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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

(Mark One)

 

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

For the quarterly period ended March 31, 2012

or

 

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

Commission file number: 001-33438

NEUROGESX, INC.

(Exact name of registrant as specified in its charter)

 

Delaware		94-3307935
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)
2215 Bridgepointe Parkway, Suite 200 San Mateo, California		94404
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (650) 358-3300

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

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  x    No  ¨

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 definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

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

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

The number of shares of common stock, $0.001 par value, outstanding as of May 8, 2012 was 33,189,871.

 

 

 

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NEUROGESX, INC.

TABLE OF CONTENTS FOR FORM 10-Q

FOR THE QUARTER ENDED MARCH 31, 2012

 

		Page
PART I. FINANCIAL INFORMATION			1
Item 1. Financial Statements (unaudited)			1
Condensed Consolidated Balance Sheets as of March 31, 2012 and December 31, 2011			1
Condensed Consolidated Statements of Operations for the three months ended March 31, 2012 and 2011			2
Condensed Consolidated Statements of Comprehensive Loss for the three months ended March  31, 2012 and 2011			3
Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2012 and 2011			4
Notes to Condensed Consolidated Financial Statements			5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			19
Item 3. Quantitative and Qualitative Disclosures About Market Risk			31
Item 4. Controls and Procedures			31
PART II. OTHER INFORMATION			32
Item 1. Legal Proceedings			32
Item 1A. Risk Factors			32
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			48
Item 3. Defaults Upon Senior Securities			48
Item 4. Mine Safety Disclosures			48
Item 5. Other Information			48
Item 6. Exhibits			49
SIGNATURES			51
EXHIBIT INDEX			52

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PART I. FINANCIAL INFORMATION

 

ITEM 1.

FINANCIAL STATEMENTS

NeurogesX, Inc.

Condensed Consolidated Balance Sheets

(in thousands)

 

		March 31, 2012				December 31, 2011
		(unaudited)				Note 1
Assets
Current assets:
Cash and cash equivalents		$	7,720			$	9,148
Short-term investments			19,678				25,161
Trade receivables			1,154				1,166
Receivable from collaboration partner			43				502
Inventories			46				654
Prepaid expenses and other current assets			890				1,364
Restricted cash			160				160
Total current assets			29,691				38,155
Property and equipment, net			386				547
Restricted cash			252				251
Other assets			257				274
Total assets		$	30,586			$	39,227
Liabilities and Stockholders’ Deficit
Current liabilities:
Accounts payable		$	915			$	1,321
Accrued compensation			1,499				2,084
Accrued research and development			248				282
Other accrued expenses			1,619				2,245
Deferred product revenue, net			1,065				1,075
Deferred collaboration revenue			7,242				7,261
Long-term obligations—current portion			6,740				4,829
Total current liabilities			19,328				19,097
Non-current liabilities:
Deferred collaboration revenue			23,312				25,098
Other long-term liabilities			133				146
Long-term obligations, net of current portion			63,263				62,746
Total non-current liabilities			86,708				87,990
Commitments and contingencies
Stockholders’ deficit:
Common stock			33				30
Additional paid-in capital			241,761				238,181
Accumulated other comprehensive income			—				1
Accumulated deficit			(317,244	)			(306,072	)
Total stockholders’ deficit			(75,450	)			(67,860	)
Total liabilities and stockholders’ deficit		$	30,586			$	39,227

See accompanying notes.

 

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NeurogesX, Inc.

Condensed Consolidated Statements of Operations

(in thousands, except share and per share data)

(unaudited)

 

		Three Months Ended March 31,
		2012				2011
Net product revenue		$	831			$	575
Collaboration revenue			2,142				2,595
Total revenues			2,973				3,170
Operating expenses:
Cost of goods sold			681				108
Research and development			2,933				3,957
Selling, general and administrative			7,263				10,282
Total operating expenses			10,877				14,347
Loss from operations			(7,904	)			(11,177	)
Interest income			12				27
Interest expense			(3,220	)			(2,200	)
Other income (expense), net			(60	)			(13	)
Net loss		$	(11,172	)		$	(13,363	)
Basic and diluted net loss per share		$	(0.35	)		$	(0.75	)
Shares used to compute basic and diluted net loss per share			31,779,736				17,870,347

See accompanying notes.

 

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NeurogesX, Inc.

Condensed Consolidated Statements of Comprehensive Loss

(in thousands)

(unaudited)

 

		Three Months Ended March 31,
		2012				2011
Net loss		$	(11,172	)		$	(13,363	)
Changes in unrealized gains (losses)			(1	)			13
Total comprehensive loss		$	(11,173	)		$	(13,350	)

See accompanying notes.

 

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NeurogesX, Inc.

Condensed Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

 

		Three Months Ended March 31,
		2012				2011
Operating activities
Net loss		$	(11,172	)		$	(13,363	)
Adjustments to reconcile net loss to cash used in operating activities:
Depreciation			91				89
Amortization of debt issuance costs and accretion of debt discount			612				20
Amortization of investment premiums			66				257
Stock-based compensation			640				578
Loss on disposal of equipment			71				—
Changes in operating assets and liabilities:
Trade receivables			12				(17	)
Receivable from collaboration partner			458				(33	)
Prepaid expenses and other current assets			403				(687	)
Inventories			608				19
Accounts payable			(406	)			130
Accrued compensation			(585	)			(362	)
Accrued research and development			(33	)			239
Accrued interest payable on long-term obligations			1,892				1,979
Deferred product revenue, net			(10	)			(14	)
Deferred collaboration revenue			(1,806	)			(1,786	)
Deferred rent			(49	)			(41	)
Other accrued expenses			(578	)			1,154
Net cash used in operating activities			(9,786	)			(11,838	)
Investing activities
Purchases of short-term investments			(6,335	)			(3,582	)
Proceeds from maturities of short-term investments			11,750				11,000
Purchases of property and equipment			—				(53	)
Net cash provided by investing activities			5,415				7,365
Financing activities
Proceeds from issuance of common stock, net of issuance costs			2,943				8
Net cash provided by financing activities			2,943				8
Net decrease in cash and cash equivalents			(1,428	)			(4,465	)
Cash and cash equivalents, beginning of period			9,148				8,705
Cash and cash equivalents, end of period		$	7,720			$	4,240
Supplemental cash flow information
Cash paid for interest		$	697			$	200

See accompanying notes.

 

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NEUROGESX, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Note 1. The Company

Nature of Operations

NeurogesX, Inc. (the “Company”) is a specialty pharmaceutical company focused on developing and commercializing a portfolio of novel non-opioid, pain management therapies to address unmet medical needs and improve patients’ quality of life.

The Company’s first commercial product, Qutenza, became commercially available in the United States and in certain European countries in the first half of 2010. Qutenza is a dermal delivery system designed to topically administer capsaicin to treat certain neuropathic pain conditions and was approved by the Food and Drug Administration (the “FDA”), in November 2009 for the management of neuropathic pain associated with postherpetic neuralgia, or PHN. Qutenza is the first prescription strength capsaicin product approved in the United States. Qutenza is also approved in the European Union for the treatment of peripheral neuropathic pain in non-diabetic adults. The Company’s most advanced product candidate, NGX-1998, is a topically applied liquid formulation containing a high concentration of capsaicin designed to treat pain associated with neuropathic pain conditions. NGX-1998 has completed three Phase 1 clinical trials and one Phase 2 clinical trial in PHN patients, and the Company believes that NGX-1998 is ready to enter Phase 3 development. The Company anticipates that an End-of-Phase 2 meeting for NGX-1998 with the FDA will occur in the third quarter of 2012.

In March 2012, the Company decided to focus its resources on the preparation for advancing NGX-1998 into a Phase 3 clinical trial. To do so, the Company significantly restructured its operations, including eliminating direct promotion, and most sales and marketing expenditures in support of Qutenza, while continuing to maintain product availability of Qutenza for patients and physicians. See Note 10 for further discussion. The Company is evaluating a number of alternative commercialization strategies which include the potential to license Qutenza to a commercialization partner in the United States and in other territories of the world outside of the Astellas Territory.

In May 2009, Qutenza received a marketing authorization (“MA”), in the European Union for the treatment of peripheral neuropathic pain in non-diabetic adults, either alone or in combination with other medicinal products for pain. In June 2009, the Company entered into a Distribution, Marketing and License Agreement (the “Astellas Agreement”) with Astellas Pharma Europe Ltd. (“Astellas” or “Collaboration Partner”), under which Astellas was granted an exclusive license to commercialize Qutenza in the European Economic Area, which includes the 27 countries of the European Union, Iceland, Norway, and Liechtenstein as well as Switzerland, certain countries in Eastern Europe, the Middle East and Africa (“Licensed Territory”). Qutenza was made available on a country by country basis commencing in April 2010 and by March 31, 2012, was available in 21 European countries.

The Company received a notice of market capitalization insufficiency from the NASDAQ Global Market on October 18, 2011 as its market value of listed shares had remained below the $50 million minimum listing requirement for more than 30 consecutive business days. On January 27, 2012, the Company received a notice of share price deficiency as the bid price of its shares of common stock had remained below the $1.00 minimum listing requirement for more than 30 consecutive business days. Each of these notices provide a 180 calendar day grace period during which time the Company may regain compliance with the minimum listing requirement by attaining the applicable minimum requirement for 10 consecutive business days. On May 3, 2012, the Company received a notice of market value of publicly held shares insufficiency as the market value of shares held by non-affiliates remained below the $15 million minimum listing requirement for more than 30 consecutive business days. The grace period to regain compliance with the minimum market value of listed securities requirement expired on April 16, 2012, the grace period to regain compliance with the minimum bid price requirement expires on July 28, 2012 and the grace period to regain compliance with the market value of publicly held shares requirement expires on October 30, 2012. With respect to the notice regarding market capitalization insufficiency, the Company did not regain compliance with such listing standard by the end of the grace period, and has requested a hearing with NASDAQ. In connection with the hearing, the Company has submitted a plan for regaining compliance with the applicable minimum listing requirement and is seeking an extension of the grace period during which the Company would seek to execute such plan. During the pendency of the hearing process, the Company’s delisting will be delayed, however, it cannot be assured that the Company will otherwise be granted any additional time to regain compliance as a result of the hearing process. If the Company has not regained compliance with the other listing standards with respect to which it has received notices by the end of its respective grace periods, the Company will similarly receive a delisting determination letter with respect to such standards, and may be able to avail itself of access to a hearing on such determinations in a similar manner as its currently pending hearing with NASDAQ. If the Company is de-listed from the NASDAQ Global Market, it may have the opportunity to apply for and potentially obtain a listing of the Company’s common stock on the NASDAQ Capital Market, subject to its meeting the continued listing requirements of such market. However, the Company currently does not meet the continued listing requirements for that exchange. If the Company is ineligible for listing on the NASDAQ Capital Market, it may seek listing on the OTC Bulletin Board or other over-the-counter market.

 

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To date, the Company has incurred recurring net losses and negative cash flows from operations, after excluding the upfront cash received from Astellas in 2009. Until the Company can generate significant cash from its operations, if ever, the Company expects to continue to fund its operations with existing cash resources, proceeds from one or more collaboration agreements, as well as potentially through royalty monetization, debt financing or the sale of equity securities. However, the Company may not be successful in obtaining additional collaboration agreements, or in receiving milestone or royalty payments under those agreements. In addition, the Company cannot be sure that its existing cash and investment resources will be adequate or that additional financing will be available when needed or that, if available, financing will be obtained on terms favorable to the Company or its stockholders. Having insufficient funds may require the Company to delay or potentially eliminate some or all of its development programs, relinquish some or even all rights to product candidates at an earlier stage of development or negotiate less favorable terms than it would otherwise choose. Failure to obtain adequate financing also may adversely affect the launch of the Company’s product candidates or its ability to continue in business. If the Company raises additional funds by issuing equity securities, substantial dilution to existing stockholders would likely result. If the Company raises 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 its ability to operate its business. The Company anticipates that its existing cash will be sufficient to meet its projected operating requirements into 2013.

The Company was incorporated in California as Advanced Analgesics, Inc. on May 28, 1998 and changed its name to NeurogesX, Inc. in September 2000. In February 2007, the Company reincorporated into Delaware. The Company is located in San Mateo, California. All of the Company’s assets are located within the United States.

Principles of Consolidation

The accompanying financial statements include the accounts of the Company and its wholly-owned subsidiary, NeurogesX UK Limited, which was incorporated as of June 1, 2004. NeurogesX UK Limited was established for the purposes of conducting clinical trials in the UK and marketing approval submission. The subsidiary has no assets other than the initial formation capital totaling one Pound Sterling.

Basis of Presentation

The accompanying unaudited condensed consolidated interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information on the same basis as the annual consolidated financial statements and in accordance with instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The unaudited condensed consolidated interim financial statements include all adjustments (consisting only of normal recurring adjustments) that management believes are necessary for the fair statement of the balances and results for the periods presented. These unaudited condensed consolidated interim financial statement results are not necessarily indicative of results to be expected for the full fiscal year or any future interim period.

The balance sheet at December 31, 2011 has been derived from the audited consolidated financial statements at that date. The unaudited condensed consolidated interim financial statements and related disclosures have been prepared with the presumption that users of such information have read or have access to the audited consolidated financial statements for the preceding fiscal year. Accordingly, these financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto for the year ended December 31, 2011 contained in the Company’s 2011 Form 10-K.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Note 2. Summary of Significant Accounting Policies

Product revenue

In April 2010, the Company made Qutenza commercially available in the United States to its specialty distributor and specialty pharmacy customers. Under the Company’s agreements with its customers, the customers take title to the product upon shipment and

 

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only have the right to return damaged product, product shipped in error and expired or short-dated product. As Qutenza is new to the marketplace, the Company is currently assessing the flow of product through its distribution channel, and cannot reasonably estimate returns. Until such time as an estimate of returns can be made, the Company is recognizing Qutenza product revenue, and related product costs, at the later of:

 

•

the time the product is shipped by the customer to healthcare professionals, and

 

•

the date of cash collection.

In March 2012, the Company implemented a restructuring plan to focus its resources on the development of NGX-1998, which resulted in the elimination of its internal sales force. We continue to support the established distribution network to allow healthcare providers to access Qutenza through specialty distributors and specialty pharmacies.

Healthcare professionals are generally ordering Qutenza in small quantities only after they have identified a patient for treatment. The Company believes that revenue recognition upon the later of customer shipment to the end user and the date of cash collection is appropriate until the Company has sufficient data on the cash collection and return patterns of its customers. The Company is performing additional procedures to further analyze shipments made by its customers by utilizing shipping data provided by its customers to determine when product is shipped by customers to healthcare professionals and are evaluating ending inventories at the Company’s customers each month to assess the risk of product returns. To date, sales returns and rebates have been insignificant.

The Company has established terms pursuant to distribution agreements with its customers providing for payment within 120 days of the date of shipment to its specialty distributor customers and 30 days of the date of shipment to its specialty pharmacy customers. Such distribution agreements generally have a term of three years.

The Company had gross shipments to its distributor customers of $0.9 million and $0.6 million for the three months ended March 31, 2012 and 2011, respectively. The application of the Company’s revenue recognition policy resulted in the recognition of net revenue of $0.8 million and $0.6 million for the three months ended March 31, 2012 and 2011, respectively. The Company’s gross shipments are reduced for chargebacks, certain fees paid to distributors and product sales allowances including rebates to qualifying federal and state government programs. At March 31, 2012, net deferred product revenues totaled $1.1 million.

Revenue from the Astellas Agreement

In June 2009, NeurogesX entered into the Astellas Agreement which provides for an exclusive license by the Company to Astellas for the promotion, distribution and marketing of Qutenza in the Licensed Territory, an option to license NGX-1998 in the Licensed Territory, participation on a joint steering committee and, through a related supply agreement entered into with Astellas (the “Supply Agreement”), supply of product until direct supply arrangements between Astellas and third-party manufacturers are established. The Company anticipates certain of the direct supply arrangements will be established in the first half of 2012. Revenue under this arrangement includes upfront non-refundable fees and may also include additional option payments for the development of and license to NGX-1998, contingent event-based payments upon achievement of certain product sales levels and royalties on product sales.

On January 1, 2011, the Company adopted Accounting Standards Update ASU No. 2009-13, Multiple Deliverable Revenue Arrangements. This update amends the guidance on accounting for arrangements with multiple deliverables to require that each deliverable be evaluated to determine whether it qualifies as a separate unit of accounting. This determination is generally based on whether the deliverable has stand-alone value to the customer. This update also establishes a selling price hierarchy for determining how to allocate arrangement consideration to identified units of accounting. The selling price used for each unit of accounting will be based on vendor-specific objective evidence, or VSOE, if available, third-party evidence if VSOE is not available, or estimated selling price if neither VSOE nor third-party evidence is available. The Company may be required to exercise considerable judgment in determining whether a deliverable is a separate unit of accounting and the estimated selling price of identified units of accounting for new agreements.

Significant management judgment is required in determining the level of effort required under an arrangement and the period over which the performance obligations are estimated to be completed. In addition, if the Company is involved in a joint steering committee as part of a multiple-element arrangement that is accounted for as a single unit of accounting, an assessment is made as to whether the involvement in the steering committee constitutes a performance obligation or a right to participate.

Revenue recognition of non-refundable upfront license fees commences when there is a contractual right to receive such payment, the contract price is fixed or determinable, the collection of the resulting receivable is reasonably assured and there are no further performance obligations under the license agreement.

 

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The Company views the Astellas Agreement and related agreements, as a multiple-element arrangement with the key deliverables consisting of an exclusive license to Qutenza in the Licensed Territory, an obligation to conduct certain development activities associated with NGX-1998, participation on a joint steering committee and supply of Qutenza components to Astellas until such time that Astellas can establish a direct supply relationship with product vendors. The Company entered into the Astellas Agreement in June 2009 and thus, prior to its January 1, 2011 adoption of ASC 2009-13. Accordingly, because not all of these elements have both standalone value and objective and reliable evidence of fair value, the Company is accounting for such elements as a single unit of accounting. Further, the agreement provides for the Company’s mandatory participation in a joint steering committee, which the Company believes represents a substantive performance obligation and also the estimated last delivered element under the Astellas Agreement and related agreements. Therefore, the Company is recognizing revenue associated with upfront payments and license fees ratably over the term of the joint steering committee performance obligation. The Company estimates this performance obligation will be delivered ratably through June 2016.

At the inception of the Astellas Agreement, the upfront license fees were subject to a refund right, which expired upon transfer of the Company’s MA for Qutenza in the European Union to Astellas. In September 2009, the transfer of the MA to Astellas was completed and, therefore, the upfront license fees became non-refundable and revenue recognition of the upfront license fees commenced.

In the accompanying financial statements, Collaboration revenue represents revenue associated with the Astellas Agreement and related agreements. Deferred collaboration revenue arises from the excess of cash received or receivable over cumulative revenue recognized for the period.

Under the terms of the Astellas Agreement, the Company earns royalties based on each sale of Qutenza into the Licensed Territory. The royalty rate is tiered based on the level of sales achieved. These royalties are considered contingent consideration as there is no remaining contract performance obligation of the Company and, therefore, the royalties are excluded from the single unit of accounting treatment discussed above. The Company reports royalty revenue based upon Astellas’ reported net sales of Qutenza in the Licensed Territory. The Company recognizes royalty revenue from Astellas on a quarter lag basis due to the timing of Astellas reporting such royalties to the Company.

Additionally, the Company can earn milestone payments from Astellas if Astellas achieves certain sales levels as outlined in the Astellas Agreement. As these payments are contingent on Astellas’ performance, they are excluded from the single unit of accounting treatment discussed above. The milestones will be recorded as revenue when earned as there is no remaining contractual performance obligation of the Company.

The Company recognizes the revenue net of related costs for collaboration supplies sold to Astellas upon product being delivered to Astellas. The revenue and related costs of the product supplied to Astellas are included in Collaboration revenue. Prior to delivery to Astellas, the costs accumulated for the manufacturing of the collaboration supplies are included in Prepaid expenses and other current assets on the Company’s balance sheet.

