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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For The Quarterly Period Ended September 30, 2013

OR

FOR THE TRANSITION PERIOD FROM            TO           .

Commission File Number 001-33523

COMBIMATRIX CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s telephone number, including area code:  (949) 753-0624

N/A

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

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

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

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

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

As of November 12, 2013, 4,737,807 shares of CombiMatrix Corporation common stock, $0.001 par value were issued and outstanding.

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COMBIMATRIX CORPORATION

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COMBIMATRIX CORPORATION

CONSOLIDATED BALANCE SHEETS

(In thousands)

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

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COMBIMATRIX CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except share and per share information)

(Unaudited)

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

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COMBIMATRIX CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

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

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COMBIMATRIX CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.    OVERVIEW AND BACKGROUND

CombiMatrix Corporation (the “Company,” “we,” “us” and “our”) was originally incorporated in October 1995 as a California corporation and later reincorporated as a Delaware corporation in September 2000.  In December 2002, we merged with and became a wholly owned subsidiary of Acacia Research Corporation (“Acacia”). In August 2007, we split-off from Acacia and became publicly traded on The Nasdaq Stock Market.  As a result of the split-off, we ceased to be a subsidiary of, or affiliated with, Acacia.

Description of the Company

We provide valuable molecular diagnostic solutions and comprehensive clinical support for the highest quality of care.  We specialize in miscarriage analysis, prenatal and pediatric healthcare, offering DNA-based testing for the detection of genetic abnormalities beyond what can be identified through traditional methodologies.  We perform genetic testing utilizing a variety of advanced cytogenomic techniques, including microarray, standardized and customized FISH and high resolution karyotyping.   We emphasize support for healthcare professionals, to ensure data understanding and communication of results to patients.  We deliver high-technology driven answers, with a high degree of assistance for the ordering physician and staff.  Our clinical lab and corporate offices are located in Irvine, California.

We also own a one-third minority interest in Leuchemix, Inc. (“Leuchemix”), a private drug development company focused on developing a series of compounds to address a number of oncology-related diseases.

Reverse Stock Split

On December 4, 2012, we filed a Certificate of Amendment to our Certificate of Incorporation with the Secretary of State of the State of Delaware to effect a reverse split of our common stock at a ratio of one-for-ten (the “Reverse Stock Split”), which became effective at the close of business on that day.  As a result, each share of our common stock outstanding as of December 4, 2012 was automatically changed into one-tenth of a share of common stock and each of our Nasdaq-listed warrants outstanding as of December 4, 2012 to purchase a single share of our common stock was automatically changed into a Nasdaq-listed warrant to purchase one-tenth of a share of common stock.  No fractional shares were issued in connection with the Reverse Stock Split, and cash paid to stockholders for potential fractional shares was insignificant.  The number of shares of common stock subject to all other outstanding options, warrants and convertible securities were also reduced by a factor of ten as of December 4, 2012.  All historical share and per share amounts reflected throughout this document have been adjusted to reflect the Reverse Stock Split.  The authorized number of shares and the par value per share of our common stock were not affected by the Reverse Stock Split.

Basis of Presentation

The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 8-03 of Regulation S-X.  Accordingly, certain information and footnotes required by generally accepted accounting principles in annual financial statements have been omitted or condensed.  These interim consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2012, as reported by us in our Annual Report on Form 10-K filed with the SEC on March 25, 2013.  The year-end consolidated balance sheet data was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States of America.  The consolidated financial statements include all adjustments of a normal recurring nature which, in the opinion of management, are necessary for a fair statement of our financial position as of September 30, 2013, and results of operations and cash flows for the interim periods presented.  The results of operations for the three and nine months ended September 30, 2013 are not necessarily indicative of the results to be expected for the entire year.

Liquidity and Risks

We have a history of incurring net losses and net operating cash flow deficits.  We are also deploying new technologies and continue to develop new and improve existing commercial diagnostic testing services.  At September 30, 2013, we had cash and cash equivalents of $4.0 million and anticipate that our cash and cash equivalent balances, inclusive of recent financing activities (see Note 4), will be sufficient to meet our cash requirements into the second quarter of 2014.  However, the uncertainty regarding our ability to execute our business plan beyond this point raises substantial doubt about our ability to continue as a going concern.

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COMBIMATRIX CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

In order for us to continue as a going concern beyond the second quarter of 2014 and ultimately to achieve profitability, we may be required to obtain capital from external sources, increase revenues and reduce operating costs.  However, there can be no assurance that our operations will become profitable or that external sources of financing, including the issuance of debt and/or equity securities, will be available at times and at terms acceptable to us, or at all.  The issuance of additional equity or convertible debt securities will also cause dilution to our stockholders.  If external financing sources are not available or are inadequate to fund our operations, we will be required to reduce operating costs, including research projects and personnel, which could jeopardize our future strategic initiatives and business plans.

Our business operations are also subject to certain risks and uncertainties, including:

·                  market acceptance of our diagnostic testing services;

·                  receiving adequate reimbursement for tests performed and billed;

·                  technological advances that may make our services obsolete or less competitive;

·                  increases in operating costs, including costs for supplies, personnel and equipment;

·                  the availability and cost of capital;

·                  governmental regulation that may restrict our business.

Our services are concentrated in a highly competitive market that is characterized by rapid technological advances, frequent changes in customer requirements and evolving regulatory requirements and industry standards.  Failure to anticipate or respond adequately to technological advances, changes in customer requirements, changes in regulatory requirements or industry standards, or any significant delays in the development or introduction of planned services, could have a material adverse effect on our business and operating results.  The accompanying consolidated financial statements have been prepared assuming that we will continue as a going concern.  The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the matters discussed herein.

