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, 2011

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

For the transition period from to

Commission File Number: 000-31135

INSPIRE PHARMACEUTICALS, INC.

(Exact Name of Registrant as Specified in Its Charter)


Delaware		04-3209022
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

8081 Arco Corporate Drive, Suite 400 Raleigh, North Carolina		27617
(Address of Principal Executive Offices)		(Zip Code)

Registrant’s Telephone Number, Including Area Code: (919) 941-9777

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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES ¨ 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 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 Exchange Act). YES ¨ NO x

As of April 1, 2011, there were 83,292,192 shares of Inspire Pharmaceuticals, Inc. common stock outstanding.

TABLE OF CONTENTS


	Page

PART I: FINANCIAL INFORMATION

Item 1. Financial Statements (unaudited)		3

Condensed Balance Sheets – March 31, 2011 and December 31, 2010		3

Condensed Statements of Operations – Three months ended March 31, 2011 and 2010		4

Condensed Statements of Cash Flows – Three months ended March 31, 2011 and 2010		5

Notes to Condensed Financial Statements		6

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		23

Item 3. Quantitative and Qualitative Disclosures about Market Risk		44

Item 4. Controls and Procedures		45

PART II: OTHER INFORMATION

Item 1. Legal Proceedings		46

Item 1A. Risk Factors		47

Item 5. Other Information		67

Item 6. Exhibits		67

SIGNATURES		68

We own or have rights to various trademarks, copyrights and trade names used in our business. AzaSite® is a trademark owned by InSite Vision Incorporated. Restasis® and Elestat® are trademarks owned by Allergan, Inc. Diquas^TM is a trademark owned by Santen Pharmaceutical Co., Ltd. This report also includes trademarks, service marks and trade names of other companies.

PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

INSPIRE PHARMACEUTICALS, INC.

Condensed Balance Sheets

(in thousands, except per share amounts)

(Unaudited)


	March 31, 2011			December 31, 2010
Assets
Current assets:
Cash and cash equivalents	$	31,188		$	42,204
Investments		43,272			47,510
Trade receivables, net		16,301			22,442
Prepaid expenses and other receivables		2,693			3,792
Inventories, net		1,126			776

Total current assets		94,580			116,724

Property and equipment, net		2,905			7,896
Investments		2,765			3,922
Restricted deposits		615			615
Intangibles, net		12,755			13,154
Other assets		188			188

Total assets	$	113,808		$	142,499


Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	8,504		$	12,766
Accrued expenses		24,846			31,467

Total current liabilities		33,350			44,233

Other long-term liabilities		1,280			3,028

Total liabilities		34,630			47,261

Commitments and contingencies (Note 9)
Stockholders’ equity:
Preferred stock, $0.001 par value, 1,860 shares authorized; no shares issued and outstanding		—			—
Common stock, $0.001 par value, 200,000 shares authorized; 83,279 and 83,159 shares issued and outstanding, respectively		83			83
Additional paid-in capital		532,583			530,983
Accumulated other comprehensive income		25			63
Accumulated deficit		(453,513	)		(435,891	)

Total stockholders’ equity		79,178			95,238


Total liabilities and stockholders’ equity	$	113,808		$	142,499

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

INSPIRE PHARMACEUTICALS, INC.

Condensed Statements of Operations

(in thousands, except per share amounts)

(Unaudited)


	Three Months Ended
	March 31, 2011			March 31, 2010
Revenues:
Product sales, net	$	10,937		$	8,696
Product co-promotion and royalty		10,157			13,372


Total revenue		21,094			22,068

Operating expenses:
Cost of sales		4,615			3,015
Research and development		3,600			9,593
Selling and marketing		12,841			13,694
General and administrative		5,551			10,236
Restructuring		12,215			—


Total operating expenses		38,822			36,538


Loss from operations		(17,728	)		(14,470	)

Other income/(expense):
Interest income		106			169
Interest expense		—			(486	)


Other income/(expense), net		106			(317	)


Net loss	$	(17,622	)	$	(14,787	)


Basic and diluted net loss per common share	$	(0.21	)	$	(0.18	)


Weighted average common shares used in computing basic and diluted net loss per common share		83,212			82,402

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

INSPIRE PHARMACEUTICALS, INC.

Condensed Statements of Cash Flows

(in thousands)

(Unaudited)


	Three Months Ended
	March 31, 2011			March 31, 2010
Cash flows from operating activities:
Net loss	$	(17,622	)	$	(14,787	)
Adjustments to reconcile net loss to net cash used in operating activities:
Amortization expense		399			454
Depreciation of property and equipment		635			221
Asset impairment		4,533			—
Loss/(gain) on disposal of property and equipment		81			1
Stock-based compensation expense		1,208			4,793
Allowance for doubtful accounts		(35	)		(18	)
Inventory reserve		—			10
Changes in operating assets and liabilities:
Trade receivables		6,176			5,944
Prepaid expenses and other receivables		1,099			691
Inventories		(350	)		(34	)
Accounts payable		(3,550	)		(407	)
Accrued expenses and other liabilities		(7,764	)		(3,957	)
Deferred rent		168			—


Net cash used in operating activities		(15,022	)		(7,089	)


Cash flows from investing activities:
Purchase of investments		(15,044	)		(16,817	)
Proceeds from sale of investments		20,401			9,450
Purchase of property and equipment		(1,755	)		(2,000	)
Proceeds from sales of property and equipment		12			44


Net cash provided by/(used in) investing activities		3,614			(9,323	)


Cash flows from financing activities:
Issuance of common stock, net – stock compensation plans		392			137
Payments related to settlement of employee stock-based awards		—			(203	)
Payments on notes payable and capital lease obligations		—			(4,843	)


Net cash provided by/(used in) financing activities		392			(4,909	)


Decrease in cash and cash equivalents		(11,016	)		(21,321	)
Cash and cash equivalents, beginning of period		42,204			52,256


Cash and cash equivalents, end of period	$	31,188		$	30,935


Supplemental disclosure of non-cash investing information:
Purchase of equipment included in accrued expenses	$	—		$	98

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

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

1.	Organization

Inspire Pharmaceuticals, Inc. (the “Company” or “Inspire”) was incorporated in October 1993 and commenced operations in March 1995. Inspire is located in Raleigh, North Carolina.

Inspire is a specialty pharmaceutical company focused on developing and commercializing ophthalmic products. The Company’s specialty eye care sales force generates revenue from the promotion of AzaSite (azithromycin ophthalmic solution) 1% for bacterial conjunctivitis. The Company receives royalties based on net sales of Restasis (cyclosporine ophthalmic emulsion) 0.05% for dry eye and began receiving royalties in 2011 based on net sales of Diquas Ophthalmic Solution 3% (diquafosol tetrasodium) for dry eye in Japan.

Inspire has incurred losses and negative cash flows from operations since inception. Based on current operating plans, the Company expects it has sufficient liquidity to continue its planned operations beyond 2011. The Company’s liquidity needs will largely be determined by the commercial success of its products, key development and regulatory events and whether it successfully in-licenses or acquires additional products. The Company will continue to incur operating losses until revenues reach a level sufficient to support ongoing operations.

2.	Basis of Presentation

The accompanying unaudited Condensed Financial Statements have been prepared in accordance with generally accepted accounting principles in the United States of America and applicable Securities and Exchange Commission (“SEC”) regulations for interim financial information. These financial statements do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. It is presumed that users of this interim financial information have read or have access to the audited financial statements from the preceding fiscal year contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair statement of the Company’s financial position and operations for the interim periods presented have been made.

Revenue, expenses, assets and liabilities can vary during each quarter of the year. Therefore, the results and trends in the unaudited Condensed Financial Statements and accompanying notes may not be indicative of the results for the full year or any future period.

Use of Estimates

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

Fair Value of Financial Instruments

The Company discloses the fair value of financial instruments for assets and liabilities for which it is practicable to estimate that value. The carrying amounts of all cash equivalents, available-for-sale securities and restricted deposits approximate fair value based upon quoted market prices. The fair value of trade accounts receivables and accounts payable approximates their respective carrying values due to their short-term nature.

Other long-term assets include the Company’s common stock investment of $200 in a non-public entity for which fair value is not readily determinable. The investment is carried at cost and is subject to potential write-down for impairment whenever events or changes in circumstances indicate that the carrying value is not recoverable. Other long-term liabilities typically represent deferred fees, credits and cost reimbursement arrangements. The carrying value of these long-term assets and liabilities approximate their fair values.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

Net Loss Per Common Share

Basic net loss per common share is computed by dividing net loss attributable to common stockholders by the weighted average number of common shares outstanding during the period. Diluted net loss per common share is computed by dividing net loss attributable to common stockholders by the weighted average number of common shares outstanding and dilutive potential common shares then outstanding. Dilutive potential common shares consist of shares issuable upon the exercise of stock options and restricted stock units that are paid in shares of the Company’s stock upon conversion. The calculation of diluted earnings per share for the three months ended March 31, 2011 and 2010 does not include 292 and 1,129, respectively, of potential common shares, as their impact would be antidilutive.

Intangible Assets

Costs associated with obtaining patents on the Company’s product candidates and license initiation and preservation fees, including milestone payments by the Company to its licensors, are evaluated based on the stage of development of the related product candidate and whether the underlying product candidate has an alternative use. Costs of these types incurred for product candidates not yet approved by the U.S. Food and Drug Administration (“FDA”) and for which no alternative future use exists are recorded as an expense. In the event a product candidate has been approved by the FDA or an alternative future use exists for a product candidate, patent and license costs are capitalized and amortized over the expected life of the related product candidate. Milestone payments to the Company’s collaborators are recognized when the underlying requirement is met.

Upon FDA approval of AzaSite in April 2007, the Company paid a $19,000 milestone payment to InSite Vision Incorporated (“InSite Vision”). The $19,000 is being amortized ratably on a straight-line basis through the term of the underlying patent coverage for AzaSite, or March 2019, which represents the expected period of commercial exclusivity. As of March 31, 2011 and December 31, 2010, the Company had $6,245 and $5,846, respectively, in accumulated amortization related to this milestone payment.

The carrying values of intangible assets are periodically reviewed to determine if the facts and circumstances suggest that a potential impairment may have occurred. The review includes a determination of the carrying values of intangible assets based on an analysis of undiscounted cash flows over the remaining amortization period. If the review indicates that carrying values may not be recoverable, the Company would record an impairment charge to reduce the carrying values to the estimated fair value. The Company had no impairments of its intangible assets for the three months ended March 31, 2011 and 2010.

Revenue Recognition

The Company records all of its revenue from: (1) sales of AzaSite; (2) product co-promotion activities and earned royalties; and (3) collaborative research agreements, when realized or realizable and earned. Revenue is realized or realizable and earned when all of the following criteria are met: (i) persuasive evidence of an arrangement exists; (ii) delivery has occurred or services have been rendered; (iii) the seller’s price to the buyer is fixed or determinable; and (iv) collectibility is reasonably assured.

Product Revenues

The Company recognizes revenue for sales of AzaSite when title and substantially all the risks and rewards of ownership have transferred to the customer, which generally occurs on the date of shipment to wholesalers and distributors. In the United States, the Company sells AzaSite to wholesalers and distributors, who, in turn, sell to pharmacies and federal, state and commercial health care organizations.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

Sales deductions consist of statutory rebates to state Medicaid, Medicare and other government agencies, contractual rebates with commercial managed care organizations, wholesaler chargebacks, sales discounts (including trade discounts and distribution service fees), allowances for coupon and voucher programs and product returns. These deductions are recorded as reductions to revenue from AzaSite in the same period as the related sales with estimates of future utilization derived from historical experience adjusted to reflect known changes in the factors that impact such reserves.

The Company utilizes data from external sources to help it estimate gross-to-net sales adjustments as they relate to the recognition of revenue for AzaSite sold. External sourced data includes, but is not limited to, information obtained from certain wholesalers with respect to their inventory levels and sell-through to customers, targeted surveys as well as data from IMS Health, a third-party supplier of market research data to the pharmaceutical industry. The Company also utilizes this data to help estimate and identify prescription trends and patient demand, as well as product levels in the supply chain.

The Company accounts for these sales deductions in accordance with the Financial Accounting Standards Board (“FASB”) authoritative guidance on revenue recognition when consideration is given by a vendor to a customer as well as when the right of return exists.

The Company has categorized and described more fully the following significant sales deductions, all of which involve estimates and judgments, which the Company considers to be critical accounting estimates, and requires it to use information from external sources.

Rebates and Chargebacks

Statutory rebates to state Medicaid agencies and Medicare and contractual rebates to commercial managed care organizations are based on statutory or negotiated discounts to AzaSite’s selling price. As it can take up to nine months or more for information to be received on actual usage of AzaSite in managed care and Medicaid and other governmental programs as well as on the total discounts to be reimbursed, the Company maintains reserves for amounts payable under these programs relating to AzaSite sales.

Chargebacks claimed by wholesalers are based on the differentials between product acquisition prices paid by wholesalers and lower government contract pricing paid by eligible customers covered under federally qualified programs.

The amount of the reserve for rebates and chargebacks is based on multiple qualitative and quantitative factors, including the historical and projected utilization levels, historical payment experience, changes in statutory laws and interpretations as well as contractual terms, product pricing (both normal selling prices and statutory or negotiated prices), changes in prescription demand patterns and utilization of the Company’s product through private or public benefit plans, and the levels of AzaSite inventory in both the wholesale and retail distribution channel. Other factors that the Company may consider, if determined relevant, would include price changes from competitors and introductions of generics and/or competitive new products. The Company acquires prescription utilization data from IMS Health, a third-party supplier of market research data to the pharmaceutical industry. The Company applies these multiple factors, the quantitative historical data along with other qualitative aspects, such as management’s judgment regarding future utilization trends, to the respective period’s sales of AzaSite to determine the rebate accrual and related expense. The Company updates its estimates and assumptions each period and records any necessary adjustments to its reserves. Settlements of rebates and chargebacks typically occur within nine months from point of sale. To the extent actual rebates and chargebacks differ from the Company’s estimates, additional reserves may be required or reserves may need to be reversed, either of which would impact current period product revenue. As of March 31, 2011 and December 31, 2010, reserves for rebates and chargebacks were $5,670 and $9,085, respectively.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

Discounts and Other Sales Incentives

Discounts and other sales incentives consist of the following:

•

Prompt pay discounts —Prompt payment discounts are offered to all wholesalers in return for payment within 30 days following the invoice date. The Company records sales of AzaSite net of the discount amount based on historical experience. The Company adjusts the reserve at the end of each reporting period to approximate the percentage discount applicable to the outstanding gross accounts receivable balances.