Cost of Goods Sold

Cost of goods sold includes costs to procure, manufacture and distribute Qutenza including certain shipping and handling costs incurred in the distribution channel, as well as royalties payable to The Regents of the University of California and Lohmann Therapie-Systeme AG. Costs associated with the manufacture of Qutenza prior to FDA approval were previously expensed as research and development in the period incurred. Cost of goods sold associated with deferred product revenue is deferred and recognized in the same period as the associated product revenue. During the three months ended March 31, 2012, the Company recorded a charge to cost of goods sold of $0.6 million for Qutenza patches that the Company does not expect to sell prior to their expiration date, primarily as a result of the Company’s decision to eliminate direct promotion efforts of Qutenza in March 2012. The Company recorded a write-down of excess inventory to cost of goods sold of less than $0.1 million during the three months ended March 31, 2011. At March 31, 2012, the Company had deferred cost of goods sold of $0.1 million, which is included in deferred product revenue, net on the Company’s condensed consolidated balance sheets.

Trade Receivables

Trade accounts receivable are recorded net of allowances for customer chargebacks related to government rebate programs, doubtful accounts and sales returns. Estimates for customer chargebacks for government rebates and sales returns are based on contractual terms, historical trends and the Company’s expectations regarding the utilization rates for these programs. The Company’s estimate for allowance for doubtful accounts is determined based on existing contractual payment terms, historical payment patterns of its customers and individual customer circumstances. To date, the Company has determined that an allowance for uncollectible accounts receivable is not required. The Company does not require collateral in support of its trade receivables.

 

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Inventories

Inventories are determined at the lower of cost or market value with cost determined under the specific identification method. Inventories consist of raw materials, work-in-process and finished goods. Raw materials include certain starting materials used in the production of the active pharmaceutical ingredient of Qutenza. Work-in-process includes the bulk inventory of the active pharmaceutical ingredient, patches and cleansing gel of Qutenza that are in the process of being manufactured or have completed manufacture and are awaiting final packaging, including related internal labor and overhead costs. Finished goods include the final packaged kits that contain the Qutenza patch and cleansing gel and that are ready for commercial sale. On a quarterly basis, the Company analyzes its inventory levels against forecasted sales volumes, which are subject to change, and writes down inventory that is obsolete, inventory that has a cost basis in excess of the expected net realizable value and inventory that is in excess of expected requirements based upon anticipated product revenue during the products’ applicable shelf life. As a result of the Company’s re-organization in March 2012 which resulted in a significant reduction of its expected revenue for United States Qutenza sales, the Company recorded a write-down of inventory of $0.6 million in the three months ended March 31, 2012. The Company recorded a write-down of excess inventory to Cost of goods sold of less than $0.1 million during the three months ended March 31, 2011. Expected inventory requirements based on product revenue and the timing of production runs are subject to significant judgment and management estimate. The Company expects that its sales forecast will change over time and thus it will continue to review the quantities of inventories on hand compared to the sales forecast.

Net Loss Per Share

Basic net loss per share is calculated by dividing net loss by the weighted-average number of common shares outstanding during the period less the weighted-average unvested common shares subject to repurchase and without consideration of common stock equivalents. Diluted net loss per share is computed by dividing the net loss by the weighted-average number of common shares outstanding and common stock equivalents outstanding for the period. For purposes of this calculation, warrants and options to purchase common stock and restricted stock unit grants are considered to be common stock equivalents but have been excluded from the calculation of diluted net loss per share as their effect is anti-dilutive. The following table is a reconciliation of the numerator and denominator used in the calculation of basic and diluted net loss per share:

 

		Three Months Ended March 31,
		2012				2011
Numerator:
Net loss		$	(11,172	)		$	(13,363	)
Denominator:
Weighted-average common shares outstanding for basic and diluted net loss per share			31,779,736				17,870,347
Basic and diluted net loss per share		$	(0.35	)		$	(0.75	)

Common stock equivalents not included in diluted net loss per share because their effect will be anti-dilutive are as follows:

 

		March 31,
		2012				2011
Options to purchase common stock			4,657,010				3,958,649
Restricted common stock units			1,060,500				—
Warrants outstanding			9,090,628				1,265,846
			14,808,138				5,224,495

Recently Issued and Adoption of New Accounting Standards

Effective January 1, 2012, the Company adopted revised guidance related to the presentation of comprehensive income that increases comparability between U.S. GAAP and International Financial Reporting Standards. This guidance eliminates the current

 

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option to report other comprehensive income (OCI) and its components in the statement of changes in stockholders’ equity. The Company adopted this guidance during the first quarter of 2012, which had no impact on the Company’s financial position, operations, or cash flows.

In May 2011, the Financial Accounting Standards Board (“FASB”) issued new guidance to achieve common fair value measurement and disclosure requirements between GAAP and International Financial Reporting Standards. This new guidance amends current fair value measurement and disclosure guidance to include increased disclosures regarding valuation inputs and investment categorization. The adoption of this new accounting guidance in 2012 did not have a material impact on the Company’s financial position, operations or cash flows.

Note 3. License Agreements

Collaboration Agreement – Astellas

In June 2009, NeurogesX entered into the Astellas Agreement granting Astellas an exclusive license to commercialize Qutenza in the Licensed Territory. The Astellas Agreement provided for an upfront payment for past development and the commercialization rights granted, of 30.0 million Euro, or $41.8 million. In addition, the agreement provided for an upfront payment of 5.0 million Euro, or $7.0 million, for future development expenses and an option to license NGX-1998. Other elements of the Astellas Agreement include future milestone payments of up to 65.0 million Euro if certain predefined sales thresholds of the products licensed under the agreement are met and royalties, as a percentage of net sales made by Astellas of products under the agreement, with such royalties starting in the high teens and escalating into the mid twenties as revenues increase. The Company believes that the milestone payments are not substantive since the achievement of these milestones is predominantly based on Astellas’ sales performance. The Company is participating on a joint steering committee with Astellas to oversee the development and commercialization activities related to Qutenza and NGX-1998 during the term of the agreement, not to exceed ten years. On the seventh anniversary of the Astellas Agreement, the Company has the unilateral right to opt-out of participation on the joint steering committee. The Astellas Agreement further provides that upon delivery of certain data related to NGX-1998, Astellas may pay two additional NGX-1998 option payments totaling 5.0 million Euros. Subsequent to Astellas’ exercise of the option to exclusively license NGX-1998 in the Territory, both companies would cooperate on Phase 3 clinical trials and will share applicable costs equally.

The Company commenced recognizing revenue related to the upfront and option payments upon transfer of the MA for Qutenza to Astellas, which occurred in September 2009. The Company recognized $1.8 million as Collaboration revenue related to the upfront and option payments for both of the three-month periods ended March 31, 2012 and 2011. As of March 31, 2012, the Company had deferred revenue totaling $30.6 million, of which $7.2 million is reflected as current. The Astellas upfront license fee and option payments are accounted for as a single unit of accounting, and accordingly, such payments are being recognized ratably through June 2016, which is the Company’s estimate of its substantive performance obligation period related to the joint steering committee. Subsequent option exercise payments received, if any, are expected to be recognized ratably over the remaining estimated period of performance.

The Astellas Agreement will remain effective on a country-by-country and product-by-product basis until the later of ten years after the first commercial sale, expiration or abandonment of the last valid patent claim or expiration of all applicable periods of regulatory exclusivity. Astellas may terminate the agreement for any reason without penalty, consequence or compensation on a country-by-country and product-by-product basis upon written notice to the Company.

Pursuant to the Supply Agreement, the Company has agreed to provide Astellas with a sufficient supply of Qutenza to support their commercialization efforts until Astellas can establish a direct supply relationship with product vendors. These products will be charged to Astellas at contractually agreed upon costs per unit which are intended to reflect the Company’s direct cost of goods and related internal labor and overhead costs without mark-up for profit. The Company reports amounts received from product transactions net of direct costs incurred as a component of collaboration revenue.

For the three months ended March 31, 2012 and 2011, the Company included in Collaboration revenue zero and $0.6 million, respectively, from product supply transactions, net of direct costs incurred as a component of Collaboration revenue. The Company does not anticipate reporting significant revenues from supply transactions in the future.

For the three months ended March 31, 2012 and 2011, the Company recognized $0.3 million and $0.2 million, respectively, in royalty revenue related to the Astellas Agreement. The Company recognizes royalty revenue from Astellas on a one quarter lag basis.

University of California

In October 2000 and as amended, the Company licensed multiple patents in various jurisdictions, including a method patent, from the University of California (“UC”) (the “U.C. License Agreement”) for prescription strength capsaicin for neuropathic pain.

 

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Under the terms of the agreement, the Company is required to pay royalties on net sales of the licensed product up to a maximum of $1.0 million per annum as well as a percentage of upfront and milestone payments received by the Company from sublicensing the Company’s rights under the agreement (“Sublicense Fee”). The Company recognized $5,000 and $3,000 in royalty expense due to UC for the three months ended March 31, 2012 and 2011, respectively, related to Qutenza product sales in the United States.

On April 3, 2012, the Company entered into a Settlement, Release and Patent Assignment Agreement with two individuals (the “Settlement Agreement”) related to the U.C. License Agreement. See Note 11 for further discussion.

LTS Lohmann Therapie-Systeme AG

In January 2007, the Company entered into a Commercial Supply and License Agreement (“LTS Agreement”) with LTS Lohmann Therapie-Systeme AG (“LTS”) to manufacture commercial and clinical supply of Qutenza. Under the terms of the agreement, the Company is required to pay a transfer price for product purchased as well as a royalty on net sales of product purchased under the LTS Agreement. The Company recognized $15,000 and $10,000 in royalty expense due to LTS for the three months ended March 31, 2012 and 2011, respectively, related to Qutenza product sales in the United States.

The Company has a liability for royalties due to UC and LTS totaling $19,000 included in deferred product revenue, net, on the March 31, 2012 condensed consolidated balance sheet.

Note 4. Cash and Cash Equivalents and Short-Term Investments

The following table summarizes cash, cash equivalents and short-term investments (in thousands):

 

As of March 31, 2012		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Estimated Fair Value
Cash and money market funds		$	7,720			$	—			$	—			$	7,720
Government sponsored enterprise debt securities			19,678				1				(1	)			19,678
		$	27,398			$	1			$	(1	)		$	27,398
Reported as:
Cash and cash equivalents														$	7,720
Short-term investments															19,678
														$	27,398

 

As of December 31, 2011:		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Estimated Fair Value
Cash and money market funds		$	3,908			$	—			$	—			$	3,908
Government sponsored enterprise debt securities			23,900				2				(1	)			23,901
U.S. Treasury securities			6,500				—								6,500
		$	34,308			$	2			$	(1	)		$	34,309
Reported as:
Cash and cash equivalents														$	9,148
Short-term investments															25,161
														$	34,309

All of the Company’s marketable securities are classified as available-for-sale. At March 31, 2012 and December 31, 2011, the contractual maturities of investments held were less than one year. The Company did not sell any of its investments prior to maturity during the three months ended March 31, 2012 or March 31, 2011.

 

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Note 5. Inventories

The components of inventories are as follows (in thousands):

 

		March 31, 2012				December 31, 2011
Raw materials		$	11			$	10
Work-in-process			23				591
Finished goods			12				53
Total		$	46			$	654

As a result of the Company’s re-organization in March 2012 which resulted in a significant reduction of its expected revenue for United States Qutenza sales, the Company recorded a write-down of inventory of $0.6 million in the three months ended March 31, 2012. This inventory write-down relates primarily to supplies of the active pharmaceutical ingredient which may be utilized in development activities for NGX-1998 or other purposes, including potential sale to Astellas for manufacture of Qutenza for their territory.

Note 6. Fair Value Measurements

The Company discloses its cash and short term investments under a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value, which are the following:

Level 1—Quoted prices in active markets for identical assets or liabilities.

Level 2—Inputs other than quoted prices included within Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3—Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

The following table summarizes the valuation of the Company’s financial instruments that were determined by using the following inputs as of March 31, 2012 and December 31, 2011 (in thousands):

 

As of March 31, 2012:		Quoted Prices in Active Markets for Identified Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)				Total
Components of cash equivalents and short-term investments:
Money market funds		$	7,340			$	—			$	—			$	7,340
Government sponsored enterprise debt securities			—				19,678				—				19,678
Total financial assets		$	7,340			$	19,678			$	—				27,018
Operating cash															380
Total cash and cash equivalents														$	27,398

 

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As of December 31, 2011:		Quoted Prices in Active Markets for Identified Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)				Total
Components of cash equivalents and short-term investments:
Money market funds		$	3,855			$	—			$	—			$	3,855
U.S. Treasury securities			—				6,500				—				6,500
Government sponsored enterprise debt securities			—				23,901				—				23,901
Total financial assets		$	3,855			$	30,401			$	—				34,256
Operating cash															53
Total cash and cash equivalents														$	34,309

The Level 2 assets are valued using quoted market prices for similar instruments.

In addition to Level 1 and Level 2 assets held by the Company at March 31 2012, the Company measures its contingent put option liability related to the loan agreement with Hercules Technology Growth Capital, Inc. (“Hercules”) (see Note 8), utilizing Level 3 measurements. The fair value of the contingent put option of $0.1 million was determined by evaluating multiple potential outcomes of an event of default, including a change of control, using an income approach and discounting the values back to March 31, 2012.

Note 7. Stockholders’ Equity

Common Stock

On February 3, 2012, the Company completed a private placement of its common stock under a Securities Purchase Agreement, dated as of January 31, 2012, by and among the Company and the Purchasers (as defined therein), pursuant to which the Company issued shares of common stock for an aggregate purchase price of $3.0 million, at a per share price of $1.01. The price of each share of common stock is based on the January 31, 2012 consolidated closing bid price of the Company’s common stock on the NASDAQ Global Market of $1.01 per share. The net proceeds to the Company, after deducting expenses of $0.1 million, were $2.9 million. The total number of shares of common stock issued in connection with the transaction was 2,969,685.

2007 Stock Plan

The Company’s 2007 Stock Plan provides for the grant of incentive stock options by the Company’s board of directors to employees and for the grant of nonstatutory stock options, restricted stock, restricted stock units, stock appreciation rights, performance units and performance shares to its employees, directors and consultants.

During the three months ended March 31, 2012, the Company granted options, other than the market-based grants described in the next paragraph, to purchase a total of 1,963,200 shares of the Company’s common stock to employees, officers and members of the Company’s board of directors with a fair value of $0.9 million, which is expected to be amortized through 2016. In addition, during the three months ended March 31, 2012, 349,500 restricted stock units were granted to the Company’s employees with a grant dated fair value of $0.3 million which is being amortized over the vesting period.

On March 5, 2012, the Company’s board of directors committed to a restructuring plan whereby the Company reduced its workforce by 43 individuals. A portion of the severance given included a full acceleration of vesting on the affected employees’ restricted stock units (“RSUs”) and an extension of the exercise period for vested stock options. The expense for the acceleration of RSUs and extension of vesting period was approximately $0.1 million. See Note 10 for further discussion.

2011 Inducement Stock Plan

On September 20, 2011, the Company’s board of directors adopted the 2011 Inducement Stock Plan (the “Inducement Plan”). The purposes of the Inducement Plan are to provide a material inducement for the best available individuals to enter into the employment of the Company and thereby to promote the success of the Company’s business. The Inducement Plan provides for the grant of nonstatutory stock options, stock appreciation rights, restricted stock, restricted stock units, performance units and performance shares by the Company’s board of directors to its employees. The term of the Inducement Plan is ten years from the date adopted by the board of directors.

The Company’s independent compensation committee has the authority to determine the terms of the awards, including exercise price, the number of shares subject to each such award, individuals to whom awards may be granted, the exercisability of the awards

 

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and consideration payable upon exercise. Upon adoption of the plan, the Company reserved 1,000,000 shares of its common stock for issuance under the Inducement Plan. In connection with the hiring of the Company’s new Chief Executive Officer on January 2, 2012, the Company issued 600,000 shares under the Inducement Plan. At March 31, 2012, 400,000 shares remain available for grant under the Inducement Plan.

Stock-Based Compensation Expense

The Company recognizes stock-based compensation expense for all share-based payments. Stock-based compensation expense for awards made to employees and directors is measured at the date of grant, based on the fair value of the award, and is recognized as expense on a straight-line basis over the requisite service period. The Company has elected to use the Black-Scholes option valuation model to estimate the fair value of stock options for all options granted except for the market-based stock options granted in February 2011. The Company used the Monte Carlo valuation method to estimate the fair value of market-based stock options.

The following table shows the assumptions used to compute stock-based compensation expense for stock options granted to employees and members of the board of directors, excluding market-based stock option grants, and the assumptions used to compute stock-based compensation expense for the Company’s Employee Stock Purchase Plan (“ESPP”) for the three months ended March 31, 2012 and 2011 using the Black-Scholes valuation model:

 

		Three Months Ended March 31,
		2012		2011
Stock Options
Expected dividend yield		0%		0%
Expected volatility		74%		66%
Expected life (in years)		6.0		6.0
Risk-free interest rate		1.1%		2.5%
ESPP
Expected dividend yield		0%		0%
Expected volatility		58 – 74%		55 – 58%
Expected life (in years)		0.5 – 1.0		0.5 – 1.0
Risk-free interest rate		0.1 – 0.2%		0.2 – 0.4%

Non-cash stock-based compensation expense included in operating expenses for the three months ended March 31, 2012 and 2011 was as follows (in thousands):

 

		Three Months Ended March 31,
		2012				2011
Research and development		$	109			$	203
Selling, general and administrative			531				375
		$	640			$	578

In connection with the above mentioned restructuring plan in March 2012, the Company recorded a non-cash stock-based compensation charge of $0.2 million related to modifications to the impacted employees’ equity awards.

 

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Note 8. Long-Term Obligations

The following table summarizes the carrying amount of the Company’s borrowings under various long-term obligations (in thousands):

 

		March 31, 2012				December 31, 2011
Cowen Financing Agreement		$	55,608			$	53,344
Hercules Technology Growth Capital, Inc. – Term loan			14,395				14,231
Total			70,003				67,575
Less: Long-term obligations – current portion			6,740				4,829
Long-term obligations		$	63,263			$	62,746

Cowen Financing Agreement

On April 30, 2010, the Company entered into a Financing Agreement (the “Financing Agreement”) with Cowen Healthcare Royalty Partners, L.P., a limited partnership organized under the laws of the State of Delaware (“Cowen”). Under the terms of the Financing Agreement, the Company borrowed $40.0 million from Cowen (the “Borrowed Amount”) and the Company agreed to repay such Borrowed Amount together with a return to Cowen, as described below, out of royalty, milestone, option and certain other payments (collectively, “Revenue Interest”) that the Company may receive under the Astellas Agreement or a replacement licensee, as a result of commercializing the Company’s product, Qutenza, in the Licensed Territory, including payments that Astellas may make to the Company to maintain its option to commercialize NGX-1998 in the Licensed Territory.

Under the Financing Agreement, the Company is obligated to pay to Cowen:

 

•

All of the Revenue Interest payments due to the Company under the Astellas Agreement, until Cowen has received $90.0 million of Revenue Interest payments; and

 

•

5% of the Revenue Interest payments due to the Company under the Astellas Agreement for Revenue Interest received by Cowen over $90.0 million and until Cowen has received $106.0 million of Revenue Interest payments.

The Company also has the option to pay a prepayment amount to terminate the Financing Agreement at the Company’s election at any time or in connection with a change of control of the Company. Such amount is set at a base amount of $76.0 million (or $68.0 million if it is being exercised in connection with a change of control), or, if higher, an amount that generates a specified internal rate of return, as noted below, on the Borrowed Amount as of the date of prepayment, in each case reduced by the Revenue Interest payments received by Cowen up to the date of prepayment.

The obligation of the Company to pay Revenue Interest during the term of the Financing Agreement (which is defined below) is secured by rights that the Company has to Revenue Interest under the Astellas Agreement, and by intellectual property and other rights of the Company to the extent necessary or used to commercialize products covered by the Astellas Agreement in the Licensed Territory.

Unless terminated earlier pursuant to a prepayment, the Financing Agreement terminates on the earlier of:

 

•

The time when Cowen has received at least $106.0 million of Revenue Interest payments; or

 

•

The maturity date, which is the latest to occur of 10 years following the first commercial sale of Qutenza in the Licensed Territory or the last to expire of any patents or regulatory exclusivity covering the products commercialized under the Astellas Agreement in the Licensed Territory.

If Cowen has not received Revenue Interest payments totaling at least $40.0 million by the maturity date, the Company will be obligated to pay to Cowen the difference between such amount and the Revenue Interest paid to Cowen under the Financing Agreement up to such date. This represents the Company’s minimum financial obligation under the Financing Agreement.