2.    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

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

Principles of Consolidation.  The accompanying consolidated financial statements include the accounts of the Company and our wholly owned and majority-owned subsidiaries.  Investments for which we possess the power to direct or cause the direction of the management and policies, either through majority ownership or other means, are accounted for under the consolidation method.  Material intercompany transactions and balances have been eliminated in consolidation.  Investments in companies in which we maintain an ownership interest of 20% to 50% or exercise significant influence over operating and financial policies are accounted for under the equity method.  The cost method is used where we maintain ownership interests of less than 20% and do not exercise significant influence over the investee.

Revenue Recognition. We recognize revenue when (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred or services have been performed, (iii) amounts are fixed or determinable and (iv) collectability of amounts is reasonably assured.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

Service revenues from providing diagnostic tests are recognized when the testing process is complete and test results are reported to the ordering physician or clinic.  These diagnostic services are billed to various payors, including commercial insurance companies, healthcare institutions, government payors including Medicare and Medicaid, and individuals.  We report revenues from contracted payors based on a contractual rate, or in the case of Medicare and Medicaid, published fee schedules for our tests.  We report revenues from non-contracted payors based on the amounts expected to be collected.  The differences between the amounts billed and the amounts expected to be collected from non-contracted payors are recorded as contractual allowances to arrive at net recognized revenues.  The expected revenues from non-contracted payors are based on the historical collection experience of each payor or payor group, as appropriate.  In each reporting period, we review our historical collection experience for non-contracted payors and adjust our expected revenues for current and subsequent periods accordingly.  We also recognize additional revenue from actual cash payments that exceed amounts initially recognized, in the period the payments are received.  For the three and nine months ended September 30, 2013 and 2012, net positive revenue adjustments were $169,000, $437,000, $41,000 and $416,000, respectively.  Because a substantial portion of our revenues is from non-contracted third-party payors, it is likely that we will be required to make adjustments to accounting estimates with respect to contractual allowances in the future, which may positively or adversely affect our results of operations.  In all cases described above, we report revenues net of any applicable statutory taxes collected from customers, as applicable.

Clinical trials support services revenue is recognized when the related support services have been delivered to and accepted by the customer.  Royalty revenue is recognized in the period when earned.

Cash and Cash Equivalents.  We consider all highly liquid, short-term investments with original maturities of three months or less when purchased to be cash equivalents.

Fair Value Measurements.  We measure fair value as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.  As such, fair value is a market-based measurement that is determined based on assumptions that market participants would use in pricing an asset or liability.  We utilize a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows:

Concentration of Credit Risks.  Cash equivalents are invested in deposits with certain financial institutions and may, at times, exceed federally insured limits.  We have not experienced any significant losses on our deposits of cash and cash equivalents.

Accounts Receivable and Allowance for Doubtful Accounts.  Accounts receivable are stated at principal amounts and are primarily comprised of amounts contractually due from customers for services performed.  An allowance for doubtful accounts is recorded for estimated uncollectible amounts due from various payor groups such as commercial insurance companies, healthcare institutions, government payors and individuals.  The process for estimating the allowance for doubtful accounts involves significant assumptions and judgments.  Specifically, the allowance for doubtful accounts is adjusted periodically and is principally based upon specific identification of past due or disputed accounts.  We also review the age of receivables by payor class to assess our allowance at each period end.  The payment realization cycle for certain governmental and commercial insurance payors can be lengthy, involving denial, appeal and adjudication processes, and is subject to periodic adjustments that may be significant.  Accounts receivable are periodically written off when identified as uncollectible and deducted from the allowance for doubtful accounts after appropriate collection efforts have been exhausted. Additions to the allowance for doubtful accounts are charged to bad debt expense as a component of general and administrative expenses in the consolidated statements of operations.  Collection of governmental, private health insurer, and client receivables are generally a function of providing complete and correct billing information to the insurers and clients within the filing deadlines required by each payor.  Collection of receivables due from patients and clients is generally subject to increased credit risk due to credit-worthiness or inability to pay.

Derivative Financial Instruments.  We evaluate financial instruments for freestanding or embedded derivatives.  Derivative instruments that do not qualify for permanent equity classification are recorded as liabilities at fair value, with changes in value recognized as other income (expense) in the consolidated statements of operations in the period of change.  Derivative liabilities are categorized as either short-term or long-term based upon management’s estimates as to when the derivative instrument may be realized or based upon the holder’s ability to realize the instrument.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

Stock-Based Compensation.  The compensation cost for all stock-based awards is measured at the grant date, based on the fair value of the award, and is recognized as an expense, on a straight-line basis, over the employee’s requisite service period (generally the vesting period of the equity award) which is generally four years.  The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model.  Stock-based compensation expense is recognized only for those awards that are expected to vest using an estimated forfeiture rate.  We estimate pre-vesting option forfeitures at the time of grant and reflect the impact of estimated pre-vesting option forfeitures in compensation expense recognized.  Stock-based compensation expense for all periods presented attributable to our functional expense categories were as follows (in thousands):

Net Loss Per Share.  Basic and diluted net loss per share has been computed by dividing the net loss by the weighted average number of common shares issued and outstanding during the periods presented.  Options and warrants to purchase common stock as well as preferred stock convertible into shares of common stock are anti-dilutive and therefore are not included in the determination of the diluted net loss per share.  The following table reflects the excluded dilutive securities for all periods presented:

