 7.5% per annum. We are obligated to pay interest on the loan through December 31, 2011, and to thereafter pay the principal balance of the loan and interest in 24 equal monthly installments starting on January 1, 2012 and continuing through December 31, 2013. At our option, we may prepay all or any part of the outstanding principal balance, subject to a pre-payment fee of $150,000. We will be required to repay the entire outstanding principal balance if a generic version of Silenor enters the market while the loan is outstanding. We paid to the Lenders an initial fee of $150,000 upon the closing of the term loan. In the event of the final payment of the loan, either through repayment of the loan in full at maturity or upon any pre-payment, we are required to pay a final payment fee of $637,500. In connection with the loan agreement, we granted the Lenders a security interest in substantially all of our personal property now owned or hereafter acquired, excluding intellectual property. Under the loan agreement, we are subject to certain affirmative and negative covenants, including limitations on our ability to: undergo certain change of control events; convey, sell, lease, license, transfer or otherwise dispose of assets, other than in certain specified circumstances; create, incur, assume, guarantee or be liable with respect to certain indebtedness; grant liens; pay dividends and make certain other restricted payments; and make certain investments. In addition, under the loan agreement, subject to certain exceptions, we are required to maintain with SVB our primary cash and investment accounts, which accounts are also covered by control agreements for the benefit of the Lenders. We have currently met all of our obligations under the loan agreement.

The Lenders have the right to declare the loan immediately due and payable in an event of default under the Loan Agreement, which includes, among other things, a material adverse change in our business, operations or financial condition or a material impairment in the prospect of repayment of the loan. Based on the Lenders’ right to declare the loan immediately due and payable, we have classified the outstanding debt balance as a current liability as of September 30, 2011.

As part of the financing, the Lenders received warrants to purchase up to an aggregate of 583,152 fully paid and non-assessable shares of our common stock at an exercise price equal to $1.5433 per share. The warrants will expire ten years from the date of the grant.

Equity Sales Agreement

In August 2011, we entered into the sales agreement with Citadel pursuant to which we agreed to sell, at our option, up to an aggregate of $30.0 million in shares of our common stock through Citadel, as sales agent. Sales of the common stock made pursuant to the sales agreement, if any, will be made on the NASDAQ Stock Market under our currently-effective Registration Statements on Form S-3 by means of ordinary brokers’ transactions at market prices. Additionally, under the terms of the sales agreement, we may also sell shares of our common stock through Citadel, on the NASDAQ Stock Market or otherwise, at negotiated prices or at prices related to the prevailing market price. Under the terms of the sales agreement, we may also sell shares to Citadel as principal for Citadel’s own account at a price agreed upon at the time of sale pursuant to a separate terms agreement to be entered into with Citadel at such time. We pay Citadel a commission equal to 3% of the gross proceeds from the sale of shares of our common stock under the sales agreement. We or Citadel may terminate the sales agreement at any time. The offering of common stock pursuant to the sales agreement will terminate upon the earlier of (a) the sale of all of the common stock subject to the sales agreement or (b) the termination of the sales agreement by us or Citadel. Either party may terminate the agreement in its sole discretion at any time upon written notice to the other party. During the three months ended September 30, 2011, we sold an aggregate of 786,825 shares of our common stock under the sales agreement, received gross proceeds of $0.8 million, and paid $0.3 million of legal and accounting fees associated with the execution of the sales agreement and commissions.

Litigation

We have received notices from each of Actavis Elizabeth LLC and Actavis Inc., or collectively, Actavis, Mylan Pharmaceuticals Inc. and Mylan, Inc., or collectively, Mylan, Par Pharmaceutical, Inc. and Par Pharmaceutical Companies, Inc., or collectively, Par, and Zydus Pharmaceuticals USA, Inc. and Cadila Healthcare Limited (d/b/a Zydus Cadila), or collectively, Zydus, that each has filed with the FDA an ANDA for a generic version of Silenor 3 mg and 6 mg tablets. The notices included “paragraph IV certifications” with respect to eight of the nine patents listed in the Orange Book for Silenor. A paragraph IV certification is a certification by a generic applicant that in the opinion of that applicant, the patent(s) listed in the Orange Book for a branded product are invalid, unenforceable, and/or will not be infringed by the manufacture, use or sale of the generic product.

We, together with ProCom, have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus. The lawsuits allege that each of Actavis, Mylan, Par and Zydus have infringed U.S. Patent No. 6,211,229, or the ’229 patent, by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

In addition, we have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that such parties have infringed U.S. Patent No. 7,915,307, or the ’307 patent, by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

Pursuant to the provisions of the Hatch-Waxman Act, FDA final approval of the Actavis and Mylan ANDAs can occur no earlier than May 3, 2013, FDA final approval of the Par ANDA can occur no earlier than June 23, 2013 and FDA final approval of the Zydus ANDA can occur no earlier than November 13, 2013, unless in each case there is an earlier court decision that the ’229 patent and the ’307 patent are not infringed and/or invalid or unless any party to the action is found to have failed to cooperate reasonably to expedite the infringement action.

At this time, the other patents included in Orange Book have not been asserted against these parties.

We intend to vigorously enforce our intellectual property rights relating to Silenor, but we cannot predict the outcome of these matters.

The prosecution of the lawsuits against Actavis, Mylan, Par and Zydus will increase our cash expenditures. Any adverse outcome in this litigation could result in one or more generic versions of Silenor being launched before the expiration of the listed patents, which could adversely affect our ability to successfully execute our business strategy to increase sales of Silenor and would negatively impact our financial condition and results of operations, including causing a significant decrease in our revenues and cash flows.

Contractual Obligations

In May 2011, we entered into a new lease arrangement to rent approximately 12,100 square feet of office space, which we plan to use as our new corporate headquarters. The lease commenced on August 25, 2011. The lease will expire on December 24, 2016, and we will have the option to extend the term for an additional five years at the then-current fair market rental rate (as defined in the lease). We have paid the first month’s rent of approximately $30,000 and the monthly rent following lease commencement will be approximately $30,000. However, the second through thirteenth month’s rent will be abated by one-half provided that we are not in default of the lease. After the first year, the monthly rent will increase by 3.5% per year, and we will provide reimbursements for our proportional share of any increases in operating expenses over the first year’s operating expenses (as defined in the lease). We also have a $200,000 letter of credit in favor of our landlord to secure our obligations under the lease.

In August 2011, we entered into a new loan and security agreement with the Lenders, pursuant to which the Lenders made us a term loan in the principal amount of $15.0 million. At September 30, 2011, the future principal payments under the agreement for the years then ended are as follows (in thousands):

2011 (remaining three months)		$	—
2012			7,220
2013			7,780
Total		$	15,000

A summary of our other minimum contractual obligations related to our major outstanding contractual commitments is included in our Annual Report on Form 10-K for the year ended December 31, 2010.

Off-Balance Sheet Arrangements

We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Recent Accounting Pronouncements

In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2009-13 “Revenue Recognition,” which provides guidance on recognizing revenue in arrangements with multiple deliverables. This standard impacts the determination of when the individual deliverables included in a multiple element arrangement may be treated as a separate unit of accounting. It also modifies the manner in which the consideration received from the transaction is allocated to the multiple deliverables and no longer permits the use of the residual method of allocating arrangement consideration. This accounting standard was effective for the first year beginning on or after June 15, 2010, with early adoption permitted. The adoption of ASU 2009-13, which occurred on January 1, 2011, did not have a material impact on our financial statements.

In December 2010, the FASB issued ASU No. 2010-27 “Other Expenses: Fees Paid to the Federal Government by Pharmaceutical Manufacturers,” which provides guidance concerning the recognition and classification of the new annual fee payable by branded prescription drug manufacturers and importers on branded prescription drugs which was mandated under the health care reform legislation enacted in the United States in March 2010. Under this new authoritative guidance, the annual fee should be estimated and recognized in full as a liability upon the first qualifying commercial sale with a corresponding deferred cost that is amortized to operating expenses using a straight-line method unless another method better allocates the fee over the calendar year in which it is payable. This new guidance was effective for calendar years beginning on or after December 31, 2010, when the fee initially becomes effective. The adoption of ASU 2010-27, which occurred on January 1, 2011, did not have a material impact on our financial statements.

In May 2011, the FASB issued ASU No. 2011-04 “Fair Value Measurement: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs”. Some of the amendments clarify the FASB’s intent about the application of existing fair value measurement requirements. Other amendments change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. This guidance is effective for interim and annual periods beginning after December 15, 2011. We are still evaluating the potential future effects of this guidance.

In June 2011, the FASB issued ASU No. 2011-05 “Comprehensive Income: Presentation of Comprehensive Income.” Under the new guidance, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. This guidance is effective for interim and annual periods beginning after December 15, 2011. We have evaluated the potential future effects of this guidance and do not expect the adoption of ASU 2011-05 to have a material impact on our financial statements.