In addition, in the event of the Company’s default under the Financing Agreement, the Company is obligated to pay to Cowen the borrowed amount together with interest accrued thereon from the effective date of the Financing Agreement, to the date of repayment at an internal rate of return equal to the lesser of a 19% rate of interest or the maximum rate permitted by law, less any Revenue Interest payments received by Cowen. Under the Financing Agreement, an event of default includes standard insolvency and bankruptcy terms, including a failure to maintain liquid assets equal to at least the Company’s liabilities due and payable during the following three months.

 

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The upfront cash receipt of $40.0 million less a discount of $0.5 million in cost reimbursements paid to Cowen was recorded in long-term obligations at issuance. The Company is accreting the discount to interest expense over the term of the related debt. The carrying value of the long-term obligation at March 31, 2012, including accrued interest of $16.0 million, is $55.6 million. The carrying value of the long-term obligation at December 31, 2011, including accrued interest of $13.8 million, was $53.3 million. The Company received $0.3 million and $0.2 million of royalty payments from Astellas in the three months ended March 31, 2012 and 2011, respectively, and consistent with the provisions of the arrangement, the Company paid that amount to Cowen as a reduction of the obligation.

The best estimate of future payments, the timing of which determines the short- and long-term classification of the obligation under the Financing Agreement, was based upon estimates of royalties due from Astellas over the term of the agreement and returning to Cowen an internal rate of return of 19% through Revenue Interest payments. The accrued interest on the long-term debt obligations is presented on the condensed consolidated balance sheets as of March 31, 2012 in two components, the long-term obligations—current portion, which totals $3.0 million and the remaining $13.0 million included in long-term obligations. At December 31, 2011, the long-term obligations—current portion was $2.5 million of accrued interest and the remaining $11.3 million of accrued interest was included in long-term obligations. The Company recorded interest expense of $2.6 million and $2.2 million during the three months ended March 31, 2012 and 2011, respectively.

The Company capitalized $0.3 million of debt issuance costs related to the agreement which are being amortized over the term. At both March 31, 2012 and December 31, 2011, the unamortized debt issuance cost was $0.3 million, and is included in prepaid expenses and other current assets and other assets on the Company’s condensed consolidated balance sheets.

The estimated fair value of the Cowen Borrowed Amount at March 31, 2012 and December 31, 2011 was $46.8 million and $43.6 million, respectively, and the fair value was measured using Level 3 inputs. The estimated fair market value was calculated using the income method of valuation. The key assumptions required for the calculation were an estimate of the amount and timing of future royalty revenues to be received from Astellas and an estimated cost of capital. Management’s estimate of the future royalty revenues to be received from Astellas is subject to significant variability due to the state of the product launch, regulatory processes still to be conducted for significant portions of the Astellas territory and the extended time period associated with the Cowen Financing Agreement.

Hercules Loan Agreement

In August 2011, the Company entered into a loan agreement with Hercules, which includes both a $5.0 million accounts receivable line and a $15.0 million term loan. Under the terms of the loan agreement, the $15.0 million term loan is required to be repaid over the course of the 42-month maturity period, which includes a 12-month interest only period at the beginning of the term. Interest on the term loan has a minimum rate of 9.5%, which can increase based on fluctuations in the prime rate. The $5.0 million accounts receivable line is a revolving line that is available until December 31, 2012 and then is renewable at the option of Hercules each year thereafter. The accounts receivable line bears interest at a minimum interest rate of 6.75%, which can also increase based on fluctuations in the prime rate, and the maximum borrowing availability under the revolving line is based upon a percentage of eligible accounts receivable of the Company. The Company may prepay and terminate the term loan at any time, subject to certain prepayment fees, and is obligated to also pay a fee of $0.6 million when the term loan is repaid and which is being accrued to interest expense over the term of the loan. The obligations of the Company under the loan agreement are secured by certain personal property of the Company.

The loan agreement also contains customary negative covenants and is subject to customary events of default, such as a failure to make a scheduled principal or interest payment, insolvency, and breaches of covenants under loan agreement and agreements and instruments entered into in connection with the loan agreement, including covenants in the Hercules warrant. Upon an event of default, including a change of control, Hercules has the option to accelerate repayment of the loan, including payment of any applicable prepayment charges, which range from 1%-3% of the outstanding loan balance and accrued interest, as well as a final payment fee of $0.6 million. This option is considered a contingent default provision liability as the holder of the loan may exercise the option in the event of default and, is a derivative which must be bifurcated and valued separately in the Company’s financial statements. As of March 31, 2012, the estimated fair value of the contingent put option upon an event of default liability was $0.1 million which was determined by evaluating multiple potential outcomes of an event of default, including a change of control, using an income approach and discounting the values back to March 31, 2012. As of March 31, 2012, the contingent put option liability is included in other long-term liabilities on the condensed consolidated balance sheet. The contingent put option liability will be revalued at the end of each reporting period and any change in the fair value will be recognized in the statements of operations.

 

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In connection with the entry of the Company into the loan agreement, Hercules was issued a warrant for 791,667 shares of the Company’s common stock (the Hercules Warrant). The warrant has a term of five years, contains a net-exercise provision, and has an exercise price of $1.80 per share. In March 2012, the Company entered into an amendment to the Hercules Warrant in which it amended the covenant with respect to the requirement to maintain its listing on the NASDAQ Global Market to allow for the NASDAQ Capital Market and certain over-the-counter markets to be permissible alternative markets on which the Company can list its shares of common stock. Under the terms of the amendment, the number of shares underlying the warrant was increased to 1,950,000 and the exercise price per share of common stock was reduced to $0.50. The fair value of the warrants originally issued was approximately $1.1 million based on a Black-Scholes valuation model; $0.8 million of which was attributable to the warrants issued in connection with the term loan, and $0.3 million of which was attributable to warrants issued in connection with the accounts receivable line. Under the Black-Scholes option pricing model, the value of the amended warrant did not result in incremental value. The fair value of the warrants issued in connection with the term loan resulted in a debt discount, which is being amortized to interest expense over the life of the loan using the effective interest method. The fair value of the warrants issued in connection with the accounts receivable line was recorded in prepaid and other current assets and other assets, respectively. The Company will amortize these assets on a straight-line basis over the initial term of the accounts receivable line that ends December 31, 2012. The Company also paid $0.4 million in issuance costs which were allocated to the term loan and accounts receivable line and accounted for consistent with the warrants as described above. The recorded value of the term loan is $13.8 million after deducting expenses of $0.3 million paid to Hercules, $0.8 million for the value of the warrants allocated to the term loan and $0.1 million for the value ascribed to the default provision of the agreement. The estimated fair value of the Hercules term loan and the default provision was $14.6 million and $0.1 million, respectively, at March 31, 2012 and the liabilities were measured at fair value using Level 3 inputs. The estimated fair market value was calculated using the income method of valuation. The key assumptions required for the calculation were an estimate of the amount and timing of future payments to Hercules.

The Company had $1.0 million available for draw-down on the accounts receivable line at March 31, 2012 based upon a percentage of the then eligible account receivables of the Company. The Company has not drawn any funds from the accounts receivable line and in May 2012, the Company initiated the process to terminate the facility.

Note 9. Commitments and Contingencies

The Company has issued non-cancellable purchase orders to third-party manufacturers of Qutenza and NGX-1998 for manufacturing, stability and related services including reimbursable amounts from Astellas for the supply of Qutenza based on the Astellas Agreement. These purchase orders totaled $1.6 million as of March 31, 2012 and included $1.1 million for stability and related services, $0.2 million related to Qutenza product manufacturing costs for the U.S. market and NGX-1998 clinical supply development cost, along with $0.3 million of commitments related to supply of Qutenza to Astellas. The Company will record these amounts in its financial statements when title to the applicable materials has transferred to the Company.

The Company is subject to various legal disputes that arise in the normal course of business. These include or may include employment matters, contract disputes, intellectual property matters, product liability actions, and other matters. The Company does not know whether it would prevail in these matters nor can it be assured that a remedy could be reached on commercially viable terms, if at all. Based on currently available information, the Company does not believe that any of these disputes will have a material adverse impact on its business, results of operations, liquidity or financial position.

Note 10. Restructuring

On March 5, 2012, the Company’s board of directors committed to a restructuring plan whereby the Company reduced its workforce by 43 individuals. The restructuring plan was approved in connection with the Company’s plan to focus its resources on its NGX-1998 development program. The Company communicated the plan to the impacted employees on March 7, 2012 with the expectation that the restructuring would be effective and completed on or about such date. The Company recorded a cash charge for severance and other payroll related termination costs of $1.4 million in the three months ended March 31, 2012. The Company also recorded an additional non-cash charge of $0.8 million related to inventory and capital equipment write-downs, as well as stock compensation charges for modifications to the impacted employees’ equity awards under the 2000 Stock Incentive Plan and 2007 Stock Plan. As of March 31, 2012, $0.3 million of severance and other payroll related termination costs remained accrued.

Note 11. Subsequent Events

On April 3, 2012, the Company entered into a Settlement, Release and Patent Assignment Agreement with two individuals (the “Settlement Agreement”). Under the terms of the Settlement Agreement, the Company obtained from these individuals certain releases and covenants not to sue and an assignment of certain intellectual property, including certain intellectual property relating to the Company’s Qutenza product. In exchange, the Settlement Agreement provides for these individuals to each receive (i) an initial

 

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cash payment of $300,000, (ii) potential additional cash payments of up to an individual aggregate of $450,000 in the event the Company achieves certain annual sales milestones for Qutenza and (iii) certain royalties on net sales of products utilizing intellectual property licensed by the Company under the U.C. License Agreement. Additionally, pursuant to the terms of the Settlement Agreement, these individuals have each been granted, pursuant to the terms of the Company’s 2007 Stock Plan, as amended, a restricted stock purchase award for 75,000 shares of common stock of the Company that they may elect to purchase within five years of the date of the Agreement. The purchase price for such shares was set at $0.3904 per share.

In connection with the entry by the Company into the Settlement Agreement, the Company and the UC also entered into Amendment Number Four to Exclusive License Agreement on April 3, 2012 (the “UC Amendment”). Under the terms of the UC Amendment, the U.C. License Agreement was amended to provide for the Company the right to offset 50% of the cash and royalty payments to be paid by the Company to these individuals under the Settlement Agreement against amounts the Company would otherwise be obligated to pay to the UC under the U.C. License Agreement.

Maritime Asset Management, LLC on Behalf of Itself and All Others Similarly Situated v. NeurogesX, Inc., Anthony A. DiTonno, Stephen F. Ghiglieri and Jeffrey K. Tobias, M.D.

On April 23, 2012, the Company received a copy of a complaint filed by Maritime Asset Management, LLC with the United States District Court Southern District of New York against the Company and the current and former executive officers listed above. The complaint alleges, among other things, violations of Section 10(b), Section 20(a) and Rule 10b-5 of the Securities and Exchange Act of 1934 (the “Exchange Act”), breach of contract, fraud and aiding and abetting arising out of disclosures made prior to the departure of the Company’s former Chief Medical Officer and Executive Vice President of Research and Development, Dr. Jeffrey K. Tobias. The challenged disclosures were made in connection with the Company’s July 26, 2011 private placement of common stock and common stock warrants and the Company’s periodic reports filed pursuant to the Exchange Act from May 9, 2011 through September 27, 2011. The complaint states that the plaintiff is seeking monetary damages, but no amounts are specified. The Company’s Board of Directors and management believe the claims are without merit and intend to vigorously defend against the action. Based on currently available information, the Company is unable to estimate whether or not the complaint will ultimately have an adverse impact to its financial results.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This discussion and analysis should be read in conjunction with our financial statements and accompanying notes included elsewhere in this report. Operating results are not necessarily indicative of results that may occur in future periods.

This report contains forward-looking statements that are based upon current expectations within the meaning of the Private Securities Reform Act of 1995. We intend that such statements be protected by the safe harbor created thereby. Forward-looking statements involve risks and uncertainties and our actual results and the timing of events may differ significantly from the results discussed in the forward-looking statements. Examples of such forward-looking statements include, but are not limited to, statements about or relating to:

 

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anticipated development of NGX-1998, including plans and timing with respect to an End of Phase 2 meeting with the U.S. Food and Drug Administration, or FDA and the potential entry of such product candidate into Phase 3 clinical trials;

 

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potential benefits of NGX-1998 as compared to Qutenza, including broader sites of application, timing and method of treatment necessary to obtain therapeutic benefits, treatment settings and potential additional indications for treatment;

 

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potential benefits of cross application of our development experience with Qutenza for the development of NGX-1998;

 

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our plans with regard to the commercialization of Qutenza® in the United States and the plans of Astellas Pharma Europe Ltd., or Astellas, for commercialization of Qutenza pursuant to the terms of the Distribution, Marketing Agreement and License Agreement, or the Astellas Agreement;

 

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timing of completion of clinical trials for Qutenza being conducted by Astellas, and potential efforts for label expansion for Qutenza in the United States and the European Union that may be carried out if such trials are successful;

 

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expectations with respect to potential entry into commercial strategic partnerships for Qutenza and potential entry into development and commercial strategic partnerships for NGX-1998;

 

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maintenance of availability of Qutenza in the marketplace;

 

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expectations with respect to revenues for Qutenza as a result of our restructuring of commercial operations;

 

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sufficiency of existing resources to fund our operations into 2013;

 

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capital requirements and our needs for additional financing including the potential forms such financing may take, including our needs for additional financing to fund development of NGX-1998;

 

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anticipated development of other potential product candidates;

 

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losses, costs, expenses, expenditures and cash flows:

 

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potential competitors and competitive products;

 

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future payments under lease obligations and equipment financing lines;

 

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patents and our and others’ intellectual property; and

 

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expected future sources of revenue and capital.

 

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We undertake no obligation to, and expressly disclaim any obligation to, revise or update the forward-looking statements made herein or the risk factors whether as a result of new information, future events or otherwise. Forward-looking statements involve risks and uncertainties, which are more fully described in the section of this quarterly report entitled “Risk Factors”, including, but not limited to, those risks and uncertainties relating to:

 

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difficulties or inability to meet our obligations and covenants under our debt arrangements, including our arrangements with Hercules Technology Growth Capital, Inc., or Hercules, and Cowen Royalty Partners, L.P., or Cowen Royalty;

 

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difficulties or delays in development, testing, obtaining regulatory approval for, and undertaking production and marketing of NGX-1998, and in potential label expansion development efforts for Qutenza;

 

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unexpected adverse side effects or inadequate therapeutic efficacy of our product candidates, including NGX-1998 and Qutenza, could slow or prevent product approval or approval for particular indications (including the risk that current and past results of clinical trials or preclinical studies are not indicative of future results of clinical trials, and the difficulties associated with clinical trials for pain indications);

 

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positive results in clinical trials may not be sufficient to obtain FDA or European regulatory approval for NGX-1998 or for label expansion for Qutenza;

 

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physician or patient reluctance to use Qutenza or payer coverage for Qutenza and for the procedure to administer it, which may impact physician utilization of Qutenza;

 

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our inability to obtain additional financing if necessary;

 

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changing standards of care and the introduction of products by competitors or alternative therapies for the treatment of indications we target;

 

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the uncertainty of protection for our intellectual property, through patents, trade secrets or otherwise; and

 

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potential infringement of the intellectual property rights or trade secrets of third parties.

When used in this quarterly report, unless otherwise indicated, “NeurogesX,” “the Company,” “we,” “our” and “us” refers to NeurogesX, Inc. and its subsidiaries.

Qutenza^® and NeurogesX^® are registered trademarks in the United States. We have also applied for these trademarks in several other countries. Other service marks, trademarks and trade names referred to in this quarterly report are the property of their respective owners.

The following discussion should be read in conjunction with the section of this quarterly report entitled “Risk Factors.”

Overview

We are a specialty pharmaceutical company focused on developing and commercializing a portfolio of novel non-opioid, pain management therapies to address unmet medical needs and improve patients’ quality of life.

Our first commercial product, Qutenza, became commercially available in the United States and in certain European countries in the first half of 2010. Qutenza is a dermal delivery system designed to topically administer capsaicin to treat certain neuropathic pain conditions and was approved by the FDA in November 2009 for the management of neuropathic pain associated with postherpetic neuralgia, or PHN. Qutenza is the first prescription strength capsaicin product approved in the United States. Qutenza is also approved in the European Union for the treatment of peripheral neuropathic pain in non-diabetic adults.

Our most advanced drug candidate is NGX-1998. NGX-1998 is a topical liquid formulation of high concentration capsaicin that we are developing to treat neuropathic pain conditions. In November 2011, we announced positive top-line results from our Phase 2 clinical study of NGX-1998, in patients with PHN. The 12-week, multicenter, randomized, double-blinded, placebo-controlled clinical trial met its protocol-specified objectives, which include the primary endpoint of a percentage change from baseline as compared to placebo in a patient-reported numeric pain rating scale, score during weeks two through eight of the trial. We believe that the Phase 2 data support moving forward to a NGX-1998 Phase 3 clinical trial. We are scheduled to have an End-of-Phase 2 meeting with the FDA in the third quarter of 2012. We are presently examining a range of potential indications for NGX-1998, including but not

 

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limited to PHN, HIV associated peripheral neuropathy, or HIV-PN, painful diabetic neuropathy, or PDN, Chemotherapy-induced peripheral neuropathy, and post-traumatic (e.g. surgical) pain. Our decision as to which indications to pursue in Phase 3 clinical trials is expected to be based on a number of criteria including, but not limited to, our assessments of probability of clinical development success, market size and potential regulatory pathways to possible approval.

We believe that NGX-1998 has the potential to represent a significant improvement over Qutenza. To date, the clinical data suggests that NGX-1998 does not require pre-treatment with a topical anesthetic and administration of NGX-1998 for five minutes may provide a similar response to that experienced with Qutenza after a 60-minute application, that is, that a patient may experience meaningful pain relief for up to 12 weeks from that single five minute application. As a result, we believe that NGX-1998 has the potential to be more readily accepted by physicians and may also demonstrate efficacy in a number of neuropathic pain conditions. Additionally, we believe that the liquid formulation represents a more versatile delivery model which is well suited for treating hard to reach places on the body. Further, we believe that our experience in conducting clinical trials with capsaicin and the approval of Qutenza may benefit our efforts to obtain clinical success for NGX-1998. Finally, in April 2011, NGX-1998 was granted patent protection under a patent entitled “Methods and Compositions for Administration of TRPV1 Agonists.” The allowed claims include method of use, formulation and system claims. The patent, including the Patent Term Adjustment, expires in 2027. In February 2012, we received a notice of allowance from the Japanese Patent Office for a patent that covers NGX-1998 with a set of claims that are similar to those issued in the United States. A similar patent application is also under review in the European Union.

In March 2012, we decided to focus our resources on the preparation for advancing NGX-1998 into a Phase 3 clinical trial, as a result of the opportunity we believe exists with NGX-1998. To do so, we significantly restructured our operations, including eliminating most of sales and marketing expenditures in support of Qutenza, while continuing to maintain product availability of Qutenza for patients and physicians. While we believe a market opportunity exists for Qutenza, we believe that the resources required to attain that potential are better utilized to speed the development of NGX-1998. We are evaluating a number of alternative commercialization strategies which include the potential to license Qutenza to a commercialization partner in the United States and in other territories of the world outside of the territory addressed by Astellas.

In September 2011, we submitted a supplemental new drug application, or sNDA, to the FDA regarding potentially expanding the Qutenza label to include treatment of pain associated with HIV-PN. On February 9, 2012, the Anesthetic and Analgesic Drug Product Advisory Committee of the FDA Panel voted unanimously against approval of Qutenza in such indication as the committee determined that the data did not represent adequate evidence of efficacy. In March 2012, we received a complete response from the FDA regarding our sNDA. The complete response letter indicated that in order to gain approval for the use of Qutenza for the proposed indication, we would need to submit additional clinical data from at least one adequate and well-controlled Phase 3 clinical trial to support the proposed indication. However, we do not anticipate investing in further clinical trials for Qutenza at this time.

Although we are limiting our investment in Qutenza in the United States, Astellas continues to conduct studies with Qutenza for its Licensed Territory for commercialization of Qutenza which includes the 27 countries of the European Union, Iceland, Norway, and Liechtenstein as well as Switzerland, certain countries in Eastern Europe, the Middle East and Africa, which we refer to as the Licensed Territory. Astellas is currently conducting three clinical trials in response to follow up measures requested by the European Medicines Agency. These studies include a long-term safety study in on-label indications and two studies, a long-term safety study and an efficacy study, in patients with PDN. The results of these studies are not expected until sometime in 2013. However, if the PDN clinical trials are successful, we plan to explore the potential for such trials to support further label expansion opportunity in the United States.