•

Inventory Management Agreement (“IMA”) Fees —Per contractual agreements with the Company’s largest wholesalers, the Company provides an IMA fee based on a percentage of their purchases of AzaSite. The IMA fee rates are set forth in the individual contracts. The Company tracks sales to these wholesalers each period and accrues a liability relating to the unpaid portion of these fees by applying the contractual rates to such sales.

•

Product coupons and vouchers —Product coupons and vouchers, made available by the Company online or through pharmacies and prescribing physicians, offer patients the ability to receive free or discounted product. The Company uses a third-party administrator who coordinates program activities and invoices on a periodic basis for the cost of coupons and vouchers redeemed in the period. The Company bases its estimates on the historical coupon and voucher redemption rate of similar programs.

As of March 31, 2011 and December 31, 2010, the Company’s reserves for discounts and other sales incentives were $1,004 and $1,159, respectively.

Product Returns

At the time of sale of AzaSite, the Company records product return allowances based on its estimate of the portion of sales that will be returned by its customers in the future. The return allowances are established in accordance with the Company’s returned goods policy. The Company’s returned goods policy generally allows for returns of AzaSite within an 18-month period, from six months prior to the expiration date and up to 12 months following the expiration date, but may differ from customer to customer, depending on certain factors. Future estimated returns of AzaSite are based primarily on the return data for comparative products and the Company’s own historical experience with AzaSite. Historical return data on AzaSite is analyzed on a specific production lot basis. In determining the Company’s return allowance, the Company also considers other relevant factors, including:

•

Levels of inventory in the distribution channel and any significant changes to these levels;

•

Estimated expiration date or remaining shelf life of inventory in the distribution channel;

•

Current and projected demand of AzaSite that could be impacted by introductions of generic products and/or introductions of competitive new products; and

•

Competitive product shortages, recalls and/or discontinuances.

The Company’s estimates of the level of AzaSite inventory in the distribution channel is based on inventory data provided by wholesalers and third-party prescription data. As of March 31, 2011 and December 31, 2010, reserves for returns of AzaSite were $2,911 and $2,590, respectively.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

Product Co-promotion and Royalty Revenues

During the fiscal quarter ended March 31, 2011, the Company recognized co-promotion revenue based on net sales of Elestat and royalty revenue based on net sales of Restasis, as reported to the Company by Allergan, Inc. (“Allergan”). In addition, the Company recognizes royalty revenue based on net sales of Diquas, as reported to the Company by Santen Pharmaceutical Co., Ltd. (“Santen”). The Company’s co-promotion and royalty revenues are based upon Allergan’s and Santen’s revenue recognition policies and other accounting policies over which the Company has limited or no control and on the underlying terms of the agreements. Allergan and Santen recognize revenue from product sales when goods are shipped and title and risk of loss transfers to the customer. The agreements with Allergan and Santen provide for gross sales to be reduced by estimates of sales returns, credits and allowances, normal trade and cash discounts, managed care sales rebates and other allocated costs as defined in the agreements, all of which are determined by Allergan and Santen and are outside the Company’s control. The Company has recorded the applicable percentage of reported net sales for Elestat as co-promotion revenue and for Restasis and Diquas as royalty revenue. The Company receives monthly sales information from Allergan and performs analytical reviews and trend analyses using prescription information that it receives from IMS Health. In addition, the Company exercises its audit rights under the contractual agreements with Allergan to annually perform an examination of Allergan’s sales records of both Restasis and Elestat. The Company makes no adjustments to the amounts reported to it by Allergan other than reductions in net sales to reflect the incentive programs managed by the Company. The rebates associated with the programs that the Company manages represent an insignificant amount, as compared to the rebate and discount programs administered by Allergan and as compared to the Company’s aggregate co-promotion and royalty revenue. In accordance with the terms of the Company’s agreement with Santen, Santen is only required to report Diquas sales information to the Company on a quarterly basis. Due to the timing of receiving the quarterly sales information from Santen, all royalty revenue from net sales of Diquas is being recorded by the Company one quarter in arrears.

Collaborative Research and Development Revenues

The Company recognizes revenue under its collaborative research and development agreements when the Company or its collaborative partner have met a contractual milestone triggering a payment to the Company. The Company is entitled to receive milestone payments under its collaborative research and development agreements based upon the achievement of agreed upon development events that are substantively at-risk by its collaborative partners or the Company. This collaborative research and development revenue is recognized upon the achievement and acknowledgement of the Company’s collaborative partner of a development event, which is generally at the date payment is received from the collaborative partner or is reasonably assured. Accordingly, the Company’s revenue recognized under its collaborative research and development agreements may fluctuate significantly from period to period.

Comprehensive Loss

Accumulated other comprehensive loss is comprised of unrealized gains and losses on marketable securities and is disclosed as a component of stockholders’ equity. The Company had $25 and $63 of unrealized gains on its investments that are classified as accumulated other comprehensive income at March 31, 2011 and December 31, 2010, respectively. The Company’s comprehensive loss consists of the following components:


	Three Months Ended March 31,
	2011			2010

Net loss	$	(17,622	)	$	(14,787	)
Change in unrealized gain/(loss) on investments		(38	)		28


Total comprehensive loss	$	(17,660	)	$	(14,759	)

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

Risks from Third Party Manufacturing and Distribution Concentration

The Company relies on single source manufacturers for its commercial products. Allergan is responsible for the manufacture of both Restasis and Elestat and relies on single source manufacturers for the API in both products. Santen is responsible for the manufacture of Diquas and relies on a single source manufacturer for the API in Diquas. The Company relies on InSite Vision for the supply of the API for AzaSite, which InSite Vision obtains from a single source manufacturer. The Company is responsible for the remaining finished product manufacturing of AzaSite, for which it relies on a single source manufacturer. Additionally, the Company relies upon a single third party to provide warehousing and distribution services for AzaSite.

Delays in the manufacture or distribution of any product could adversely impact the marketing and sale of the Company’s products. Furthermore, the Company has no control over the manufacturing or the overall product supply chain of Restasis, Elestat and Diquas.

Significant Customers and Risk

The Company relies primarily on three pharmaceutical wholesalers to purchase and supply the majority of AzaSite at the retail level. These three pharmaceutical wholesalers accounted for greater than 85% of all AzaSite product sales in the three months ended March 31, 2011 and the year ended December 31, 2010, and accounted for approximately 38% and 27% of the Company’s outstanding trade receivables as of March 31, 2011 and December 31, 2010, respectively. The loss of one or more of these wholesalers as a customer could negatively impact the commercialization of AzaSite. During the fiscal quarter ended March 31, 2011, the Company was entitled to receive co-promotion revenue from net sales of Elestat and royalty revenue from net sales of Restasis under the terms of its applicable agreements with Allergan, and accordingly, all trade receivables for these two products are solely due from Allergan and accounted for 60% and 71% of the Company’s outstanding trade receivables as of March 31, 2011 and December 31, 2010, respectively. Due to the nature of these agreements, Allergan has significant influence over the commercial success of Restasis and Elestat.

Risk from Generic Competition

The Company’s revenues are subject to risk due to generic product entrants.

On March 14, 2011, the FDA approved an Abbreviated New Drug Application (“ANDA”) for a generic epinastine hydrochloride ophthalmic solution. On May 2, 2011, Cypress Pharmaceutical, Inc. announced that it had commercially launched a generic epinastine ophthalmic solution. Epinastine hydrochloride is the API in Elestat. As previously disclosed, the Company has been expecting such an approval and launch, resulting in the termination of the Company’s co-promotion agreement with Allergan. The Company will be entitled to receive post-termination payments from Allergan, based on any remaining net sales of Elestat for a period of 36 months. During the three successive 12-month periods immediately following the termination of the agreement, Allergan will be obligated to pay to the Company 20%, 15% and 10%, respectively, on any net sales of Elestat in the United States.

The manufacture and sale of Restasis is protected in the United States by a formulation patent that expires in May 2014. While a formulation patent may afford certain limited protection, a competitor may attempt to gain FDA approval for a cyclosporine product using a different formulation. Furthermore, following the expiration of the formulation patent in 2014, a generic form of Restasis could be introduced into the market. If and when Restasis experiences competition from a cyclosporine product, including a generic cyclosporine product, the Company’s revenues attributable to Restasis may be significantly impacted.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

3.	Recent Accounting Pronouncements

In December 2010, the FASB ratified a consensus of the Emerging Issues Task Force related to an annual fee to be paid to the federal government by pharmaceutical manufacturers that meet certain sales levels as mandated by the Patient Protection and Affordable Care Act as amended by the Health Care and Education Reconciliation Act. This consensus requires the liability related to the annual fee to be estimated and recorded in full upon the first qualifying sale with a corresponding deferred cost that is amortized to expense generally using a straight-line method of allocation over the calendar year that it is payable. This guidance is effective for calendar years beginning after December 31, 2010, when the fee initially became effective. The adoption of this guidance and the recording of the estimated annual fee during the first quarter of 2011 did not have a significant impact on the Company’s financial statements and results of operations.

4.	Investments

A summary of the fair market value of the Company’s investments by classification, as well as contractual maturities of marketable debt securities, is as follows:


	March 31, 2011		December 31, 2010

Available-for-sale debt securities:
Less than one year	$	43,272	$	47,510
After one year through five years		2,565		3,722

Total available-for-sale debt securities	$	45,837	$	51,232
Preferred stock		200		200

Total Investments	$	46,037	$	51,432

The following is a summary of the Company’s marketable debt securities which are classified as available-for-sale as of March 31, 2011 and December 31, 2010:


	Cost		Gross Unrealized Gain		Gross Unrealized Loss			Fair Value
As of March 31, 2011:
Corporate bonds and commercial paper	$	34,258	$	26	$	(11	)	$	34,273
U.S. Treasury		3,009		2		—			3,011
U.S. Government agencies		8,546		7		—			8,553

Total	$	45,813	$	35	$	(11	)	$	45,837


As of December 31, 2010:
Corporate bonds and commercial paper	$	36,630	$	54	$	(5	)	$	36,679
U.S. Treasury		3,012		—		—			3,012
U.S. Government agencies		9,518		17		—			9,535
International Government		2,007		—		(1	)		2,006

Total	$	51,167	$	71	$	(6	)	$	51,232

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

The following table shows the gross unrealized losses and fair value of the Company’s investments in marketable debt securities with unrealized losses that are deemed to be temporarily impaired, aggregated by length of time that the individual securities have been in a continuous unrealized loss position as of March 31, 2011 and December 31, 2010:


	Less than 12 months
	Fair Value		Unrealized Loss
As of March 31, 2011:
Corporate bonds and commercial paper	$	13,942	$	(11	)

Total	$	13,942	$	(11	)


As of December 31, 2010:
Corporate bonds and commercial paper	$	12,319	$	(5	)
International Government		2,006		(1	)

Total	$	14,325	$	(6	)

The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. Because the Company has the ability and intent to hold its investments until a recovery of fair value, which may be at maturity, the Company does not consider its investments to be other-than-temporarily impaired at March 31, 2011. The Company did not have any investments in marketable debt securities that have been in a continuous unrealized loss position for 12 months or greater as of March 31, 2011 and December 31, 2010. There were no realized gains or losses on the Company’s available-for-sale securities for the three months ended March 31, 2011 and 2010, respectively.

5.	Inventories

The Company’s inventories are related to AzaSite and are valued at the lower of cost or market using the first-in, first-out (i.e., FIFO) method. Cost includes materials, labor, overhead, shipping and handling costs. The Company’s inventories are subject to expiration dating and the Company has reserved for potential overstocking. The Company’s inventories consisted of the following:


	As of
	March 31, 2011			December 31, 2010
Finished Goods	$	190		$	230
Work-in-Process		485			152
Raw Materials		501			444

Total Inventories		1,176			826
Less Valuation Reserve		(50	)		(50	)

Total Inventories, net	$	1,126		$	776

6.	Restructuring

On January 3, 2011, the Company announced that the top-line results from its second Phase 3 clinical trial, TIGER-2, with denufosol tetrasodium for the treatment of cystic fibrosis did not achieve statistical significance for its primary efficacy endpoint and for three key secondary endpoints. Based upon the overall data relating to the program, the Company decided to discontinue development of denufosol tetrasodium.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

In February 2011, the Company announced a strategic corporate restructuring, discontinuing its pulmonary therapeutic area focus. The corporate restructuring included a workforce reduction of approximately 65 positions, primarily effecting functions in research and development; manufacturing and technical operations; and general and administrative. In connection with the restructuring, the Company recorded restructuring charges of $12,215 for the three months ended March 31, 2011. The Company recorded its restructuring activities in accordance with FASB authoritative guidance regarding the accounting for the impairment and disposal of long-lived assets and the accounting for costs associated with exit or disposal activities.

For the three months ended March 31, 2011, the Company incurred the following restructuring charges:


	Three months ended March 31, 2011
	Accruals		Non-cash items			Total

Employee separation costs	$	4,547		—		$	4,547
Asset impairments		—	$	4,992			4,992
Contracts and other		4,301		(1,915	)		2,386
Facility related		290		—			290


Total Restructuring Charges	$	9,138	$	3,077		$	12,215

•

Employee separation costs of $4,547 consisted of one-time termination benefits, primarily severance costs, associated with the reduction in the Company’s workforce.

•

Asset impairments of $4,992 consisted of property and equipment, the majority of which related to equipment developed and intended for the commercial production of denufosol API. Additionally, the Company incurred impairment charges for the furniture, fixtures, equipment and accelerated the depreciation of leasehold improvements associated with idle facility space at its Raleigh, North Carolina headquarters, as described below. The Company performed an impairment analysis and determined that the carrying value of the idle assets exceeded their fair value. Fair value was based on internally established estimates and the selling prices of similar assets. Due to the customization of the denufosol equipment, the Company has determined the fair value of these assets to be $0.