Caution on Forward-Looking Statements

Any statements in this report about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and are forward-looking statements. You can identify these forward-looking statements by the use of words or phrases such as “believe,” “may,” “could,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “seek,” “plan,” “expect,” “should” or “would.” Among the factors that could cause actual results to differ materially from those indicated in the forward-looking statements are risks and uncertainties inherent in our business including, without limitation: our ability to successfully commercialize Silenor, including our ability to successfully execute on our increased DTC sales and marketing efforts; the market potential for insomnia treatments, and our ability to compete within that market; the potential to enter into an agreement with P&G relating to over-the-counter, or OTC, rights for Silenor; our ability, together with any partner, to receive FDA approval for an OTC version of Silenor; our ability to successfully hire, manage and utilize a sales force to market Silenor, including the transition of Publicis representatives to Somaxon employees; our ability to successfully enforce our intellectual property rights and defend our patents, including any developments relating to the recent submission of ANDAs for generic versions of Silenor 3 mg and 6 mg tablets and related patent litigation; the scope, validity and duration of patent protection and other intellectual property rights for Silenor; whether the approved label for Silenor is sufficiently consistent with such patent protection to provide exclusivity for Silenor; the possible introduction of generic competition of Silenor; our ability to ensure adequate and continued supply of Silenor to successfully meet anticipated market demand; our ability to raise sufficient capital to fund our operations, including patent infringement litigation, and the impact of any financing activity on the level of our stock price; the impact of any inability to raise sufficient capital to fund ongoing operations, including any patent infringement litigation; our ability to comply with the covenants under the loan and security agreement with the Lenders; the potential for an event of default under the loan and security agreement, and the corresponding risk of acceleration of repayment and potential foreclosure on the assets pledged to secure the loan; our ability to fully utilize the sales agreement with Citadel as a source of future financings, whether due to market conditions, our ability to satisfy various conditions required to sell shares under the agreement; Citadel’s performance of its obligations under the agreement or otherwise; the impact on the level of our stock price, which may decline, in connection with the implementation of the sales agreement or the occurrence of any sales under the agreement; changes in healthcare regulation and reimbursement policies; our ability to operate our business without infringing the intellectual property rights of others; our reliance on our licensee, Paladin, for critical aspects of the commercial sales process for Silenor outside of the United States; the performance of Paladin and its adherence to the terms of its contracts with us; inadequate therapeutic efficacy or unexpected adverse side effects relating to Silenor that could result in recalls or product liability claims; other difficulties or delays in development, testing, manufacturing and marketing of Silenor; the timing and results of post-approval regulatory requirements for Silenor, and the FDA’s agreement with our interpretation of such results; and other risks detailed in this report under Part II — Item 1A — Risk Factors below and previously disclosed in our Annual Report on Form 10-K.

Although we believe that the expectations reflected in our forward-looking statements are reasonable, we cannot guarantee future results, events, levels of activity, performance or achievement. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless required by law. This caution is made under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995.

Item 3.		Quantitative and Qualitative Disclosures about Market Risk

Our cash and cash equivalents at September 30, 2011 consisted primarily of money market funds and marketable securities. The primary objective of our investment activities is to preserve principal while maximizing the income we receive from our investments without significantly increasing risk. Historically, our primary exposure to market risk is interest rate sensitivity. This means that a change in prevailing interest rates may cause the value of the investment to fluctuate. For example, if we purchase a security that was issued with a fixed interest rate and the prevailing interest rate later rises, the value of our investment will probably decline. Currently, our holdings are in money market funds and marketable securities, and therefore this interest rate risk is minimal. To minimize our interest rate risk going forward, we intend to continue to maintain our portfolio of cash, cash equivalents and marketable securities in a variety of securities consisting of money market funds and United States government debt securities, all with various maturities. In general, money market funds are not subject to market risk because the interest paid on such funds fluctuates with the prevailing interest rate. We also generally time the maturities of our investments to correspond with our expected cash needs, allowing us to avoid realizing any potential losses from having to sell securities prior to their maturities.

Our cash is invested in accordance with a policy approved by our board of directors which specifies the categories, allocations, and ratings of securities we may consider for investment. We do not believe our cash and cash equivalents and short-term investments have significant risk of default or illiquidity. We made this determination based on discussions with our treasury managers and a review of our holdings. While we believe our cash and cash equivalents and short-term investments are well diversified and do not contain excessive risk, we cannot provide absolute assurance that our investments will not be subject to future adverse changes in market value.

Item 4.		Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports made under the Securities Exchange Act of 1934, as amended, or the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by SEC Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level as of September 30, 2011.

Changes in Internal Control Over Financial Reporting

There has been no change in our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

Item 1.		Legal Proceedings

We have received notices from Actavis, Mylan, Par, and Zydus that each has filed with the FDA an ANDA for a generic version of Silenor 3 mg and 6 mg tablets. The notices included “paragraph IV certifications” with respect to eight of the nine patents listed in the Orange Book for Silenor.

We, together with ProCom, have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus. The lawsuits allege that each of Actavis, Mylan, Par and Zydus have infringed the ’229 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

In addition, we have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that such parties have the ’307 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

Pursuant to the provisions of the Hatch-Waxman Act, FDA final approval of the Actavis and Mylan ANDAs can occur no earlier than May 3, 2013, FDA final approval of the Par ANDA can occur no earlier than June 23, 2013 and FDA final approval of the Zydus ANDA can occur no earlier than November 13, 2013, unless in each case there is an earlier court decision that the ’229 patent and the ’307 patent are not infringed and/or invalid or unless any party to the action is found to have failed to cooperate reasonably to expedite the infringement action. We do not know when there will be a court decision on the merits in any of these cases.

At this time, the other patents included in Orange Book have not been asserted against these parties.

We intend to vigorously enforce our intellectual property rights relating to Silenor, but we cannot predict the outcome of these matters.

Item 1A.		Risk Factors

Investing in our common stock involves a high degree of risk. Our Annual Report on Form 10-K for the year ended December 31, 2010 includes a detailed discussion of our risk factors under the heading “Part I, Item 1A—Risk Factors.” Set forth below are certain changes from the risk factors previously disclosed in our Annual Report on Form 10-K. You should carefully consider the risk factors discussed in our Annual Report on Form 10-K and in this report, as well as the other information in this report, before deciding whether to invest in shares of our common stock. The occurrence of any of the risks discussed in the Annual Report on Form 10-K or this report 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. Except with respect to our trademarks, the trademarks, trade names and service marks appearing in this report are the property of their respective owners.

Risks Related to Our Business

We will require substantial additional funding and may be unable to raise capital when needed, which could force us to delay, reduce or eliminate planned activities or result in our inability to continue as a going concern.

We began generating revenues from the commercialization of Silenor late in the third quarter of 2010, and our operations to date have generated substantial needs for cash. We expect our negative cash flows from operations to continue until we are able to generate significant cash flows from the commercialization of Silenor. Based on our recurring losses, negative cash flows from operations and working capital levels, we will need to raise substantial additional funds to finance our operations. If we are unable to maintain sufficient financial resources, including by raising additional funds when needed, our business, financial condition and results of operations will be materially and adversely affected.

In November 2010, we completed a public offering of 8,800,000 shares of our common stock at a public offering for aggregate net proceeds of approximately $24.8 million. In June 2011, we completed a private placement of 2,184,769 shares of our common stock to Paladin for aggregate net proceeds of approximately $5.0 million in connection with a license of the rights to market Silenor in Canada, South America, Africa and the Caribbean.

In August 2011, we received $14.9 million in net proceeds pursuant to a loan and security agreement the Lenders. The Lenders have the right to declare the loan immediately due and payable in an event of default under the loan agreement, which includes, among other things, a material adverse change in our business, operations or financial condition or a material impairment in the prospect of repayment of the loan. In addition, under the loan agreement, we are required to maintain with SVB our primary cash and investment accounts, which accounts are also covered by control agreements for the benefit of the Lenders. Based on the Lenders’ ability to declare the loan immediately due and payable, we have classified the outstanding debt balance as a current liability as of September 30, 2011.

In August 2011, we entered into an at-the-market sales agreement with Citadel. However, there can be no assurance that Citadel will be successful in consummating sales under the agreement based on prevailing market conditions or in the quantities or at the prices that we deem appropriate. Citadel or we are permitted to terminate the sales agreement at any time. We commercially launched Silenor in September 2010 with sales representatives provided to us on an exclusive basis under our contract sales agreement with Publicis, and additional sales representatives provided to us under our co-promotion agreement with P&G. On September 30, 2011, we provided a notice of termination to Publicis of our contract sales agreement and to P&G of our co-promotion agreement, in each case effective as of December 31, 2011. At the conclusion of the contract term with Publicis, we will assume financial responsibility for the remaining vehicle lease payments associated with our Publicis sales representatives. The remaining obligation under those lease payments was approximately $0.9 million as of September 30, 2011, although we are taking steps to mitigate the obligation that we assume at the end of the contract. We intend to hire 30 sales representatives, most of whom will be hired from the Publicis sales force, to promote Silenor as Somaxon employees effective no later than January 1, 2012. The remainder of the Publicis sales force ceased promoting Silenor as of November 2, 2011. In addition, in order to reduce expenditures, we terminated the employment of 14 employees in November 2011. However, decreases in our operating expenses based on these personnel decisions will be partially offset in 2012 by our plan to allocate marketing resources to direct to consumer, or DTC, advertising for Silenor to a greater extent than we did in 2011.

At September 30, 2011 we had cash, cash equivalents, and short-term investments totaling $34.0 million, which includes our receipt of $14.9 million in net proceeds pursuant to our loan and security agreement with the Lenders. We believe we have access to sufficient financial resources to fund our operations for at least the next twelve months. We will need to obtain additional funds to finance our operations, particularly if we are unable to access adequate or timely funds under our sales agreement with Citadel. Actual financial results for the period of time through which our financial resources will be adequate to support our operations could vary based upon many factors, including but not limited to the rate of growth of Silenor sales, the actual cost of commercial activities and any potential litigation expenses we may incur.