Segments.  We have determined that we operate in one segment for financial reporting purposes.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

3.              FAIR VALUE MEASUREMENTS

The following table summarizes, for each major category of financial assets measured on a recurring basis, the respective fair value at September 30, 2013 and December 31, 2012 and the classification by level of input within the fair value hierarchy defined above (in thousands):

The following table is a reconciliation of financial liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the nine months ended September 30, 2013 (in thousands):

4.              STOCKHOLDERS’ EQUITY

Series A Convertible Preferred Stock Financing

On September 28, 2012 (the “Commitment Date”), we entered into a securities purchase agreement with certain accredited investors (the “Series A Investors”), pursuant to which we sold and issued 1,050.70039 shares of newly created Series A 6% Convertible Preferred Stock (the “Series A Stock”) to the Series A Investors at a purchase price of $1,000 per share in an initial closing that occurred on October 1, 2012 (the “Series A First Closing”) and sold and issued 1,449.29961 additional shares of Series A Stock on December 6, 2012 to the Series A Investors at a purchase price of $1,000 per share after stockholder approval was obtained on November 29, 2012 (the “Series A Second Closing”) (combined, the “Series A Financing”).  After certain offering-related costs were incurred, the net proceeds received by us from the Series A Financing were $2.0 million.  As a result of the Series A Second Closing, the conversion price for the Series A Stock was set to $1.9995 per share, or the equivalent of 1.25 million shares of common stock issuable upon conversion of all Series A Stock.  We filed resale registration statements on Form S-3 related to the Series A financing, which have been declared effective by the SEC. Until all Series A Investors no longer hold Series A warrants to purchase common stock: (i) we may not sell any variable rate securities or dilutive securities except for certain exempt issuances; (ii) if we enter into a subsequent financing on more favorable terms than the Series A Stock financing, then the agreements between us and the Series A Investors will be amended to include such more favorable terms; and (iii) we may not sell securities at an effective price per share less than $4.91 except for certain exempt issuances, unless waivers from the Series A Investors are obtained.  For a period of twelve months following the Series A First Closing, we have granted the Series A Investors a right of first offer on certain future issuances of securities.

Holders of the Series A Stock were entitled to receive accruing dividends at the annual rate of 6%, payable semi-annually.  Upon conversion of Series A Stock into common stock, we paid to each holder of Series A Stock converting to common stock, as a “make-whole” payment in common stock, an amount equal to $118 per $1,000 of stated value of Series A Stock so converted, less the aggregate amount of dividends previously paid on such converting Series A Stock.  During December 2012, the Series A Investors converted 855.54814 shares of Series A Stock into 427,878 shares of common stock.  In addition, 12,871 shares of common stock were issued to the Series A Investors in payment of the make-whole dividends related to the Series A Stock conversions.  On January 4, 2013, accrued Series A dividends of $22,000 were paid by issuing 4,164 shares of common stock to the Series A Investors.  During the first quarter of 2013, the Series A Investors converted all of the remaining 1,644.45186 shares of Series A Stock into 822,421 shares of common stock.  In addition, 50,307 shares of common stock were issued to the Series A Investors in payment of the make-whole and accrued dividends related to the Series A Stock conversions.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

The combination of make-whole and accrued dividends paid in shares of common stock for the first quarter ended March 31, 2013 and for the nine months ended September 30, 2013, was $246,000.

In addition to the issuance of the Series A Stock, at the Series A First Closing, we issued warrants to purchase 213,945 shares of common stock to the Series A Investors.  These warrants have a term of 5.5 years and initially were to become exercisable six months from the Series A First Closing, with an initial exercise price of $9.50 per share.  At the Series A Second Closing, we issued warrants to purchase 724,825 shares of common stock to the Series A Investors.  These warrants have a term of 5½ years and initially were to become exercisable six months from the Series A Second Closing, with an initial exercise price of $2.364 per share (collectively, the “Series A Warrants”).  The exercise price of the Series A Warrants and the number of shares of common stock underlying the Series A Warrants are subject to full-ratchet anti-dilution adjustments in the event we issue securities, other than certain excepted issuances, at a price below the then current exercise price of the Series A Warrants.  On February 26, 2013, we entered into an agreement with the Series A Investors to modify the Series A Warrants such that they would become immediately exercisable as of February 22, 2013 (the “Modification Date”).  Since the Modification Date through September 30, 2013, 949,634 shares of common stock have been issued from exercise of the Series A Warrants, resulting in proceeds to the Company of $2.4 million.  See discussion below regarding further adjustments to the Series A Warrants as a result of the Series B and C financings executed during 2013.

We account for stock purchase warrants as either equity instruments or derivative liabilities depending on the specific terms of the warrant agreements.  Under applicable accounting guidance, stock warrants must be accounted for as derivative financial instruments if the warrants contain full-ratchet anti-dilution provisions, which preclude the warrants from being considered indexed to our own stock.  The Series A Warrants issued to Series A Investors contain such provisions, thus requiring us to treat them as derivative financial instruments, to be recorded at fair value at issuance and subsequently adjusted to fair value at each reporting date, with the corresponding adjustment reflected as a non-operating credit / charge in the consolidated statement of operations.  We valued the Series A Warrants using the Monte-Carlo simulation method using the following assumptions at September 30, 2013:  (i) closing stock price and Series A Warrant contractual exercise price; (ii) term to expiration commensurate with the remaining Series A Warrant terms of 4.5 years; (iii) historical volatilities commensurate with the term of the remaining Series A Warrants of 121.3%; (iv) risk-free interest rates commensurate with the term of the remaining Series A Warrants of 1.2%; and (v) simulated anti-dilution impact assuming various probabilities that we will raise additional capital by issuing equity securities at prices above or below the current contractual Series A Warrant exercise price during the Series A Warrant terms.  The result of these valuation simulations was to value the remaining Series A Warrants at $1.1 million, which was $119,000 below their carrying value as of June 30, 2013.  As a result, we recognized a $119,000 non-operating, warrant derivative gain in our consolidated statement of operations for the three months ended September 30, 2013.  As a result of similar valuation analyses performed during the first and second quarters of 2013, the combined warrant derivative gains recognized in our consolidated statement of operations for the nine months ended September 30, 2013 was $3.4 million.