•

Contract and other charges of $4,301 consisted of costs associated with contractual commitments and work performed subsequent to the restructuring related to the denufosol program. These costs primarily relate to the shutdown and closeout of the remaining trials and other work and materials associated with the denufosol development program that no longer supports the Company’s therapeutic focus and business strategy.

•

Facility related charges of $290 consisted of estimated losses associated with leased facility space at the Company’s Raleigh, North Carolina headquarters that the Company no longer using in its operations. The unoccupied leased space is approximately 15,000 square feet and the lease term is through December 2017. The Company used a discounted cash-flow analysis to calculate the amount of this liability. The probability-weighted discounted cash-flow analysis is based on management’s assumptions and estimates of its ongoing lease obligations, including contractual rental commitments, build-out commitments and building operating costs, estimates of income from subleases, and market conditions for similar rental properties in its geographic area and is adjusted for deferred rent. The estimated cash flows were discounted using a credit-adjusted risk free rate of approximately 12%. The Company will incur approximately $299 of accretion expense over the term of the lease.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

The restructuring charges described above were reduced by the reversal of a long-term liability of $1,915 as the Company has no further obligations to the Cystic Fibrosis Foundation Therapeutics, Inc. (“CFFT”). This liability had been previously recorded based on the Company’s agreement with the CFFT associated with the CFFT’s funding of one Phase 2 clinical trial for denufosol. The agreement with the CFFT terminated upon the failure of denufosol to yield statistically significant results in the TIGER-2 clinical trial.

The following table sets forth activity in the restructuring liability for the three months ended March 31, 2011:


	Employee separation costs			Facilities related charges		Contract Terminations and other charges			Total

Balance at December 31, 2010	$	—		$	—	$	—		$	—
Accruals		4,547			290		4,301			9,138
Payments		(794	)				(2,247	)		(3,041	)


Balance at March 31, 2011		3,753			290		2,054			6,097

The liability associated with employee separation costs and contract terminations and other charges will be fully paid by the end of fiscal 2011. The liability associated with facilities will be reduced as monthly payments are made through the lease term, which ends in December 2017.

7. Fair Value

The Company’s financial assets recorded at fair value on a recurring basis have been categorized based upon a fair value hierarchy. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. Specifically, Level 1 fair values are defined as observable inputs such as quoted prices in active markets; Level 2 fair values are defined as inputs other than quoted prices in active markets that are either directly or indirectly observable. These include quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; and inputs to valuation models or other pricing methodologies that do not require significant judgment; Level 3 fair values are defined as inputs for which little or no market data exists, therefore requiring an entity to develop its own assumptions.

The following fair value hierarchy tables present information about the Company’s financial assets measured at fair value on a recurring basis as of March 31, 2011 and December 31, 2010:


	Total Balance		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)

As of March 31, 2011:
Cash equivalents	$	22,802	$	14,504	$	8,298
Investments - Available-for-sale securities:
U.S. Treasury		3,011		3,011		—
U.S. Government agencies		8,553		—		8,553
Corporate bonds and commercial paper		34,273		—		34,273


Total	$	68,639	$	17,515	$	51,124


As of December 31, 2010:
Cash equivalents	$	27,433	$	21,185	$	6,248
Investments - Available-for-sale securities:
U.S. Treasury		3,012		3,012		—
U.S. Government agencies		9,535		—		9,535
Corporate bonds and commercial paper		36,679		—		36,679
International Government		2,006		—		2,006


Total	$	78,665	$	24,197	$	54,468

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

Level 1 cash equivalents consist of investments concentrated in money market funds which are primarily invested in U.S. Treasury securities. Level 2 cash equivalents and available-for-sale securities consist of investments in U.S. government agency securities, corporate bonds and commercial paper and international government securities. The fair value of these securities is derived using a market approach such as pricing models that rely on relevant observable market data including interest rates, yield curves, recently reported trades of comparable securities, and benchmark securities.

The Company’s investment policy dictates that investments in money market instruments are limited to those that have a rating of at least A-1 and P-1 according to Standard & Poor’s and Moody’s Investor Services, respectively. Likewise, for investments made in corporate obligations, the Company’s investment policy requires ratings of at least A and A-2 according to Standard & Poor’s and Moody’s Investor Services.

Level 3 Fair Valued Assets

The Company recorded an impairment charge for the three months ended March 31, 2011 of $4,992 to reduce certain fixed assets to their fair value, primarily equipment developed and intended for the commercial production of denufosol API, which the Company has determined to be $0 based on the customization of the equipment.

8.	Stock-Based Compensation

The Company accounts for stock-based compensation in accordance with FASB authoritative guidance regarding share-based payments. Total stock-based compensation was allocated as follows:


	Three Months Ended March 31,
	2011		2010

Research and development	$	158	$	302
Selling and marketing		426		494
General and administrative		624		3,997


Total stock-based compensation expense	$	1,208	$	4,793

Equity Compensation Plans

The Company’s stock-based compensation plan, the Amended and Restated 2010 Equity Compensation Plan (the “2010 Plan”), allows for the granting of both incentive and non-qualified stock options, stock appreciation rights, restricted stock and restricted stock units to directors, officers, employees and consultants. At March 31, 2011, there were 7,998 shares available for grant as options, deferred stock units (“DSUs”), restricted stock units (“RSUs”) or other forms of share-based payments under the 2010 Plan.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

The Board of Directors, or an appropriate committee of the Board of Directors, determines the terms of all options and other equity arrangements under both plans. The maximum term for any option grant under the 2010 Plan is seven years from the date of the grant. Options granted to executive employees vest 25% upon completion of one full year of employment from date of grant and on a monthly basis over the following three years of their employment and have a term of seven years. Options granted to non-executive employees vest 33% upon completion of one full year of employment from date of grant and on a monthly basis over the following two years of their employment and have a term of five years. Options granted to members of the Board of Directors vest on a quarterly basis over one year and have a term of seven years. The vesting period typically begins on the date of hire for new employees and on the date of grant for existing employees.

CEO Transition

In February 2010, Christy Shaffer, resigned as the Company’s CEO and Adrian Adams was hired as CEO. As part of this transition, certain existing stock options and DSUs previously granted to Dr. Shaffer were modified. In addition, Dr. Shaffer was also granted 100 stock options which vested immediately and a stock award for 100 shares of the Company’s common stock. The modification of the existing options and the granting of the new awards to Dr. Shaffer resulted in stock-based compensation expense of $2,230 during the three months ended March 31, 2010.

As part of his hiring, Mr. Adams was granted 350 stock options. On the date of grant, 25% of these options vested immediately and the remaining 75% will vest ratably over the 36 months following the first anniversary of the effective date of Mr. Adams’ employment. In addition, Mr. Adams was granted an award of 650 RSUs. On the date of grant, 25% of these RSUs became non-forfeitable or vested and the remaining 75% will become non-forfeitable ratably over the 36 months following the first anniversary of the effective date of his employment. The total value of these awards to Mr. Adams was $5,199, of which $1,300 was expensed during the three months ended March 31, 2010.

Basis for Fair Value Estimate of Share-Based Payments

Stock Options

The Company uses its own historical volatility to estimate its future volatility. Actual volatility, and future changes in estimated volatility, may differ substantially from the Company’s current estimates.

Prior to 2011, the Company utilized the simplified method of calculating the expected life of options for grants made to its employees under the 2010 Plan due to the lack of adequate historical data with regard to exercise activity on options. Beginning in 2011, the Company estimates the expected life of options for grants made to employees based upon its historical experience. For options granted to directors under the 2010 Plan, the Company uses the contractual term of seven years as the expected life of options. The Company estimates the forfeiture rate based on its historical experience. These estimates will be revised in future periods if actual forfeitures differ from the estimate. Changes in forfeiture estimates impact compensation cost in the period in which the change in estimate occurs.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

The table below presents the weighted-average expected life of options granted during the period indicated. The risk-free rate of the stock options is based on the U.S. Treasury yield curve in effect at the time of grant, which corresponds with the expected term of the option granted. The fair value of share-based payments, granted during the period indicated, was estimated using the Black-Scholes option pricing model with the following assumptions and weighted average fair values as follows:


	Stock Options for Three Months Ended March 31,
	2011			2010

Risk-free interest rate		1.00	%		1.97	%
Dividend yield		0	%		0	%
Expected volatility		83	%		68	%
Expected life of options (years)		3.8			4.0

Weighted average fair value of grants	$	2.39		$	3.23

The following table summarizes the stock option activity for the three months ended March 31, 2011:


	Number of Shares			Weighted Average Exercise Price (per share)			Weighted Average Remaining Contractual Term (in Years)		Aggregate Intrinsic Value

Outstanding at December 31, 2010		12,839		$	6.94			3.1	$	32,183
Granted		3			4.09
Exercised		(107	)		(3.69	)
Forfeited/cancelled/expired		(1,408	)		(6.61	)

Outstanding at March 31, 2011		11,327		$	7.01			2.7	$	513


Vested and exercisable at March 31, 2011		8,409		$	7.50			1.9	$	459
Expected to vest at March 31, 2011		11,213		$	7.01			2.7	$	512

Total intrinsic value of stock options exercised for the three months ended March 31, 2011 was $459. Due to the Company’s net loss position, no windfall tax benefits have been realized during the three months ended March 31, 2011. As of March 31, 2011, approximately $7,224 of total unrecognized compensation cost related to unvested stock options is expected to be recognized over a weighted-average period of 2.3 years.

Deferred Restricted Stock Units

In July 2006, the Compensation Committee authorized the issuance of DSUs to each of the Company’s then executive officers. The value of DSUs granted was based on the closing market price of the Company’s common stock on the date of grant and is amortized on a straight-line basis over the five year requisite service period. A total of 195 DSUs were granted and had a total fair value at the date of grant of $811. The DSUs vest 20% annually over five years from the date of grant. Any DSUs that have not vested at the time of termination of service to the Company are forfeited. The DSUs do not have voting rights, and the shares underlying the DSUs are not considered issued and outstanding until conversion. Any vested units will convert into an equivalent number of shares of common stock upon termination of employment with the Company.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

The following table summarizes the DSU activity for the three months ended March 31, 2011:


	Number of Shares		Weighted Average Grant Date Fair Value (per share)

Nonvested Awards at December 31, 2010		16	$	4.16
Vested		—		—
Forfeited		—		—

Nonvested Awards at March 31, 2011		16	$	4.16


Vested and deferred awards at March 31, 2011		150	$	4.16

No DSUs became vested during the three months ended March 31, 2011. DSUs outstanding at March 31, 2011 had a weighted-average remaining contractual life of 0.3 years and a total aggregate intrinsic value of $657.

Time-Based Restricted Stock Units

Beginning in 2010, the Compensation Committee began approving grants of RSUs to the Company’s executive officers and to certain other employees. In general, the RSUs vest on an annual basis over 4 years. Any RSUs that have not vested at the time of termination of service to the Company are forfeited. The RSUs do not have voting rights, and the shares underlying the RSUs are not considered issued and outstanding until vested and released. The Company also began granting RSUs to its Board of Directors which vest annually over one year.

The following table summarizes the time-based RSU activity for the three months ended March 31, 2011:


	Number of Shares			Weighted Average Grant Date Fair Value (per share)

Outstanding Awards at December 31, 2010		1,001		$	5.91
Granted		634			3.92
Vested		(14	)		(6.08	)
Forfeited		(107	)		(3.95	)

Outstanding and nonvested Awards at March 31, 2011		1,514		$	5.21

During the three months ended March 31, 2011, approximately 14 RSUs with an aggregate fair value of $53 became vested. RSUs outstanding at March 31, 2011 had a weighted-average remaining contractual life of 1.9 years and a total aggregate intrinsic value of $5,995. RSUs outstanding and expected to vest at March 31, 2011 had a weighted-average remaining contractual life of 1.8 years and a total aggregate intrinsic value of $5,624.

Stock Awards

As discussed earlier, during the three months ended March 31, 2010, 100 stock awards were granted to Dr. Shaffer as part of the CEO transition. The 100 stock awards were issued, fully vested upon grant, with an aggregate fair value of $627.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

9.	Subsequent Events

Agreement and Plan of Merger

On April 5, 2011, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Merck & Co., Inc. (“Merck”) and Monarch Transaction Corp., a wholly-owned subsidiary of Merck (“Monarch”). Under the terms of the Merger Agreement, Merck, through Monarch, has commenced a tender offer for all outstanding common stock of Inspire at a price of $5.00 per share, payable net to the seller in cash without interest thereon, less any applicable withholding taxes (the “Tender Offer”). The transaction has a total cash value of approximately $430 million. The transaction has been unanimously approved by the Company’s and Merck’s Boards of Directors, and the Company’s Board of Directors has recommended that the Company’s stockholders tender their shares pursuant to the Tender Offer. In addition, Warburg Pincus Private Equity IX, L.P., which owns approximately 28 percent of the outstanding shares of the Company’s common stock as of April 1, 2011, has agreed to tender all of its shares into the Tender Offer.

Class Action Lawsuits

Following the announcement of the Merger Agreement with Merck and Monarch, the following putative class action lawsuits were filed: (i) Anthony S. Luttenberger, individually and on behalf of all others similarly situated v. Inspire Pharmaceuticals, Inc. et al., No. 6363, filed on April 11, 2011, in the Court of Chancery of the State of Delaware, which plaintiffs’ subsequently moved to voluntarily dismiss on April 14, 2011, or the Luttenberger Dismissed Complaint; (ii) Norris Foster, Noah Alpern and Louis Alpern, individually and on behalf of all others similarly situated v. George Abercrombie, et al., Case No. 5:11-CV-00180, filed on April 14, 2011, as amended on April 19, 2011, in the United States District Court for the Eastern District of North Carolina, or the Foster Complaint; (iii) Steve Dougherty, individually and on behalf of all others similarly situated v. Inspire Pharmaceuticals, Inc. et al., No. 6378, filed on April 14, 2011, as amended on April 20, 2011, in the Court of Chancery of the State of Delaware, or the Dougherty Complaint; (iv) Maz Aiyub, individually and on behalf of all others similarly situated v. George Abercrombie, et al., Case No. 6381, filed on April 15, 2011, in the Court of Chancery of the State of Delaware; (v) Pradeep Bheda, individually and on behalf of all others similarly situated v. George Abercrombie, et al., Case No. 6382, filed on April 15, 2011, in the Court of Chancery of the State of Delaware; and (vi) Raymond Chan, on behalf of himself and all others similarly situated v. Inspire Pharmaceuticals, Inc., et al., Case No. 6401, filed on April 21, 2011, in the Court of Chancery of the State of Delaware.