The Astellas Agreement, described below, provides Astellas an option to exclusively license NGX-1998 in the Licensed Territory. If Astellas was to exercise its option, they would collaborate with us on the Phase 3 clinical trials and share equally in certain of Phase 3 development costs that benefit the regulatory process in their territory. We are also exploring the possibility of a strategic alliance for development and commercialization of NGX-1998 in the United States and potentially, other world markets.

In addition to Qutenza and NGX-1998, we have a series of compounds which represent an early stage pipeline of potential product candidates consisting of prodrugs of acetaminophen for potential use in acute pain, including traumatic pain, post-surgical pain and fever. These product candidates are in the pre-clinical stage of development and may or may not be the subject of further development in 2012 or beyond.

To date, we have not generated any significant product revenue and have funded our operations primarily by selling equity securities, establishing debt facilities and through the Astellas Agreement. Our accumulated deficit as of March 31, 2012 was $317.2 million. We had cash, cash equivalents and short-term investments totaling $27.4 million at March 31, 2012 and during the three months ended March 31, 2012, we used cash of $9.8 million in operating activities. We expect to continue to incur annual operating losses for the foreseeable future as we support the continued availability of Qutenza in the United States and work to complete the NGX-1998 development program.

 

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In April 2010, we borrowed $40.0 million from Cowen Royalty, and agreed to repay Cowen Royalty up to $106 million by assigning Cowen Royalty one hundred percent of royalty, milestone, option and other payments that we may receive under the Astellas Agreement until our repayment obligation is satisfied in full.

In August 2011, we entered into a loan agreement with Hercules Technology Growth Capital, Inc., or Hercules, which includes both a $5.0 million accounts receivable line and a $15.0 million term loan. Under the terms of the loan agreement, the $15.0 million term loan is required to be repaid over the course of the 42-month maturity period, which includes a 12-month interest only period at the beginning of the term. In connection with our entry into the loan agreement, we issued to Hercules a warrant for 791,667 shares of our common stock. The warrant has a term of five years, contains a net-exercise provision, and has an exercise price of $1.80 per share. The fair value of the original warrants issued was approximately $1.1 million. In March 2012, we entered into an amendment to the Hercules warrant, in which we amended the covenant with respect to the requirement to maintain our listing on the NASDAQ Global Market to allow for the NASDAQ Capital Market and certain over the counter markets to be permissible alternative markets on which we can list our shares of common stock. Under the terms of the amendment, the number of shares underlying the warrant was increased to 1,950,000 and the exercise price per share of common stock was reduced to $0.50. Under the Black-Scholes option pricing model, the value of the amended warrant did not result in incremental value. The loan agreement also contains customary negative covenants and is subject to customary events of default, such as a failure to make a scheduled principal or interest payment, insolvency, and breaches of covenants under loan agreement and agreements and instruments entered into in connection with the loan agreement, including covenants in the Hercules warrant.

In February 2012, we completed a private placement of our common stock under a Securities Purchase Agreement pursuant to which we issued shares of common stock for an aggregate purchase price of approximately $3.0 million, at a per share price of $1.01. The price of each share of common stock is based on the January 31, 2012 consolidated closing bid price of our common stock on the NASDAQ Global Market of $1.01 per share. The total number of shares of common stock issued in connection with the transaction is 2,969,685. The net proceeds to us, after deducting expenses of $0.1 million, were approximately $2.9 million.

We received a notice of market capitalization insufficiency from the NASDAQ Global Market on October 18, 2011 as our market value of listed shares had remained below the $50 million minimum listing requirement for more than 30 consecutive business days. On January 27, 2012, we received a notice of share price deficiency as the bid price of our shares of common stock had remained below the $1.00 minimum listing requirement for more than 30 consecutive business days. Each of these notices provide a 180 calendar day grace period during which time we may regain compliance with the minimum listing requirement by attaining the applicable minimum requirement for 10 consecutive business days. On May 3, 2012, we received a notice of market value of publicly held shares insufficiency as the market value of shares held by non-affiliates remained below the $15 million minimum listing requirement for more than 30 consecutive business days. The grace period to regain compliance with the minimum market value of listed securities requirement expired on April 16, 2012, the grace period to regain compliance with the minimum bid price requirement expires on July 28, 2012 and the grace period to regain compliance with the market value of publicly held shares requirement expires on October 30, 2012. With respect to the notice regarding market capitalization insufficiency, we did not regain compliance with such listing standard by the end of the grace period, and have requested a hearing with NASDAQ. In connection with the hearing, we have submitted a plan for regaining compliance with the applicable minimum listing requirement and are seeking an extension of the grace period during which we would seek to execute such plan. During the pendency of the hearing process, our delisting will be delayed, however, we cannot be assured that we will otherwise be granted any additional time to regain compliance as a result of the hearing process. If we have not regained compliance with the other listing standards with respect to which we have received notices by the end of their respective grace periods, we will similarly receive a delisting determination letters with respect to such standards, and may be able to avail ourselves of access to a hearing on such determinations in a similar manner as our currently pending hearing with NASDAQ. If we are de-listed from the NASDAQ Global Market, we may have the opportunity to apply for and potentially obtain a listing of our common stock on the NASDAQ Capital Market, subject to our meeting the continued listing requirements of such market. However, we currently do not meet the continued listing requirements for that exchange. If we are ineligible for listing on the NASDAQ Capital Market, we may seek listing on the OTC Bulletin Board or other over-the-counter market.

We anticipate that our existing cash will be sufficient to meet our projected operating requirements into 2013.

Maritime Asset Management, LLC on Behalf of Itself and All Others Similarly Situated v. NeurogesX, Inc., Anthony A. DiTonno, Stephen F. Ghiglieri and Jeffrey K. Tobias, M.D.

On April 23, 2012, we received a copy of a complaint filed by Maritime Asset Management, LLC with the United States District Court Southern District of New York against us and the current and former executive officers listed above. The complaint

 

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alleges, among other things, violations of Section 10(b), Section 20(a) and Rule 10b-5 of the Securities and Exchange Act of 1934, breach of contract, fraud and aiding and abetting arising out of disclosures made prior to the departure of our former Chief Medical Officer and Executive Vice President of Research and Development, Dr. Jeffrey K. Tobias. The challenged disclosures were made in connection with our July 26, 2011 private placement of common stock and common stock warrants and our periodic reports filed pursuant to the Exchange Act from May 9, 2011 through September 27, 2011. The complaint states that the plaintiff is seeking monetary damages, but no amounts are specified. Our board of directors and management believe the claims are without merit and intend to vigorously defend against the action.

Critical Accounting Policies and Significant Judgments and Estimates

Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these 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.

While our significant accounting policies are described in more detail in Note 2 of the Notes to Condensed Consolidated Financial Statements included elsewhere in this report, we believe the following accounting policies to be critical to the judgments and estimates used in the preparation of our financial statements.

Revenue Recognition

Effective January 1, 2011, we adopted the provisions of Accounting Standards Update, or ASU, 2009-13, Multiple-Deliverable Revenue Arrangements, or ASU 2009-13, which is included within the Codification as Revenue Recognition-Multiple Element Arrangements, on a prospective basis. Under the provisions of ASU 2009-13, we no longer rely on objective and reliable evidence of the fair value of the elements in a revenue arrangement in order to separate a deliverable into a separate unit of accounting, and the use of the residual method has been eliminated. We instead use a selling price hierarchy for determining the selling price of a deliverable, which is used to determine the allocation of consideration to each unit of accounting under an arrangement. The selling price used for each deliverable will be based on vendor-specific objective evidence, if available, third-party evidence if vendor-specific objective evidence is not available or estimated selling price if neither vendor-specific objective evidence nor third-party evidence is available. As of March 31, 2012, we had not applied the provisions of ASU 2009-13 to any of our revenue arrangements as we had not entered into any new, or materially modified any of our existing, revenue arrangements since our adoption of ASU 2009-13. Therefore, there was no material impact on our financial position or results of operations from adopting ASU 2009-13. However, the provisions of ASU 2009-13 could have a material impact on the revenue recognized from any collaboration agreements that we enter into, or materially modify, in future periods.

Product Revenue

In April 2010, we made Qutenza commercially available in the United States to our specialty distributor and specialty pharmacy customers. Under the agreements with our customers, the customers take title to the product upon shipment and only have the right to return damaged product, product shipped in error and expired or short-dated product. As Qutenza is new to the marketplace, we are currently assessing the flow of product through our distribution channel, and cannot currently reasonably estimate returns. Until such time as an estimate of returns can be made we are recognizing Qutenza product revenues, and related product costs, at the later of:

 

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the time the product is shipped by the customer to healthcare professionals, and

 

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the date of cash collection.

Healthcare professionals are generally ordering Qutenza in small quantities only after they have identified a patient for treatment. We believe that revenue recognition upon the later of customer shipment to the end user and the date of cash collection is appropriate until we have sufficient data on cash collection and return patterns of our customers. We are performing additional procedures to further analyze shipments made by our customers by utilizing shipping data provided by our customers to determine when product is shipped by the customers to healthcare professionals and are evaluating ending inventory levels at our customers each month to assess the risk of product returns.

We have established terms pursuant to distribution agreements with our specialty distributor customers providing for payment within 120 days of the date of shipment to our specialty distributor customers and 30 days of the date of shipment to our specialty pharmacy customers. Such distribution agreements have terms ranging from one to three years.

 

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We had gross shipments to our distributor customers of $0.9 million and $0.6 million for the three months ended March 31, 2012 and 2011, respectively. The application of the above revenue recognition policy resulted in the recognition of net product revenue of $0.8 million and $0.6 million for the three months ended March 31, 2012 and 2011, respectively. Our gross shipments are reduced for chargebacks, certain fees paid to distributors and product sales allowances including rebates to qualifying federal and state government programs. At March 31, 2012, net deferred product revenue totaled $1.1 million.

Revenue from the Astellas Agreement

In June 2009, we entered into the Astellas Agreement which provides for an exclusive license by us to Astellas for the promotion, distribution and marketing of Qutenza in the Licensed Territory, an option to license NGX-1998, in the Licensed Territory, participation on a joint steering committee and, through a related supply agreement entered into with Astellas supply of product until direct supply arrangements between Astellas and third-party manufacturers are established, some of which we anticipate to occur in 2012. Revenue under this arrangement includes upfront non-refundable fees and may also include additional option payments for the development of and license to NGX-1998, milestone payments upon achievement of certain product sales levels and royalties on product sales.

On January 1, 2011, we adopted ASU No. 2009-13, Multiple Deliverable Revenue Arrangements. This update amends the guidance on accounting for arrangements with multiple deliverables to require that each deliverable be evaluated to determine whether it qualifies as a separate unit of accounting. This determination is generally based on whether the deliverable has stand-alone value to the customer. This update also establishes a selling price hierarchy for determining how to allocate arrangement consideration to identified units of accounting. The selling price used for each unit of accounting will be based on vendor-specific objective evidence, or VSOE, if available, third-party evidence if VSOE is not available, or estimated selling price if neither VSOE nor third-party evidence is available. We may be required to exercise considerable judgment in determining whether a deliverable is a separate unit of accounting and the estimated selling price of identified units of accounting for new agreements.

Significant management judgment is required in determining the level of effort required under an arrangement and the period over which the performance obligations are estimated to be completed. In addition, if we are involved in a joint steering committee as part of a multiple-element arrangement that is accounted for as a single unit of accounting, an assessment is made as to whether the involvement in the steering committee constitutes a performance obligation or a right to participate.

Revenue recognition of non-refundable upfront license fees commences when there is a contractual right to receive such payment, the contract price is fixed or determinable, the collection of the resulting receivable is reasonably assured and there are no further performance obligations under the license agreement.

We view the Astellas Agreement and related agreements, as a multiple-element arrangement with the key deliverables consisting of an exclusive license to Qutenza in the Licensed Territory, an obligation to conduct certain development activities associated with NGX-1998, participation on a joint steering committee and supply of Qutenza components to Astellas until such time that Astellas can establish a direct supply relationship with product vendors. Because not all of these elements have both standalone value and objective and reliable evidence of fair value, we are accounting for such elements as a single unit of accounting. Further, the agreement provides for our mandatory participation in a joint steering committee, which we believe represents a substantive performance obligation and also the estimated last delivered element under the Astellas Agreement and related agreements. Therefore, we are recognizing revenue associated with upfront payments and license fees ratably over the term of the joint steering committee performance obligation. We estimate this performance obligation will be delivered ratably through June 2016.

At the inception of the Astellas Agreement, the upfront license fees were subject to a refund right, which expired upon transfer of our marketing authorization, or MA, for Qutenza in the European Union to Astellas. In September 2009, the transfer of the MA to Astellas was completed and, therefore, the upfront license fees became non-refundable and revenue recognition of the upfront license fees commenced.

In the accompanying financial statements, collaboration revenue represents revenue associated with the Astellas Agreement and related agreements. Deferred collaboration revenue arises from the excess of cash received or receivable over cumulative revenue recognized for the period.

Under the terms of the Astellas Agreement, we earn royalties based on each sale of Qutenza into the Licensed Territory. The royalty rate is tiered based on the level of sales achieved. These royalties are considered contingent consideration as we have no remaining contract performance obligation and, therefore, the royalties are excluded from the single unit of accounting discussed above. We report royalty revenue based upon Astellas’ reported net sales of Qutenza in the Licensed Territory. We recognize royalty revenue from Astellas on a quarter lag basis due to the timing of Astellas reporting such royalties to us.

 

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For events for which the occurrences are contingent solely upon the passage of time or are the result of the collaborative partner’s performance, the contingent payments will not be accounted for in accordance with the provisions of ASU 2010-17 and will be recognized as revenue when payments are earned, the amounts are fixed or determinable and collectability is reasonably assured.

Additionally, we can earn contingent event-based payments from Astellas if they achieve certain sales levels as outlined in the Astellas Agreement. As these payments are contingent on Astellas’ performance, they are excluded from the single unit of accounting discussed above. The contingent event-based payments will be recorded as revenue when earned as we have no remaining contract performance obligation.

We recognize revenue net of related costs for collaboration supplies sold to Astellas upon the product being delivered to Astellas. The revenue and related costs of the product supplied to Astellas are included in collaboration revenue. Prior to delivery to Astellas, the costs accumulated for the manufacturing of the collaboration supplies are included as prepaid expenses and other current assets on our condensed consolidated balance sheets.

Stock-Based Compensation

We account for our stock-based compensation in accordance with the fair value recognition provisions of current authoritative guidance. Under the authoritative guidance, stock-based awards, including stock options and restricted common stock units, are recorded at fair value as of the grant date and recognized to expense over the employee’s requisite service period (generally the vesting period), which we have elected to amortize on a straight-line basis. Because non-cash stock compensation expense is based on awards ultimately expected to vest, it has been reduced by an estimate for future forfeitures. We estimate forfeitures at the time of grant and revise, if necessary, in subsequent periods.

We estimate the fair value of stock options and restricted stock units granted using the Black-Scholes valuation model and the assumptions used shown in Note 7 to the Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q. In addition the fair value of certain stock options is measured by utilizing a Monte Carlo simulation model. Significant judgment is required on the part of management in determining the proper assumptions used in these models. The assumptions used in the Black-Scholes option valuation model include the risk free interest rate, expected term, expected volatility and expected dividend yield. We base our assumptions on historical data when available or when not available, on a peer group of companies. However, these assumptions consist of estimates of future market conditions, which are inherently uncertain, and therefore subject to management’s judgment. See Note 7 of Notes to Condensed Consolidated Financial Statements included elsewhere in this report for further discussion.

Clinical Trials

We accrue and expense costs for clinical trial activities performed by third parties, including clinical research organizations and clinical investigators, based upon estimates made, as of the reporting date, of the work completed through the reporting date as a percentage of the total work contracted for under our agreements with such third parties. We make our estimates at the end of each reporting period after discussion with internal personnel and outside service providers and thorough evaluation as to progress or stage of completion of trials or services. On a periodic basis we adjust our estimated clinical trial costs to reflect actual expenses incurred to date. Due to the nature of the estimation of clinical trial costs, we may be required to make changes to our estimates in the future as we become aware of additional information about the status or conduct of clinical trials.

Long-Term Obligations

On April 30, 2010, the Company entered into a financing agreement with Cowen Royalty, or the Financing Agreement. Under the terms of the Financing Agreement, we borrowed $40 million from Cowen Royalty, or the Borrowed Amount, and we agreed to repay such Borrowed Amount together with a return to Cowen Royalty, out of royalty, milestone, option and certain other payments, collectively, the Revenue Interest, that we may receive under the Astellas Agreement.

The accounting for the Financing Arrangement requires us to make certain estimates and assumptions, including the timing and extent of royalty, milestone, option and other payments to be received from Astellas and an internal rate of return we are to pay to Cowen. Changes in the estimated Revenue Interest payments can result in changes in our classification of the current and long-term portions of the amounts payable pursuant to the Financing Agreement, as well as the internal rate of return paid to Cowen.

We are also required to make assumptions for the calculation of the estimated fair market value of the long-term obligation disclosed in the footnotes to our financial statements. The key assumptions required for the estimated fair market value calculation are estimates of the amounts and timing of the future royalty revenues and other payments to be received from Astellas, the amount and timing of payments to Cowen Royalty to repay the Borrowed Amount and an estimated cost of capital.

 

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The estimate of the future royalty revenues and other payments to be received from Astellas is subject to significant variability due to the recent product launch and regulatory process still to be conducted for significant portions of the Astellas territory and thus are subject to significant uncertainty (see further discussion of this long-term obligations under Liquidity and Capital Resources).

In August 2011, we entered into a loan agreement with Hercules which includes both a $5.0 million accounts receivable line and a $15.0 million term loan. Under the terms of the loan agreement, the $15.0 million term loan is required to be repaid over the course of the 42-month maturity period, which includes a 12-month interest only period at the beginning of the term. Principal payments are scheduled to commence in September 2012. Interest on the term loan has a minimum rate of 9.5%, which can increase based on fluctuations in the prime rate. The $5.0 million accounts receivable line is a revolving line that is available until December 31, 2012 and then is renewable by Hercules each year thereafter. Under the terms of the loan agreement with Hercules and the warrant as originally issued on August 5, 2011, if our shares of common stock were delisted from the NASDAQ Global Market, as may occur pursuant to the market value of listed shares and bid price delinquency notices we received from NASDAQ, such an event would trigger an event under the loan agreement. As a result, in March 2012, we entered into an amendment to the Hercules warrant, in which we amended the covenant with respect to the requirement to maintain our listing on the NASDAQ Global Market to allow for the NASDAQ Capital Market and certain over-the-counter markets to be permissible alternative markets on which we can list our shares of common stock. Under the terms of the amendment, the number of shares underlying the warrant was increased to 1,950,000 and the exercise price per share of common stock was reduced to $0.50.

We are also required to make assumptions for the calculation of the estimated fair market value of the Long-term obligation disclosed in the footnotes to our financial statements. The key assumptions required for the estimated fair market value calculation are estimates of the amounts and timing of the future royalty revenues and other payments to be received from Astellas, the amount and timing of payments to Cowen Royalty to repay the Borrowed Amount, the timing of payment to Hercules and an estimated cost of capital.

The estimate of the future royalty revenues and other payments to be received from Astellas is subject to significant variability due to the recent product launch and regulatory process still to be conducted for significant portions of the Astellas territory and thus are subject to significant uncertainty (see further discussion of this Long-term obligation under Liquidity and Capital Resources).

Results of Operations

In November 2009, we received marketing approval from the FDA for Qutenza for the management of neuropathic pain associated with PHN. In April 2010, we launched Qutenza in the United States. In March 2012, we implemented a restructuring plan to focus our resources on the development of NGX-1998, which resulted in the elimination of our internal sales force. See Note 10 of Notes to Condensed Consolidated Financial Statements included elsewhere in this report for further discussion. We continue to support the established distribution network to allow healthcare providers to access Qutenza through specialty distributors and specialty pharmacies. However, as we have eliminated direct promotion of Qutenza, revenues from US product sales for Qutenza may decline in future quarters.

We commenced recording collaboration revenue for the upfront payments from Astellas in 2009, when the upfront payment of $48.8 million received from Astellas became nonrefundable as a result of our transfer of the Qutenza MA to Astellas. We recognized $1.8 million of the upfront payment as revenue in each of the first quarters of 2012 and 2011. As of March 31, 2012, we have $30.6 million remaining in deferred collaboration revenue which will be recognized on a straight-line basis over the remaining service period of the joint steering committee, which we estimate will expire in June 2016. Under our Supply Agreement with Astellas, we are obligated to supply product, at a contractual price which approximates our cost, until such time as Astellas establishes its own supply relationship.