We are responsible for the costs relating to the commercialization of Silenor in the U.S. As a result, commercial activities relating to Silenor are likely to result in the need for substantial additional funds. Our future capital requirements will depend on, and could increase significantly as a result of, many factors, including:

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our success in generating cash flows from the commercialization of Silenor;

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the costs of establishing or contracting for commercial programs and resources, and the scope of the commercial programs and resources we pursue;

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the terms and timing of any future collaborative, licensing and other arrangements that we may establish;

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the costs of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights;

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the extent to which we acquire or in-license new products, technologies or businesses;

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the rate of progress and cost of any future non-clinical studies, any future clinical trials and other development activities;

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the scope, prioritization and number of development programs we pursue; and

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the effect of competing technological and market developments.

In addition to the amounts available under our sales agreement with Citadel, we intend to obtain any additional funding we require through public or private equity or debt financings, strategic relationships, assigning receivables or royalty rights, or other arrangements and cannot assure that such funding will be available on reasonable terms, or at all. If we are unsuccessful in raising additional required funds, we may be required to delay, scale-back or eliminate plans or programs relating to our business, relinquish some or all rights to Silenor, or renegotiate less favorable terms with respect to such rights than we would otherwise choose or cease operating as a going concern. In addition, if we do not meet our payment obligations to third parties as they come due, we may be subject to litigation claims. Even if we are successful in defending against these claims, litigation could result in substantial costs and distract management, and may result in unfavorable outcomes that could further adversely impact our financial condition.

If we raise additional funds by issuing equity securities, substantial dilution to existing stockholders would result. If we raise additional funds by incurring debt financing, the terms of the debt may involve significant cash payment obligations as well as covenants and specific financial ratios that may restrict our ability to operate our business. If we are unable to continue as a going concern, we may have to liquidate our assets and may receive less than the value at which those assets are carried on our financial statements, and it is likely that investors will lose all or a part of their investments.

We will need to hire and retain qualified sales and marketing personnel and successfully manage our commercialization programs and resources in order to successfully commercialize Silenor.

On September 30, 2011, we provided a notice of termination to Publicis of our contract sales agreement and to P&G of our co-promotion agreement, in each case effective as of December 31, 2011. We intend to hire 30 sales representatives, most of whom will be hired from the Publicis sales force, to promote Silenor as Somaxon employees effective no later than January 1, 2012. The remainder of the Publicis sales force ceased promoting Silenor as of November 2, 2011. In 2012, we also intend to allocate significantly more marketing resources to DTC advertising for Silenor than we did in 2011. We expect that the DTC advertising will be concentrated into regions within which we plan to hire and retain sales representatives and where we believe there is the potential for sales growth based on managed care coverage and other factors. Although our goal is to prove the concept that Silenor sales growth can occur in these concentrated regions based on the combination of DTC advertising, promotional activities and other factors, these efforts may not be successful and we may see not a positive return on investment from these activities.

To the extent we are not successful in transitioning qualified sales personnel to employment with us and managing and retaining such personnel, and in utilizing direct to consumer advertising to generate patient and physician demand for Silenor, we may not be able to effectively achieve prescription growth and broad market acceptance for Silenor on a timely basis, or at all.

Prior to December 31, 2011, any revenues we receive from sales of Silenor will largely depend upon the efforts P&G and Publicis, which in many instances will not be within our control. Thereafter, we will be solely relying on our sales representatives to market and sell Silenor and our sales in the short term may suffer as we make this transition and may in the short term and may continue to suffer in the long term if such transition is not successful. In addition, our marketing strategy of focusing on an overall smaller, but more concentrated, geography may not be successful. We may not be able to cover all of the prescribing physicians for insomnia at the same level of reach and frequency as our competitors, either before or after the termination of our agreements with P&G and Publicis, and we ultimately may need to further expand our selling efforts in order to effectively compete.

Restrictions on or challenges to our patent rights relating to our products and limitations on or challenges to our other intellectual property rights may limit our ability to prevent third parties from competing against us.

Our success will depend on our ability to obtain and maintain patent protection for Silenor and any other product candidate we develop or commercialize, preserve our trade secrets, prevent third parties from infringing upon our proprietary rights and operate without infringing upon the proprietary rights of others. The patent rights that we have in-licensed relating to Silenor are limited in ways that may affect our ability to exclude third parties from competing against us. In particular, we do not hold composition of matter patents covering the active pharmaceutical ingredient, or API, of Silenor. Composition of matter patents on APIs are a particularly effective form of intellectual property protection for pharmaceutical products as they apply without regard to any method of use or other type of limitation. As a result, competitors who obtain the requisite regulatory approval can offer products with the same active ingredients as our products so long as the competitors do not infringe any method of use or formulation patents that we may hold.

The principal patent protection that covers, or that we expect will cover, Silenor consists of method of use patents. This type of patent protects the product only when used or sold for the specified method. However, this type of patent does not limit a competitor from making and marketing a product that is identical or similar to our product for an indication that is outside of the patented method. Moreover, physicians may prescribe such a competitive or similar identical product for off-label indications that are covered by the applicable patents. Some physicians are prescribing generic 10 mg doxepin capsules and generic oral solution doxepin for insomnia on such an off-label basis. In addition, some managed health care plans are requiring the substitution of these generic doxepin products for Silenor, and some pharmacies are suggesting such substitution. Although such off-label prescriptions may induce or contribute to the infringement of method of use patents, the practice is common and such infringement is difficult to prevent or prosecute.

Because products with active ingredients identical to ours have been on the market for many years, there can be no assurance that these other products were never used off-label or studied in such a manner that such prior usage would not affect the validity of our method of use patents. Due to some prior art that we identified, we initiated a reexamination of one of the patents we have in-licensed covering Silenor, (specifically, U.S. Patent No. 5,502,047, “Treatment for Insomnia”) which claims the treatment of chronic insomnia using doxepin in a daily dosage of 0.5 mg to 20 mg and expires in March 2013. The reexamination proceedings terminated and the U.S. Patent and Trademark Office, or USPTO, issued a reexamination certificate narrowing certain claims, so that the broadest dosage ranges claimed by us are 0.5 mg to 20 mg for otherwise healthy patients with chronic insomnia and for patients with chronic insomnia resulting from depression, and 0.5 mg to 4 mg for all other chronic insomnia patients. We also requested reissue of this same patent to consider some additional prior art and to add intermediate dosage ranges below 10 mg. In two office actions relating to this reissue request, the USPTO raised no prior art objections to 32 of the 34 claims we were seeking and raised a prior art objection to the other two, as well as some technical objections. Each of the claims objected to by the USPTO related to dosages above 10 mg. After further review of the prior art submitted, the USPTO withdrew all of its prior art objections. We then determined that the proposed addition of the intermediate dosage ranges and the resolution of the technical objections no longer warranted continuation of the reissue proceeding. As a result, we elected not to continue that proceeding.

We also have multiple internally developed pending patent applications. No assurance can be given that the USPTO or other applicable regulatory authorities will allow pending applications to result in issued patents with the claims we are seeking, or at all.

Patent applications in the United States are confidential for a period of time until they are published, and publication of discoveries in scientific or patent literature typically lags actual discoveries by several months. As a result, we cannot be certain that the inventors of issued patents to which we hold rights were the first to conceive of inventions covered by pending patent applications or that the inventors were the first to file patent applications for such inventions.

In addition, third parties may challenge issued patents to which we hold rights and any additional patents that we may obtain, which could result in the invalidation or unenforceability of some or all of the relevant patent claims, or could attempt to develop products utilizing the same APIs as our products that do not infringe the claims of our in-licensed patents or patents that we may obtain.

When a third party files an ANDA for a product containing doxepin for the treatment of insomnia at any time during which we have patents listed for Silenor in the FDA’s Orange Book publication, the applicant will be required to certify to the FDA concerning the listed patents. Specifically, the applicant must certify that: (1) the required patent information relating to the listed patent has not been filed in the NDA for the approved product; (2) the listed patent has expired; (3) the listed patent has not expired, but will expire on a particular date and approval is sought after patent expiration; or (4) the listed patent is invalid or will not be infringed by the manufacture, use or sale of the new product. A certification that the new product will not infringe the Orange Book-listed patents for Silenor or that such patents are invalid is called a paragraph IV certification.

We have received notices from each of Actavis, Mylan, Par, and Zydus that each has filed with the FDA an ANDA for a generic version of Silenor 3 mg and 6 mg tablets. The notices included paragraph IV certifications with respect to eight of the nine patents listed in the Orange Book for Silenor.

We, together with ProCom, have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus. The lawsuits allege that each of Actavis, Mylan, Par and Zydus have infringed the ’229 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

In addition, we have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that such parties have infringed the ’307 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

Pursuant to the provisions of the Hatch-Waxman Act, FDA final approval of the Actavis and Mylan ANDAs can occur no earlier than May 3, 2013, FDA final approval of the Par ANDA can occur no earlier than June 23, 2013 and FDA final approval of the Zydus ANDA can occur no earlier than November 13, 2013, unless in each case there is an earlier court decision that the ’229 patent and the ’307 patent are not infringed and/or invalid or unless any party to the action is found to have failed to cooperate reasonably to expedite the infringement action. We do not know when there will be a court decision on the merits in any of these cases. At this time, the other patents included in Orange Book have not been asserted against these parties.

We intend to vigorously enforce our intellectual property rights relating to Silenor, but we cannot predict the outcome of these matters. Any adverse outcome in this litigation could result in one or more generic versions of Silenor being launched before the expiration of the listed patents, which could adversely affect our ability to successfully execute our business strategy to increase sales of Silenor and would negatively impact our financial condition and results of operations, including causing a significant decrease in our revenues and cash flows. Such events could also significantly impact our ability to continue as a going concern.