All of the suits name the Company, the members of its Board of Directors, Merck and Monarch as defendants. All of the lawsuits are brought by purported holders of the Company’s common stock, both individually and on behalf of a putative class of our stockholders, alleging that the Company’s Board of Directors breached its fiduciary duties in connection with the Tender Offer and the Merger by purportedly failing to maximize stockholder value, and that the Company, Merck, and Monarch aided and abetted the alleged breaches. All of the lawsuits seek equitable relief, including, among other things, to enjoin consummation of the Tender Offer and the Merger, rescission of the Merger Agreement and an award of all costs, including reasonable attorneys’ fees. In addition, the Dougherty Complaint alleges the Company’s Board of Directors breached its fiduciary duty to disclose material information and the Foster Complaint alleges (i) the Company, its Board of Directors and Merck disseminated false and misleading statements relating to, among other things, the sale process of the Company in violation of §14(e) of the Exchange Act and (ii) certain control person liability under § 20(a) of the Exchange Act against the Company, the Board of Directors and Merck.

On April 22, 2011, all defendants filed motions seeking to dismiss the Foster Complaint. The court has not ruled on this motion. On April 19, 2011, plaintiffs in the Foster Complaint filed an emergency motion for expedited discovery and to set a briefing schedule and hearing date for a preliminary injunction hearing and all defendants, subsequently, filed an opposition to that motion. On May 2, 2011, the court denied plaintiffs’ motion for expedited discovery and granted their motion to set a briefing schedule and hearing date on their motion for a preliminary injunction. That motion will be fully briefed by May 9, 2011 and the court will hold a preliminary injunction hearing on May 10, 2011.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

On April 25, 2011, Vice Chancellor Parsons of the Court of Chancery of the State of Delaware signed an order consolidating all of the Delaware actions (with the exception of the Luttenberger Dismissed Complaint) into one action called In re Inspire Shareholders Litig., C.A. 6328-VCP.

On May 3, 2011, all parties to the consolidated Delaware Chancery Court action executed a Memorandum of Understanding pursuant to which, among other things, the parties will enter into a definitive settlement agreement, whereby they will move to certify conditionally the consolidated action as a class action and will move to dismiss all claims. The settlement of the consolidated Delaware Chancery Court action is subject to negotiation of definitive settlement documentation and approval by the Delaware Court of Chancery and is conditioned upon consummation of the Merger.

The Company believes that the claims made in these lawsuits are without merit and it intends to defend such claims vigorously. Due to the preliminary nature of all the suits, the Company is unable at this time to estimate their outcome.

Sandoz ANDA

On April 21, 2011, the Company announced that it had received a Paragraph IV certification notice letter, dated April 15, 2011 (the “Notice Letter”), regarding an ANDA submitted to the FDA by Sandoz Inc. (“Sandoz”) requesting approval to market and sell a generic version of AzaSite. Pursuant to an arrangement between InSite Vision and Sandoz, Sandoz is currently the manufacturer of the active pharmaceutical ingredient used in the manufacture of AzaSite.

In the Notice Letter, Sandoz claims U.S. Patent Nos. 6,159,458, 6,239,113, 6,569,443 and 7,056,893 (the “InSite Patents”) issued to InSite Vision and U.S. Patent No. 6,861,411 (the “Pfizer Patent” and, together with the InSite Patents, the “US Patents”) issued to Pfizer Inc. (“Pfizer”) to be invalid and/or will not be infringed by the manufacture, use, importation, sale or offer for sale of the product described in the ANDA.

The Company was granted an exclusive license to the InSite Patents and an exclusive sublicense to the Pfizer Patent pursuant to that certain License Agreement by and between the Company and InSite Vision, dated as of February 15, 2007, as amended (the “InSite License Agreement”). Pursuant to the InSite License Agreement, the Company obtained step-in rights with respect to the initiation, prosecution and control of any patent infringement lawsuits relating to the US Patents under certain circumstances, including but not limited to InSite Vision’s failure to initiate such a proceeding against an infringer (the “Step-In Rights”).

InSite Vision, Pfizer and the Company have 45 days from the date of their respective receipt of the Notice Letter to commence a patent infringement lawsuit against Sandoz that would result in an automatic stay, or bar, of the FDA’s approval of the ANDA for up to 30 months or until a final court decision in the infringement suit in favor of Sandoz, whichever occurs first.

If required, Inspire intends to vigorously enforce its intellectual property rights, pursuant to the Step-In Rights, relating to AzaSite.

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

Launch of Generic Epinastine Ophthalmic Solution

On May 2, 2011, Cypress Pharmaceutical, Inc. announced that it had commercially launched a generic epinastine ophthalmic solution. Epinastine hydrochloride is the API in Elestat. As previously disclosed, the Company has been expecting such an approval and launch, resulting in the termination of the Company’s co-promotion agreement with Allergan. The Company will be entitled to receive post-termination payments from Allergan, based on any remaining net sales of Elestat for a period of 36 months. During the three successive 12-month periods immediately following the termination of the agreement, Allergan will be obligated to pay to the Company 20%, 15% and 10%, respectively, on any net sales of Elestat in the United States.

Item 2.

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

CAUTIONARY STATEMENT

The discussion herein contains forward-looking statements regarding our financial condition and our results of operations that are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted within the United States, as well as projections for the future. The preparation of these financial statements requires our management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We evaluate our estimates on an ongoing basis. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. The results of our estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.

We operate in a highly competitive environment that involves a number of risks, some of which are beyond our control. We are subject to risks common to specialty pharmaceutical companies, including risks inherent in our development and commercialization efforts, clinical trials, uncertainty of regulatory actions and marketing approvals, reliance on collaborative partners, enforcement of patent and proprietary rights, the need for future capital, competition associated with products, potential competition associated with our product candidates and retention of key employees. In order for any of our product candidates to be commercialized, it will be necessary for us, or our collaborative partners, to conduct clinical trials, demonstrate efficacy and safety of the product candidate to the satisfaction of regulatory authorities, obtain marketing approval, enter into manufacturing, distribution and marketing arrangements, and obtain market acceptance and adequate reimbursement from government and private insurers. We cannot provide assurance that we will generate significant revenues or achieve and sustain profitability in the future. In addition, we can provide no assurance that we will have sufficient funding to meet our future capital requirements. Statements contained in Management’s Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this report which are not historical facts are, or may constitute, forward-looking statements. Forward-looking statements involve known and unknown risks that could cause our actual results to differ materially from expected results. The most significant known risks are discussed in the section entitled “Risk Factors.” Although we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements.

Our revenues are difficult to predict and depend on numerous factors. The effectiveness of our ability and the ability of third parties on which we rely to help us manufacture, distribute and market AzaSite; physician and patient acceptance of AzaSite; competitor response to AzaSite; as well as discounts, pricing and coverage on governmental and commercial formularies, and the recently passed healthcare reform legislation are all factors, among others, that will impact the level of revenue recorded for AzaSite in subsequent periods. Our royalty revenues are based upon Allergan’s and Santen’s revenue recognition policies and other accounting policies, over which we have limited or no control, and on the underlying terms of our agreements. Our royalty revenues are impacted by the number of governmental and commercial formularies upon which Restasis is listed, the discounts and pricing under such formularies, as well as the estimated and actual amount of rebates, all of which are managed by Allergan. Other factors that are difficult to predict and that impact our royalty revenues are the extent and effectiveness of Allergan’s sales and marketing efforts, our sales and marketing efforts, timing of a generic epinastine launch, coverage and reimbursement under Medicare Part D and Medicaid programs, the recently passed healthcare reform legislation and the sales and marketing activities of competitors. Additionally, our ability to receive revenues on future sales of AzaSite, Restasis, and Diquas are dependent upon the duration of market exclusivity and the strength of patent protection.

Our operating expenses are also difficult to predict and depend on several factors. Cost of sales related to AzaSite is comprised of variable and fixed cost components. Research and development expenses, drug manufacturing, and clinical research activities, depend on the ongoing requirements of our development programs, availability of capital and direction from regulatory agencies, which are difficult to predict. In addition, we have incurred and expect to continue to incur significant selling and marketing expenses to commercialize our products. Management may be able to control the timing and level of research and development, selling and marketing and general and administrative expenses, but many of these expenditures will occur irrespective of our actions due to contractually committed activities and/or payments.

As a result of these factors, we believe that period to period comparisons are not necessarily meaningful and you should not rely on them as an indication of future performance. Due to all of the foregoing factors, it is possible that our operating results will be below the expectations of market analysts and investors. In such event, the prevailing market price of our common stock could be materially adversely affected.

OVERVIEW

We are a specialty pharmaceutical company focused on developing and commercializing ophthalmic products. Our strategy is to create a sustainable portfolio of ophthalmic products by leveraging our commercial capabilities and pipeline assets and pursuing corporate development and licensing opportunities. Our specialty eye care sales force generates revenue from the promotion of AzaSite (azithromycin ophthalmic solution) 1% for bacterial conjunctivitis. We receive royalties based on net sales of Restasis (cyclosporine ophthalmic emulsion) 0.05% for dry eye and began receiving royalties in 2011 based on net sales of Diquas Ophthalmic Solution 3% (diquafosol tetrasodium) for dry eye in Japan. We will also continue to receive tail payments from sales of Elestat despite the fact that we are no longer co-promoting it.


PRODUCTS AND PRODUCT CANDIDATES	THERAPEUTIC AREA/ INDICATION	CONTRACTUAL PARTNER ⁽¹⁾	CURRENT STATUS

Products

AzaSite	Bacterial conjunctivitis	InSite Vision	Promoting

Elestat	Allergic conjunctivitis	Allergan	Generic launched ⁽²⁾

Restasis	Dry eye disease	Allergan	Receiving royalty

Diquas	Dry eye disease	Santen Pharmaceutical	Receiving royalty

Product Candidates

Denufosol tetrasodium	Cystic fibrosis	None	Phase 3 ⁽³⁾

Prolacria (diquafosol tetrasodium)	Dry eye disease	None	Phase 3 ⁽⁴⁾

DE-089 (diquafosol tetrasodium)	Dry eye disease	Santen Pharmaceutical	Phase 3 ⁽⁵⁾

AzaSite	Blepharitis	InSite Vision	Phase 2

INS115644, INS117548	Glaucoma	Wisconsin Alumni Research Foundation	Phase 1

(1)	See “Agreements” in Item 1 of our Annual Report on Form 10-K for the year ended December 31, 2010 for a detailed description of our agreements with these contractual partners.

(2)

On May 2, 2011, Cypress Pharmaceutical, Inc. announced the launch of a generic epinastine hydrochloride ophthalmic solution. Such launch resulted in the termination of our co-promotion agreement with Allergan and we are no longer co-promoting Elestat. We are entitled to receive tail payments with respect to sales of Elestat in accordance with our agreement with Allergan.

(3)	In January 2011, we announced that our Phase 3 clinical trial (TIGER-2) did not meet its primary or key secondary endpoints. In February 2011, we announced our decision to discontinue our development of denufosol.

(4)	In January 2010, we announced that our Phase 3 clinical trial (Trial 03-113) did not meet its primary or secondary endpoints. We are not currently proceeding with the clinical development of Prolacria.

(5)	Santen is conducting Phase 3 clinical trials with DE-089 in China.

We were incorporated as a Delaware corporation in October 1993 and commenced operations in March 1995. Our corporate headquarters are located in Raleigh, North Carolina.

Tender Offer and Pending Merger

On April 5, 2011, Merck & Co., Inc., or Merck, and Monarch Transaction Corp., a Delaware corporation and a wholly-owned subsidiary of Merck, or Monarch, entered into an Agreement and Plan of Merger, or the Merger Agreement, with us. Pursuant to the Merger Agreement, Merck, through Monarch, commenced a cash tender offer, or the Tender Offer, on April 15, 2011 to purchase all of our outstanding common stock for $5.00 per share in cash, or the Offer Price, without interest. The Tender Offer will expire at 12:00 midnight on May 12, 2011, subject to possible extension in accordance with the terms set forth in the Merger Agreement. Pursuant to the Merger Agreement, after consummation of the Tender Offer, and subject to satisfaction or waiver of certain conditions set forth in the Merger Agreement, Monarch will merge with and into us, or the Merger, and we will survive as a wholly-owned subsidiary of Merck. If Monarch holds 90% or more of our outstanding common shares immediately prior to the Merger, it may effect the Merger without a meeting of our stockholders.

The Merger Agreement contains representations, warranties and covenants of the parties customary for transactions of this type. The Merger Agreement also contains customary termination provisions for us and Merck and provides that, in connection with the termination of the Merger Agreement under specified circumstances, we may be required to pay Merck a termination fee of $17 million.

Pursuant to the Merger Agreement, we granted Monarch an option, or the Top-Up Option, to purchase that number of shares of our common stock that, when added to the aggregate number of shares of our common stock owned by Merck, Monarch and any other subsidiary of Merck, shall constitute 5,000 shares more than 90% of the shares of our common stock outstanding after such exercise. Pursuant to the Merger Agreement and subject to applicable law, Monarch is required to exercise the Top-Up Option if the shares issued pursuant to the Top-Up Option will enable Monarch to own at least 5,000 shares more than 90% of the issued and outstanding shares of our common stock after giving effect to such exercise. In no event will the Top-Up Option be exercisable for a number of shares in excess of the total number of the then authorized but unissued shares of our common stock. Based on the number of shares of our common stock outstanding as of the date of the Merger Agreement, Monarch would be required to exercise the Top-Up Option if approximately 76% or more of the outstanding shares of our common stock are tendered into the Tender Offer, and all other conditions to the Tender Offer have been satisfied or waived. The per share exercise price of the Top-Up Option is equal to the Offer Price. The closing of the Top-Up Option is subject to customary conditions. The Top-Up Option terminates concurrently with any termination of the Merger Agreement.