As of March 31, 2012, Astellas has made Qutenza commercially available in 21 European countries and Astellas has informed us that it is continuing its focus on intensive site training on a country by country basis. We believe that Astellas plans to expand Qutenza availability in the European Union and seek regulatory approvals in certain countries in the remainder of the Licensed Territory in 2012.

Cost of goods sold includes the cost of products sold, costs associated with services provided by our third-party logistics partner for managing the shipping, billing and other administrative functions associated with the distribution channel, estimated inventory obsolescence charges and also includes royalty obligations due to our intellectual property licensors, the University of California, or UC, and LTS Lohmann Therapie-Systeme AG, or LTS. We recognize costs associated with our third-party logistics provider in the period in which those costs are incurred, however, costs to manufacture product and royalty obligations due to third parties are deferred and recognized in the period in which the associated revenue is recognized. Costs associated with the manufacture of Qutenza prior to regulatory approval were previously expensed in the period in which those costs were incurred. We believe that the effect on cost of goods sold of previously expensed materials prior to approval is immaterial, as compared to what cost of goods sold would have been if such costs were expensed in the period that the product was sold.

 

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Our research and development expenses consist of internal and external costs. Our internal costs are primarily employee salaries and benefits, contract employee expense, non-cash stock-based compensation expense, allocated facility and other overhead costs. Our external costs are primarily expenses related to the development of product candidates, including formulation development, manufacturing process development, non-clinical studies, clinical trial costs, such as the cost of clinical research organizations and clinical investigators, milestone payments to our licensors in connection with the use of certain intellectual property, and costs associated with preparation and filing of regulatory submissions. Additionally, external and internal costs related to manufacturing and quality assurance activities for production batches of our active pharmaceutical ingredient, patches and cleansing gel, which are destined for commercial sale in the United States, were recorded to research and development expense if purchase of such components occurred prior to FDA approval.

We commence tracking the separate, external costs of a project when we determine that a project has a reasonable chance of entering clinical development. Senior management discusses the possibility of entering clinical development, along with the possibility of meeting other regulatory milestones, throughout the development cycle. These discussions include consideration of the costs and time required to bring the project to market and potential market acceptance for a product from the project, if one receives marketing approval. We do not maintain and evaluate research and development costs by specific therapeutic indications within a program due to the difficulties in allocating such costs to specific indications. We use our internal research and development resources across several projects and some of their efforts may not be attributable to specific projects or indications.

The following table reflects the distribution of our research and development costs by development program for the three months ended March 31, 2012 and 2011 (in thousands):

 

		Three Months Ended March 31,
		Qutenza				NGX-1998				Acetaminophen Prodrug and Opioid Prodrug				Unallocated Internal Costs				Total
2012		$	1,165			$	1,520			$	5			$	243			$	2,933
2011			1,449				2,198				47				263				3,957

The process of conducting pre-clinical testing and clinical trials necessary to obtain marketing approvals in the United States and other regions is costly and time consuming. The probability of success for each product candidate and clinical trial may be affected by a variety of factors, including, among others, patient enrollment, manufacturing capabilities, successful clinical results, our funding, and competitive and commercial viability. As a result of these and other factors, we are unable to determine the duration and completion costs of current or future clinical stages of our product candidates or when or to what extent we will generate revenues from commercialization and sale of any of our unapproved product candidates. In November 2011, we reported the top line results of our Phase 2 clinical study of NGX-1998, our most advanced product candidate, in patients with PHN. The clinical trial met its protocol-specific objectives, which include the primary endpoint of a percentage change from baseline versus placebo in a patient-reported numeric pain rating scale. Costs to complete development of NGX-1998 could be significant. We intend to seek a partner to aid in the continued development and commercialization of NGX-1998 in the United States and other markets of the world not already partnered. Pursuant to the Astellas Agreement, Astellas has an option to license NGX-1998 in the Licensed Territory, and if they were to exercise the option, the Astellas Agreement provides for Astellas to be responsible for 50% of the costs incurred for Phase 3 clinical development. If we do not obtain regulatory approval for NGX-1998 or our other product candidates, or for other indications for Qutenza, our ability to achieve additional revenue, our operating results, and our financial position will be adversely affected.

Our selling, general and administrative expenses consist primarily of salaries and benefits, including those of our sales, marketing, commercial operations and administrative functions, such as finance, human resources, legal, medical affairs and information technology. Additionally, selling, general and administrative expenses include marketing expenses, commercialization costs, pharmacovigilance costs, costs associated with our status as a public company and patent costs. In addition, general and administrative expenses include allocated facility, basic operational and support costs and insurance costs.

 

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Comparison of the Three Months Ended March 31, 2012 and 2011

 

		Three Months Ended March 31,								Increase (Decrease)
(in thousands)		2012				2011				$				%
Product revenue		$	831			$	575			$	256				45	%
Collaboration revenue			2,142				2,595				(453	)			-17	%
Cost of goods sold			681				108				573				531	%
Research and development expenses			2,933				3,957				(1,024	)			-26	%
Selling, general and administrative expenses			7,263				10,282				(3,019	)			-29	%
Interest income			12				27				(15	)			-56	%
Interest expense and other			(3,280	)			(2,213	)			(1,067	)			48	%

Product Revenue. Due to limited history of product returns and cash collections from our customers (specialty distributors and specialty pharmacies), we recognize revenue for Qutenza at the later of the time our customers ship product to healthcare professionals and cash collections received by us from our customers. We recorded gross shipments of Qutenza to our distributor customers totaling $0.9 million and $0.6 million in the three months ended March 31, 2012 and 2011, respectively. Based on our revenue recognition methodology, we recognized $0.8 million and $0.6 million as Qutenza revenue, respectively, in the three months ended March 31, 2012 and 2011. We have deferred product revenue of $1.1 million at March 31, 2012, which is reported net of associated cost of goods sold of $0.1 million in our condensed consolidated balance sheet as of March 31, 2012.

Collaboration Revenue. Collaboration revenue of $2.1 million recorded in the three months ended March 31, 2012 consisted of $1.8 million of the amortization of upfront payments received pursuant to the Astellas Agreement and $0.3 million in royalty income. Collaboration revenue of $2.6 million recorded in the three months ended March 31, 2011 consisted of $1.8 million of the amortization of upfront payments received pursuant to the Astellas Agreement, $0.6 million of Collaboration revenue under our Supply Agreement with Astellas and $0.2 million in royalty income. Under our Supply Agreement with Astellas, we are obligated to supply product, at a contractually agreed upon cost for materials and our related labor and overhead, until such time as Astellas establishes its own supply relationship with suppliers.

Cost of goods sold. Cost of goods sold were $0.7 million for the three months ended March 31, 2012. Cost of goods sold included $0.1 million for the cost of the finished goods sold that were recognized as revenue in the three months ended March 31, 2012 and a charge of $0.6 million for Qutenza patches which we do not expect to sell prior to their expiration date. Our expectation of future U.S. Qutenza product revenue is that it may decline over the coming months as a result of our decision to curtail our investment in marketing and sales activity. As a result, gross margins will likely decrease as the fixed costs component of cost of goods sold has a more significant impact on overall gross margins.

Research and Development expenses. Research and development expenses were $2.9 million for the three months ended March 31, 2012, a decrease of $1.0 million, or 26%, compared to $4.0 million for the three months ended March 31, 2011. The decrease was primarily related to lower clinical trial costs of $0.7 million and decreased headcount related expenses of $0.3 million related to the restructuring plans implemented in March 2012 and October 2011.

Selling, General and Administrative expenses. Selling, general and administrative expenses were $7.3 million for the three months ended March 31, 2012, a decrease of $3.0 million, or 29%, compared to $10.3 million for the three months ended March 31, 2011. This decrease was related to reduced marketing activities, materials and contracted services. These amounts were partially offset by higher employee costs that included severance costs of $1.2 million related to the March 2012 restructuring.

Interest expense. Interest expense was $3.2 million for the three months ended March 31, 2012, as compared to $2.2 million for the three months ended March 31, 2011. This increase was primarily due to interest on the $40 million long-term obligation related to the Financing Agreement entered into with Cowen Royalty in April 2010 and the loan agreement entered into with Hercules in August 2011. Interest expense on the Financing Agreement continues to accrue at 19%.

Liquidity and Capital Resources

Since our inception through March 31, 2012, we have funded our operations primarily by selling equity securities, establishing debt facilities and through a collaboration agreement with Astellas. In April 2010, we borrowed $40.0 million under a Financing

 

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Agreement with Cowen. In July 2011, we completed a private placement under a Securities Purchase Agreement which resulted in net cash proceeds of $18.6 million, after deducting total expenses including placement agent fees and other offering-related expenses. In August 2011, we borrowed $15.0 million under a loan agreement with Hercules. In February 2012, we completed a private placement under a Securities Purchase Agreement which resulted in net cash proceeds of $2.9 million, after deducting offering related expenses.

At March 31, 2012, we had approximately $27.4 million in cash, cash equivalents and short-term investments and working capital of $18.7 million, adjusted to exclude the current portion of non-cash deferred revenue of approximately $8.3 million. Our cash and investment balances are generally held in money market funds and obligations of U.S. government agencies. Cash in excess of immediate operational requirements is invested in accordance with our investment policy primarily with a view to capital preservation and liquidity. Further, to reduce portfolio risk, our investment policy specifies a concentration limit of 10% in any one issuer or group of issuers of corporate bonds or commercial paper at the time of purchase. Our investment holdings at March 31, 2012 consisted of $19.7 million in government sponsored enterprise debt securities, and $7.7 million in cash and money market funds.

Net cash used in operating activities was $9.8 million and $11.8 million for the three months ended March 31, 2012 and 2011, respectively. The increase in cash used in operating activities in 2012 as compared to 2011 resulted primarily from a smaller loss in 2012 than in 2011.

Net cash provided by investing activities was $5.4 million and $7.4 million for the three months ended March 31, 2012 and 2011, respectively. Investing activities consisted primarily of the purchase, sale and maturity of marketable securities and to a lesser extent, the purchase of capital equipment.

Net cash provided by financing activities in the three months ended March 31, 2012 and 2011 was $2.9 million and $8,000, respectively.

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

 

•

the progress of our development programs including the number, size and scope of clinical trials and non-clinical development;

 

•

the success of the commercialization of our products;

 

•

the scope and cost of commercial activities including, but not limited to, costs associated with pharmacovigilance and medical affairs activities;

 

•

the conduct of manufacturing activities;

 

•

the costs of carrying out our obligations under our commercial arrangement with Astellas;

 

•

our ability to establish and maintain strategic collaborations, including licensing and other arrangements that we have or may establish;

 

•

the costs and timing of seeking regulatory approvals;

 

•

the costs involved in enforcing or defending patent claims or other intellectual property rights; and

 

•

the extent to which we acquire or invest in other products, technologies and businesses.

We had $1.0 million available for draw-down on our accounts receivable line at March 31, 2012 based upon a percentage of the then eligible account receivables. We have not drawn any funds from the accounts receivable line and in May 2012, we initiated the process to terminate the facility.

If we were to default under the Financing Agreement with Cowen, we are obligated to pay to Cowen the borrowed amount together with interest accrued thereon from the effective date of the Financing Agreement, to the date of repayment at an internal rate of return equal to the lesser of the 19% rate of interest or the maximum rate permitted by law, less any Revenue Interest payments received by Cowen. Under the Financing Agreement, an event of default includes standard insolvency and bankruptcy terms, including a failure to maintain liquid assets equal to at least our liabilities due and payable during the following three months.

To date, we have incurred recurring net losses and negative cash flows from operations, after excluding the upfront cash received from Astellas in 2009. Until we can generate significant cash from our operations, if ever, we expect to continue to fund our operations with existing cash resources, as well as through proceeds from potential additional collaboration agreements, potential

 

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royalty monetization transactions, debt facilities or the sale of equity securities. However, we may not be successful in obtaining additional collaboration agreements, in receiving milestone or royalty payments under those agreements, or in obtaining capital from additional equity or debt financings. In addition, we cannot be sure that our existing cash and investment resources will be adequate or that additional financing will be available when needed or that, if available, financing will be obtained on terms favorable to us or our stockholders. Having insufficient funds may require us to delay or potentially eliminate some or all of our development programs, relinquish some or even all rights to product candidates at an earlier stage of development or negotiate less favorable terms than we would otherwise choose. Failure to obtain adequate financing also may adversely affect the launch of our product candidates or our ability to continue in business. If we raise additional funds by issuing equity securities, substantial dilution to existing stockholders would likely 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. We anticipate that our cash and investments at March 31, 2012 will be sufficient to meet our projected operating requirements into 2013.

Off-balance Sheet Arrangements

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

Contractual Obligations

We have issued non-cancellable purchase orders to third-party manufacturers of Qutenza and NGX-1998 for manufacturing, stability and related services including reimbursable amounts from Astellas for the supply of Qutenza based on the Astellas Agreement. These purchase orders totaled $1.6 million as of March 31, 2012 and included $1.1 million for stability and related services, $0.2 million related to Qutenza product manufacturing costs for the U.S. market and NGX-1998 clinical supply development cost, along with $0.3 million of commitments related to supply of Qutenza to Astellas. We plan to record these amounts in our financial statements when title to the applicable materials has transferred to us.

Recently Issued and Adoption of New Accounting Standards

Effective January 1, 2012, we adopted revised guidance related to the presentation of comprehensive income that increases comparability between U.S. GAAP and International Financial Reporting Standards. This guidance eliminates the current option to report other comprehensive income (OCI) and its components in the statement of changes in stockholders’ equity. We adopted this guidance during the first quarter of 2012, which had no impact on our financial position, operations, or cash flows.

In May 2011, the Financial Accounting Standards Board issued new guidance to achieve common fair value measurement and disclosure requirements between GAAP and International Financial Reporting Standards. This new guidance amends current fair value measurement and disclosure guidance to include increased disclosures regarding valuation inputs and investment categorization. The adoption of this new accounting guidance in 2012 did not have a material impact on our financial position, operations or cash flows.

 

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ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We believe there has been no material change in our exposure to market risk from that discussed in our Form 10-K filed for the year ended December 31, 2011.

Foreign Currency Exchange Rate Risk

Our third-party manufacturers including the manufacturer of our active pharmaceutical ingredient, trans-capsaicin, the manufacturer of Qutenza and the manufacturer of our cleansing gel are located in countries outside the United States. As a result, we may experience changes in product supply costs as a result of changes in exchange rates between the U.S. dollar and the local currency where the manufacturing activities occur. In addition, as we supply Astellas with our product components for commercial sale in the European Union and to supply the U.S. market, our exposure to foreign currency exchange rates, primarily the Euro, will increase.

Amounts paid to us by Astellas under the Astellas Agreement may be based in Euro or other currency which will then be converted to U.S. dollars before payment to us. To the extent that these potential receipts are different than our net payable exposure in Euro to our suppliers mentioned above, and to the extent that the timing of these potential payments and receipts differ, we will have a net receivable or payable exposure in Euro.

We currently do not engage in foreign currency hedging activities as the short-term exposure to fluctuations in foreign currency is relatively small.

 

ITEM 4.

CONTROLS AND PROCEDURES

(a) Evaluation of disclosure controls and procedures

Our management evaluated, with the participation and under the supervision of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded, subject to the limitations described below, that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and that such information is accumulated and communicated to management as appropriate to allow timely decisions regarding required disclosures.

(b) Changes in internal control over financial reporting

Our management, including our Chief Executive Officer and Chief Financial Officer, has evaluated any changes in our internal control over financial reporting that occurred during the quarter ended March 31, 2012, and has concluded that there was no change during such quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

(c) Limitations on the Effectiveness of Controls

A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the controls are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues, if any, within a company have been detected. Accordingly, our disclosure controls and procedures are designed to provide reasonable, not absolute, assurance that the objectives of our disclosure control system are met.

 

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PART II. OTHER INFORMATION

 

ITEM 1.

LEGAL PROCEEDINGS

Maritime Asset Management, LLC on Behalf of Itself and All Others Similarly Situated v. NeurogesX, Inc., Anthony A. DiTonno, Stephen F. Ghiglieri and Jeffrey K. Tobias, M.D.

On April 23, 2012, we received a copy of a complaint filed by Maritime Asset Management, LLC with the United States District Court Southern District of New York against us and the current and former executive officers listed above. The complaint alleges, among other things, violations of Section 10(b), Section 20(a) and Rule 10b-5 of the Securities and Exchange Act of 1934 (the “Exchange Act”), breach of contract, fraud and aiding and abetting arising out of disclosures made prior to the departure of our former Chief Medical Officer and Executive Vice President of Research and Development, Dr. Jeffrey K. Tobias. The challenged disclosures were made in connection with our July 26, 2011 private placement of common stock and common stock warrants and our periodic reports filed pursuant to the Exchange Act from May 9, 2011 through September 27, 2011. The complaint states that the plaintiff is seeking monetary damages, but no amounts are specified. Our board of directors and management believe the claims are without merit and intend to vigorously defend against the action.

We are subject to various legal disputes that arise in the normal course of business. These include or may include employment matters, contract disputes, intellectual property matters, product liability actions, and other matters. We do not know whether we would prevail in these matters nor can it be assured that a remedy could be reached on commercially viable terms, if at all. Based on currently available information, we do not believe that any of these disputes will have a material adverse impact on our business, results of operations, liquidity or financial position.

 

ITEM 1A.

RISK FACTORS

You should consider carefully the risk factors described below, and all other information contained in or incorporated by reference in this quarterly report on Form 10-Q before making an investment decision. If any of the following risks actually occur, they may materially harm our business, financial condition, operating results or cash flows. As a result, the market price of our common stock could decline, and you could lose all or part of your investment. Additional risks and uncertainties that are not yet identified or that we think are immaterial may also materially harm our business, operating results or financial condition and could result in a complete loss of your investment.

Risks Related to our Business

Our success depends on our ability to obtain regulatory approval for our lead product candidate NGX-1998.

Our success depends substantially on the approval of our most advanced product candidate, NGX-1998, a topical liquid formulation of high concentration capsaicin, for use in certain neuropathic pain conditions. In order to obtain regulatory approval, we will need to demonstrate in Phase 3 clinical trials that NGX-1998 is safe and effective for use in each target indication. The FDA generally requires successful completion of at least two adequate and well-controlled Phase 3 clinical trials for each indication for which we seek regulatory approval. The successful outcome of Phase 3 clinical trials and the required capital expenditure for such trials will depend in part on our ability to successfully design, initiate and complete enrollment and conclude any such trials on a timely basis. We may not have adequate financial or other resources to pursue this product candidate for any indications through the clinical trial process. Additionally, such trials may not achieve positive results, and, even if the results are positive, may not adequately support approval by the FDA. If we fail to complete clinical trials for NGX-1998, or if such clinical trials fail to demonstrate with substantial evidence that NGX-1998 is both safe and effective, we will not be able to obtain regulatory approval to market the product candidate. To date, NGX-1998 has only been tested for efficacy in a single Phase 2 clinical trial in PHN patients. There can be no assurance that the results we obtained in such trial will be replicated in any subsequent trials or that the results obtained in the PHN population would be replicated in other neuropathic pain indications. Further, there can be no assurance that the clinical trial data for our approved Qutenza product will be relevant or provide any meaningful insight into the design of clinical trials for NGX-1998 or that we will be able to use the clinical trial data from Qutenza with respect to obtaining approval.

Our clinical trials may fail to demonstrate adequately the safety and efficacy of our product candidates, which could prevent or delay regulatory approval and commercialization.

Before obtaining regulatory approvals for the commercial sale of our product candidates, we must demonstrate through lengthy, complex and expensive preclinical testing and clinical trials that the product is both safe and effective for use in each target indication. Clinical trial results from the study of neuropathic pain are inherently difficult to predict. The primary measure of pain is subjective

 

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patient feedback, which can be influenced by factors outside of our control, and can vary widely from day to day for a particular patient, and from patient to patient and site to site within a clinical study. The results we have obtained in completed clinical trials may not be predictive of results from our ongoing or future trials. Additionally, our product candidate may fail to show efficacy in additional clinical trials, even after promising results in earlier studies.