Certain pharmaceutical companies’ patent settlement agreements with generic pharmaceutical companies have been challenged by the U.S. Federal Trade Commission alleging a violation of Section 5(a) of the Federal Trade Commission Act, and any patent settlement agreement that we may enter into with any generic pharmaceutical company may be subject to similar challenges, which will be both expensive and time consuming and may render such settlement agreements unenforceable. In addition, legislation has been proposed by Congress that, if passed, would subject patent settlement agreements to further restrictions.

We also rely upon unpatented trade secrets and improvements, unpatented know-how and continuing technological innovation to develop and maintain our competitive position, which we seek to protect, in part, by confidentiality agreements with our collaborators, employees and consultants. We also have invention or patent assignment agreements with our employees and certain consultants. There can be no assurance that inventions relevant to us will not be developed by a person not bound by an invention assignment agreement with us. There can be no assurance that binding agreements will not be breached, that we would have adequate remedies for any breach, or that our trade secrets will not otherwise become known or be independently discovered by our competitors.

Litigation or other proceedings to enforce or defend intellectual property rights is often very complex in nature, expensive and time-consuming, may divert our management’s attention from our core business and may result in unfavorable results that could adversely impact our ability to prevent third parties from competing with us.

We are subject to uncertainty relating to healthcare reform measures, reimbursement policies and regulatory proposals which, if not favorable to Silenor or any other product that we commercialize, could hinder or prevent our commercial success.

Our ability to successfully commercialize Silenor and any other product to which we obtain rights will depend in part on the extent to which governmental authorities, private health insurers and other organizations establish appropriate coverage and reimbursement levels for the cost of our products and related treatments. Based on third party formulary data, we believe that 74% of patients in commercial health plans have coverage for Silenor.

The continuing efforts of the government, insurance companies, managed care organizations and other payors of healthcare services to contain or reduce costs of healthcare may adversely affect:

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the ability to obtain a price we believe is fair for our products;

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the ability to generate revenues and achieve or maintain profitability;

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the future revenues and profitability of our potential customers, suppliers and collaborators; and

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the availability of capital.

The U.S. Congress recently enacted legislation to reform the healthcare system. A major goal of the new healthcare reform law was to provide greater access to healthcare coverage for more Americans. Accordingly, the new healthcare reform law required individual U.S. citizens and legal residents to maintain qualifying health coverage, imposed certain requirements on employers with respect to offering health coverage to employees, amended insurance regulations regarding when coverage can be provided and denied to individuals, and expanded existing government healthcare coverage programs to more individuals in more situations. Among other things, the new healthcare reform law specifically:

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established annual, non-deductible fees on any entity that manufactures or imports certain branded prescription drugs, beginning in 2011;

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increased minimum Medicaid rebates owed by manufacturers under the Medicaid Drug Rebate Program, retroactive to January 1, 2010;

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redefined a number of terms used to determine Medicaid drug rebate liability, including average manufacturer price and retail community pharmacy, effective October 2010;

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extended manufacturers’ Medicaid rebate liability to covered drugs dispensed to individuals who are enrolled in Medicaid managed care organizations, effective March 2010;

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expanded eligibility criteria for Medicaid programs by, among other things, allowing states to offer Medicaid coverage to additional individuals beginning April 2010 and by adding new mandatory eligibility categories for certain individuals with income at or below 133 percent of the Federal Poverty Level beginning 2014, thereby potentially increasing manufacturers’ Medicaid rebate liability;

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established a new Patient-Centered Outcomes Research Institute to oversee, identify priorities in and conduct comparative clinical effectiveness research;

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required manufacturers to participate in a coverage gap discount program, under which they must agree to offer 50 percent point-of-sale discounts off negotiated prices of applicable brand drugs to eligible beneficiaries during their coverage gap period, as a condition for the manufacturer’s outpatient drugs to be covered under Medicare Part D, beginning 2011; and

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increased the number of entities eligible for discounts under the Public Health Service pharmaceutical pricing program, effective January 2010.

While this legislation will, over time, increase the number of patients who have insurance coverage for our products, it also is likely to adversely affect our results of operations. Some states are also considering legislation that would control the prices of drugs, and state Medicaid programs are increasingly requesting manufacturers to pay supplemental rebates and/or requiring prior authorization by the state program. It is likely that federal and state legislatures and health agencies will continue to focus on additional healthcare reform in the future.

As a result of these or other reform measures, we may determine to change our current manner of operation or change our contract arrangements, any of which could harm our ability to operate our business efficiently or on the scale we would like and our ability to raise capital. In addition, in certain foreign markets, the pricing of prescription drugs is subject to government control and reimbursement may in some cases be unavailable or insufficient.

Current healthcare reform measures and any future legislative proposals to reform healthcare or reduce government insurance programs may result in lower prices for Silenor and any other product that we commercialize or exclusion of Silenor or any such other product from coverage and reimbursement programs. Either of those could harm our ability to market our products and significantly reduce our revenues from the sale of our products.

Managed care organizations are increasingly challenging the prices charged for medical products and services and, in some cases, imposing restrictions on the coverage of particular drugs. 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. The process for obtaining coverage can be lengthy and costly, and we expect that it could take several months before a particular payor initially reviews our product and makes a decision with respect to coverage. For example, third-party payors may require cost-benefit analysis data from us in order to demonstrate the cost-effectiveness of any product we might bring to market. For any individual third-party payor, we may not be able to provide data sufficient to gain reimbursement on a similar or preferred basis to competitive products, or at all.

In addition, many insurers and other healthcare payment organizations encourage the use of less expensive alternative generic brands and OTC products through their prescription benefits coverage and reimbursement policies. The availability of generic prescription and OTC products for the treatment of insomnia has created, and will continue to create, a competitive reimbursement environment. Insurers and other healthcare payment organizations frequently make the generic or OTC alternatives more attractive to the patient by providing different amounts of reimbursement so that the net cost of the generic or OTC product to the patient is less than the net cost of a prescription branded product to the patient. Aggressive pricing policies by our generic or OTC product competitors and the prescription benefit policies of insurers could have a negative effect on our product revenues and profitability.

The competition among pharmaceutical companies to have their products approved for reimbursement also results in downward pricing pressure in the industry and in the markets where our products compete. In some cases, we may discount our products in order to obtain reimbursement coverage, and we may not be successful in any efforts we take to mitigate the effect of a decline in average selling prices for our products. Declines in our average selling prices would also reduce our gross margins.

In addition, once reimbursement at an agreed level is approved by a third-party payor, we may lose that reimbursement entirely. As reimbursement is often approved for a period of time, this risk is greater at the end of the time period, if any, for which the reimbursement was approved.

We may face additional challenges with regard to reimbursement which could affect our ability to successfully commercialize Silenor or any other product candidate that we commercialize, including:

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the variability of reimbursement rates likely to be caused by the use of miscellaneous drug codes and procedure codes may discourage physicians from providing Silenor or any other product candidate that we commercialize to certain or all patients depending on their insurance coverage;

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the initial use of “miscellaneous drug codes” for billing Silenor or any other product candidate that we commercialize until such time as specific drug codes are approved could result in slow and/or inaccurate reimbursement and thereby discourage product use;

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an increase in insurance plans that place more cost liability onto patients may limit patients’ willingness to pay for Silenor or any other product candidate that we commercialize and thereby discourage uptake; and

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unforeseen changes in federal health care policy guidelines may negatively impact a physician practice’s willingness to provide novel treatments.

If our products are not included within an adequate number of formularies or adequate reimbursement levels are not provided, or if those policies increasingly favor generic or OTC products, our overall business and financial condition would be adversely affected.

Further, there have been a number of legislative and regulatory proposals concerning reimportation of pharmaceutical products and safety matters. For example, in an attempt to protect against counterfeit drugs, the federal government and numerous states have enacted pedigree legislation. In particular, California has enacted legislation that requires development of an electronic pedigree to track and trace each prescription drug at the saleable unit level through the distribution system. California’s electronic pedigree requirement is scheduled to take effect beginning in January 2015. Compliance with California and future federal or state electronic pedigree requirements will likely require an increase in our operational expenses and will likely be administratively burdensome.

Even though Silenor received regulatory approval, it will still be subject to substantial ongoing regulation.

Even though U.S. regulatory approval has been obtained for Silenor, the FDA has imposed restrictions on its indicated uses or marketing and imposed ongoing requirements for post-approval studies or other activities. For example, the approved use of Silenor is limited to the treatment of insomnia characterized by sleep maintenance difficulty. In addition, the FDA has required us to implement a risk evaluation and mitigation strategy, or REMS, consisting of a medication guide. We are also required to complete a standard clinical trial assessing the safety and efficacy of Silenor in children aged 6 to 16 pursuant to the Pediatric Research Equity Act of 2003, or PREA, and to submit final results of this trial by March 2015. Any issues relating to these restrictions or requirements could have an adverse impact on our ability to achieve market acceptance of Silenor and generate revenues from its sale.

The FDA has also requested that all manufacturers of sedative-hypnotic drug products modify their product labeling to include stronger language concerning potential risks. These risks include severe allergic reactions and complex sleep-related behaviors, which may include sleep-driving. The FDA also recommended that the drug manufacturers conduct clinical studies to investigate the frequency with which sleep-driving and other complex behaviors occur in association with individual drug products. Our approved label for Silenor includes warnings relating to risks of complex sleep behaviors.