PRODUCTS

AzaSite

AzaSite (azithromycin ophthalmic solution) 1% is a topical anti-infective, in which azithromycin is formulated into an ophthalmic solution utilizing DuraSite®, a novel ocular drug delivery system. Azithromycin is a semi-synthetic antibiotic that is derived from erythromycin and, since 1992, has been available via oral administration by Pfizer Inc., or Pfizer, under the trade name Zithromax®. In April 2007, AzaSite was approved by the U.S. Food and Drug Administration, or FDA, for the treatment of bacterial conjunctivitis in adults and children one year of age and older.

We entered into a license agreement, dated as of February 15, 2007, as amended, or the InSite License Agreement, with InSite Vision Incorporated, or InSite Vision, pursuant to which we acquired exclusive rights to commercialize AzaSite for use in the treatment of human ocular or ophthalmic indications. The InSite License Agreement grants us exclusive rights to develop, make, use, market, commercialize and sell AzaSite in the United States and Canada. We are obligated to pay InSite Vision royalties on net sales of AzaSite in the United States and Canada. In August 2007, we launched AzaSite in the United States and are promoting it to eye care specialists.

On April 21, 2011, we announced that we had received a Paragraph IV certification notice letter, dated April 15, 2011, or the Notice Letter, regarding an Abbreviated New Drug Application, or ANDA, submitted to the FDA by Sandoz Inc., or Sandoz, requesting approval to market and sell a generic version of AzaSite. Pursuant to an arrangement between InSite Vision and Sandoz, Sandoz is currently the manufacturer of the active pharmaceutical ingredient used in the manufacture of AzaSite.

In the Notice Letter, Sandoz claims U.S. Patent Nos. 6,159,458, 6,239,113, 6,569,443 and 7,056,893, or the InSite Patents, issued to InSite Vision and U.S. Patent No. 6,861,411, or the Pfizer Patent, issued to Pfizer (the Pfizer Patent together with the InSite Patents are referred to as the US Patents) to be invalid and/or will not be infringed by the manufacture, use, importation, sale or offer for sale of the product described in the ANDA. The latest InSite Patent expires in March 2019 and the Pfizer Patent expires in November 2018.

We were granted an exclusive license to the InSite Patents and an exclusive sublicense to the Pfizer Patent pursuant to the InSite License Agreement. Pursuant to the InSite License Agreement, we obtained step-in rights with respect to the initiation, prosecution and control of any patent infringement lawsuits relating to the US Patents under certain circumstances, including but not limited to InSite Vision’s failure to initiate such a proceeding against an infringer.

InSite Vision, Pfizer and we have 45 days from the date of their respective receipt of the Notice Letter to commence a patent infringement lawsuit against Sandoz that would result in an automatic stay, or bar, of the FDA’s approval of the ANDA for up to 30 months or until a final court decision in the infringement suit in favor of Sandoz, whichever occurs first.

If required, we intend to vigorously enforce our intellectual property rights, pursuant to the step-in rights relating to AzaSite pursuant to the InSite License Agreement.

Elestat

Elestat (epinastine HCl ophthalmic solution) 0.05% is a topical antihistamine developed by Allergan, Inc., or Allergan, for the prevention of ocular itching associated with allergic conjunctivitis. Elestat was approved by the FDA in October 2003 and is indicated for adults and children at least three years old.

During the fiscal quarter ended March 31, 2011, we received co-promotion revenue from Allergan on its U.S. net sales of Elestat.

The FDA approved an ANDA for a generic epinastine hydrochloride ophthalmic solution on March 14, 2011. On May 2, 2011, Cypress Pharmaceutical, Inc. announced the launch of a generic epinastine hydrochloride ophthalmic solution. Epinastine hydrochloride is the active pharmaceutical ingredient, or API, in Elestat. As previously disclosed, we have been expecting such an approval and launch, resulting in the termination of our co-promotion agreement with

Allergan. We will be entitled to receive post-termination payments from Allergan, based on any remaining net sales of Elestat for a period of 36 months. During the three successive 12-month periods immediately following the termination of the agreement, Allergan will be obligated to pay us 20%, 15% and 10%, respectively, on any net sales of Elestat in the United States.

See “Risk Factors — “Our agreement with Allergan to co-promote Elestat is no longer in effect, and our revenues from sales of Elestat will be nominal” - for further discussion of the risk related to the approval of an ANDA for a generic epinastine hydrochloride.

Restasis

Restasis (cyclosporine ophthalmic emulsion) 0.05% is the first approved prescription product in the United States for the treatment of dry eye disease. It is indicated to increase tear production in adults and children at least 16 years old whose tear production is presumed to be suppressed due to ocular inflammation associated with keratoconjunctivitis sicca, or dry eye disease. Restasis was approved by the FDA in December 2002, and Allergan launched the product in the United States in April 2003.

In June 2001, we entered into an agreement with Allergan to develop and commercialize our product candidate, Prolacria (diquafosol tetrasodium), for the treatment of dry eye disease. The agreement also provided that Allergan pay us royalties on net sales of Restasis. In August 2010, we amended and restated our agreement with Allergan. Under the amended and restated agreement, which runs through December 31, 2020, we are entitled to receive revenues at one global rate based on net sales of Restasis and any other human ophthalmic formulation of cyclosporine owned or controlled by Allergan, with no requirement to co-promote Restasis. Effective January 1, 2011, the worldwide rate stepped down from the 2010 rate by three percentage points. The rate will step down a further 0.25 percentage point in 2013 and a final 0.50 percentage point in 2014, remaining at this level through the end of the term in 2020.

The manufacture and sale of Restasis is protected in the United States by a formulation patent that expires in May 2014.

Diquas

Diquas ophthalmic solution 3% (diquafosol tetrasodium) has been developed by Santen Pharmaceutical Co., Ltd., or Santen, as a treatment for dry eye.

In December 1998, we entered into an agreement with Santen that allows Santen to develop diquafosol tetrasodium for the therapeutic treatment of ocular surface diseases, such as dry eye disease, in Japan and nine other Asian countries, and provides for certain milestone payments to be paid to us upon achievement of development milestones by Santen. In December 2010, we received a milestone payment of $1.25 million as Diquas received pricing approval and was launched for sale in Japan. We are entitled to receive royalty payments based upon a tiered rate on net sales of Diquas in Japan, with a minimum rate in the high single digits and a maximum rate in the low double digits. There are no future milestones to be earned by us under the agreement.

Applications for patent term extension for two Japanese patents owned by Inspire that cover Diquas have been approved. As a result, an additional five years of exclusivity has been granted for one patent and approximately 4.5 years of exclusivity has been granted with respect to another patent. Accordingly, the manufacture and sale of Diquas is protected in Japan under patents that have claims to the drug substance, the formulation, and method of making that now expire in February 2023.

Product Risks

For a more detailed discussion of the risks associated with these products, please see Item 1A. — Risk Factors located in Part II of this Quarterly Report on Form 10-Q, or this Report.

PRODUCT CANDIDATES

Denufosol tetrasodium for the treatment of cystic fibrosis

Overview. Denufosol tetrasodium is an ion channel regulator that was being developed to address the underlying ion transport defect in the lungs of patients with cystic fibrosis. Denufosol was designed to enhance airway hydration and mucociliary clearance through receptor-mediated mechanisms that increase chloride secretion, inhibit sodium absorption and increase ciliary beat frequency. The manufacture and sale of denufosol tetrasodium is protected in the United States under patents that have claims to the drug substance, the formulation, and method of use that expire in February 2017, subject to any applicable patent restoration that may extend protection up to an additional five years from the date of expiration of the applicable patent, if any, for which restoration is sought.

Development Status. In June 2008, we announced top-line results from the 24-week placebo-controlled portion of our first Phase 3 clinical trial, TIGER-1, with denufosol tetrasodium for the treatment of cystic fibrosis. The clinical trial demonstrated statistical significance for its primary efficacy endpoint, which was the change in FEV₁ from baseline at the clinical trial endpoint (at 24 weeks or last observation carried forward). Patients treated with denufosol had a statistically significant improvement in FEV₁ compared to placebo (45 milliliter treatment group difference in adjusted means, p = 0.047). On average, patients on denufosol improved in FEV₁ relative to baseline whereas patients on placebo remained essentially unchanged. Secondary endpoints were also evaluated during the placebo-controlled portion of TIGER-1. There was a trend in differences in FEF_25%-75% (Forced Expiratory Flow 25%-75%), a measure of small airway function, favoring denufosol over placebo (87.5 milliliters/second treatment group difference, p = 0.072).

In January 2011, we announced the top-line results from our second Phase 3 clinical trial, TIGER-2, The trial did not achieve statistical significance for its primary efficacy endpoint, which was change from baseline in FEV₁ (Forced Expiratory Volume in One Second) at the Week 48 Endpoint (48 weeks or last observation carried forward). Based on our assessment of the full data set from the TIGER-2 Phase 3 trial of denufosol, the open-label denufosol-only trial (Trial 08-114) data and our current corporate resources, we decided to discontinue Inspire’s development of denufosol.

Prolacria (diquafosol tetrasodium) for the treatment of dry eye disease

Overview. Prolacria, the proposed U.S. tradename for diquafosol tetrasodium ophthalmic solution 2%, was being developed for the treatment of dry eye disease.

Development Status. In January 2010, we announced that a Phase 3 clinical trial (Trial 03-113) did not meet its primary endpoint (p = 0.526) or its secondary endpoint (p = 0.368). We are not currently proceeding with the clinical development of Prolacria. Under our amended and restated agreement with Allergan, we have sole control over any future Prolacria development and commercialization.

DE-089 (diquafosol tetrasodium) for the treatment of dry eye disease

Overview. Our agreement with Santen allows Santen to develop diquafosol tetrasodium for the therapeutic treatment of ocular surface diseases, such as dry eye disease, in Japan, the People’s Republic of China and eight other Asian countries.

Development Status. Santen is conducting Phase 3 clinical trials with DE-089 in China. We are eligible to receive a single digit royalty on net sales of DE-089 in China, if it is ultimately approved and commercialized in China.

AzaSite for the treatment of blepharitis

Overview. Blepharitis is an ocular disease characterized by inflammation of the lid margin that is common, complex, and has a multi-factorial etiology. Blepharitis coexists with other common ocular surface conditions and we believe is often under-diagnosed and misdiagnosed in general clinical practice. Blepharitis can be subdivided into two categories: anterior and posterior blepharitis. Although they are distinct diseases, they can overlap. Anterior blepharitis is generally associated with the presence of bacteria, lid debris and/or sebaceous gland activity and is most often an acute disease. Posterior blepharitis is almost always associated with dysfunctional meibomian glands or altered meibomian gland secretions and is generally considered a chronic disease.

Our market research and input from eye care specialists suggests that blepharitis is an under-diagnosed and under-treated disease. Survey data published in The Ocular Surface and funded by us indicated that 15% of adults reported having at least one of the three symptoms that clinicians associate with anterior blepharitis at least half of the time in the previous 12 months. Based on the overall U.S. adult population of 232 million, this implies potentially as many as 34 million adults might have suffered from some form of blepharitis over such time frame. Currently, there are no FDA-approved prescription pharmaceutical products indicated for the treatment of this disease. Patients currently manage the acute and often chronic effects of blepharitis with the use of warm compresses, lid hygiene, topical antibiotic ointments and, when exacerbated, with topical steroids or oral antibiotics.

Development Status. In May 2009, we initiated Phase 2 work which consisted of two randomized, vehicle-controlled clinical trials that enrolled approximately 600 patients with anterior blepharitis. Trial 044-101 included a two-week treatment period with a two-week follow-up period and Trial 044-102 included a four-week treatment period with a four-week follow-up period. Patients were randomized to AzaSite or the DuraSite vehicle and received one drop in each eye twice-a-day for the first two days, then one drop in each eye daily for the remainder of the treatment period. All patients in the trials performed lid hygiene using commercially available lid scrubs once daily for the duration of the trials.

In March 2010, we announced the results of these two trials. In the four-week trial, improvements for AzaSite compared to vehicle were achieved for a number of blepharitis signs and symptoms at various time points with p-values £ 0.05, but statistical significance was not achieved for the primary endpoint of mean lid margin hyperemia. In the two-week trial, there were no statistically significant improvements for AzaSite compared to vehicle, including for the primary endpoint of clearing of lid debris. In both trials, the AzaSite treatment group and the vehicle treatment group showed statistically significant improvements relative to baseline for all measured signs and symptoms of blepharitis. Additionally, AzaSite was well-tolerated in both trials.

In December 2010, we initiated an exploratory Phase 2, double-masked, vehicle-controlled clinical trial (Trial 044-103) comparing AzaSite to vehicle for four weeks of treatment with an eight-week follow-up period in up to 300 blepharitis patients at approximately 25 U.S. sites. In this clinical trial, we are assessing the patient population, length of dosing and measurements of multiple signs and symptoms of blepharitis, including utilizing photographic methods and a centralized reading center.

Given the limited data available and the early stage of development of this program, we are currently unable to reasonably project the future dates and costs associated with clinical trials or a prospective NDA filing for this program.

Glaucoma product candidates

Overview. In November 2004, we licensed technology for use in developing and commercializing new treatments for glaucoma from the Wisconsin Alumni Research Foundation, or WARF.

Development Status. In 2007, we initiated a Phase 1 proof-of-concept placebo-controlled, dose-ranging clinical trial (Trial 032-101) for INS115644, the first compound in a series of compounds, in glaucoma patients to evaluate the safety and tolerability of INS115644, as well as changes in intraocular pressure, or IOP. In 2008, we

initiated a Phase 1 proof-of-concept placebo-controlled, dose-ranging clinical trial (Trial 037-101) for a second compound, referred to as INS117548, to evaluate the safety, tolerability and IOP-lowering effects of INS117548 in approximately 80 subjects with early stage glaucoma or ocular hypertension.

In September 2009, we announced top-line results of these trials. In Trial 032-101 with INS115644, a Latrunculin B formulation, we observed dose-dependent IOP-lowering effects and the compound was well-tolerated. Trial 037-101 with INS117548, which is one of a series of Rho kinase molecules we have developed, showed mild IOP-lowering effects but had some dose-related tolerability issues, specifically with ocular discomfort such as burning and stinging. We are in the process of evaluating next steps for the overall glaucoma program, based on our clinical and preclinical data, expert opinions and resource availability.