Amortization of the deferred offering-related costs allocated to the Series A Warrants was $280,000 during the first quarter of 2013 and was recognized as a component of interest expense in the nine months ended September 30, 2013 consolidated statement of operations.

Series B Convertible Preferred Stock Financing

On March 19, 2013, we entered into a securities purchase agreement (the “Series B Purchase Agreement”) with an existing institutional investor (the “Series B Investor”) to purchase 130,000 shares of common stock at a price of $3.05 per share and approximately 1,610.4 units consisting of, in the aggregate, Series B 6% convertible preferred stock (the “Series B Stock”) and warrants to purchase up to 275,000 shares of common stock at an exercise price of $3.49 per share (the “Series B Warrants”) in a registered direct offering (the “Series B Financing”) of securities sold off of our existing shelf registration statement on Form S-3 (File No. 333-176372).  The Series B Financing closed on March 20, 2013 (the “Series B Closing”).  The Series B Stock and Series B Warrants were sold in multiples of fixed combinations, with each fixed combination consisting of one share of Series B Stock and a Series B Warrant to purchase approximately 171 shares of common stock.  Each fixed combination of Series B Stock and Series B Warrants was sold at a price of $1,000.  The Series B Stock was initially convertible into an aggregate of 528,000 shares of common stock at an initial conversion price of $3.05 per share.  The Series B Warrants are not exercisable for six months from the Series B Closing, and the Series B Stock will accrue dividends at an annual rate of 6% beginning six months after the Series B Closing, assuming the Series B Stock has not been converted by that time.  Upon the Series B Closing, we received proceeds of $1.8 million, net of placement agent fees and other related paid and accrued costs.  Given that the effective conversion price of the Series B Stock was below the closing market price of our common stock at the time of the Series B Closing, we recognized a beneficial conversion feature in the amount of $417,000.  Since the Series B Stock was immediately convertible into common stock, the beneficial conversion feature was treated as a deemed dividend charged to retained earnings.  Also, as a result of the Series B Financing, the exercise price of the Series A Warrants issued in the Series A First Closing automatically ratcheted down by their terms from their original exercise price of $9.50 per share to an adjusted exercise price of $3.05 per share, and the underlying shares exercisable as of the Series B Closing were automatically increased from 213,935 shares to 666,375 shares at that time.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

Pursuant to the Certificate of Designation of Preferences, Rights and Limitations of Series B 6% Convertible Preferred Stock filed by the Company with the Delaware Secretary of State on March 19, 2013, the Series B Stock is non-voting (except to the extent required by law and except for certain consent rights relating to amending the certificate of incorporation or bylaws, and the like), but ranks senior to the common stock with respect to dividends and with respect to distributions upon a deemed dissolution, liquidation or winding-up of the Company.  Each share of Series B Stock carries a 6% per annum dividend that will begin accruing six months after the Series B Closing and will be payable only in cash.  Subject to certain exceptions, the conversion price of the Series B Stock is subject to full ratchet anti-dilution adjustment in the event we issue any convertible debt or equity below the then-current conversion price (subject to the limits imposed by General Instruction I.B.6. of Form S-3).  In the event we commit material and intentional fraud, we may be required to redeem the Series B Stock in exchange for the issuance of common stock valued at 130% of the stated value divided by 75% of the average of the preceding 10-day volume-weighted average price of the common stock, subject to limits imposed by General Instruction I.B.6. of Form S-3.

The Series B Warrants have a 5.5 year term as well as a cashless exercise provision in the event there is no effective registration statement covering the common stock issuable upon exercise of the Series B Warrants, and are not exercisable for the first six months following issuance.  The Series B Warrants are not subject to price anti-dilution protection.

Pursuant to the terms of the Series B Purchase Agreement, we have also agreed with the Series B Investor that while such Series B Investor holds Series B Preferred Stock or Series B Warrants, we will not effect or enter into an agreement to effect a “Variable Rate Transaction,” which means a transaction in which we: (i) issue or sell any convertible securities either (A) at a conversion, exercise or exchange rate or other price that is based upon and/or varies with the trading prices of, or quotations for, the shares of the common stock at any time after the initial issuance of such convertible securities, or (B) with a conversion, exercise or exchange price that is subject to being reset at some future date after the initial issuance of such convertible securities or upon the occurrence of specified or contingent events directly or indirectly related to our business; or (ii) enter into any agreement (including, without limitation, an equity line of credit) whereby we may sell securities at a future determined price.