In addition, in August 2011 the FDA requested that we provide information about the pharmacokinetic and pharmacodynamic properties and adverse event profile of Silenor, including differences that might arise due to demographic factors, to enable the FDA to assess whether morning drug levels may remain high enough in some individuals or identifiable patient subgroups to impair driving to a degree that presents an unacceptable risk both to individuals and the public. The FDA’s request indicated that the same request was made to all sponsors of sedative hypnotic medications.

Silenor is also subject to ongoing FDA requirements for the labeling, packaging, storage, advertising, promotion, record-keeping and submission of safety and other post-market information. For example, the FDA may require modifications to our REMS for Silenor at a later date if warranted by new safety information. Any future requirements imposed by the FDA may require substantial expenditures.

In addition, all marketing activities associated with Silenor, as well as marketing activities related to any other products that we promote, are subject to numerous federal and state laws governing the marketing and promotion of pharmaceutical products. The FDA regulates post-approval promotional labeling and advertising to ensure that such activities conform to statutory and regulatory requirements. Such regulation and FDA review could require us to alter our marketing materials or strategy, incur additional costs or delay certain of our promotional activities.

In addition to FDA restrictions, the marketing of prescription drugs is subject to laws and regulations prohibiting fraud and abuse under government healthcare programs. For example, the federal health care 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 health care item or service reimbursable under Medicare, Medicaid or other federally financed health care programs. This statute has been interpreted to apply to arrangements between pharmaceutical manufacturers on the 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 or other regulatory sanctions, the exemptions and safe harbors are drawn narrowly, and practices that involve remuneration intended to induce prescribing, purchases or recommendations may be subject to scrutiny if they do not qualify for an exemption or safe harbor. 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 have a false claim paid. Recently, several pharmaceutical and other health care companies have been prosecuted under these laws for allegedly inflating drug prices they report to pricing services, which in turn are used by the government to set Medicare and Medicaid reimbursement rates, and for allegedly providing free product to customers with the expectation that the customers would bill federal programs for the product. In addition, certain marketing practices, including off-label promotion, may also violate false claims laws. 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, which apply regardless of the payor. If we fail to comply with applicable FDA regulations or other laws or regulations relating to the marketing of Silenor or any other product, we could be subject to criminal prosecution, civil penalties, seizure of products, injunction, or exclusion of such products from reimbursement under government programs, as well as other regulatory actions.

Approved products, manufacturers and manufacturers’ facilities are subject to continual review and periodic inspections. If a regulatory agency discovers previously unknown problems with a product, such as adverse events of unanticipated severity or frequency, or problems with the facility where the product is manufactured, a regulatory agency may impose restrictions on that product or on us, including requiring withdrawal of the product from the market.

The distribution of pharmaceuticals is also regulated by state regulatory agencies, including the requirement to obtain and maintain distribution permits or licenses in many states. Compliance with these requirements may require the expenditure of substantial resources and could impact the manner and scope of our distribution operations. If we fail to comply with applicable state regulations relating to the distribution of Silenor or any other product we market, we could be subject to criminal prosecution, civil penalties, seizure of products, injunctions, or other regulatory actions.

We have implemented a comprehensive compliance program and related infrastructure, but we cannot provide absolute assurance that we are or will be in compliance with all potentially applicable laws and regulations.

If our operations relating to Silenor fail to comply with applicable regulatory requirements, a regulatory agency may:

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issue warning letters or untitled letters;

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impose civil or criminal penalties, including fines;

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require that we change the way the product is administered, change the labeling of the product or implement a new or amended REMS;

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suspend regulatory approval;

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impose requirements to conduct additional clinical, non-clinical or other studies;

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suspend any ongoing clinical trials;

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refuse to approve pending applications or supplements to approved applications filed by us;

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impose restrictions on operations, including costly new manufacturing requirements; or

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seize or detain products or require a product recall.

We expect intense competition in the marketplace for Silenor and any other product to which we acquire rights, and new products may emerge that provide different and/or better therapeutic alternatives for the disorders that our products are intended to treat.

Silenor competes with well established drugs approved for the treatment of insomnia, including Lunesta, marketed by Sunovion Pharmaceuticals Inc., a wholly-owned subsidiary of Dainippon Sumitomo Pharma Co., Ltd., and the branded and generic versions of Sanofi-Synthélabo, Inc.’s Ambien and Ambien CR and Pfizer Inc.’s Sonata, all of which are GABA-receptor agonists, and Takeda Pharmaceuticals North America, Inc.’s Rozerem, a melatonin receptor antagonist.

A number of companies are marketing reformulated versions of previously approved GABA-receptor agonists. For example, Meda AB and Orexo AB launched Edluar, formerly known as Sublinox, a sublingual tablet formulation of zolpidem in the third quarter of 2009. ECR Pharmaceuticals Company, Inc., a wholly owned subsidiary of Hi-Tech Pharmacal Co., Inc., launched NovaDel Pharma, Inc.’s ZolpiMist, an oral mist formulation of zolpidem, in the United States in February 2011.

In addition to the currently approved products for the treatment of insomnia, a number of new products may enter the insomnia market over the next several years. Transcept Pharmaceuticals, Inc. resubmitted an NDA for Intermezzo, a low-dose sublingual tablet formulation of zolpidem in September 2011, and announced that the Prescription Drug User Fee Act action date for its NDA is November 27, 2011. Transcept and Purdue Pharmaceutical Products L.P. have entered into an exclusive license and collaboration agreement to commercialize Intermezzo in the United States. It has been reported that Neurim Pharmaceuticals Ltd. is seeking FDA approval of Circadin, a prescription form of melatonin that is already approved in the EU and several other countries. Neurim also announced positive results from Phase 1 and 1b clinical trials for Neu-P11, a melatonin and serotonin agonist for the treatment of insomnia associated with pain.

Alexza Pharmaceuticals, Inc. has announced positive results from a Phase 1 clinical trial of an inhaled formulation of zaleplon, the API in Sonata. In July 2010, Alexza announced that it was advancing this product candidate into Phase 2 clinical trials during the first half of 2011 for the treatment of insomnia in patients who have difficulty falling asleep, including those patients who awake in the middle of the night and have difficulty falling back asleep, but has not yet done so. Somnus Therapeutics, Inc. has announced positive results from two Phase 1 clinical trials of a delayed-release formulation of zaleplon and has initiated Phase 2 clinical trials of that product candidate.

Vanda Pharmaceuticals Inc. has completed two Phase 3 clinical trials of tasimelteon, a melatonin receptor agonist. Tasimelteon received orphan drug designation status for non-24 hour sleep/wake disorder in blind individuals with no light perception. Vanda has initiated Phase 3 clinical trials for tasimelteon to treat this disorder and plans to file an NDA with the FDA in the first half of 2013.

Merck & Co., Inc. has suvorexant, an orexin antagonist, in Phase 3 clinical trials for the treatment of insomnia and MK-6096 and MK-3697 in Phase 2 clinical trials for the treatment of insomnia. Merck has announced that it plans to file regulatory applications for suvorexant in 2012.

Several other companies, including Sunovion Pharmaceuticals, are evaluating 5HT2 antagonists as potential hypnotics, and Eli Lilly and Company is evaluating a potential hypnotic that is a dual histamine/5HT2 antagonist. Additionally, several other companies are evaluating new formulations of existing compounds and other compounds for the treatment of insomnia.

Furthermore, generic versions of Ambien, Ambien CR and Sonata have been launched and are priced significantly lower than approved, branded insomnia products. Some managed health care plans require that patients try generic versions of these branded insomnia products before the patient can be reimbursed for Silenor. Sales of all of these drugs may reduce the available market for, and could put downward pressure on, the price we are able to charge for Silenor, which could ultimately limit our ability to generate significant revenues.

The active ingredient of Silenor is doxepin, which has been used at higher doses for over 40 years for the treatment of depression and anxiety. Doxepin is available generically in strengths as low as 10 mg in capsule form, as well as in a concentrated liquid form dispensed by a marked dropper and calibrated for 5 mg. Some physicians are prescribing generic 10 mg doxepin capsules and generic oral solution doxepin for insomnia off-label for insomnia. In addition, some managed health care plans are requiring the substitution of these generic doxepin products for Silenor, and some pharmacies are suggesting such substitution. Such off label uses of generic doxepin may reduce the sales of Silenor and may put a downward pressure on the price we are able to charge for Silenor, which could ultimately limit our ability to generate significant revenues.

Upon the expiration of, or successful challenge to, our patents covering Silenor, generic competitors may introduce a generic version of Silenor at a lower price. Some generic manufacturers have also demonstrated a willingness to launch generic versions of branded products before the final resolution of related patent litigation, known as an “at-risk launch”. A launch of a generic version of Silenor could have a material adverse effect on our business and we could suffer a significant loss of sales and market share in a short period of time.

We have received notices from Actavis, Mylan, Par, and Zydus that each has filed with the FDA an ANDA for a generic version of Silenor 3 mg and 6 mg tablets. The notices included paragraph IV certifications with respect to eight of the nine patents listed in the Orange Book for Silenor.

We, together with ProCom, have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus. The lawsuits allege that each of Actavis, Mylan, Par and Zydus have infringed the ’229 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

In addition, we have filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that such parties have infringed the ’307 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

Pursuant to the provisions of the Hatch-Waxman Act, FDA final approval of the Actavis and Mylan ANDAs can occur no earlier than May 3, 2013, FDA final approval of the Par ANDA can occur no earlier than June 23, 2013 and FDA final approval of the Zydus ANDA can occur no earlier than November 13, 2013, unless in each case there is an earlier court decision that the ’229 patent and the ’307 patent are not infringed and/or invalid or unless any party to the action is found to have failed to cooperate reasonably to expedite the infringement action. We do not know when there will be a court decision on the merits in any of these cases. At this time, the other patents included in the Orange Book have not been asserted against these parties.