Due to the uncertainty of the future of this program, and given the limited data available and the early stage of development of this program, we are currently unable to reasonably project the future dates and costs associated with clinical trials or a prospective NDA filing for either of these product candidates.

Product Candidates Risks

For a discussion of the risks associated with our development programs, please see Item 1A. — Risk Factors located in Part II of this Report.

RESULTS OF OPERATIONS

Three Months Ended March 31, 2011 and 2010

Revenues

Total revenues were approximately $21.1 million for the three months ended March 31, 2011, as compared to approximately $22.1 million for the same period in 2010. The decrease in 2011 revenue of approximately $1.0 million, or 4%, as compared to the same period in 2010, was primarily due to a decrease in royalty revenue from net sales of Restasis and a reduction in co-promotion revenue from net sales of Elestat, partially offset by an increase in product revenue from net sales of AzaSite and royalty revenue from the initial sales of Diquas in Japan following its launch in December 2010.

Product Sales, net

Product sales of AzaSite, net of rebates and discounts, for the three months ended March 31, 2011 were approximately $10.9 million, as compared to approximately $8.7 million for the same period in 2010. The increase in revenue for AzaSite of approximately $2.2 million, or 26%, for the three months ended March 31, 2011, as compared to the same period in 2010, was primarily due to increased patient and physician usage of AzaSite, evidenced by an increase of prescriptions year-over-year, as well as price increases for the product between the periods. Additionally, approximately $1.0 million of revenue from sales of AzaSite for the three months ended March 31, 2010 was associated with hospital usage of AzaSite as a substitute during a temporary supply shortage of erythromycin ophthalmic ointment (0.5%), as discussed below. The erythromycin ophthalmic ointment supply shortage began in the third quarter of 2009 and was resolved in the first quarter of 2010.

In September 2009, erythromycin ophthalmic ointment was placed on the FDA Drug Shortages website. Erythromycin ophthalmic ointment is a macrolide antibiotic routinely used in neonates for prophylaxis of ophthalmia neonatorum, a form of bacterial conjunctivitis that may be contracted by newborns during delivery. Due to this shortage, the Centers for Disease Control and Prevention asked healthcare professionals to reserve erythromycin supplies for neonatal use and also recommended the use of AzaSite as an acceptable substitute for neonatal prophylaxis use when erythromycin was not available.

The increase in AzaSite revenues for the three months ended March 31, 2011, as compared to the same period in 2010, was partially offset by an increase in gross-to-net sales deductions. Total sales deductions as a percentage of gross revenues increased approximately 2%. The impact of the net rate increase as a percentage of gross revenues was approximately $303,000 in additional provisions for the three months ended March 31, 2011. The increase was primarily attributable to an approximate 2% increase in rebates and discounts due to (1) an increase in the number of formularies that now list AzaSite and (2) the price concessions required to secure this coverage under Medicare and commercial managed care organizations. Our reserves related to rebates and discounts for the three months ended March 31, 2011 were not significantly impacted by the new U.S. healthcare reform legislation passed in March 2010 and those provisions of the legislation that became effective during the first quarter of 2010.

For the three months ended March 31, 2011, based on prescription data from IMS Health, there were approximately 181,000 prescriptions written for AzaSite, representing approximately 4% of all prescriptions in the single agent ocular antibiotic market, defined as both branded and generic single agent ocular antibiotics. In comparison, approximately 164,000 prescriptions were written for AzaSite for the three months ended March 31, 2010, excluding hospital usage, representing approximately 4% of all prescriptions in the single agent ocular antibiotic market. For the three months ended March 31, 2011, the average monthly prescriptions per sales force associate and the average monthly prescriptions per targeted physician increased 10% and 11%, respectively, as compared to the same period in 2010. Since launch, actual units of AzaSite dispensed have been slightly higher than the number of prescriptions as reported by IMS Health due to the issuance of multiple unit prescriptions by some physicians. For the three months ended March 31, 2011, the single agent ocular antibiotic market, in terms of prescriptions, increased approximately 6% from the prior year.

Our average market share in our primary call audience of eye care specialists, mainly ophthalmologists and optometrists, was approximately 21% for the three months ended March 31, 2011, as compared to approximately 19% for the same period in 2010. In addition, our average market share in our target call audience of eye care specialists was approximately 11% for both the three months ended March 31, 2011 and 2010.

Product Co-Promotion and Royalty

Total co-promotion and royalty revenue for the three months ended March 31, 2011 was approximately $10.2 million, as compared to approximately $13.4 million for the same period in 2010, representing a decrease of approximately $3.2 million, or 24%.

Restasis

Our royalty revenue from net sales of Restasis for the three months ended March 31, 2011 was approximately $7.2 million, as compared to approximately $9.8 million for the same period in 2010. In August 2010, we amended and restated our agreement with Allergan. Under the amended and restated agreement, which runs through December 31, 2020, we are entitled to receive revenues at one global rate based on net sales of Restasis and any other human ophthalmic formulation of cyclosporine owned or controlled by Allergan, with no requirement to co-promote Restasis. The royalty rate for Restasis in the United States remained unchanged for 2010. Effective January 1, 2011, the annual global rate stepped down from the 2010 rate by three percentage points. The rate will step down a further 0.25 percentage point in 2013 and a final 0.50 percentage point in 2014, remaining at this level through the end of the term in 2020. For the three months ended March 31, 2011, Allergan recorded revenue from net sales of Restasis of approximately $161 million, as compared to approximately $133 million for the same period in 2010.

Elestat

Co-promotion revenue from net sales of Elestat for the three months ended March 31, 2011 was approximately $2.7 million, as compared to approximately $3.6 million for the same period in 2010. The decrease in co-promotion revenue from net sales of Elestat of approximately $905,000, or 25%, as compared to the same period in 2010, was primarily due to a reduction in share of the total U.S. allergic conjunctivitis market, partially offset by an annual price increase that became effective in the first quarter of 2011.

Elestat is a seasonal product with product demand mirroring seasonal trends for topical allergic conjunctivitis products. Typically, demand is highest during the Spring months followed by moderate demand in the Summer and Fall months. The lowest demand is during the Winter months. Based upon national prescription data from IMS Health, for the three months ended March 31, 2011 and 2010, Elestat prescriptions, as a percentage of the total U.S. allergic conjunctivitis market, represented approximately 5% and 7%, respectively, of the total U.S. allergic conjunctivitis market. Based upon monthly data from IMS Health, for the three months ended March 31, 2011, the total U.S. allergic conjunctivitis market, in terms of prescriptions, increased approximately 7% as compared to the same period in 2010.

On March 14, 2011 the FDA approved an ANDA for a generic epinastine hydrochloride ophthalmic solution. On May 2, 2011, the launch of a generic epinastine hydrochloride ophthalmic solution was announced by a third-party. Epinastine hydrochloride is the active pharmaceutical ingredient, or API, in Elestat. As previously disclosed, we have been expecting such an approval and launch, resulting in the termination of our co-promotion agreement with Allergan. We will be entitled to receive post-termination payments from Allergan, based on any remaining net sales of Elestat for a period of 36 months. During the three successive 12-month periods immediately following the termination of the agreement, Allergan will be obligated to pay us 20%, 15% and 10%, respectively, on any net sales of Elestat in the United States. We expect any revenue from net sales of Elestat received during this 36-month post-termination period to be nominal compared to revenue in years where we were actively co-promoting the product. Loss of our co-promotion revenue from Elestat will adversely impact our future results of operations and cash flows.

Diquas

In December 2010, Santen received pricing approval for Diquas Ophthalmic Solution 3% (diquafosol tetrasodium), for which we received a milestone payment of $1.25 million. There are no future milestones to be earned under the amended agreement with Santen. We receive royalty payments based upon a tiered rate on net sales of Diquas in Japan, which Santen launched in December 2010, with a minimum rate in the high single digits and a maximum rate in the low double digits. We recorded approximately $316,000 in royalty revenue in the three months ended March 31, 2011, based on net sales of Diquas as reported to us from Santen for the time period of December 10-31, 2010.

Miscellaneous

Our future revenue will depend on various factors including the effectiveness of our commercialization of AzaSite and continued commercial success and duration of commercial exclusivity of Restasis. In addition to the foregoing, pricing, rebates, discounts and returns for all products; the effect of competing products; coverage and reimbursement under commercial or government plans; and the recently passed healthcare reform legislation will impact future revenues. If Allergan significantly under-estimates or over-estimates rebate amounts, there could be a material effect on our revenue. In addition to the continuing sales of AzaSite and Restasis, our future revenue will also depend on Santen’s ability to successfully commercialize Diquas, our ability to enter into additional collaboration agreements, and to achieve milestones under future collaboration agreements, as well as whether we obtain regulatory approvals for our product candidates.

Cost of Sales

Cost of sales related to the sales of AzaSite were approximately $4.6 million for the three months ended March 31, 2011, as compared to approximately $3.0 million for the same period in 2010. The increase in cost of sales of $1.6 million, or 53%, as compared to the same period in 2010, was primarily due to increased sales volume of AzaSite, which resulted in increased royalties, as well as the accrual of additional royalty expense in anticipation of a shortfall of the minimum royalty due to InSite Vision in 2011.

Under the terms of the license agreement with InSite Vision, our obligation to pay royalties to InSite Vision is subject to pre-determined minimum annual royalty payments. The determination of whether or not we will owe any such payments is based upon the amount of royalties accrued over a 12-month royalty period. There are five successive 12-month minimum royalty periods, the third of which commenced on October 1, 2010. Based on actual net sales from AzaSite during the fourth quarter of 2010 and the first quarter of 2011, and our expectation of net sales from AzaSite in the second and third quarters of 2011, we anticipate incurring a shortfall of the minimum royalty due at the end of September 30, 2011. As a result, beginning with the fourth quarter of 2010, we have started to accrue additional royalty expense based on our anticipated shortfall from the minimum royalty. To date, approximately $1.2 million of the anticipated shortfall to the minimum royalty has been accrued. The total shortfall, if any, does not have to be paid until the end of the 12-month minimum royalty period.

Cost of sales expense consists of variable and fixed cost components. Variable cost components include royalties to InSite Vision on net sales of AzaSite, the cost of AzaSite inventory sold, distribution, shipping and logistic service charges from our third-party logistics provider, and changes to our inventory reserve for overstocking, short-dated or otherwise unmarketable product or unusable materials. Fixed cost components are primarily the amortization of the $19.0 million approval milestone that we paid InSite Vision as part of our licensing agreement. This approval milestone is being amortized ratably on a straight-line basis through the term of the underlying patent coverage for AzaSite, which expires in March 2019.

Certain costs included in cost of sales are subject to annual increases for which we have limited control. We expect that cost of sales will increase in relation to, but not proportionately to, the increases in revenue from sales of AzaSite.

Research and Development Expenses

Research and development expenses were approximately $3.6 million for the three months ended March 31, 2011, as compared to approximately $9.6 million for the same period in 2010.

The decrease in research and development expenses of approximately $6.0 million, or 62%, for the three months ended March 31, 2011, as compared to the same period in 2010, was primarily due to the discontinuation of the denufosol cystic fibrosis development program as well as the restructuring in the first quarter of 2011 that eliminated the research and development infrastructure associated with the pulmonary therapeutic area. These decreases in expenses were partially offset by increased costs associated with our Phase 2 clinical trial researching AzaSite for the treatment of blepharitis, which was initiated in December 2010.

Research and development expenses include all direct and indirect costs, including salaries for our research and development personnel, consulting fees, clinical trial costs, including the development and manufacture of drug product for clinical trials, sponsored research costs, clinical trial insurance, upfront license fees and milestone payments relating to research and development as well as other fees and costs related to the development of product candidates. Research and development expenses vary according to the number of programs in clinical development and the stage of development of our clinical programs. Later stage clinical programs tend to cost more than earlier stage programs due to the length of the clinical trials and the number of patients enrolled in later stage clinical trials.

Our future research and development expenses will depend on the results and magnitude or scope of our clinical activities and requirements imposed by regulatory agencies. Year over year spending on active development programs can vary due to the differing levels and stages of development activity, the timing of certain expenses and other factors. Accordingly, our research and development expenses may fluctuate significantly from period to period. In addition, if we in-license or out-license rights to product candidates, our research and development expenses may fluctuate significantly from prior periods.

Our research and development expenses for the three months ended March 31, 2011 and 2010, and from the respective project’s inception, are shown below and includes the percentage of overall research and development expenditures for the periods listed.


	(In thousands)
	Three Months Ended March 31,								Cumulative from Inception to March 31, 2011		%
	2011		%		2010		%		Cumulative from Inception to March 31, 2011		%
AzaSite for blepharitis	$	1,299		36	$	641		7	$	10,616		3

Denufosol tetrasodium for cystic fibrosis		851		24		7,241		75		131,654		32

AzaSite ⁽¹⁾		711		20		795		8		21,445		5

INS115644 and INS117548 for glaucoma and related research and development		174		5		43		1		16,886		4

Prolacria (diquafosol tetrasodium) for dry eye disease		54		1		548		6		58,528		14

Other research, preclinical and development costs		511		14		325		3		174,595		42


Total	$	3,600		100	$	9,593		100	$	413,724		100

(1)	Expenses include costs associated with new bottle design and development activities

Selling and Marketing Expenses

Selling and marketing expenses were approximately $12.8 million for the three months ended March 31, 2011, as compared to approximately $13.7 million for the same period in 2010.

The decrease in selling and marketing expenses of approximately $853,000, or 6%, for the three months ended March 31, 2011, as compared to the same period in 2010, was primarily due to a decrease in market research related activities, as well as the timing of certain other marketing activities.

Our commercial organization currently focuses its promotional efforts on approximately 10,000 eye care specialists. Our selling and marketing expenses include all direct costs associated with the commercial organization, which include our sales force and marketing programs. Our sales force expenses include salaries, training and educational program costs, product sample costs, fleet management and travel. Our marketing and promotion expenses include product management, promotion, advertising, public relations, Phase 4 clinical trial costs, physician training and continuing medical education and administrative expenses. We adjust the timing, magnitude and targeting of our advertising, promotional, Phase 4 clinical trials and other commercial activities for our products based on seasonal trends and other factors, and accordingly, these costs can fluctuate from period to period.