We also agreed with the Series B Investor pursuant to the Series B Purchase Agreement that, except under certain permitted circumstances: (i) until the later of the date that is six months from the Series B Closing or 30 days following the date on which the Series B Stock is no longer outstanding we will not issue, or enter into any agreement to issue, any shares of common stock or equivalents thereof; (ii) until the time that less than 7.5% of the Series B Warrants remain outstanding, neither we nor our subsidiaries shall issue, or enter into any agreement to issue, common stock or equivalents thereof at a price below the exercise price of the Series B Warrants; (iii) so long as any shares of Series B Stock are outstanding, neither we nor our subsidiaries shall issue, or enter into any agreement to issue, common stock or equivalents at a price below the conversion price of the Series B Stock unless all shares of common stock underlying the Series B Stock (taking into consideration the effect of the full adjustment of the anti-dilution provisions from such dilutive issuance) are permitted by General Instruction I.B.6. of Form S-3 to be issued under the registration statement; (iv) if we issue securities within the nine months following the Series B Closing under the Series B Purchase Agreement, and subject to the preexisting rights of other security holders, the Series B Investor shall have the right to purchase all of the securities on the same terms, conditions and price provided for in the proposed issuance of securities; and (v) we will indemnify the Series B Investor against certain losses resulting from our breach of any of our representations, warranties, or covenants under agreements with the Series B Investor, as well as under certain other circumstances described in the Series B Purchase Agreement.

The Series B Investor has agreed to be subject to a blocker that (i) would prevent its common stock ownership at any given time from exceeding 4.99% (which may be increased, but not above 9.99%) of our outstanding common stock; or (ii) would prevent us from issuing any shares of common stock to the Series B Investor upon the conversion by such Series B Investor of Series B Stock if the issuance of such shares to the Series B Investor, when aggregated with all other shares of common stock sold to the Series B Investor under the Series B Purchase Agreement together with all shares of common stock issued upon the conversion of Series B Stock, would result in the total issuance of common stock to exceed 19.99% of our outstanding common stock, without first obtaining the approval of our stockholders.  We obtained stockholder approval at our June 27, 2013 Annual Stockholders’ Meeting for the terms of the Series B Stock and the issuance and delivery in the aggregate of that number of shares of common stock exceeding 19.99% of the outstanding shares of common stock upon conversion of the Series B Stock.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

Since the Series B Closing through September 30, 2013, the Series B Investor has converted 1,589.274133 shares of Series B stock into 528,000 shares of common stock.  See discussion below regarding additional adjustments to the Series B Stock as a result of the Series C Financing.

Series C Convertible Preferred Stock Financing

On May 3, 2013, we entered into a securities purchase agreement (the “Series C Purchase Agreement”) with certain accredited investors (the “Series C Investors”), pursuant to which we sold and issued 1,200 shares of our newly created Series C 6% convertible preferred stock (the “Series C Stock”) to the Series C Investors at a purchase price of $1,000 per share in an initial closing that occurred on May 6, 2013 (the “Series C First Closing”) and sold and issued 1,200 additional shares of Series C Stock to the Series C Investors on June 28, 2013 at a purchase price of $1,000 per share after stockholder approval was obtained on June 27, 2013 (the “Series C Second Closing”) (combined, the “Series C Financing”). After certain offering-related costs, the net proceeds from the Series C Financing were $2.15 million.

As a result of the Series C Second Closing, the conversion price for the Series C Stock was set to $2.85759 per share, or the equivalent of 839,870 shares of common stock issuable upon conversion of all Series C Stock.  The conversion price of the Series C Stock also is subject to proportional adjustment for stock splits, stock dividends, recapitalizations and the like.  The Series C Stock is entitled to 6% annual dividends, which rate shall increase by 1% per year for as long as the Series C Stock is outstanding, up to a maximum rate of 10%. Accrued dividends are payable semi-annually, and also on the date of conversion of any Series C Stock, in cash or, subject to certain conditions and at our election, in shares of common stock. If the dividends are paid in shares of common stock, the number of shares of common stock comprising the dividend on each share of Series C Stock will be valued at a 20% discount to the average of the daily volume weighted average price for the five-day trading period immediately prior to the dividend payment date.  Given that the effective conversion price of the Series C Stock was below the closing market price of our common stock at the time of both of the Series C closings, we recognized beneficial conversion features in the amount of $1.2 million, which were limited to and reduced the net proceeds allocated to the Series C Stock.  Since the Series C Stock was immediately convertible into common stock, the beneficial conversion feature was treated as a deemed dividend charged to retained earnings.  Accrued dividends relating to the first semi-annual payment for the Series C Stock were $10,400 as of June 30, 2013, and were paid in July of 2013 by issuing 3,604 shares of common stock to the Series C Investors.  For the three month period ended September 30, 2013, we have accrued $4,000 in Series C Stock dividends related to the next semi-annual dividends payment due at the end of 2013.

Also as a result of the Series C Second Closing, the exercise price of the Series A Warrants issued in the Series A First Closing automatically ratcheted down by their terms from their most recent exercise price of $3.05 per share to an adjusted exercise price of $2.86 per share, and the underlying shares exercisable as of the Series C Second Closing were automatically increased from 441,566 shares to 470,907 shares.  In addition, the conversion price of the Series B Stock automatically ratcheted down by their terms from $3.05 per share to an adjusted conversion price of $2.85759 per share, and the underlying shares issuable from conversion of Series B Stock as of the Series C Second Closing were automatically increased from 109,837 shares to 117,231 shares.

In addition to the issuance of the Series C Stock, we issued warrants at the Series C First Closing to purchase 491,803 shares of our common stock with an exercise price of $3.77 per share and at the Series C Second Closing, we issued additional warrants to purchase 491,803 shares of our common stock with an exercise price of $3.55 per share (collectively, the “Series C Warrants”).  The exercise price of the Series C Warrants issued equaled 110% of the market value (as defined by Nasdaq rules) of one share of common stock on each closing date.  The Series C Warrants have a 5.5 year term, are not exercisable for the first six months following issuance and include a cash-less exercise provision which is only applicable if the common stock underlying the Series C Warrants is not subject to an effective registration statement or otherwise cannot be sold without restriction pursuant to Rule 144.