Some of our trial results have been negatively affected by factors that had not been fully anticipated prior to our examination of the trial results. For example, we have from time to time observed a significant “placebo effect” within our control groups—a phenomenon in which a sham treatment or, in the case of our studies, a low-dose capsaicin treatment that we believed would not be effective, results in a beneficial effect. Although we design our clinical study protocols to address known factors that may negatively affect our study results, there can be no assurance that our protocol designs will be adequate or that unknown factors will not have a negative effect on the results of our clinical trials, which could significantly disrupt our efforts to obtain regulatory approvals and commercialize our product candidates. In addition, clinical trials in new indications or in a larger patient population could reveal more frequent, more severe or additional side effects that were not seen or deemed unrelated in earlier studies, any of which could interrupt, delay or halt clinical trials of our product candidates and could result in the FDA or other regulatory authorities stopping further development of or denying approval of our product candidates. Based on results at any stage of clinical trials, we may decide to repeat or redesign a trial or, modify our regulatory strategy, which would likely delay the date of potential regulatory approval, or even discontinue development of one or more of our product candidates.

A number of companies in the biotechnology and pharmaceutical industries have suffered significant setbacks in advanced clinical trials, even after obtaining promising results in earlier trials. If our product candidates, including NGX-1998, are not shown to be both safe and effective in clinical trials, our business, financial condition and results of operations will be adversely affected.

Our success depends on our ability to secure adequate funding to complete the development program for NGX-1998.

Currently, we believe that we have sufficient cash reserves to fund operations into 2013. However, our current cash reserves are not be sufficient to fully fund Phase 3 development of NGX-1998, and as a result, we will need additional funding to complete the development of this product candidate and to fund operations generally. We are currently seeking to enter potential strategic partnerships related to both NGX-1998 and Qutenza to provide funding for continued development of NGX-1998, support of our commercialization operations with respect to Qutenza, potentially support commercialization for NGX-1998, if approved for marketing, and support funding of general operations. However, there can be no assurance that such a strategic partnership would be completed or on terms that are favorable to us. If we are unable to reach agreement with a potential strategic partner or if a strategic partnership does not provide adequate funding, we would need to obtain additional funding to complete the clinical development of NGX-1998. Raising additional equity capital may be difficult since our share price is near historical lows compared to its trading history, and due to our potential delisting from the NASDAQ Global Market, as a result of failure to meet certain minimum requirements. If we are unable to raise sufficient capital to fund our development programs and operations generally, we will be unable to proceed with the development of NGX-1998 and our business and financial condition will be significantly harmed.

Additionally, Astellas has an option pursuant to the Astellas Agreement to obtain an exclusive license to commercialize NGX-1998 in the Licensed Territory. There can be no assurance that any data and other information we provide to Astellas regarding development of NGX-1998 and its prospects for potential approval and commercialization will be sufficient for Astellas to elect to exercise such option. If Astellas decides not exercise its option with respect to NGX-1998, we will not receive funding for Phase 3 development of NGX-1998 under the Astellas Agreement, and, additionally, we will not be permitted to commercialize NGX-1998 in the Licensed Territory. A failure of Astellas to exercise its co-development and commercialization option with respect to NGX-1998 may delay or prevent us from obtaining funding for the continued development of NGX-1998 and the operation of our business will be significantly harmed.

Raising additional funds by issuing securities, engaging in debt financings or through licensing arrangements may cause substantial dilution to existing stockholders, restrict our operations or require us to relinquish proprietary rights.

To the extent that we raise additional capital by issuing equity securities as we did in July 2011 and February 2012, our existing stockholders’ ownership may be substantially diluted. Royalty monetization structures may require us to give up or assign certain rights to certain current and future assets. Any debt financing we enter into may involve covenants that restrict our operations or our ability to enter into other funding arrangements. These restrictive covenants may include limitations on additional borrowing and specific restrictions on the use of our assets, as well as prohibitions on our ability to create liens, pay dividends, redeem our stock or make investments. In addition, if we raise additional funds through licensing arrangements, it may be necessary to relinquish potentially valuable rights to our potential products or proprietary technologies, or grant licenses on terms that are not favorable to us.

 

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Failure to meet our loan obligations with Hercules could adversely affect our financial condition.

Under the terms of our agreement with Hercules, we are subject to certain negative covenants and events of default. If we were to default under Hercules Agreement, we would be obligated to pay to Hercules the amount we borrowed under such agreement together with any unpaid interest, a 5% interest penalty on any past due amount, and the end of loan charge of $0.6 million. If we were required to pay the amounts due in the event of default under the Hercules Agreement, we would be required to raise additional capital and there can be no assurances that we would be able to do so.

Failure to meet our loan obligations with Cowen could adversely affect our financial condition.

Under the terms of our Financing Agreement with Cowen, we are subject to certain negative covenants and events of default. Under the Financing Agreement, an event of default includes a covenant to maintain liquid assets equal to expected cash needs during the following three months. If we were to default under the Financing Agreement with Cowen we are obligated to immediately pay to Cowen the borrowed amount together with interest accrued thereon from the effective date of the Financing Agreement to the date of repayment at an internal rate of return equal to the lesser of the 19% rate of interest or the maximum rate permitted by law, less any payments received by Cowen. If we were required to pay the amounts due in the event of default under the Cowen Agreement, we would be required to raise additional capital and there can be no assurances that we would be able to do so.

If we fail to meet the requirements for continued listing on the NASDAQ Global Market and do not meet initial listing requirements to transfer to the NASDAQ Capital Market, our common stock could be delisted from trading, which would adversely affect the liquidity of our common stock and our ability to raise additional capital.

Our common stock is currently listed on the NASDAQ Global Market and to maintain our listing we must meet certain financial and other requirements in accordance with the rules of Nasdaq. On October 18, 2011, we received a notification from Nasdaq that we failed to maintain the required minimum market value of listed securities level of $50.0 million for a 30 consecutive business day period. By the April 16, 2012 expiration of our cure period for such non-compliance, we had not met this standard, and Nasdaq issued a delisting determination letter. In connection with the determination letter, we requested a hearing with Nasdaq, have submitted a plan for regaining compliance with the applicable minimum listing requirement and are seeking an extension of the grace period during which we would seek to execute such plan. During the pendency of the hearing process, our delisting will be delayed, however, we cannot be assured that we will otherwise be granted any additional time to regain compliance as a result of the hearing process. On January 27, 2012, we received a notification from Nasdaq that we failed to maintain the required $1.00 minimum bid price for a 30 consecutive business day period. We have until July 28, 2012 to cure this non-compliance by meeting or exceeded such requirement for a minimum of ten consecutive business days. On May 3, 2012, we received a notice of market value of publicly held shares insufficiency as the market value of shares held by non-affiliates remained below the $15 million minimum listing requirement for more than 30 consecutive business days. We have until October 30, 2012 to cure this non-compliance by meeting or exceeding such requirement for a minimum of ten consecutive business days. There can be no assurance that we will receive in our hearing with Nasdaq an additional cure period to come into compliance with the market value of listed securities requirement, be able to cure our other violations by the end of their respective cure periods, be able to transfer to the NASDAQ Capital Market or maintain our listing on either market in the future. Any potential delisting of our common stock would adversely affect the liquidity of our common stock and our ability to raise additional capital.

If we do not raise additional capital, we may be forced to delay, reduce or eliminate our commercialization efforts or development programs.

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

 

•

the progress of our development programs including the number, size and scope of clinical trials and non-clinical development, including the initiation and conduct of Phase 3 clinical trials for NGX-1998;

 

•

our ability to meet our obligations under the loan agreement with Hercules and our Financing Agreement with Cowen;

 

•

the success of the commercialization of our products and the amount of revenue we generate;

 

•

the costs of maintaining sales and marketing infrastructure, distribution capabilities and other market support functions such as medical affairs and pharmacovigilance;

 

•

the conduct of manufacturing activities including the manufacture of commercial product supply and clinical product supply;

 

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•

the costs of carrying out our obligations under our commercial arrangement with Astellas;

 

•

our ability to establish and maintain strategic collaborations, including licensing, distribution and other arrangements that we have or may establish;

 

•

our ability to meet our obligation under the Financing Agreement with Cowen including liquidity maintenance requirements;

 

•

the costs and timing of additional regulatory approvals;

 

•

the costs involved in enforcing or defending patent claims or other intellectual property rights; and

 

•

the extent to which we acquire or invest in other products, technologies and businesses.

We intend to seek additional funding through strategic alliances and/or debt facilities or other financing vehicles which may include the public or private sales of our equity securities. There can be no assurance, however, that additional funding will be available on reasonable terms, if at all. If adequate funds are not available, we may be required to further delay, reduce the scope of, or eliminate one or more of our planned development, commercialization or expansion activities.

Our success depends in part on our ability to cost-effectively maintain Qutenza^® (capsaicin) 8% patch on the market in the United States.

Our product Qutenza^® (capsaicin) 8% patch, was approved by the FDA in November 2009 for the management of neuropathic pain associated with PHN. We initially launched Qutenza in April 2010 in the United States with our own commercial sales organization. Over the two years since launch, we invested significant time and cash resources into commercialization of Qutenza. In March 2012, we concluded that we could no longer invest significant resources in Qutenza. As a result, we ceased direct promotion of Qutenza by eliminating our sales force and by reducing our expenses in support of commercial operations. Despite our cost control efforts with respect to Qutenza, the costs of maintaining availability of Qutenza in the market could be greater, and the revenues deriving from sales of Qutenza could be less, than we currently anticipate. Further, there are certain ongoing activities that are required for maintaining a pharmaceutical product in the market, such as maintaining a safety database. If the costs of maintaining Qutenza in the market are significantly greater than we expect, or the revenues significantly lower, our business could be seriously harmed and our ability to continue development of NGX-1998 would be adversely affected.

Qutenza and our product candidates may never achieve market acceptance.

The commercial success of Qutenza or any other product candidates we develop including NGX-1998, if approved, will depend on, among other things, acceptance by healthcare professionals, patients and payers. Market acceptance of, and demand for any products that we develop and commercialize will depend on many factors, including:

 

•

with respect to Qutenza, healthcare professionals and patients willingness and ability to accommodate the time necessary for each Qutenza treatment;

 

•

our ability to fund the size and scope of sales and marketing activities necessary to support a product such as Qutenza;

 

•

the effectiveness of our sales and marketing strategies;

 

•

the ability to obtain adequate pricing and sufficient insurance and other third-party payer coverage and reimbursement;

 

•

patient acceptance of the treatment procedure, efficacy or safety of Qutenza;

 

•

availability, relative cost and relative efficacy and safety of alternative and competing treatments;

 

•

the effectiveness of our or our collaborators’ sales, marketing and distribution strategy;

 

•

publicity concerning our products or competing products and treatments;

 

•

potential product recalls; and

 

•

post marketing approval pharmacovigilance or other studies showing safety issues not seen in previous studies.

If Qutenza, or our product candidates if approved, fail to gain market acceptance, we may be unable to earn sufficient revenue to continue our business.

 

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We outsource the manufacturing of Qutenza and our other product candidates and accordingly depend on other parties for our manufacturing operations. If these manufacturers fail to meet our requirements and strict regulatory requirements, Qutenza commercialization efforts and further product development efforts may be negatively affected.

We currently depend on four contract manufacturers as single source suppliers for the components of Qutenza: an intermediate material used in the synthesis of capsaicin, synthetic capsaicin, the dermal delivery system and the associated cleansing gel. We have entered into long-term commercial supply agreements for these components. In addition we have entered into a long-term agreement for the assembly of the Qutenza treatment kits in the United States. If relationships with any of these manufacturers is terminated, or if any manufacturer is unable to produce required quantities on a timely basis or in compliance with current good manufacturing practices, or cGMP, and other regulatory requirements, our operations would be negatively impacted and our business harmed.

We are currently in the process of identifying potential manufacturers for NGX-1998. Potential suppliers of NGX-1998 will need to meet technical and regulatory requirements related to safely manufacturing of the liquid formulation of capsaicin, filling the liquid formulation into its finished applicator and manufacturing of the applicator itself. The high concentration capsaicin used in NGX-1998 is difficult to safely manufacture. If we are unable to identify one or more suitable suppliers in a timely manner, if those suppliers are unable to meet our technical or regulatory requirements then our development program may be delayed and the planned costs of the development program may increase significantly.

Any products that we, our contract manufacturers or others with whom we have development manufacturing or commercialization arrangements manufacture or distribute under FDA, EMA or other state or national governmental regulatory, approvals are subject to pervasive and continuing regulation by such authorities, including record-keeping requirements and reporting of adverse experiences with the products. Drug manufacturers and their subcontractors are required to register with the governmental authorities and are subject to periodic unannounced inspections for compliance with cGMP, regulations which impose procedural and documentation requirements upon us and each third-party manufacturer we utilize. This ongoing regulation and evaluation results in an obligation on us to continually evaluate the manufacturing process, the applicability of our analytical methods and the specifications that are used to release product for sale and evaluate long term stability of our product to ensure they continue to meet their objective of ensuring that such processes and methods enable the consistent manufacture of product that meets regulatory approved specifications. This process often results in identification of matters that can result in changes to specifications, analytical methods and manufacturing processes as part of normal and ongoing process improvement or may result in cessation of supply of products. This process can identify matters that can have significant implications including the potential for reduction in applicable product shelf life, suspension of product manufacturing or commercialization, or requirement of product recalls, all of which would have a material adverse effect on us. We are undertaking such ongoing process improvement processes with our contract manufacturers and we cannot assure you that the outcome of such initiatives will not have a material effect on our business.

Reliance on contract manufacturers exposes us to additional risks, including:

 

•

failure of current and future manufacturers to comply with strictly-enforced regulatory requirements which may result in their inability to continue to supply us with product that meets regulatory requirements for commercialization;

 

•

failure to manufacture products that meet our specifications throughout their shelf lives;

 

•

failure to deliver sufficient quantities in a timely manner;

 

•

the possibility that we may terminate a contract manufacturer and need to engage a replacement;

 

•

the possibility that current and future manufacturers may not be able to manufacture our product candidates and products without infringing the intellectual property rights of others;

 

•

the possibility that current and future manufacturers may not have adequate intellectual property rights to provide for exclusivity and prevent competition; and

 

•

insufficiency of intellectual property rights to any improvements in the manufacturing processes or new manufacturing processes for our products.

Any of these factors could result in insufficient supply of Qutenza to meet demand which would have a significant impact on our financial results and adversely impact any revenues we may derive from Qutenza. With respect to our product candidates, such factors could result in significant delay or suspension of clinical trials, regulatory submissions, or receipt of required approvals, all of which could significantly harm our business.

 

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Because our third-party manufacturers operate outside of the United States, and many of the raw materials and the labor that are used to manufacture Qutenza and our product candidates are based in foreign countries, we may experience currency exchange rate risks, even though, in some instances our contracts are denominated in U.S. dollars. We do not currently engage in forward contracts to hedge this currency risk and as a result, may suffer adverse financial consequences as a result of this currency risk.

Materials used by these entities to manufacture our product candidates originate outside the United States, including certain materials which may be sourced from China and India. The FDA has increased its diligence with regard to foreign-sourced materials and manufacturing processes. Increased FDA scrutiny of foreign manufacturers could result in delays in product availability, which could have a negative impact on our business.

Furthermore, because we are currently required to supply Qutenza to Astellas under the Supply Agreement, the foregoing risks to us related to supply of Qutenza and its components could also harm Astellas’ ability to commercialize Qutenza in the Licensed Territory. Whether we supply Qutenza to Astellas or Astellas enters into direct supply arrangements with our suppliers, Astellas’ ability to generate revenue and in turn our ability to generate royalty and sales-milestone revenue, would be impacted by these foregoing risks relating to manufacturing.

Our success will depend, in part, on the successful efforts of our collaboration partner in the European Union, certain countries in Eastern Europe, the Middle East and Africa.

The success of sales of Qutenza in the Licensed Territory will be dependent on Astellas’ ability to successfully launch and commercialize Qutenza pursuant to the Astellas Agreement. The manner in which Qutenza is being launched, including the timing of launch in each country of the European Union and the pricing that has or will be established in each such country, will have a significant impact on the ultimate success of Qutenza in the European Union, and ultimately the success of the overall commercial arrangement with Astellas. If commercial launch of Qutenza throughout the remainder of the Licensed Territory is delayed or prevented, our revenues will suffer and our stock price will decline. Further, if sales of Qutenza are less than anticipated, our stock price will decline. The outcome of Astellas’ commercialization efforts could also have an effect on investors’ perception of potential sales of Qutenza in the United States, which could cause a decline in our stock price if such efforts are unsuccessful.

The Astellas Agreement provides for Astellas to be responsible for conducting certain studies for Qutenza in the European Union, both to satisfy post-marketing commitments that were made in conjunction with the Qutenza MA in the European Union and to carry out in support of Astellas’ commercialization plans for Qutenza in the Licensed Territory. Astellas has now commenced three studies in this regard. The planning and execution of these studies is primarily the responsibility of Astellas, and may not be carried out in accordance with our indicated preferences, or may yield results that are detrimental to Astellas’ sales of Qutenza in the Licensed Territory or detrimental in our efforts to develop or commercialize Qutenza outside the Licensed Territory, including in the United States. Together with Astellas, we have attempted to design such studies with a view toward having the resulting data be supportive of regulatory and commercial efforts in both the European Union and the United States, such as potential label expansion studies that may be carried out with respect to use of Qutenza to treat pain associated with PDN. However, such studies may have limited or no utility to support such efforts and may negatively impact our revenues.

Within the Licensed Territory, regulatory approval for Qutenza has been obtained within the European Economic Area, Switzerland and Georgia. Other regulatory jurisdictions in the Licensed Territory may require further clinical and manufacturing activities to gain approval for sales of Qutenza in these countries. There can be no assurance that these activities will be successful and that approval in these countries will be obtained in a timely manner, if at all. Further, there can be no assurance that such clinical or manufacturing activities will not negatively impact the regulatory processes in the European Economic Area, United States or other markets where regulatory approval of Qutenza may have been obtained or may be in the process of being sought.

The Astellas Agreement requires us to expend resources in support of our commercial relationship with Astellas. Although we believe that our contractual arrangement with Astellas provides for reimbursement for many of these activities, the time and financial costs of managing such a relationship can be significant and may occur at a time when we are executing the commercialization of Qutenza in the United States.

The Supply Agreement we entered into in connection with the Astellas Agreement requires us to supply components of Qutenza to Astellas at the same cost we obtain such components from our third-party manufacturers. Because we have never overseen commercial manufacturing processes and quantities of these components, we may incur non-reimbursable costs related to manufacturing scale up, quality assurance and release, which could negatively impact our financial results. Such Supply Agreement also provides for Astellas to enter into direct supply relationships with our current suppliers to replace the need for us to provide Astellas with pass-through supply of Qutenza components. There can be no assurance that the establishment of such separate supply relationships will not negatively impact our ability to obtain our own supply of Qutenza components in support of our commercialization of Qutenza in the United States or other markets outside the Licensed Territory that we seek to commercialize.

 

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The Astellas Agreement grants to Astellas an option to exclusively license our second generation product, NGX-1998. In connection with this option, we are required to execute a development plan for NGX-1998 and achieve certain objectives. After completion of an initial set of objectives, Astellas may make an additional payment to us to retain its option to license NGX-1998 until further agreed upon development of NGX-1998 has been performed by us. Upon completion of these objectives, Astellas may elect to make a final payment to us in order to exercise its option. If Astellas determines not to make one of these payments, the option to license NGX-1998 will expire, Astellas will not be required to provide further funding for NGX-1998, and we would be precluded from marketing NGX-1998 in the Licensed Territory. If Astellas fails to exercise its options with respect to NGX-1998, we may not have adequate funding for development of NGX-1998, we will be unable to generate revenues from potential sales of NGX-1998 in the Licensed Territory, and our business will be harmed.

Astellas’ commercialization of Qutenza in the Licensed Territory may result in lower levels of income to us than if we marketed Qutenza in the Licensed Territory on our own. Astellas may not fulfill its obligations or commercialize Qutenza as quickly as we would like. We could also become involved in disputes with Astellas, which could lead to delays in or termination of the Astellas Agreement and time-consuming and expensive litigation or arbitration. If Astellas terminates or breaches its agreement with us, or otherwise fails to complete its obligations in a timely manner, the chances of successfully developing or commercializing Qutenza in the Licensed Territory would be materially and adversely affected.

Qutenza will be subject to ongoing regulatory requirements and may face regulatory or enforcement action.

Any product candidate for which regulatory approval is obtained is subject to significant review and ongoing and changing regulation by the FDA, the EMA, and other worldwide regulatory agencies. These ongoing regulatory requirements may include, but are not limited to:

 

•

obtaining additional post-approval clinical study data;

 

•

regulatory review of advertising, promotional and education activities for the product;

 

•

establishment and monitoring of pharmacovigilance programs and annual reports; and

 

•

periodic regulatory agency inspections and reviews of third-party manufacturing facilities and processes.