Future selling and marketing expenses will depend on the level of our future commercialization activities. We expect selling and marketing expenses will increase in periods that immediately precede and follow product launches. In addition, if we in-license or out-license rights to products, our selling and marketing expenses may fluctuate significantly from prior periods.

General and Administrative Expenses

General and administrative costs were approximately $5.6 million for the three months ended March 31, 2011, as compared to approximately $10.2 million for the same period in 2010.

The decrease in general and administrative expenses of approximately $4.6 million, or 46%, for the three months ended March 31, 2011, as compared to the same period in 2010, was primarily due to a decrease in executive compensation expense. For the three months ended March 31, 2010, we incurred personnel related expenses associated with our Chief Executive Officer transition of approximately $5.0 million. The majority of expenses associated with the CEO transition were non-cash stock based compensation costs of approximately $3.5 million. This decrease was partially offset by an increase in legal fees, primarily associated with the proposed acquisition of us by Merck.

Our general and administrative expenses consist primarily of personnel, facility and related costs for general corporate functions, including business development, finance, accounting, legal, human resources, quality/compliance, facilities and information systems.

Future general and administrative expenses will depend on the level and extent of support required to conduct our future research and development, commercialization, business development, and corporate activities.

Restructuring

On January 3, 2011, we announced that the top-line results from our second Phase 3 clinical trial, TIGER-2, with denufosol tetrasodium for the treatment of cystic fibrosis did not achieve statistical significance for its primary efficacy endpoint and for three key secondary endpoints. Based upon the overall data relating to the program, we decided to discontinue development of denufosol tetrasodium.

In February 2011, we announced a strategic corporate restructuring, discontinuing our pulmonary therapeutic area. We recorded restructuring charges of $12.2 million during the three months ended March 31, 2011, primarily comprised of costs to (i) restructure our research and development organization and eliminate our infrastructure associated with the pulmonary therapeutic area; (ii) complete all necessary remaining contractual activities associated

with TIGER-2 and the open-label denufosol-only clinical trial as well as other denufosol activities; and (iii) record an impairment charge associated with the equipment that was developed and purchased in anticipation of FDA approval and costs related to idle facilities. The corporate restructuring also included a workforce reduction of approximately 65 positions or approximately 27% of our full-time employee base, primarily effecting functions in research and development; manufacturing and technical operations; and general and administrative. The restructuring charge also reflects the reversal of a long-term liability of $1.9 million that we had recorded based on an agreement with the Cystic Fibrosis Foundation Therapeutics, Inc., or CFFT. The agreement with the CFFT terminated upon the failure of denufosol to yield statistically significant results in the TIGER-2 clinical trial. We recorded our restructuring activities in accordance with FASB authoritative guidance regarding the accounting for the impairment and disposal of long-lived assets and the accounting for costs associated with exit or disposal activities.

The corporate restructuring is expected to reduce fiscal 2011 operating expenses by greater than $40 million, as compared to fiscal 2010, when excluding cost of sales and restructuring charges.

Other Income/(Expense)

For the three months ended March 31, 2011, we incurred other income, net of approximately $106,000, as compared to approximately $317,000 in other expense, net for the same period in 2010.

The increase in other income, net of approximately $423,000 for the three months ended March 31, 2011, as compared to the same period in 2010, was due to a decrease in interest expense. In December 2010, we repaid the remaining principal balance of our term loan facility.

Other income/(expense) fluctuates from year to year depending on the level of interest income earned on variable cash and investment balances, realized gains and losses on investments due to changes in fair market value and interest expense on debt. Future other income/(expense) will depend on the level of our future cash and investment balances, as well as the return and change in fair market value on our investments.

LIQUIDITY AND CAPITAL RESOURCES

We have financed our operations primarily through the sale of equity securities, including private sales of preferred stock and public offerings of common stock and, to a lesser extent, through a term loan facility. We also currently receive product revenue from net sales of AzaSite, and royalty revenue from net sales of Restasis and Diquas. We expect any revenue from net sales of Elestat received during the 36-month post-termination period following the launch of a generic epinastine product to be nominal compared to revenue in years where we were actively co-promoting the product. We do not expect our revenue to exceed our operating expenses in 2011.

As of March 31, 2011, we had net working capital of approximately $61.2 million, a decrease of approximately $11.3 million from approximately $72.5 million at December 31, 2010. The decrease in working capital was principally due to the funding of normal operating expenses associated with commercialization activities and costs related to the 2011 restructuring. Our principal sources of liquidity at March 31, 2011 were approximately $31.2 million in cash and cash equivalents, approximately $45.8 million in investments, which are considered available-for-sale, and approximately $16.3 million in trade receivables.

Net cash used in operating activities was approximately $15.0 million for the three months ended March 31, 2011, as compared to approximately $7.1 million for the same period in 2010. The increase in net cash used in operating activities for the three months ended March 31, 2011, as compared to the same period in 2010, was primarily attributable to an increase in our net loss for the period, as well as decreases in accounts payable and accrued expenses as of March 31, 2011. We expect 2011 revenues to decrease from 2010 levels due to the anticipated introduction of a generic form of epinastine ophthalmic solution into the market and the 3% reduction in our royalty rate for Restasis in accordance with the terms of the amended and restated agreement with Allergan.

Net cash provided by investing activities was approximately $3.6 million for the three months ended March 31, 2011, as compared to net cash used in investing activities of approximately $9.3 million for the same period in 2010. Increases in net cash provided by investing activities are generally the result of the conversion of our investments in available-for-securities to cash enabling us to fund our ongoing operating activities. Increases in net cash used in investing activities generally occur when we have raised cash either through the sale of equity securities or through borrowings and have invested the proceeds in available-for-sale securities.

Net cash provided by financing activities was approximately $392,000 for the three months ended March 31, 2011, as compared to net cash used in financing activities of approximately $4.9 million for the same period in 2010. Net cash used in financing activities in the three months ended March 31, 2010 was primarily associated with the scheduled repayments of our term loan facility, which was fully repaid in December 2010.

At March 31, 2011, our cash and investments totaled approximately $77.8 million, for which all but $815,000 of these investments provide short-term liquidity and can be readily liquidated into cash to fund our ongoing operations. These investments, in conjunction with the restructuring activities announced in February 2011 which significantly reduced our expected future operating expenses, will allow us to adequately fund our operations in 2011 and for the next several years with the potential ability to achieve cash flow positive operations in that time period. Our future working capital requirements, including the need for additional working capital, will be largely determined by the commercial success of our products, the successful and timely completion of our blepharitis development program, and the in-licensing or acquisition of any additional products that we may identify in the future.

More specifically, our working capital requirements will be dependent on: the number, magnitude, scope and timing of our development programs; regulatory approval of our product candidates; the commercial potential and success of our product candidates; the loss of commercial exclusivity of any of our products; the loss of revenue from our products due to competition or loss of market share; the level of ongoing costs related to the commercialization of AzaSite; the cost, timing and outcome of regulatory reviews, regulatory investigations, and changes in regulatory requirements; the costs of obtaining patent protection for our product candidates; the timing and terms of business development activities; the rate of technological advances relevant to our operations; the timing, method and cost of the commercialization of our product candidates; the efficiency of manufacturing processes developed on our behalf by third parties; the level of required administrative support for our daily operations; and our ability to successfully restructure our operations, among other factors.

Off Balance Sheet Arrangements

As of March 31, 2011, we were not a party to any off-balance sheet arrangements.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The accompanying discussion and analysis of our financial condition and results of operations are based upon our financial statements and the related disclosures, which have been prepared in accordance with generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. We evaluate our estimates, judgments and the policies underlying these estimates on a periodic basis, as situations change and regularly discuss financial events, policies, and issues with members of our audit committee and our independent registered public accounting firm. In addition, recognition of revenue from product co-promotion and earned royalties is affected by certain estimates and judgments made by Allergan and Santen on which we rely when recording this revenue. We routinely evaluate our estimates and policies regarding revenue recognition, product returns, rebates and incentives, inventory and manufacturing, taxes, stock-based compensation, research and development, marketing and other expenses and any associated liabilities.

We believe the following policies to be the most critical to an understanding of our financial condition and results of operations because they require us to make estimates and judgments about matters that are inherently uncertain.

Revenue Recognition

We record all of our revenue from: (1) sales of AzaSite; (2) product co-promotion activities and earned royalties; and (3) collaborative research agreements, when realized or realizable and earned. Revenue is realized or realizable and earned when all of the following criteria are met: (i) persuasive evidence of an arrangement exists; (ii) delivery has occurred or services have been rendered; (iii) the seller’s price to the buyer is fixed or determinable; and (iv) collectibility is reasonably assured.

Product Revenues

We recognize revenue for sales of AzaSite when title and substantially all the risks and rewards of ownership have transferred to the customer, which generally occurs on the date of shipment to wholesalers and distributors. In the United States, we sell AzaSite to wholesalers and distributors, who, in turn, sell to pharmacies and federal, state and commercial health care organizations.

We utilize data from external sources to help us estimate our gross-to-net sales adjustments as they relate to the recognition of revenue for AzaSite sold. External sourced data includes, but is not limited to, information obtained from certain wholesalers with respect to their inventory levels and sell-through to customers, targeted surveys as well as data from IMS Health, a third-party supplier of market research data to the pharmaceutical industry. We also utilize this data to help estimate and identify prescription trends and patient demand, as well as product levels in the supply chain.

We account for these sales deductions in accordance with the Financial Accounting Standards Board, or FASB, authoritative guidance on revenue recognition when consideration is given by a vendor to a customer as well as when the right of return exists.

We have categorized and described more fully, the following significant sales deductions, all of which involve estimates and judgments, which we consider to be critical accounting estimates, and require us to use information from external sources.

Rebates and Chargebacks

Statutory rebates to state Medicaid agencies and Medicare and contractual rebates to commercial managed care organizations are based on statutory or negotiated discounts to AzaSite’s selling price. As it can take up to nine months or more for information to be received on actual usage of AzaSite in managed care and Medicaid and other governmental programs as well as on the total discounts to be reimbursed, we maintain reserves for amounts payable under these programs relating to AzaSite sales.

negotiated prices), changes in prescription demand patterns and utilization of our product through private or public benefit plans, and the levels of AzaSite inventory in both the wholesale and retail distribution channel. Other factors that we may consider, if determined relevant, would include price changes from competitors and introductions of generics and/or competitive new products. We acquire prescription utilization data from IMS Health, a third-party supplier of market research data to the pharmaceutical industry. We apply these multiple factors, the quantitative historical data along with other qualitative aspects, such as management’s judgment regarding future utilization trends, to the respective period’s sales of AzaSite to determine the rebate accrual and related expense. We update our estimates and assumptions each period and record any necessary adjustments to our reserves. Settlements of rebates and chargebacks typically occur within nine months from point of sale. To the extent actual rebates and chargebacks differ from our estimates, additional reserves may be required or reserves may need to be reversed, either of which would impact current period product revenue. As of March 31, 2011 and December 31, 2010, reserves for rebates and chargebacks were $5.7 million and $9.1 million, respectively.

Discounts and Other Sales Incentives

Discounts and other sales incentives consist of the following:

•

Prompt pay discounts —Prompt payment discounts are offered to all wholesalers in return for payment within 30 days following the invoice date. We record sales of AzaSite net of the discount amount based on historical experience. We adjust the reserve at the end of each reporting period to approximate the percentage discount applicable to the outstanding gross accounts receivable balances.

•

Inventory Management Agreement (“IMA”) Fees —Per contractual agreements with our largest wholesalers, we provide an IMA fee based on a percentage of their purchases of AzaSite. The IMA fee rates are set forth in the individual contracts. We track sales to these wholesalers each period and accrue a liability relating to the unpaid portion of these fees by applying the contractual rates to such sales.

•

Product coupons and vouchers —Product coupons and vouchers, made available by us online or through pharmacies and prescribing physicians, offer patients the ability to receive free or discounted product. We use a third-party administrator who coordinates program activities and invoices us on a periodic basis for the cost of coupons and vouchers redeemed in the period. We base our estimates on the historical coupon and voucher redemption rate of similar programs.

As of March 31, 2011 and December 31, 2010, reserves for discounts and other sales incentives were $1.0 million and $1.2 million, respectively.

Product Returns

At the time of sale of AzaSite, we record product return allowances based on our estimate of the portion of sales that will be returned by our customers in the future. The return allowances are established in accordance with our returned goods policy. Our returned goods policy generally allows for returns of AzaSite within an 18-month period, from six months prior to the expiration date and up to 12 months following the expiration date, but may differ from customer to customer, depending on certain factors. Future estimated returns of AzaSite are based primarily on the return data for comparative products and our own historical experience with AzaSite. Historical return data on AzaSite is analyzed on a specific production lot basis. In determining our return allowance we also consider other relevant factors, including:

•

Levels of inventory in the distribution channel and any significant changes to these levels;

•

Estimated expiration date or remaining shelf life of inventory in the distribution channel;

•

Current and projected demand of AzaSite that could be impacted by introductions of generic products and/or introductions of competitive new products; and

•

Competitive product shortages, recalls and/or discontinuances.

Our estimates of the level of AzaSite inventory in the distribution channel is based on inventory data provided by wholesalers and third-party prescription data. As of March 31, 2011 and December 31, 2010, reserves for returns of AzaSite were $2.9 million and $2.6 million, respectively.