We intend to vigorously enforce our intellectual property rights relating to Silenor, but we cannot predict the outcome of these matters. Any adverse outcome in this litigation could result in one or more generic versions of Silenor being launched before the expiration of the listed patents, which could adversely affect our ability to successfully execute our business strategy to increase sales of Silenor and would negatively impact our financial condition and results of operations, including causing a significant decrease in our revenues and cash flows.

The biotechnology and pharmaceutical industries are subject to rapid and intense technological change. We face, and will continue to face, competition in the development and marketing of Silenor or any other product candidate to which we acquire rights from academic institutions, government agencies, research institutions and biotechnology and pharmaceutical companies. There can be no assurance that developments by others, including the development of other drug technologies and methods of preventing the incidence of disease, will not render Silenor or any other product candidate that we develop obsolete or noncompetitive.

Compared to us, many of our potential competitors have substantially greater:

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capital resources;

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manufacturing, distribution and sales and marketing resources and experience;

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research and development resources, including personnel and technology;

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regulatory experience;

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experience conducting non-clinical studies and clinical trials, and related resources; and

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expertise in prosecution of intellectual property rights.

As a result of these factors, our competitors may develop drugs that are more effective and less costly than ours and may be more successful than we are in manufacturing, marketing and selling their products. Our competitors may also obtain patent protection or other intellectual property rights or seek to invalidate or otherwise challenge our intellectual property rights, limiting our ability to successfully commercialize products.

In addition, manufacturing efficiency and selling and marketing capabilities are likely to be significant competitive factors. We currently have no commercial manufacturing capability and more limited sales and marketing infrastructure than many of our competitors and potential competitors.

If the manufacturers upon whom we rely fail to produce our products in the volumes that we require on a timely basis, or to comply with stringent regulations applicable to pharmaceutical drug manufacturers, we may face delays in the development and commercialization of, or be unable to meet demand for, our products and may lose potential revenues.

We do not manufacture Silenor, and we do not plan to develop any capacity to do so. We have a contract with Patheon Pharmaceuticals Inc. to manufacture our future required clinical supplies, if any, of Silenor, and we have entered into a manufacturing and supply agreement with Patheon to manufacture our commercial supply of Silenor. We have also entered into agreements with Plantex USA, Inc. to manufacture our supply of doxepin active pharmaceutical ingredient and with Anderson Packaging, Inc. to package Silenor finished products.

In addition, in October 2006, we entered into a supply agreement with JRS Pharma L.P., or JRS, under which we purchase from JRS all of our requirements for ProSolv^®HD90, an ingredient used in our formulation for Silenor. In August 2008, we amended our supply agreement to provide us with the exclusive right to use this ingredient and any successor product to ProSolv^®HD90 in combination with doxepin, as well as the right to list the U.S. patents owned by JRS and covering ProSolv^®HD90 in the Orange Book relating to Silenor. JRS also agreed to enforce any such patents listed in the Orange Book on our behalf. The term of the agreement runs through January 1, 2013, but it will be automatically extended for additional one year periods unless we terminate the license upon written notice at least 90 days prior to the end of the term. Either party may terminate the agreement upon written notice to the other party if the other party commits a material breach of its obligations and fails to remedy the breach within 30 days, or upon the filing of bankruptcy, reorganization, liquidation, or receivership proceedings relating to the other party. We also have the right to terminate the agreement if JRS no longer has any valid patent claim in the U.S. covering ProSolv^®HD90 or any successor product to ProSolv^®HD90 used by us in combination with doxepin. Each of the current patents listed in the Orange Book by us relating to Silenor expires in 2015.

As part of the amendment, we made an upfront license payment of $0.2 million and are obligated to pay a royalty of less than 1% on net sales of Silenor beginning as of the expiration of the statutory exclusivity period for Silenor in each country in which a Silenor formulation containing ProSolv^®HD90 or any successor product to ProSolv^®HD90 is marketed, which with respect to U.S. sales of Silenor we expect to occur in March 2013. This royalty is only payable if one or more patents under the license agreement continues to be valid in each such country and a patent relating to our formulation for Silenor has not issued in such country.

The manufacture of pharmaceutical products requires significant expertise and capital investment, including the development of advanced manufacturing techniques and process controls. Manufacturers of pharmaceutical products often encounter difficulties in production, particularly in scaling up and validating initial production. These problems include difficulties with production costs and yields, quality control, including stability of the product and quality assurance testing, shortages of qualified personnel, as well as compliance with strictly enforced federal, state and foreign regulations. Our manufacturers may not perform as agreed or may terminate their agreements with us. Additionally, our manufacturers may experience manufacturing difficulties due to resource constraints or as a result of labor disputes or unstable political environments. If our manufacturers were to encounter any of these difficulties, or otherwise fail to comply with their contractual obligations, our ability to sell Silenor or any other product candidate that we commercialize or provide any product candidates to patients in our clinical trials would be jeopardized. Any delay or interruption in the supply of clinical trial supplies could delay the completion of our clinical trials, increase the costs associated with maintaining our clinical trial program and, depending upon the period of delay, require us to commence new clinical trials at significant additional expense or terminate the clinical trials completely. In addition, any delay or interruption in our ability to meet commercial demand for Silenor will result in the loss of potential revenues.

In addition, all manufacturers of pharmaceutical products must comply with current good manufacturing practice, or cGMP, requirements enforced by the FDA through its facilities inspection program. The FDA is also likely to conduct inspections of our manufacturers’ facilities as part of their review of any marketing applications we submit. These cGMP requirements include quality control, quality assurance and the maintenance of records and documentation. Manufacturers of our products may be unable to comply with these cGMP requirements and with other FDA, state and foreign regulatory requirements. A failure to comply with these requirements may result in fines and civil penalties, suspension of production, suspension or delay in product approval, product seizure or recall, or withdrawal of product approval. If the safety of any quantities supplied is compromised due to our manufacturers’ failure to adhere to applicable laws or for other reasons, we may not be able to obtain regulatory approval for or successfully commercialize our products.

Moreover, our manufacturers and suppliers may experience difficulties related to their overall businesses and financial stability, which could result in delays or interruptions of our supply of Silenor. We do not have alternate manufacturing plans in place at this time. If we need to change to other manufacturers, the FDA and comparable foreign regulators must approve these manufacturers’ facilities and processes prior to our use, which would require new testing and compliance inspections, and the new manufacturers would have to be educated in or independently develop the processes necessary for production.

Any of these factors could adversely affect the commercial activities for Silenor or suspend clinical trials, regulatory submissions, and required approvals for any other product candidate that we develop, or entail higher costs or result in our being unable to effectively commercialize our products. Furthermore, if our manufacturers failed to deliver the required commercial quantities of raw materials, including bulk drug substance, or finished product on a timely basis and at commercially reasonable prices, we would likely be unable to meet demand for our products and we would lose potential revenues.

We, Paladin or any other future licensee may never receive approval or commercialize our products outside of the United States, or our or their activities may not be effective or in compliance with applicable laws.

We have licensed to Paladin the rights to commercialize Silenor in Canada, South America, the Caribbean and Africa. Silenor has not been approved for marketing in any jurisdiction outside of the United States. Paladin will be responsible for regulatory submissions for Silenor in the licensed territories and will have the exclusive right to commercialize Silenor in the licensed territories. We believe that Paladin intends to make a New Drug Submission filing in Canada in the fourth quarter of 2011. We may license rights to Silenor or other future products to others for territories outside the United States in the future.

Compared to a development and commercialization strategy for an ex-U.S. product that involves a third-party collaborator, the development and commercialization of such a product by us without a collaborator is likely to require substantially greater resources on our part and potentially adversely impact the timing and results of the development or commercialization of the product.

In order to market any products outside of the United States, we or our licensees must establish and comply with numerous and varying regulatory requirements regarding safety and efficacy. Approval procedures vary among countries and can involve additional product testing and additional administrative review periods. Any additional clinical studies that may be required to be conducted as part of the regulatory approval process may not corroborate the results of the clinical studies we have previously conducted or may have adverse results or effects on our ability to maintain regulatory approvals in the United States or obtain them in other countries. The time required to obtain approval might differ from that required to obtain FDA approval for Silenor.

The regulatory approval process in other countries may include all of the risks regarding FDA approval in the U.S. as well as other risks. Regulatory approval in one country does not ensure regulatory approval in another, but a failure or delay in obtaining regulatory approval in one country may have a negative effect on the regulatory process in others. Failure to obtain regulatory approval in other countries or any delay or setback in obtaining such approval could limit the uses of the product candidate and have an adverse effect on potential royalties and product sales. Such approval may be subject to limitations on the indicated uses for which the product may be marketed or require costly, post-marketing follow-up studies.

In addition, any revenues we receive from sales of Silenor outside the United States will likely depend upon the efforts of Paladin or any other future licensees, as applicable, which in many instances will not be within our control. If we are unable to maintain our license agreements or to effectively establish alternative arrangements to market such products, or if Paladin or any future licensees do not perform adequately under such agreements or arrangements or comply with applicable laws, our business could be adversely affected and we could be subject to regulatory sanctions.

We or any collaborator may not be successful in developing, receiving approval for or commercializing an OTC product for Silenor.