Failure to comply with regulatory requirements may subject us or our collaboration partner to administrative and judicially-imposed sanctions. These may include warning letters, adverse publicity, civil and criminal penalties, injunctions, product seizures or detention, product recalls, total or partial suspension of production, and refusal to approve pending product marketing applications.

Even if regulatory approval to market a particular product candidate is obtained, the approval could be conditioned on conducting additional costly post-approval studies or could limit the indicated uses included in such product’s labeling. For example, the Qutenza MA owned by Astellas in the European Union requires the conduct of certain post-authorization follow up measurers including ongoing evaluations of safety of Qutenza’s use in the labeled indications, as well as clinical evaluation in patients with PDN. These studies, which are funded by Astellas pursuant to the Astellas Agreement, may prove difficult and expensive to complete and their results may identify safety, efficacy or other issues related to Qutenza’s use that could hinder or prevent commercialization efforts. Moreover, the product may later be found in the course of these studies or through our pharmacovigilance programs to cause adverse effects that limit its use, force us or our partner to withdraw it from the market or impede or delay the ability to obtain regulatory approvals in additional countries.

We are subject to various statutes and regulations pertaining to the marketing of our products.

We are subject to various federal and state laws pertaining to healthcare fraud and abuse, including inducing, facilitating or encouraging submission of false claims to government programs and prohibitions on the offer of payment or acceptance of kickbacks or other remuneration for the purchase of Qutenza. Specifically, these anti-kickback laws make it illegal for a prescription drug manufacturer to solicit, offer, or pay any remuneration in exchange for purchasing, leasing or ordering any service or items including the purchase or prescription of a particular drug for which payment may be made under a federal healthcare program. Because of the sweeping language of the federal anti-kickback statute, many potentially beneficial business arrangements would be prohibited if the statute were strictly applied. To avoid this outcome, the U.S. Department of Health and Human Services has published regulations – known as “safe harbors” – that identify exceptions or exemptions to the statute’s prohibitions. Arrangements that do not fit within the

 

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safe harbors are not automatically deemed to be illegal, but must be evaluated on a case-by-case basis for compliance with the statute. We seek to comply with anti-kickback statutes and if possible to fit within one of the defined “safe harbors”; we are unaware of any violations of these laws. However, due to the breadth of the statutory provisions and the absence of uniform guidance in the form of regulations or court decisions, there can be no assurance that our practices will not be challenged under anti-kickback or similar laws. Violations of such restrictions may be punishable by significant civil or criminal sanctions, including fines and civil monetary penalties, as well as the possibility of exclusion from U.S. federal healthcare programs (including Medicaid and Medicare). Any such violations could have a material adverse effect on our business, financial condition, results of operations and cash flows.

Several recently enacted state and federal laws in Massachusetts and Vermont, and the Federal Physician Payment Sunshine Act, now require, among other things extensive tracking and maintenance of data bases regarding disclosure of relationships and payments to physicians and healthcare providers. These laws require us to implement the necessary and costly infrastructure to track and report certain payments to healthcare providers. Failure to comply with these new tracking and reporting laws could subject us to significant civil monetary penalties.

In addition, the FDA has the authority to regulate the claims we make in marketing our prescription drug products to ensure that such claims are true, not misleading, supported by scientific evidence and consistent with the labeled use of the drug. Failure to comply with FDA requirements in this regard could result in, among other things, warning letters, suspensions of approvals, seizures or recalls of products, injunctions against a product’s manufacturer, distribution, sales and marketing, operating restrictions, civil penalties and criminal prosecutions. Any of these FDA actions could negatively impact our product sales and profitability.

Delays in the commencement or completion of clinical testing could result in increased costs to us and delay our ability to generate additional revenues.

We do not know whether clinical trials will begin on time or be completed on schedule, if at all. The commencement and completion of clinical trials can be disrupted for a variety of reasons, including difficulties in:

 

•

recruiting and enrolling patients to participate in a clinical trial;

 

•

obtaining regulatory approval to commence a clinical trial;

 

•

reaching agreement on acceptable terms with prospective clinical research organizations and trial sites;

 

•

manufacturing sufficient quantities of a product candidate; and

 

•

obtaining institutional review board approval to conduct a clinical trial at a prospective site.

A clinical trial may also be suspended or terminated by us, the FDA or other regulatory authorities due to a number of factors, including:

 

•

failure to conduct the clinical trial in accordance with regulatory requirements or in accordance with our clinical protocols;

 

•

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

 

•

unforeseen safety issues; or

 

•

inadequate patient enrollment or lack of adequate funding to continue the clinical trial.

In addition, changes in regulatory requirements and guidance may occur and we may need to amend clinical trial protocols to reflect these changes, which could impact the cost, timing or successful completion of a clinical trial. If we experience delays in the commencement or completion of our clinical trials, the commercial prospects for our product candidates will be harmed, and our ability to generate product revenues will be delayed. Many of the factors that cause, or lead to, a delay in the commencement or completion of clinical trials may also lead to the denial of regulatory approval of a product candidate.

 

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Finally, our discussions with potential or actual development and commercialization partners for NGX-1998 could result in significant delays in our planned timing of clinical trial initiation and may significantly change other elements of our current development plan. Any of these changes could result in delays, increased cost and changes to the potential probability of a successful outcome of our development program, any of which could negatively impact our business.

We rely on third parties to conduct our clinical trials. If these third parties do not perform as contractually required or otherwise expected, we may not be able to obtain regulatory approval for our product candidates.

We do not currently conduct clinical trials on our own, and instead rely on third parties, such as contract research organizations, medical institutions, clinical investigators and contract laboratories, to assist us with our clinical trials. We are also required to comply with regulations and standards, commonly referred to as good clinical practices, for conducting, recording and reporting the results of clinical trials to assure that data and reported results are credible and accurate and that the trial participants are adequately protected. If these third parties do not successfully carry out their duties to us or regulatory obligations or meet expected deadlines, if the third parties need to be replaced, or if the quality or accuracy of the data they obtain is compromised due to the failure to adhere to our clinical protocols or regulatory requirements or for other reasons, our preclinical development activities or clinical trials may be extended, delayed, suspended or terminated, and we may not be able to obtain regulatory approval for our product candidates.

We face potential product liability exposure, and if successful claims are brought against us, we may incur substantial liability and may have to limit our commercialization efforts for Qutenza or our development efforts with respect to our product candidates.

The use of our product candidates in clinical trials and the sale of Qutenza expose us to the risk of product liability claims. Product liability claims might be brought against us by consumers, health care providers, pharmaceutical companies or others selling our products. If we cannot successfully defend ourselves against these claims, we will incur substantial liabilities. Regardless of merit or eventual outcome, liability claims may result in:

 

•

decreased demand for our product candidates;

 

•

impairment of our business reputation;

 

•

costs of related litigation;

 

•

substantial monetary awards to patients or other claimants;

 

•

loss of revenues;

 

•

the inability to commercialize our product candidates; and

 

•

withdrawal of clinical trial participants.

Although we currently have product liability insurance coverage with limits that we believe are customary and adequate to provide us with coverage for foreseeable risks associated with our Qutenza commercialization and product candidate development efforts, our insurance coverage may not reimburse us or may be insufficient to reimburse us for the actual expenses or losses we may suffer. Moreover, in the future, we may not be able to maintain insurance coverage at a reasonable cost or in sufficient amounts to protect us against losses due to liability.

Our products are expected to face substantial competition which may result in others discovering, developing or commercializing products before or more successfully than us or our collaborators.

Qutenza competes, and NGX-1998 will compete, if approved for marketing, against more established products marketed by large pharmaceutical companies with far greater name recognition and resources than we or Astellas have. The most directly-competitive currently-marketed products in the United States are Lidoderm, an FDA-approved 5% lidocaine topical patch for the treatment of PHN marketed by Endo Pharmaceuticals, and Lyrica, an oral anti-convulsant, marketed by Pfizer for use in the treatment of PHN. In January 2011, Depomed Inc. received FDA approval for Gralise, a formulation of gabapentin that is a once daily tablet for the treatment of PHN. In addition to these branded drugs, the FDA has approved gabapentin (Neurontin) for use in the treatment of PHN. Gabapentin is marketed by Pfizer and multiple generic manufacturers, and is the most widely-prescribed drug in the United States for treatment of neuropathic pain. Pfizer has also received FDA approval for Lyrica for the treatment of PDN, fibromyalgia, epilepsy and general anxiety disorder. Additionally, a number of products that are approved for other diseases are used by physicians to treat PHN.

 

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Competition may become stronger and more direct and products in development, including products that we are unaware of, may compete with Qutenza. There are many other companies working to develop new drugs and other therapies to treat pain in general and neuropathic pain in particular, including Eli Lilly & Co, Pfizer, UCB Pharma SA, GlaxSmithKline plc, Merz, GW Pharmaceuticals, Novartis AG, Novo Nordisk A/S, Dainippon Pharmaceutical Co Ltd., AVANIR Pharmaceuticals, Xenoport, EpiCept, Newron Pharmaceuticals SpA, Pharmagesic Holding Inc., Arcion Therapeutics Inc., Endo Pharmaceuticals, AstraZeneca plc, Allergan, Inc., Bristol-Myers Squibb Co., Bio3 Research Srl, Relevare Pharmaceuticals Ltd., Depomed, Inc., and Ortho-McNeil-Janssen Pharmaceuticals. Many of the compounds in development by such companies are already marketed for other indications, such as anti-depressants, anti-convulsants or opioids. In addition, physicians employ other interventional procedures, such as nerve stimulation or nerve blocks, to treat patients with difficult to treat neuropathic pain conditions.

Furthermore, new developments, including the development of other drug technologies and methods of preventing the incidence of disease, such as vaccines including Zostavax, occur in the biopharmaceutical industry at a rapid pace. Any of these developments may render our products or product candidates obsolete or noncompetitive.

Many of our potential competitors, either alone or together with their partners, have substantially greater financial resources, research and development programs, clinical trial and regulatory experience, expertise in prosecution of intellectual property rights, and manufacturing, distribution and sales and marketing capabilities than we and Astellas do. As a result of these factors, our competitors may:

 

•

initiate or withstand substantial price competition more successfully;

 

•

have greater success in recruiting skilled scientific workers from the limited pool of available talent;

 

•

more effectively negotiate third-party licenses and strategic alliances;

 

•

take advantage of acquisition or other opportunities more readily than we can; and

 

•

develop product candidates and market products that are less expensive, safer, more effective or involve more convenient treatment procedures than our current and future products.

The life sciences industry is characterized by rapid technological change. If we fail to stay at the forefront of technological change our products may be unable to compete effectively.

The efforts of government entities and third-party payers to contain or reduce the costs of health care may adversely affect our sales and limit the commercial success of our products.

In certain foreign markets, pricing or profitability of pharmaceutical products is subject to various forms of direct and indirect governmental control, including the control over the amount of reimbursement provided to the patient who is prescribed specific pharmaceutical products.

In the United States, there have been, and we expect there will continue to be, various proposals to implement similar controls. For example, the health care reform act passed in March 2010, increased the rebate levels for pharmaceutical products sold to Medicaid patients by eight percent. The commercial success of our products could be limited if federal or state governments adopt any such proposals. In addition, in the United States and elsewhere, sales of pharmaceutical products depend in part on the availability of reimbursement to the consumer from third-party payers, such as government and private insurance plans. These third-party payers are increasingly utilizing their significant purchasing power to challenge the prices charged for pharmaceutical products and seek to limit reimbursement levels offered to consumers for such products. We expect these third-party payers to focus their cost control efforts on our products, especially with respect to prices of and reimbursement levels for products prescribed outside their labeled indications. In these cases, their efforts may negatively impact our product sales and profitability.

The Hatch-Waxman Act data exclusivity and any equivalent regulatory data exclusivity protection in other jurisdictions for Qutenza, may not prevent new competition which may negatively impact our financial results.

The Hatch-Waxman Act provides five years of data exclusivity to the first applicant to gain approval of an NDA under Section 505(b) of the Food, Drug and Cosmetic Act for a new chemical entity. Qutenza has been recognized by the FDA as a new chemical entity and therefore has been granted five year data exclusivity under the Hatch-Waxman Act through November 2014. Hatch-Waxman provides data exclusivity by prohibiting abbreviated new drug applications, or ANDAs, and 505(b)(2) applications, which are marketing applications where the applicant does not own or have a legal right of reference to all the data required for

 

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approval, to be submitted by another company for another version of such drug during the exclusivity period. Protection under Hatch-Waxman will not prevent the filing or approval of a full NDA under Section 505(b)(1) for the same active ingredient, although the applicant would be required to conduct its own adequate and well-controlled clinical trials to demonstrate safety and effectiveness.

Even though Qutenza has been granted five year Hatch-Waxman data exclusivity in the United States and ten-year market exclusivity which may be extended to eleven-year market exclusivity upon meeting certain criteria and eight-year data exclusivity by the EMA, there can be no assurance that the exclusivity granted will effectively prevent competition, either generic or otherwise. Such competition could significantly harm our business.

Additional clinical trials of Qutenza may not support label expansion for Qutenza for such indication, which would adversely impact our long-term success.

We have not prepared for or conducted any Qutenza clinical trials for indications other than PHN, HIV-PN and PDN. Generally, two successful Phase 3 clinical trials are required to obtain regulatory approval in the U.S. We have conducted two Phase 3 clinical trials with Qutenza for patients with HIV-PN, one of which met its primary endpoint and one which did not meet its primary endpoint. Given that only one HIV-PN controlled study met its primary endpoint and that the pre-specified analysis plan in that study did not allow for examination of the proposed recommended dose, the FDA did not accept the data submitted as sufficient for approval of the HIV-PN indication under the sNDA we submitted with respect to such indication. We have also conducted one Phase 2 clinical trial that evaluated the use of Qutenza in patients with PDN. PDN represents a much larger market opportunity than either PHN or HIV-PN, and unless required clinical trials are successfully completed and regulatory approvals are obtained for the use of Qutenza for PDN patients, Qutenza will not be marketable for this indication in the United States and the European Union and possibly in other countries. If this occurs, our long-term ability to succeed may be significantly and negatively impacted. We believe that to market Qutenza in the United States for PDN, we may have to conduct two successful Phase 3 trials and we may be required to perform additional safety studies. In connection with the lower than expected sales of Qutenza for treatment of pain associated with PHN, we are currently not planning to pursue additional studies in PDN or HIV-PN. Although Astellas is pursuing clinical trials in PDN, there can be no assurance that the results of such trials would support label expansion of Qutenza in the European Union or support any efforts to seek label expansion in the United States.

We depend on our key personnel. If we are not able to retain them, our business will suffer.

We are highly dependent on the principal members of our management and commercial and scientific staff. The competition for skilled personnel among biopharmaceutical companies in the San Francisco Bay Area is intense and the employment services of our scientific, management and other executive officers are terminable at-will. We have encountered and may in the future experience turnover in our commercial organization. If we lose one or more of these key employees, our ability to implement and execute our business strategy successfully could be seriously harmed. Replacing key employees may be difficult and may take an extended period of time because of the limited number of individuals in our industry with the breadth of skills and experience required to develop, gain regulatory approval of and commercialize products successfully. We do not carry key man life insurance on any of our key personnel.

We have incurred operating losses in each year since inception and expect to continue to incur substantial and increasing losses for the foreseeable future.

We have incurred operating and net losses each year since our inception in 1998. Our net loss for the three months ended March 31, 2012 was approximately $11.2 million and as of March 31, 2012 we had an accumulated deficit of approximately $317.2 million. We had cash, cash equivalents and short-term investments totaling $27.4 million at March 31, 2012, and for the three months ended March 31, 2012, we used $9.8 million in operating activities. We expect to continue to incur losses for several years, as we commercialize Qutenza and continue other research and development activities, including with respect to NGX-1998. If Qutenza or NGX-1998, if approved, do not achieve market acceptance in the United States or the European Union, we will not generate significant product related revenue. We cannot assure you that we will be profitable even if Qutenza is successfully commercialized or if NGX-1998 is successfully developed and commercialized. If we fail to achieve and maintain profitability, or if we are unable to fund our continuing losses, you could lose all or part of your investment.

Risks Related to our Intellectual Property

The commercial success, if any, of NGX-1998 and Qutenza depends, in part, on the rights we have under certain patents.

The commercial success of NGX-1998 depends in part on a granted patent in the United States and a pending patent application in the European Union. The issued patent in the United States is entitled “Methods and Compositions for Administration of TRPV1 Agonists.” The commercial success, if any, of Qutenza depends, in part, on a patent granted in the United States and device patents

 

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granted in Canada, Hong Kong and certain countries of Europe concerning the use of a dermal delivery system for prescription strength capsaicin delivery for the treatment of neuropathic pain. We exclusively license these patents from the University of California. We do not currently own, and do not have rights under this license to any issued patents that cover Qutenza outside Europe, Hong Kong, Canada and the United States. Although we have filed for an extension of the term for one of the patents licensed from the University of California, there can be no assurance that such extension will be granted. In addition to other patents and patent applications which have been licensed under our agreements with third-party manufacturers, including the issued patents and pending applications licensed under our commercial supply agreement for Qutenza, we also exclusively license a method patent granted in the United States from the University of California concerning the delivery of prescription strength capsaicin for the treatment of neuropathic pain.

If we lose the rights to use, or lose exclusivity with respect to these patents we have an exclusive license to, we would be exposed to a greater risk of direct or other competition which could materially harm our business.

If we are unable to maintain and enforce our proprietary rights, we may not be able to compete effectively or operate profitably.

Our commercial success will depend, in part, on obtaining and maintaining patent protection, trade secret protection and regulatory protection (such as Hatch-Waxman protection or orphan drug designation) of our proprietary technology and information as well as successfully defending against third-party challenges to our proprietary technology and information. We will be able to protect our proprietary technology and information from use by third parties only to the extent that valid and enforceable patents, trade secrets or regulatory protection cover them and we have exclusive rights to utilize them.

Our commercial success will continue to depend in part on the patent rights we own, the patent rights we have licensed, the patent rights of our collaborators and suppliers and the patent rights we may obtain related to future products we may market. Our success also depends on our and our licensors’, collaborators’ and suppliers’ ability to maintain these patent rights against third-party challenges to their validity, scope or enforceability. Further, we do not fully control the patent prosecution of our licensed patent applications. There is a risk that our licensors will not devote the same resources or attention to the prosecution of the licensed patent applications as we would if we controlled the prosecution of the patent applications, and the resulting patent protection, if any, may not be as strong or comprehensive as if we had prosecuted the applications ourselves.

The patent positions of biopharmaceutical companies can be highly uncertain and involve complex legal and factual questions for which important legal principles remain unresolved. No consistent policy regarding the breadth of claims allowed in such companies’ patents has emerged to date in the United States. The patent situation outside the United States is even more uncertain. Changes in either the patent laws or in interpretations of patent laws in the United States or other countries may diminish the value of our intellectual property. Accordingly, we cannot predict the breadth of claims that may be allowed or enforced in our patents or in third-party patents. For example:

 

•

we or our licensors might not have been the first to make the inventions covered by each of our pending patent applications and issued patents;

 

•

we or our licensors might not have been the first to file patent applications for these inventions;

 

•

others may independently develop similar or alternative technologies or duplicate any of our technologies;

 

•

it is possible that none of our pending patent applications or the pending patent applications of our licensors will result in issued patents;

 

•

our issued patents and the issued patents of our licensors may not provide a basis for commercially viable products, or may not provide us with any competitive advantages, or may be challenged and invalidated by third parties;

 

•

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

 

•

the patents of others may have an adverse effect on our business.

 

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We also rely on trade secrets to protect our technology, especially where we do not believe patent protection is appropriate or obtainable. However, trade secrets are difficult to protect. While we seek to protect confidential information, in part, by confidentiality agreements with our employees, consultants, contractors, or scientific and other advisors, they may unintentionally or willfully disclose our information to competitors. If we were to enforce a claim that a third party had illegally obtained and was using our trade secrets, it would be expensive and time consuming, and the outcome would be unpredictable. In addition, courts outside the United States are sometimes less willing to protect trade secrets.

If we are not able to defend the patent or trade secret protection position of our technologies and product candidates, then we will not be able to exclude competitors from developing or marketing competing products, and we may not generate enough revenue from product sales to justify the cost of development of our product candidates and to achieve or maintain profitability.