Until the date that is six months following the Series C Second Closing, we have granted the Series C Investors a right of first offer on certain future issuances of securities. We have also agreed to certain standstill provisions, pursuant to which we may not issue any equity securities (or securities convertible into equity) until the later of:  (i) September 20, 2013 and (ii) the date that is 30 days following the date on which no Series C Stock remains outstanding (except for certain exempt issuances).  Until all Series C Investors no longer hold Series C Stock or Series C Warrants:  (i) we may not sell any variable rate securities except for certain exempt issuances; and (ii) if we enter into a subsequent financing on more favorable terms than the Series C Financing, then the agreements between us and the Series C Investors will be amended to include such more favorable terms.  In addition, until 7.5% or less of the Series C Warrants remain unexercised, we may not sell any dilutive securities, except for certain exempt issuances.

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COMBIMATRIX CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

The Series C Stock is non-voting (except to the extent required by law and except for certain consent rights relating to amending the certificate of incorporation or bylaws, and the like), but ranks senior to the common stock and junior to the Series A Stock and Series B Stock with respect to dividends and with respect to distributions upon a deemed dissolution, liquidation or winding-up of the Company. The Series C Investors have agreed to be subject to a blocker that would prevent their common stock ownership at any given time from exceeding 4.99% (which may be increased, but not above 9.99%) of our outstanding common stock.

The common stock underlying the Series C Stock and Series C Warrants were initially unregistered under the Securities Act of 1933.  In connection with the Series C Financing, however, we entered into a registration rights agreement with the Series C Investors (the “Registration Rights Agreement”). The Registration Rights Agreement required us to file registration statements with the SEC registering for resale:  (i) the shares of common stock issuable upon conversion of the Series C Stock; (ii) the shares of common stock issuable as dividends on the Series C Stock; (iii) the shares of common stock issuable upon exercise of the Series C Warrants; and (iv) any additional shares of common stock issuable in connection with any anti-dilution provisions associated with the Series C Stock.  We filed registration statements relating to both of the Series C closings, and both registration statements have been declared effective by the SEC.  Under the terms of the Registration Rights Agreement, we are obligated to maintain the effectiveness of the resale registration statements until all securities registered thereunder are sold or otherwise can be sold without restriction pursuant to Rule 144. The Registration Rights Agreement includes liquidated damages provisions in the event we fail to file or maintain the effectiveness of the registration statements. We do not plan, nor are we obligated, to register the Series C Stock or the Series C Warrants.

During the three months ended September 30, 2013 and through the date of this report, the Series C Investors have converted 2,100 shares of Series C stock into 734,881 shares of common stock, excluding 3,663 of additional shares of common stock issued as consideration for the 6% Series C dividends accrued as of the conversion dates.

Warrants

Outstanding warrants to purchase common stock are as follows:

(1)         Prior to the anti-dilution adjustments which occurred on March 20, 2013 and June 28, 2013, these warrants had an initial exercise price of $9.50 per share.

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COMBIMATRIX CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

5.    COMMITMENTS AND CONTINGENCIES

Executive Severance

We provide certain severance benefits such that if an executive officer of CombiMatrix Corporation is terminated for other than cause, death or disability, the executive will receive payments equal to three months’ base salary plus medical and dental benefits.  In addition, we have implemented a Restated Executive Change of Control Severance Plan (the “Severance Plan”) that affects certain of our senior management-level employees who are classified as “Section 16 Officers” of the Company.  Pursuant to the Severance Plan, if a participating employee is involuntarily terminated (other than for death, disability or for cause) or resigns for “good reason” (as defined in the Severance Plan) during the two-year period following a “change of control” (as defined in the Severance Plan) of the Company, then, subject to execution of a release of claims against the Company, the employee will be entitled to receive: (i) one-half times annual base salary; (ii) immediate vesting of outstanding compensatory equity awards; and (iii) payment of COBRA premiums for the participating employee and eligible dependents for a pre-determined period of time.  Payment of benefits under the Severance Plan will be limited by provisions contained in Section 409A of the U.S. Internal Revenue Code.  The Severance Plan is administered by a plan administrator, which initially is the Compensation Committee of the Board of Directors.  In order to participate in the Severance Plan, an eligible employee must waive any prior retention or severance agreements.

Litigation

In 2002, we entered into a settlement agreement with Nanogen, Inc. (“Nanogen”) to settle all pending litigation between the parties.  Pursuant to the terms of the settlement agreement, we agreed to make quarterly payments to Nanogen equal to 12.5% of total sales of products developed by us and our affiliates based on the patents that had been in dispute in the litigation, up to an annual maximum amount of $1.5 million.  The minimum quarterly payments under the settlement agreement are $25,000 per quarter until the patents expire in 2018.  Royalty expenses recognized under the agreement were $25,000 and $75,000 for the three and nine months ended September 30, 2013 and 2012, respectively, and are included in patent amortization and royalties in the accompanying consolidated statements of operations.