In October 2011, we notified P&G that we were beginning P&G’s 45-day evaluation period relating to an OTC pharmaceutical product containing doxepin. Pursuant to the surviving provisions of our co-promotion agreement with P&G, P&G has until November 25, 2011 to notify us of its interest in negotiating to obtain such product rights. If P&G so notifies us, P&G will have the exclusive right to negotiate with us relating to such rights for 120 days from our receipt of the notice, or such longer period as may be mutually agreed by us and P&G. We cannot assure you that P&G will elect to negotiate with us with respect to OTC rights, that if P&G does not so elect that we will find another suitable third party interested in such rights, or that any such negotiations with P&G or another third party will result in a completed transaction or that such a transaction will be successful or on attractive terms. If we are unable to establish an OTC collaboration, we will require substantial additional funds, which may not be available, in order to develop and commercialize the product on our own.

Even if we are successful in establishing a collaboration with P&G or another third party for an OTC product, we or such third party must establish and comply with numerous and varying regulatory requirements regarding safety and efficacy of OTC products prior to selling the product, and we cannot give any assurance that any such OTC product will receive applicable regulatory approval or be successfully commercialized.

Silenor or any other product candidate that we develop may cause undesirable side effects or have other properties that could delay or prevent their regulatory approval or commercialization.

Undesirable side effects caused by Silenor or any other product candidate that we develop could interrupt, delay or halt clinical trials, result in the denial or suspension of regulatory approval by the FDA or other regulatory authorities for any or all targeted indications, or cause us to evaluate the future of our development programs. Any of these occurrences could delay or prevent us from continuing to sell Silenor or from commercializing any product candidate that we develop. In addition, the FDA may require, or we may undertake, additional clinical trials to support the safety profile of Silenor or any proposed changes to the labeling for Silenor.

Silenor will be subject to continual review by the FDA, and we cannot assure you that newly discovered or developed safety issues will not arise. For example, in August 2011 the FDA requested that we provide information about the pharmacokinetic and pharmacodynamic properties and adverse event profile of Silenor, including differences that might arise due to demographic factors, to enable the FDA to assess whether morning drug levels may remain high enough in some individuals or identifiable patient subgroups to impair driving to a degree that presents an unacceptable risk both to individuals and the public. The FDA’s request indicated that the same request was made to all sponsors of sedative hypnotic medications.

With the use of any marketed drug by a wide patient population, serious adverse events may occur from time to time that initially do not appear to relate to the drug itself, and only if the specific event occurs with some regularity over a period of time does the drug become suspect as having a causal relationship to the adverse event. Any safety issues could cause us to suspend or cease marketing of our approved products, cause us to modify how we market our approved products, subject us to substantial liabilities, and adversely affect our revenues and financial condition.

In addition, if we or others identify undesirable side effects caused by Silenor or any other product candidate that we commercialize:

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regulatory authorities may require the addition of labeling statements, such as a “black box” warning or a contraindication;

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regulatory authorities may withdraw their approval of the product or place restrictions on the way it is prescribed;

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we may be required to change the way the product is administered, conduct additional clinical trials, change the labeling of the product or implement a new or amended REMS;

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we may be subject to related liability; and

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our reputation may suffer.

Any of these events could prevent us from achieving or maintaining market acceptance of the affected product or could substantially increase the costs and expenses of commercializing the affected product, which in turn could delay or prevent us from generating significant revenues from its sale.

Risks Related to Our Finances and Capital Requirements

Capital raising activities, such as issuing securities, incurring debt, assigning receivables or royalty rights or entering into collaborations or other strategic transactions, may cause dilution to existing stockholders or a reduction in our stock price, restrict our operations or require us to relinquish proprietary rights and may be limited by applicable laws and regulations.

Based on our recurring losses, negative cash flows from operations and working capital levels, we will need to raise substantial additional funds. If we are unable to maintain sufficient financial resources, including by raising additional funds when needed, our business, financial condition and results of operations will be materially and adversely affected.

Because we will need to raise additional capital to fund our business, among other things, we may conduct substantial equity offerings. For example, in August 2011 we entered into the sales agreement with Citadel pursuant to which we agreed to sell, at our option, up to an aggregate of $30.0 million in shares of our common stock through Citadel, as sales agent. Sales of the common stock made pursuant to the sales agreement, if any, will be made on the NASDAQ Stock Market under our currently-effective Registration Statements on Form S-3 by means of ordinary brokers’ transactions at then-prevailing market prices. Additionally, under the terms of the sales agreement, we may also sell shares of our common stock through Citadel, on the NASDAQ Stock Market or otherwise, at negotiated prices or at prices related to the prevailing market price. However, there can be no assurance that Citadel will be successful in consummating such sales based on prevailing market conditions or in the quantities or at the prices that we deem appropriate. Citadel or we are permitted to terminate the sales agreement at any time. Sales of shares pursuant to the sales agreement will have a dilutive effective on the holdings of our existing stockholders, and may result in downward pressure on the price of our common stock. Including the amount remaining available for sale pursuant to the sales agreement with Citadel, we may offer from time to time up to an aggregate of approximately $66.2 million in any combination of debt securities, common and preferred stock and warrants under our two effective shelf registration statements on Form S-3 filed with the SEC.

To the extent that we raise any required additional capital by issuing equity securities, our existing stockholders’ ownership will be diluted. Any such dilution of the holdings of our current stockholders may result in downward pressure on the price of our common stock.

Any debt, receivables or royalty financing we enter into may involve covenants that restrict our operations or conditions that require repayment. For example, under our new loan agreement with the Lenders, we will be required to repay the entire outstanding principal balance if a generic version of Silenor enters the market while the loan is outstanding. In addition, we are subject to certain affirmative and negative covenants, including limitations on our ability to: undergo certain change of control events; convey, sell, lease, license, transfer or otherwise dispose of assets, other than in certain specified circumstances; create, incur, assume, guarantee or be liable with respect to certain indebtedness; grant liens; pay dividends and make certain other restricted payments; and make certain investments. In addition, under the loan agreement, we are required to maintain with SVB our primary cash and investment accounts, which accounts are also covered by control agreements for the benefit of the Lenders. To secure our performance of our obligations under the Loan Agreement, we pledged substantially all of our assets other than intellectual property assets to the Lenders and agreed to maintain certain minimum cash and investment balances. We also agreed not to pledge our intellectual property assets to others, subject to specified exceptions. Our failure to comply with the covenants in the loan agreement could result in an event of default that, if not cured or waived, could result in the acceleration of all or a substantial portion of our debt. We believe we have currently met all of our obligations under the loan agreement.

Equity financing, debt financing, receivables assignments, royalty interest assignments and other types of financing are often coupled with an additional equity component, such as warrants to purchase stock. For example, in connection with our August 2011 loan agreement with the Lenders, we issued to the Lenders warrants to purchase up to 583,152 shares of our common stock with an exercise price of $1.5433 per share. To the extent that any of these warrants, or any additional warrants that are outstanding or that we may issue in the future, are exercised by their holders, dilution of our existing stockholders’ ownership interests will result.

If we raise additional funds through collaborations or other strategic transactions, it may be necessary to relinquish potentially valuable rights to our potential products or proprietary technologies, or grant licenses on terms that are not favorable to us.

In addition, rules and regulations of the SEC or other regulatory agencies may restrict our ability to conduct certain types of financing activities, or may affect the timing of and the amounts we can raise by undertaking such activities. For example, under current SEC regulations, if the aggregate market value of our common stock held by non-affiliates, or our public float, is less than $75 million, the amount that we can raise through primary public offerings of securities in any twelve-month period using one or more registration statements on Form S-3 may be limited to an aggregate of one-third of our public float.

We may not be able to sell shares of our common stock under our equity sales agreement with Citadel at times, prices or quantities that we desire and if such sales do occur, they may result in dilution to our existing stockholders.

In August 2011, we entered into the sales agreement with Citadel. Under the terms of the sales agreement, Citadel will use its commercially reasonable efforts to sell shares of our common stock designated by us. However, there can be no assurance that Citadel will be successful in consummating such sales based on prevailing market conditions or in the quantities or at the prices that we deem appropriate. In addition, we will not be able to make sales of our common stock pursuant to the sales agreement unless certain conditions are met, which include the accuracy of representations and warranties made to Citadel under the sales agreement; compliance with laws; and the continued listing of our stock on the Nasdaq Capital Market. In addition, Citadel is permitted to terminate the sales agreement at any time. If we are unable to access funds through sales under the sales agreement, or it is terminated by Citadel, we may be unable to access capital on favorable terms or at all.

Should we sell shares pursuant to the sales agreement, it will have a dilutive effective on the holdings of our existing stockholders, and may result in downward pressure on the price of our common stock. If we sell shares under the sales agreement at a time when our share price is decreasing, we will need to issue more shares to raise the same amount than if our stock price was higher. Issuances in the face of a declining share price will have an even greater dilutive effect than if our share price were stable or increasing, and may further decrease our share price. During the three months ended September 30, 2011, we sold an aggregate of 786,825 shares of our common stock and received gross proceeds of $0.8 million, and paid $0.3 million of legal and accounting fees associated with the execution of the sales agreement and commissions.

Our indebtedness under our loan agreement could adversely affect our financial health.

Under our loan agreement with the Lenders, we have incurred $15.0 million of indebtedness. We are obligated to pay interest on the loan through December 31, 2011, and to thereafter pay the principal balance of the loan and interest in 24 equal monthly installments starting on January 1, 2012 and continuing through December 31, 2013. Such indebtedness could have important consequences to our business. For example, it could:

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

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increase our vulnerability to general adverse economic and industry conditions;

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

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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;

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

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

Covenants in our loan agreement with the Lenders may limit our ability to operate our business.