If we are sued for infringing intellectual property rights of other parties, such litigation will be costly and time consuming, and an unfavorable outcome would have a significant adverse effect on our business.

Although we believe that we would have valid defenses to allegations that our current product candidates, production methods and other activities infringe the valid and enforceable intellectual property rights of any third parties of which we are aware, we cannot be certain that a third party will not challenge our position in the future. Other parties may own patent or other intellectual property rights that might be infringed by our products, trademarks or activities. There has been, and we believe that there will continue to be, significant litigation and demands for licenses in our industry regarding patent and other intellectual property rights. Our competitors or other patent or intellectual property holders may assert that our products or trademarks and the methods we employ are covered by their intellectual property rights. For example, in 2009 we received a letter indicating a possible trademark conflict for Qutenza from a company claiming that our trademark was similar to theirs. While we believe that these assertions do not have merit and that we have defenses to them, there can be no assurance that we will be successful in defending our trademark. We intend to continue to use the Qutenza trademark and to vigorously defend our use of such trademark against such assertions. These parties could bring claims against us that would cause us to incur substantial expenses and, if successful against us, could cause us to pay substantial damages or possibly prevent us from commercializing our product candidates using the Qutenza trademark which would have a significant negative effect on the Qutenza launch and global commercialization efforts. Further, if a patent infringement suit were brought against us, we could be forced to stop or delay research, development, manufacturing or sales of the product or product candidate that is the subject of the suit, or if a trademark infringement suit were brought against us or our collaboration partner Astellas, we or Astellas could be forced to cease using the name Qutenza in connection with our product.

As a result of intellectual property infringement claims, or in order to avoid potential claims, we may choose to seek, or be required to seek, a license from the third party and would most likely be required to pay license fees or royalties or both. These licenses may not be available on acceptable terms, or at all. Even if we were able to obtain a license, the rights may be non-exclusive, which would give our competitors access to the same intellectual property. Ultimately, we could be prevented from commercializing a product, or be forced to cease some aspect of our business operations if, as a result of actual or threatened infringement claims, we or our collaborators are unable to enter into licenses on acceptable terms. This could harm our business significantly.

We may incur substantial costs as a result of litigation or other proceedings relating to patent and other intellectual property rights.

The cost to us of any litigation or other proceedings relating to intellectual property rights, even if resolved in our favor, could be substantial. Some of our potential competitors, other patent or intellectual property holders may be better able to sustain the costs of complex patent litigation because they have substantially greater resources. Uncertainties resulting from the initiation and continuation of any litigation could have a material adverse effect on our ability to continue our operations. Should third parties file patent applications, or be issued patents claiming technology also claimed by us in pending applications, we may be required to participate in interference proceedings in the U.S. Patent and Trademark Office to determine priority of invention which could result in substantial costs to us or an adverse decision as to the priority of our inventions. An unfavorable outcome in an interference proceeding could require us to cease using the technology or to license rights from prevailing third parties. There is no guarantee that any prevailing party would offer us a license or that we could acquire any license made available to us on commercially acceptable terms.

If we fail to comply with our obligations in the agreements under which we license development or commercialization rights to products or technology from third parties, we could lose license rights that are important to our business.

We are a party to a number of technology licenses that are important to our business and expect to enter into additional licenses in the future. For example, we hold licenses from The University of California and LTS under patents and patent applications relating to Qutenza. These licenses impose various commercialization, milestone payment, royalty, insurance and other obligations on us. If we fail to comply with these obligations, the licensor may have the right to terminate the license, in which event we would not be able to market products covered by the license, including Qutenza.

 

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

Many of our employees were previously employed at universities or other biotechnology or pharmaceutical companies, including our competitors or potential competitors. Although no claims against us are currently pending, we may be subject to claims that these employees or we have inadvertently or otherwise used or disclosed trade secrets or other proprietary information of their former employers. Litigation may be necessary to defend against these claims. If we fail in defending such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights or personnel. A loss of key research personnel or their work product could hamper or prevent our ability to commercialize certain potential products, which could severely harm our business. Even if we are successful in defending against these claims, litigation could result in substantial costs and be a distraction to management.

Risks Related to an Investment in our Common Stock

We expect that our stock price will fluctuate significantly, and you may not be able to resell your shares at or above your investment price.

The stock market has experienced significant volatility, particularly with respect to pharmaceutical, biotechnology and other life sciences company stocks. The volatility of pharmaceutical, biotechnology and other life sciences company stocks often does not relate to the operating performance of the companies represented by the stock. Factors that could cause volatility in the market price of our common stock include, but are not limited to:

 

•

failure to meet market expectations with respect to the launch of Qutenza by us in the United States and by Astellas in the European Union;

 

•

inability of us and Astellas to successfully commercialize Qutenza in the United States and the Licensed Territory, respectively;

 

•

results from and any delays related to the clinical trials for NGX-1998;

 

•

our ability to develop and market new and enhanced product candidates on a timely basis;

 

•

failure to maintain our listing on the NASDAQ Global Market or NASDAQ Capital Market;

 

•

potential inability to preserve or raise sufficient capital to maintain our operations;

 

•

potential negative stock market reaction in the event we raise or attempt to raise additional equity capital;

 

•

failure to meet revenue estimates and revenue growth rates;

 

•

actual or anticipated quarterly variations in our results of operations or those of our collaborators or competitors;

 

•

third-party healthcare reimbursement policies or determinations;

 

•

product recalls, reported incidents of unanticipated adverse effects with respected to Qutenza, or other negative publicity related to Qutenza;

 

•

general economic conditions and slow or negative growth of our expected markets;

 

•

delay in entering, or termination of, strategic partnership relationships;

 

•

our ability to meet our obligation under the Financing Agreement with Cowen including liquidity maintenance requirements;

 

•

our ability to meet our obligation under the loan from Hercules;

 

•

failure or delays in entering additional product candidates into clinical trials;

 

•

announcements by us or our collaborators or competitors of new commercial products, clinical progress or the lack thereof, significant contracts, commercial relationships or capital commitments;

 

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•

issuance of new or changed securities analysts’ reports or recommendations for our stock or the discontinuation of one or more securities analysts’ research coverage for our stock;

 

•

inclusion in or removal from stock indices such as the Russell 3000;

 

•

developments or disputes concerning our intellectual property or other proprietary rights;

 

•

commencement of, or our involvement in, litigation;

 

•

changes in governmental statutes or regulations or in the status of our regulatory approvals;

 

•

market conditions in the life sciences sector; and

 

•

any major change in our board or management.

If the ownership of our common stock continues to be highly concentrated, it may prevent you and other stockholders from influencing significant corporate decisions and may result in conflicts of interest that could cause our stock price to decline.

Our executive officers, directors and their affiliates and 5% stockholders beneficially own or control approximately 79% of the outstanding shares of our common stock as of March 31, 2012 (after giving effect to the exercise of all of their outstanding vested options and warrants exercisable within 60 days of such date). Accordingly, these executive officers, directors and their affiliates and significant stockholders acting as a group, will have substantial influence over the outcome of corporate actions requiring stockholder approval, including the election of directors, any merger, consolidation or sale of all or substantially all of our assets or any other significant corporate transactions. These stockholders may also delay or prevent a change of control of us, even if such a change of control would benefit our other stockholders. The significant concentration of stock ownership may adversely affect the trading price of our common stock due to investors’ perception that conflicts of interest may exist or arise.

Future sales of shares by existing stockholders could cause our stock price to decline.

The market price of our common stock could decline as a result of sales by our existing stockholders of shares of common stock in the market, or the perception that these sales could occur. In particular, the significant concentration of stock ownership may adversely affect the trading price of our common stock in the event that certain large stockholders elect to sell the shares of our common stock held by them. These sales might also make it more difficult for us to sell equity securities at a time and price that we deem appropriate.

We will continue to incur increased costs and demands upon management as a result of complying with the laws and regulations affecting public companies, which could affect our operating results.

As a public company, we will continue to incur significant legal, accounting and other expenses that we did not incur as a private company, including costs associated with public company reporting requirements. We also have incurred and will incur costs associated with corporate governance requirements, including requirements under the Sarbanes-Oxley Act of 2002, the Dodd-Frank Act of 2010, as well as new rules implemented by the SEC and the NASDAQ Stock Market LLC. We expect these rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly.

Anti-takeover provisions in our charter documents and under Delaware law could make an acquisition of us, which may be beneficial to our stockholders, more difficult and may prevent attempts by our stockholders to replace or remove our current management.

Provisions in our certificate of incorporation and bylaws may delay or prevent an acquisition of us or a change in our management. These provisions include a classified board of directors, a prohibition on actions by written consent of our stockholders and the ability of our board of directors to issue preferred stock without stockholder approval. In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which prohibits stockholders owning in excess of 15% of our outstanding voting stock from merging or combining with us. Although we believe these provisions collectively provide for an opportunity to receive higher bids by requiring potential acquirers to negotiate with our board of directors, they would apply even if the offer may be considered beneficial by some stockholders. In addition, these provisions may frustrate or prevent any attempts by our stockholders to replace or remove our current management by making it more difficult for stockholders to replace members of our board of directors, which is responsible for appointing the members of our management.

 

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Events in the credit markets have, and will continue to, impact our investment returns.

As a result of events in the credit markets, we maintain an investment portfolio of primarily U.S. Treasury securities. As a result of the credit crisis and our shift in investments, we anticipate that our investment returns will be below our historic rates of return. These lower returns will likely continue for some time and we cannot predict when market conditions will improve and when higher yielding investment options may be available to us.

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

We have paid no cash dividends on any of our classes of capital stock to date, have contractual restrictions against paying cash dividends and currently intend to retain our future earnings to fund the development and growth of our business. As a result, capital appreciation, if any, of our common stock will be an investor’s sole source of gain for the foreseeable future.

In the event of an adverse outcome the lawsuits filed against us, our officers and our directors, our business may be materially harmed, and defending against these lawsuits may be expensive and will divert the attention of our management.

On April 23, 2012, we received a copy of a complaint filed by Maritime Asset Management, LLC with the United States District Court Southern District of New York against us and certain current and former executive officers of ours. The complaint alleges, among other things, violations of Section 10(b), Section 20(a) and Rule 10b-5 of the Securities and Exchange Act of 1934, breach of contract, fraud and aiding and abetting arising out of disclosures made prior to the departure of our former Chief Medical Officer and Executive Vice President of Research and Development, Dr. Jeffrey K. Tobias. The challenged disclosures were made in connection with our July 26, 2011 private placement of common stock and common stock warrants and our periodic reports filed pursuant to the Exchange Act from May 9, 2011 through September 27, 2011. The complaint states that the plaintiff is seeking monetary damages, but no amounts are specified.

We will have to incur expenses in connection with the defense of this lawsuit, and we may have to pay damages or settlement costs in connection with any resolution thereof. Any such expenses, damages or settlement costs may be substantial. Although we have insurance coverage against which we may claim recovery against some of these expenses and costs, the amount of coverage may not be adequate to cover the full amount or certain expenses and costs may be outside the scope the policies we maintain. In the event of an adverse outcome or outcomes, our business could be materially harmed from depletion of cash resources, negative impact on our reputation, or restrictions or changes to our governance or other processes that may result from any final disposition of the lawsuits. Moreover, responding to and defending pending litigation will result in a significant diversion of management’s attention from our operations.

 

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ITEM 2.

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

We previously reported the information required under this Item 2 regarding the issuance of unregistered securities in connection with our February 3, 2012 private placement on a Current Report on Form 8-K filed on February 6, 2012.

 

ITEM 3.

DEFAULTS UPON SENIOR SECURITIES

None.

 

ITEM 4.

MINE SAFETY DISCLOSURES

Not Applicable.

 

ITEM 5.

OTHER INFORMATION

None.

 

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ITEM 6.

EXHIBITS

The following exhibits have been filed with this report:

 

Exhibit Number		Exhibit Title
3.1(1)		Amended and Restated Certificate of Incorporation.
3.2(1)		Amended and Restated Bylaws.
4.1(2)		Specimen Common Stock Certificate.
4.2(1)		Third Amended and Restated Investors’ Rights Agreement by and between NeurogesX, Inc. and certain stockholders, dated as of November 14, 2005.
4.3(3)		Amendment No. 1 to the Third Amended and Restated Investors’ Rights Agreement by and between NeurogesX, Inc. and certain stockholders, dated as of December 28, 2007.
4.4(4)		Amendment No. 2 to the Third Amended and Restated Investors’ Rights Agreement by and between NeurogesX, Inc. and certain stockholders, dated as of August 5, 2010.
4.5(1)		Warrant to Purchase Series A Preferred Stock by and between NeurogesX, Inc. and Silicon Valley Bank, dated as of December 14, 2000.
4.6(1)		Warrant to Purchase Series B Preferred Stock by and between NeurogesX, Inc. and Silicon Valley Bank, dated as of May 1, 2002.
4.7(1)		Warrant to Purchase Shares of Series C2 Preferred Stock by and between NeurogesX, Inc. and Horizon Technology Funding Company II LLC, dated as of July 7, 2006.
4.8(1)		Warrant to Purchase Shares of Series C2 Preferred Stock by and between NeurogesX, Inc. and Horizon Technology Funding Company III LLC, dated as of July 7, 2006.
4.9(1)		Warrant to Purchase Shares of Series C2 Preferred Stock by and between NeurogesX, Inc. and Oxford Finance Corporation, dated as of July 7, 2006.
4.10(1)		Form of First Warrant to Purchase Series C2 Preferred Stock.
4.11(1)		Form of Second Warrant to Purchase Series C2 Preferred Stock.
4.12(3)		Registration Rights Agreement by and between NeurogesX, Inc. and certain investors, dated as of December 23, 2007.
4.13(2)		Form of Warrant to Purchase Common Stock.
4.14(5)		Registration Rights Agreement dated July 21, 2011
4.15(5)		Form of Warrant to Purchase Common Stock issued on July 21, 2011.
4.16(6)		Warrant Agreement between NeurogesX, Inc. and Hercules Technology Growth Capital, Inc., dated as of August 5, 2011.

 

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Exhibit Number		Exhibit Title
4.17(7)		First Amendment to Warrant Agreement between NeurogesX, Inc. and Hercules Technology Growth Capital, Inc., dated as of March 26, 2012.
4.18(8)		Registration Rights Agreement by and between NeurogesX, Inc. and certain investors, dated as of January 31, 2012.
10.1		Executive Employment Agreement by and between NeurogesX, Inc. and Ronald A. Martell, dated as of January 1, 2012.
10.2(8)		Securities Purchase Agreement by and between NeurogesX, Inc. and certain investors, dated as of January 31, 2012.
31.1		Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1		Certifications of the Principal Executive Officer and the Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350).
101.INS		XBRL Instance.
101.SCH		XBRL Taxonomy Extension Schema.
101.CAL		XBRL Taxonomy Extension Calculation.
101.LAB		XBRL Taxonomy Extension Labels.
101.PRE		XBRL Taxonomy Extension Presentation.

 

(1)	Incorporated by reference from our registration statement on Form S-1, registration number 333-140501, declared effective by the Securities and Exchange Commission on May 1, 2007.

(2)	Incorporated by reference from our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 28, 2012.

(3)	Incorporated by reference from our Current Report on Form 8-K, filed with the Securities and Exchange Commission on December 28, 2007.

(4)	Incorporated by reference from our Current Report on Form 8-K, filed with the Securities and Exchange Commission on August 10, 2010.

(5)	Incorporated by reference from our Current Report on Form 8-K, filed with the Securities and Exchange Commission on July 27, 2011.

(6)	Incorporated by reference from our Current Report on Form 8-K, filed with the Securities and Exchange Commission on August 9, 2011.

(7)	Incorporated by reference from our Current Report on Form 8-K, filed with the Securities and Exchange Commission on March 27, 2012.

(8)	Incorporated by reference from our Current Report on Form 8-K, filed with the Securities and Exchange Commission on February 6, 2012.

 

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SIGNATURES

Pursuant to the requirements of the Securities Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

Dated: May 10, 2012				NEUROGESX, INC.
				(Registrant)
				/s/ Ronald A. Martell
				Ronald A. Martell
				President and Chief Executive Officer
				(Principal Executive Officer)
				/s/ Stephen F. Ghiglieri
				Stephen F. Ghiglieri
				Executive Vice President, Chief Operating Officer
				and Chief Financial Officer
				(Principal Financial and Accounting Officer)

 

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EXHIBIT INDEX

The following exhibits have been filed with this report:

 

Exhibit Number		Exhibit Title
3.1(1)		Amended and Restated Certificate of Incorporation.
3.2(1)		Amended and Restated Bylaws.
4.1(2)		Specimen Common Stock Certificate.
4.2(1)		Third Amended and Restated Investors’ Rights Agreement by and between NeurogesX, Inc. and certain stockholders, dated as of November 14, 2005.
4.3(3)		Amendment No. 1 to the Third Amended and Restated Investors’ Rights Agreement by and between NeurogesX, Inc. and certain stockholders, dated as of December 28, 2007.
4.4(4)		Amendment No. 2 to the Third Amended and Restated Investors’ Rights Agreement by and between NeurogesX, Inc. and certain stockholders, dated as of August 5, 2010.
4.5(1)		Warrant to Purchase Series A Preferred Stock by and between NeurogesX, Inc. and Silicon Valley Bank, dated as of December 14, 2000.
4.6(1)		Warrant to Purchase Series B Preferred Stock by and between NeurogesX, Inc. and Silicon Valley Bank, dated as of May 1, 2002.
4.7(1)		Warrant to Purchase Shares of Series C2 Preferred Stock by and between NeurogesX, Inc. and Horizon Technology Funding Company II LLC, dated as of July 7, 2006.
4.8(1)		Warrant to Purchase Shares of Series C2 Preferred Stock by and between NeurogesX, Inc. and Horizon Technology Funding Company III LLC, dated as of July 7, 2006.
4.9(1)		Warrant to Purchase Shares of Series C2 Preferred Stock by and between NeurogesX, Inc. and Oxford Finance Corporation, dated as of July 7, 2006.
4.10(1)		Form of First Warrant to Purchase Series C2 Preferred Stock.
4.11(1)		Form of Second Warrant to Purchase Series C2 Preferred Stock.
4.12(3)		Registration Rights Agreement by and between NeurogesX, Inc. and certain investors, dated as of December 23, 2007.
4.13(3)		Form of Warrant to Purchase Common Stock.
4.14(5)		Registration Rights Agreement dated July 21, 2011.
4.15(5)		Form of Warrant to Purchase Common Stock issued on July 21, 2011.
4.16(6)		Warrant Agreement between NeurogesX, Inc. and Hercules Technology Growth Capital, Inc., dated as of August 5, 2011.

 

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Exhibit Number		Exhibit Title
4.17(7)		First Amendment to Warrant Agreement between NeurogesX, Inc. and Hercules Technology Growth Capital, Inc., dated as of March 26, 2012.
4.18(8)		Registration Rights Agreement by and between NeurogesX, Inc. and certain investors, dated as of January 31, 2012.
10.1		Executive Employment Agreement by and between NeurogesX, Inc. and Ronald A. Martell, dated as of January 1, 2012.
10.2(8)		Securities Purchase Agreement by and between NeurogesX, Inc. and certain investors, dated as of January 31, 2012.
31.1		Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1		Certifications of the Principal Executive Officer and the Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350).
101.INS		XBRL Instance.
101.SCH		XBRL Taxonomy Extension Schema.
101.CAL		XBRL Taxonomy Extension Calculation.
101.LAB		XRBL Taxonomy Extension Labels.
101.PRE		XBRL Taxonomy Extension Presentation.

 

(1)	Incorporated by reference from our registration statement on Form S-1, registration number 333-140501, declared effective by the Securities and Exchange Commission on May 1, 2007.

(2)	Incorporated by reference from our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 28, 2012.

(3)	Incorporated by reference from our Current Report on Form 8-K, filed with the Securities and Exchange Commission on December 28, 2007.

(4)	Incorporated by reference from our Current Report on Form 8-K, filed with the Securities and Exchange Commission on August 10, 2010.

(5)	Incorporated by reference from our Current Report on Form 8-K, filed with the Securities and Exchange Commission on July 27, 2011.

(6)	Incorporated by reference from our Current Report on Form 8-K, filed with the Securities and Exchange Commission on August 9, 2011.

(7)	Incorporated by reference from our Current Report on Form 8-K, filed with the Securities and Exchange Commission on March 27, 2012.

(8)	Incorporated by reference from our Current Report on Form 8-K, filed with the Securities and Exchange Commission on February 6, 2012.

 

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