On February 14, 2011, Relator Michael Strathmann (“Strathmann”) served us with a complaint (“the Complaint”) filed in the Superior Court of the State of California for the County of Orange.  The Complaint alleged that we submitted false and fraudulent insurance claims to National Union Fire Insurance Company of Pittsburgh, PA in connection with a prior lawsuit that was settled with Nanogen, Inc., thereby allegedly violating the California Insurance Fraud Prevention Act, and sought penalties and unspecified treble damages.  On May 4, 2011, the Superior Court dismissed the Complaint by ordering that it be stricken for violation of the California Anti-SLAPP statute, which prevents plaintiffs from filing abusive lawsuits against public policy.  On June 15, 2011, Strathmann filed a Notice of Appeal with the California Court of Appeals, appealing the granting of the Motion to Strike.  Subsequently, Strathmann filed a Notice of Appeal of the award of attorneys’ fees against him.  On October 24, 2012, the California Court of Appeals reversed the Superior Court’s dismissal, finding that the anti-SLAPP statute was not applicable and remanding the case to the Superior Court. Strathmann has filed an Amended Complaint, and we have filed our Answer to that pleading.  Trial has been set for June 9, 2014, in the Orange County Superior Court.  While discovery has just commenced in the case, we believe that there is no merit to Strathmann’s claims and intend to vigorously defend against them, but there can be no assurance that we will ultimately be successful.

From time to time, we are subject to other claims and legal actions that arise in the ordinary course of business.  We believe that the ultimate liability with respect to these other claims and legal actions, if any, will not have a material effect on our financial position, results of operations or cash flows.  Based on a distribution agreement executed between us and Acacia, it is expected that such claims and legal actions attributable to CombiMatrix Corporation prior to the Split-Off Date will remain with us subsequent to the Split-Off Date.  As of the date of this report and prior to such date, we are not aware of the existence of any such claims or legal actions.

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

Cautionary Statement

You should read the following discussion and analysis in conjunction with the consolidated financial statements and related notes thereto contained in Part I, Item 1 of this report.  The information contained in this Quarterly Report on Form 10-Q is not a complete description of our businesses or the risks associated with an investment in our common stock.  We urge you to carefully review and consider the various disclosures made by us in this report and in our other reports filed with the U.S. Securities and Exchange Commission, or “SEC,” including our Annual Report on Form 10-K for the year ended December 31, 2012, filed with the SEC on March 25, 2013.

This report contains forward-looking statements within the meaning of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical fact included in this report, are forward-looking statements. Reference is made in particular to the description of our plans and objectives for future operations, assumptions underlying such plans and objectives, and other forward-looking statements included in this report. Such statements may be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “would,” “could,” “expect,” “believe,” “estimate,” “anticipate,” “intend,” “plan,” “predict,” “seek,” “potential,” “continue,” “focus,” “ongoing,” or similar terms, variations of such terms or the negative of such terms, and include, but are not limited to, statements regarding projected results of operations, capital expenditures, earnings, management’s future strategic plans, services development, litigation, regulatory matters, market acceptance and performance of our services, the success and effectiveness of our technologies, our ability to retain and hire key personnel, the competitive nature of and anticipated growth in our markets, market position of our services, marketing efforts and partnerships, liquidity and capital resources, our accounting estimates, and our assumptions and judgments.  Such statements are based on management’s current expectations, estimates and projections about our industry, management’s beliefs, and certain assumptions made by us, all of which are subject to change. These forward looking statements are not guarantees of future results and are subject to a number of risks, uncertainties and assumptions that are difficult to predict and that could cause actual results to differ materially and adversely from those described in the forward-looking statements.  The risks and uncertainties referred to above include, but are not limited to, our ability to obtain additional financing for working capital on acceptable terms and in a timely manner; our ability to successfully increase the volume of our existing tests, expand the number of tests offered by our laboratory, increase the number of customers and partners and improve reimbursement for our testing; our ability to maintain compliance with Nasdaq’s continued listing requirements; our ability to continue as a going concern; changes in consumer demand; our ability to attract and retain a qualified sales force and key technical personnel; our ability to successfully develop new services; our ability to successfully introduce new technologies and services; rapid technological change in our markets; supply availability; the outcome of existing litigation; our ability to bill and obtain reimbursement for highly specialized tests; our ability to comply with regulations to which our business is subject; legislative, regulatory and competitive developments in markets in which we and our subsidiaries operate; our limited market capitalization; future economic conditions; other circumstances affecting anticipated revenues and costs; and other factors as more fully disclosed in our discussion of risk factors in Item 1A of Part II of this report and in the “Risk Factors” described in our Annual Report on Form 10-K for the year ended December 31, 2012 filed with the SEC on March 25, 2013.  Additional factors that could cause such results to differ materially from those described in the forward-looking statements are set forth in connection with the forward-looking statements.  These forward-looking statements speak only as of the date of this report and we expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based, except as required by law.

General

We provide valuable molecular diagnostic solutions and comprehensive clinical support for the highest quality of care.  We specialize in miscarriage analysis, prenatal and pediatric healthcare, offering DNA-based testing for the detection of genetic abnormalities beyond what can be identified through traditional methodologies.  We perform genetic testing utilizing a variety of advanced cytogenomic techniques, including microarray, standardized and customized fluorescent in-situ hybridization (or “FISH”) and high resolution karyotyping.   We emphasize support for healthcare professionals, to ensure data understanding and communication of results to patients.  We deliver high-technology driven answers, with a high degree of assistance for the ordering physician and staff.  Our clinical lab and corporate offices are located in Irvine, California.

We also own a one-third minority interest in Leuchemix, Inc. (“Leuchemix”), a private drug development company focused on developing a series of compounds to address a number of oncology-related diseases.