Under the loan agreement with the Lenders, we are required to maintain with SVB our primary cash and investment accounts, which accounts are also covered by control agreements for the benefit of the Lenders. We are also subject to certain affirmative covenants, including but not limited to the obligations to maintain good standing, provide various notices to the Lenders, deliver financial statements to the Lenders, maintain adequate insurance, promptly discharge all taxes, protect our intellectual property and protect the collateral. We are also subject to certain negative covenants customary for loans of this type, including but not limited to prohibitions against certain mergers and consolidations, certain management and ownership changes constituting a “change of control,” and the imposition of additional liens on collateral or other of our assets, as well as prohibitions against additional indebtedness, certain dispositions of property, changes in our business, name or location, payment of dividends, prepayment of certain other indebtedness, certain investments or acquisitions, and certain transactions with affiliates, in each case subject to certain customary exceptions, including exceptions that allow us to enter into non-exclusive and/or exclusive licenses and similar agreements providing for the use of our intellectual property in collaboration with third parties provided certain conditions are met. It is also an event of default if we experience a material impairment in the value of the collateral or in the perfection or priority of the Lenders’ security interest in the collateral, a material adverse change in our business, operations, or condition, or a material impairment of the prospect of repayment the loan.

Our future ability to comply with the covenants and other obligations in the loan agreement may be affected by events beyond our control, including prevailing economic, financial, and industry conditions. If we default under the loan agreement because of a covenant breach or otherwise, any 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.

We have never been profitable and we may not be able to generate revenues sufficient to achieve profitability.

We only began generating revenues from the commercialization of Silenor late in the third quarter of 2010, we have not been profitable since inception, and it is possible that we will not achieve profitability. We incurred net losses of $49.0 million for the nine months ended September 30, 2011, and have accumulated losses totaling $265.8 million since inception. We expect to continue to incur significant operating losses and capital expenditures. As a result, we will need to generate significant revenues to achieve and maintain profitability. We cannot assure you that we will achieve significant revenues, or that we will ever achieve profitability. Even if we do achieve profitability, we cannot assure you that we will be able to sustain or increase profitability on a quarterly or annual basis in the future. If revenues grow more slowly than we anticipate or if operating expenses exceed our expectations or cannot be adjusted accordingly, our business, results of operations and financial condition will be materially and adversely affected. If we are unable to maintain sufficient financial resources, including by raising additional funds when needed, our business, financial condition and results of operations will be materially and adversely affected and we may be unable to continue as a going concern. If we are unable to continue as a going concern, it is likely that investors will lose all or a part of their investment.

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

Our results of operations and liquidity could be materially negatively affected by economic conditions generally, both in the United States and elsewhere around the world. Domestic and international equity and debt markets have experienced and may continue to experience heightened volatility and turmoil based on domestic and international economic conditions and concerns. In the event these economic conditions and concerns continue or worsen and the markets continue to remain volatile, our results of operations and liquidity could be adversely affected by those factors in many ways, including making it more difficult for us to raise funds if necessary, and our stock price may decline. In addition, our investment securities consist primarily of money market funds and corporate and United States government agency notes. While we do not believe that our investment securities have significant risk of default or illiquidity, we cannot provide absolute assurance that our investments are not subject to adverse changes in market value. If economic instability continues and the credit ratings of the security issuers deteriorate and any decline in market value is determined to be other-than-temporary, we would be required to adjust the carrying value of the investments through impairment charges. We also maintain significant amounts of cash and cash equivalents at one or more financial institutions that are not federally insured, and we cannot provide assurance that we will not experience losses on these investments.

Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds

Not applicable.

Item 3.		Defaults Upon Senior Securities

Not applicable.

Item 4.		(Removed and Reserved)

Item 5.		Other Information

Amendment to Employment Agreement with Michael D. Allen

On November 1, 2011, we amended the employment agreement with Michael D. Allen, our Senior Vice President, Sales and Marketing, to amend certain severance benefits in the event his employment is terminated by us for disability or other than for cause or if Mr. Allen resigns with good reason.

In the event Mr. Allen’s employment is terminated as a result of his disability, he will now receive any accrued but unpaid base salary or unused paid time-off as of the date of termination, an amount equal to the greater of (i) half of his then-current annual base salary or (ii) his base salary for the 12-month period immediately prior to such termination, and, in the discretion of our Board of Directors, a pro-rated bonus for the year in which the termination occurs.

In the event Mr. Allen’s employment is terminated by us other than for cause of if Mr. Allen resigns with good reason, Mr. Allen will now receive any accrued but unpaid base salary or unused paid time-off as of the date of termination or resignation, an amount equal to the greater of (i) half of his then-current annual base salary or (ii) his base salary for the 12-month period immediately prior to such termination or resignation, 12 months of health care benefits continuation at Somaxon’s expense, 12 months of the portion of the monthly premiums for Mr. Allen’s life insurance and disability insurance coverage that are borne by Somaxon and, in the discretion of the Board, a pro-rated bonus for the year in which the termination or resignation occurs. In addition, that portion of Mr. Allen’s stock awards which would have vested if Mr. Allen had remained employed for an additional 12 months will immediately vest on the date of such termination or resignation, and he will be entitled to exercise such stock awards for 180 days following the date of termination or resignation.

Amendment to Professional Detailing Services Agreement with Publicis Touchpoint Solutions, Inc.

On November 1, 2011, we entered into an amendment to Supplement No. 1 the Professional Detailing Services Agreement between us and Publicis dated February 7, 2011. The only material change to the previous Supplement One filed as Exhibit 10.01 to the Current Report on Form 8-K/A on February 11, 2011 is the termination of all but those that will be hired as Somaxon employees from the Publicis sales force as of November 2, 2011 and the pricing adjustments related thereto.

The amendment to the Employment Agreement and the amendment to the Supplement, which are filed as Exhibits 10.5 and 10.8 respectively to this Form 10-Q, are incorporated herein by reference. The foregoing descriptions of the amendment to the Employment Agreement and the amendment to the Supplement do not purport to be complete and are qualified in their entirety by reference to such exhibits.

Reduction in Force

On November 2, 2011, we committed to a plan of termination that resulted in a work force reduction of 14 employees in order to reduce operating costs. We commenced notification of employees affected by the workforce reduction on November 2, 2011, and the workforce reduction is expected to be completed by November 4, 2011. Each affected employee will be eligible to receive a severance payment equivalent to two months of their base salary and the amount of the benefits paid by us for the previous two months. Payment of these severance benefits to each affected employee is contingent on the affected employee entering into a separation agreement with us, which agreement includes a general release of claims against us. The severance payments are expected to be approximately $0.5 million in the aggregate.

Item 6.		Exhibits

EXHIBIT INDEX

Exhibit
Number				Description
	3.1	(1)		Amended and Restated Certificate of Incorporation of the Registrant
	3.2	(2)		Amended and Restated Bylaws of the Registrant
	4.1	(3)		Form of the Registrant’s Common Stock Certificate
	4.2	(4)		Amended and Restated Investor Rights Agreement dated June 2, 2005
	4.3	(5)		Warrant dated May 21, 2008 issued to Silicon Valley Bank
	4.4	(5)		Warrant dated May 21, 2008 issued to Oxford Finance Corporation
	4.5	(5)		Warrant dated May 21, 2008 issued to Kingsbridge Capital Limited
	4.6	(6)		Form of Warrant dated July 2, 2009 issued to certain Purchasers under the Securities Purchase Agreement dated July 2, 2009
	4.7	(7)		Warrant dated August 2, 2011 issued to Silicon Valley Bank
	4.8	(7)		Warrant dated August 2, 2011 issued to Oxford Finance LLC
	4.9	(7)		Warrant dated August 2, 2011 issued to Oxford Finance LLC
	10.1	(7)		At-the-Market Equity Offering Sales Agreement between Registrant and Citadel Securities LLC dated August 1, 2011
	10.2	(7)		Loan and Security Agreement between Registrant, Oxford Finance LLC, as collateral agent, and Silicon Valley Bank and Oxford Finance LLC, as lenders, dated as of August 2, 2011
	10.3	(8)		Letter Agreement, dated September 30, 2011, between Registrant and The Procter & Gamble Distributing Company LLC, amending the Co-Promotion Agreement between Registrant and The Procter & Gamble Distributing Company, LLC dated August 24, 2010
	10.4	#(8)		Employment Agreement dated September 30, 2011, between Registrant and Michael D. Allen.
	10.5	#		Amendment dated November 1, 2011 to Employment Agreement between Registrant and Michael D. Allen
	10.6	†		First Amendment to Supplement No. 1 to the Professional Detailing Services Agreement between Registrant and Publicis Touchpoint Solutions, Inc. dated March 22, 2011
	10.7	†		Second Amendment to Supplement No. 1 to the Professional Detailing Services Agreement between Registrant and Publicis Touchpoint Solutions, Inc. dated August 15, 2011
	10.8	†		Third Amendment to Supplement No. 1 to the Professional Detailing Services Agreement between Registrant and Publicis Touchpoint Solutions, Inc. dated November 1, 2011
	31.1			Certification of chief executive officer pursuant to Rule 13a-14 and Rule 15d-14 of the Securities Exchange Act of 1934, as amended
	31.2			Certification of chief financial officer pursuant to Rule 13a-14 and Rule 15d-14 of the Securities Exchange Act of 1934, as amended
	32.1	*		Certification of chief executive officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
	32.2	*		Certification of chief financial officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002