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Overview

For the three and nine months ended September 30, 2013, our operating activities included the recognition of $1.5 million and $4.6 million of total revenues, respectively which increased by $208,000 and $744,000, respectively, from the comparable periods in 2012 due primarily to increased volumes of molecular diagnostic tests performed.  Our net loss decreased over the comparable periods in 2012 due partially to increased revenues and reduced operating expenses as a result of cost reduction efforts executed during the second quarter of 2012, but primarily due to non-cash warrant derivative gains of $3.4 million that were recognized during the nine months ended September 30, 2013.

During the second quarter of 2013, we executed an agreement to issue securities in a private placement transaction with certain accredited investors that resulted in gross proceeds to us totaling $2.4 million received in two tranches, with the first tranche having closed on May 6, 2013 and the second tranche having closed on June 28, 2013.  This financing was through the sale of Series C convertible preferred stock (the “Series C Stock”) and warrants to purchase 491,803 shares of common stock with an exercise price of $3.77 per share and 491,803 shares of common stock with an exercise price of $3.55 per share (collectively, the “Series C Warrants”).  Upon closing of both tranches, we received proceeds of $2.15 million, net of offering-related costs.

During the first quarter of 2013, we executed a registered direct offering to an existing institutional investor of Series B convertible preferred stock, common stock and warrants to purchase common stock (the “Series B Financing”), resulting in net proceeds to us of $1.8 million.

The exercise of certain warrants from our Series A convertible preferred stock financing executed during the fourth quarter of 2012 (the “Series A Warrants”) resulted in additional proceeds of $2.4 million through September 30, 2013.

Critical Accounting Estimates

Our unaudited interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America.  Preparation of these statements requires management to make judgments and estimates.  Some accounting policies have a significant impact on amounts reported in these financial statements.  A summary of significant accounting policies and a description of accounting policies that are considered critical may be found in our Annual Report on Form 10-K for the year ended December 31, 2012, filed with the SEC on March 25, 2013, in the Notes to the Consolidated Financial Statements and the Critical Accounting Estimates sections.  In addition, refer to Note 2 to the consolidated interim financial statements included in Part I, Item 1 of this report.

Comparison of the Results of Operations for the Three and Nine Months Ended September 30, 2013 and 2012

Revenues and Cost of Revenues (dollars in thousands):

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Diagnostic Services.  Diagnostic services revenues are generated from providing DNA-based genomic testing services primarily in the areas of prenatal and postnatal development disorders in children and, to a lesser extent, in oncology.  The key drivers and metrics relating to the change in diagnostic services revenues were as follows:

Although total billable testing volumes increased by 6% and 11% for the three and nine months ended September 30, 2013 over the comparable periods in 2012, respectively, diagnostic services revenues increased by 39% and 27% over the same periods, respectively.  The reason that diagnostic services revenues have increased by greater percentages than have total billable testing volumes is due to a shift in test mix during 2013 towards a higher concentration of microarray testing, particularly in the prenatal testing market.  Because microarray tests are priced and reimbursed at significantly higher rates than our non-array tests, our overall average revenue per test has also increased for all periods presented, thereby driving higher revenues in 2013 compared to 2012.  In addition, decreases in oncology and pediatric testing volumes were offset by increases in prenatal testing, resulting in an overall increase in diagnostic services revenues quarter-over-quarter and year-over-year.  The change in test mix has been driven by a change in sales and marketing efforts in mid-2012 towards the prenatal diagnostic testing market and less towards pediatric and oncology markets.  Diagnostic services revenues also include adjustments relating to our revenue recognition policy of periodically adjusting our estimate for contractual allowances for revenues from non-contracted payors as well as from receiving cash payments in excess of amounts previously recognized for services revenues. For the three and nine months ended September 30, 2013 and 2012, net positive revenue adjustments were $169,000, $437,000, $41,000 and $416,000, respectively.  Because approximately 68% of our revenues are billed to non-contracted third-party payors, it is likely that we will be required to make adjustments to accounting estimates with respect to contractual allowances in the future, which may positively or adversely affect our revenues and results of operations. In addition, recent changes by Medicare to the molecular codes used by laboratories such as ours for microarray testing could positively or negatively impact reimbursement from certain non-contracted payors for our microarray tests, which would have a commensurate impact on revenues recognized from those payors.

Clinical Trial Support Services.  In June 2012, we entered into a materials transfer agreement with Affymetrix, Inc. in support of their clinical trial program.  Under the terms of the agreement, we delivered over 300 anonymous patient samples during the third quarter of 2012.  As a result, we fully satisfied our obligations to Affymetrix, which resulted in recognition of $195,000 of clinical trial support services revenues for the three and nine months ended September 30, 2012.  There were no such programs or activities during 2013.

Royalties.  In 2010, we entered into an exclusive licensing agreement with CustomArray, Inc. (“CA”), a private company located in Washington State, for certain of our patents and intellectual property developed as part of our prior microarray manufacturing business.  This agreement requires CA to pay us royalties as a percentage of their gross revenues, not less than $25,000 per quarter.  CA’s sales activities were lower in 2013 compared to 2012, resulting in lower royalties for all periods presented in 2013 as compared to 2012.  It is uncertain whether in future periods, CA’s revenues will increase, continue at current levels or decrease to the minimum contractual amounts.

Cost of Services.  Cost of services relating to our diagnostic tests performed include direct materials such as array and laboratory costs, direct laboratory labor (wages and benefits), allocation of administrative overhead and stock-compensation expenses.   Increases in cost of services were due primarily to increased diagnostic testing volumes period-over-period, as well as increased materials costs associated with converting microarray testing platforms in the first and second quarters of 2013.

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Operating Expenses (dollars in thousands):