Product Co-promotion and Royalty Revenues

During the fiscal quarter ended March 31, 2011, we recognized co-promotion revenue based on net sales of Elestat and royalty revenue based on net sales of Restasis, as reported to us by Allergan. In addition, we recognize royalty revenue based on net sales of Diquas, as reported to us by Santen. Our co-promotion and royalty revenues are based upon Allergan’s and Santen’s revenue recognition policies and other accounting policies over which we have limited or no control and on the underlying terms of the agreements. Allergan and Santen recognize revenue from product sales when goods are shipped and title and risk of loss transfers to the customer. The agreements with Allergan and Santen provide for gross sales to be reduced by estimates of sales returns, credits and allowances, normal trade and cash discounts, managed care sales rebates and other allocated costs as defined in the agreements, all of which are determined by Allergan and Santen and are outside our control. We record the applicable percentage of reported net sales for Elestat as co-promotion revenue and for Restasis and Diquas as royalty revenue. We receive monthly sales information from Allergan and perform analytical reviews and trend analyses using prescription information that we receive from IMS Health. In addition, we exercise our audit rights under the contractual agreements with Allergan to annually perform an examination of Allergan’s sales records of both Restasis and Elestat. We make no adjustments to the amounts reported to us by Allergan other than reductions in net sales to reflect the incentive programs managed by us. The rebates associated with the programs that we manage represent an insignificant amount, as compared to the rebate and discount programs administered by Allergan and as compared to our aggregate co-promotion and royalty revenue. In accordance with the terms of our agreement with Santen, Santen is only required to report Diquas sales information to us on a quarterly basis. Due to the timing of receiving the quarterly sales information from Santen, all royalty revenue from net sales of Diquas is being recorded by us one quarter in arrears.

Collaborative Research and Development Revenues

We recognize revenue under our collaborative research and development agreements when we or our collaborative partner have met a contractual milestone triggering a payment to us. We are entitled to receive milestone payments under our collaborative research and development agreements based upon the achievement of agreed upon development events that are substantively at-risk by our collaborative partners or us. This collaborative research and development revenue is recognized upon the achievement and acknowledgement of our collaborative partner of a development event, which is generally at the date payment is received from the collaborative partner or is reasonably assured. Accordingly, our revenue recognized under our collaborative research and development agreements may fluctuate significantly from period to period. No collaborative research and development revenue was recognized for the three months ended March 31, 2011 and 2010.

Inventories

Our inventories are related to AzaSite and are valued at the lower of cost or market using the first-in, first-out (i.e., FIFO) method. Cost includes materials, labor, overhead, shipping and handling costs. Our inventories are subject to expiration dating. We regularly evaluate the carrying value of our inventories and provide valuation reserves for any estimated obsolete, short-dated or unmarketable inventories. In addition, we may experience spoilage of our raw materials, which primarily consist of API. Our determination that a valuation reserve might be required, in addition to the quantification of such reserve, requires us to utilize significant judgment. We base our analysis, in part, on the level of inventories on hand in relation to our estimated forecast of product demand, production requirements for forecasted product demand, expected market conditions and the expiration dates or remaining shelf life of inventories. As of March 31, 2011 and December 31, 2010, we had net reserves of $50,000.

Taxes

We account for uncertain tax positions in accordance with FASB authoritative guidance regarding the accounting for taxes. Significant management judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against net deferred tax assets. We have recorded a valuation allowance against all potential tax assets due to uncertainties in our ability to utilize deferred tax assets, primarily consisting of certain net operating losses carried forward, before they expire. The valuation allowance is based on estimates of taxable income in each of the jurisdictions in which we operate and the period over which our deferred tax assets will be recoverable.

Liabilities

We generally enter into contractual agreements with third-party vendors who provide research and development, manufacturing, and other services in the ordinary course of business. Some of these contracts are subject to milestone-based invoicing and services are completed over an extended period of time. We record liabilities under these contractual commitments when we determine an obligation has been incurred, regardless of the timing of the invoice. We monitor all significant research and development, manufacturing, sales and marketing and other service activities and the progression of work related to these activities. We estimate the underlying obligation for each activity based upon our estimate of the amount of work performed and compare the estimated obligation against the amount that has been invoiced. Because of the nature of certain contracts and related delay in the contract’s invoicing, the obligation to these vendors may be based upon management’s estimate of the underlying obligation. We record the larger of our estimated obligation or invoiced amounts for completed service. In all cases, actual results may differ from our estimate.

Stock-Based Compensation Expense

We recognize stock-based compensation expense in accordance with FASB authoritative guidance regarding the accounting for share-based payments, which requires us to measure compensation cost for share-based payment awards at fair value and recognize compensation expense over the service period for awards expected to vest. We utilize the Black-Scholes option-pricing model to value our awards and recognize compensation expense on a straight-line basis over the vesting periods of our awards. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Our expected volatility is determined based on our own historical volatility. The estimation of share-based payment awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. Significant management judgment is also required in determining estimates of future stock price volatility and forfeitures to be used in the valuation of the options. Actual results, and future changes in estimates, may differ substantially from our current estimates.

Impact of Inflation

We do not believe that our operating results have been materially impacted by inflation during the past three years. However, we cannot be assured that our operating results will not be adversely affected by inflation in the future. We will continually seek to mitigate the adverse effects of inflation on the costs of goods and services that we use through improved operating efficiencies and cost containment and periodic price increases for our product.

Impact of Recently Issued Accounting Pronouncements

In December 2010, the FASB ratified a consensus of the Emerging Issues Task Force related to an annual fee to be paid to the federal government by pharmaceutical manufacturers that meet certain sales levels as mandated by the Patient Protection and Affordable Care Act as amended by the Health Care and Education Reconciliation Act. This consensus requires the liability related to the annual fee to be estimated and recorded in full upon the first qualifying sale with a corresponding deferred cost that is amortized to expense generally using a straight-line method of allocation over the calendar year that it is payable. This guidance is effective for calendar years beginning after December 31, 2010, when the fee initially became effective. The adoption of this guidance and the recording of the estimated annual fee during the first quarter of 2011 did not have a significant impact on our financial statements and results of operations.

Healthcare Reform

In March 2010, Congress passed significant health reform legislation, the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act (collectively, “Affordable Care Act” or “ACA”). The legislation is designed to expand access to affordable health insurance through subsidies, Medicaid expansion, and insurance market reforms (including the development of new health benefit exchanges), financed in part through reduced federal health care spending. Among many other things, the ACA makes a number of significant changes affecting pharmaceutical manufacturers.

Although many provisions of the ACA do not take effect immediately, several provisions became effective in the first quarter of 2010. For instance, the ACA provides for increases to the minimum Medicaid rebate percentages from 15.1% to 23.1%, increased “additional rebates” for new formulations of brand name drugs, the establishment of a maximum rebate amount, and the extension of Medicaid rebates to Medicaid managed care organization utilization. In addition, the ACA broadens the definition of “average manufacturer price” effective October 1, 2010, which in turn may have the effect of increasing Medicaid rebate and Public Health Service section 340B drug discount program payment obligations.

Beginning in 2011, the ACA requires that drug manufacturers provide a 50% discount to Medicare beneficiaries whose prescription drug costs cause them to be subject to the Medicare Part D coverage gap. Also, beginning in 2011, we will be assessed our share of a new fee assessed on all branded prescription drug and biologics manufacturers and importers. This fee will be calculated based upon each organization’s historical percentage share of total branded prescription drug sales to U.S. government programs (such as Medicare, Medicaid and VA and PHS discount programs).

The Obama Administration has issued guidance on certain aspects of implementation, including the manufacturer discount program for certain Medicare Part D drugs, which we are assessing. However, details on many other ACA policies have yet to be finalized, including how the annual fee on branded prescription drugs will be calculated and allocated in 2011. We do not expect the provisions that have been enacted to date to have a significant financial impact on our revenues from AzaSite sales. We are unable to adequately assess at this time the extent of the impact of provisions that have not yet gone into effect until additional operational details are available. There can be no assurance that the other ACA provisions yet to be implemented will not impact our financial position.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Risk

We are subject to interest rate risk on our investment portfolio.

We invest in marketable securities in accordance with our investment policy. The primary objectives of our investment policy are to preserve capital, maintain proper liquidity to meet operating needs and maximize yields. Our investment policy specifies credit quality standards for our investments and limits the amount of credit exposure to any single issue, issuer or type of investment. Our investment portfolio may consist of a variety of securities, including U.S. government and agency securities, money market and mutual fund investments, municipal and corporate bonds and commercial paper and asset or mortgage-backed securities, among others. As of March 31, 2011, cash equivalents consisted of $4.3 million in a money market account, $14.5 million in money market funds and $8.3 million in corporate bonds and commercial paper. Our investment portfolio as of March 31, 2011 consisted of corporate bonds, commercial paper and U.S. Government and agency securities, which collectively had an average maturity of less than 12 months, using the stated maturity. All of our cash, cash equivalents and investments are maintained at two banking institutions.

Our investment exposure to market risk for changes in interest rates relates to the increase or decrease in the amount of interest income we can earn on our portfolio, changes in the market value due to changes in interest rates and other market factors as well as the increase or decrease in any realized gains and losses. Our investment portfolio includes only marketable securities and instruments with active secondary or resale markets to help ensure portfolio liquidity and we have implemented guidelines limiting the duration of investments. At March 31, 2011, our portfolio of available-for-sale investments consisted of approximately $43.3 million of investments maturing within one year and approximately $2.5 million of investments maturing after one year but within 24 months. In general, securities with longer maturities are subject to greater interest-rate risk than those with shorter maturities. A hypothetical 100 basis point drop in interest rates along the entire interest rate yield curve would not significantly affect the fair value of our interest sensitive financial instruments. We generally have the ability to hold our fixed-income investments to maturity and therefore do not expect that our operating results, financial position or cash flows will be materially impacted due to a sudden change in interest rates. However, our future investment income may fall short of expectations due to changes in interest rates, or we may suffer losses in principal if forced to sell securities which have declined in market value due to changes in interest rates or other factors, such as changes in credit risk related to the securities’ issuers.

We do not use interest rate derivative instruments to manage exposure to interest rate changes. We ensure the safety and preservation of invested principal funds by limiting default risk, market risk and reinvestment risk. We reduce default risk by investing in investment grade securities.

Investment Risk

In addition to our normal investment portfolio, we have an investment in Parion Sciences, Inc. of $200,000 as of March 31, 2011. This investment is in the form of unregistered common stock and is subject to higher investment risk than our normal investment portfolio due to the lack of an active resale market for the Parion Sciences, Inc. securities.

Foreign Currency Exchange Risk

The majority of our transactions occur in U.S. dollars and we do not have subsidiaries or investments in foreign countries. We receive royalties on Restasis and Diquas that are based upon sales outside the United States; however, we are compensated for these sales in royalty payments that are made in U.S. dollars. Therefore, we are not subject to significant foreign currency exchange risk. We do, however, have foreign currency exposure with regard to the purchase of active pharmaceutical ingredients as they relate to AzaSite, which is manufactured by a foreign-based company and is payable in Euros. We have established policies and procedures for assessing market and foreign exchange risk. As of March 31, 2011, we did not have any foreign currency hedges.

Item 4. Controls and Procedures

Our management is responsible for establishing and maintaining an adequate system of internal control over our financial reporting. The design, monitoring and revision of the system of internal accounting controls involves, among other items, management’s judgments with respect to the relative cost and expected benefits of specific control measures. The effectiveness of the control system is supported by the selection, retention and training of qualified personnel and an organizational structure that provides an appropriate division of responsibility and formalized procedures. The system of internal accounting controls is periodically reviewed and modified in response to changing conditions. Internal audit consultants regularly monitor the adequacy and effectiveness of internal accounting controls. In addition to the system of internal accounting controls, management maintains corporate policy guidelines that help monitor proper overall business conduct, possible conflicts of interest, compliance with laws and confidentiality of proprietary information. Our Chief Executive Officer and Chief Financial Officer have reviewed and evaluated the effectiveness of our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended, or the Exchange Act, as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that our current disclosure controls and procedures are effective.

No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the three months ended March 31, 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II: OTHER INFORMATION

Item 1. Legal Proceedings

All of the suits name us, the members of our Board of Directors, Merck and Monarch as defendants. All of the lawsuits are brought by purported holders of our common stock, both individually and on behalf of a putative class of our stockholders, alleging that our Board of Directors breached its fiduciary duties in connection with the Tender Offer and the Merger by purportedly failing to maximize stockholder value, and that we, Merck, and Monarch aided and abetted the alleged breaches. All of the lawsuits seek equitable relief, including, among other things, to enjoin consummation of the Tender Offer and the Merger, rescission of the Merger Agreement and an award of all costs, including reasonable attorneys’ fees. In addition, the Dougherty Complaint alleges our Board of Directors breached its fiduciary duty to disclose material information and the Foster Complaint alleges (i) we, our Board of Directors and Merck disseminated false and misleading statements relating to, among other things, the sale process of us in violation of §14(e) of the Exchange Act and (ii) certain control person liability under § 20(a) of the Exchange Act against us, the Board of Directors and Merck.

We believe that the claims made in these lawsuits are without merit and we intend to defend such claims vigorously. Due to the preliminary nature of all the suits, we are unable at this time to estimate their outcome.

Item 1A. Risk Factors

RISK FACTORS

An investment in our common stock involves a substantial risk of loss. You should carefully read this entire report and should give particular attention to the following risk factors. You should recognize that other significant risks may arise in the future, which we cannot foresee at this time. Also, the risks that we now foresee might affect us to a greater or different degree than expected. There are a number of important factors that could cause our actual results to differ materially from those indicated by any forward-looking statements in this report. These factors include, without limitation, the risk factors listed below and other factors presented throughout this report and any other reports filed by us with the SEC.

Risks Related to Our Pending Merger with Merck and the Related Tender Offer

Completion of the tender offer and the merger are subject to various conditions, and there can be no assurances that either the tender offer or the pending merger will be consummated or consummated on the timing anticipated.

The Merger may not be completed for numerous reasons, including but not limited to, the following:

•

Uncertainties as to whether sufficient shares may be tendered by our stockholders needed to satisfy the minimum tender condition to the closing of the Tender Offer;

•

The existence of a “Company Material Adverse Effect” as defined in the Merger Agreement;

•

Competing offers or acquisition proposals may be made;

•

Various closing conditions as set forth in the Merger Agreement may not be satisfied or waived; and

•

The stockholder litigation in connection with the Tender Offer or the Merger may delay or prevent the closing of the Merger.

We cannot predict whether the closing conditions for the Tender Offer and the Merger set forth in the Merger Agreement will be satisfied. As a result, we cannot assure you that the Tender Offer or the Merger contemplated by the Merger Agreement will be completed.

Failure to complete the proposed merger could negatively impact our stock price and adversely affect our future financial condition, operations and prospects.

If the Merger is not completed, our ongoing business may be adversely affected and, without realizing any of the benefits of having completed the Merger, we will be subject to a number of risks, including the following:

•

We will remain liable for significant legal and other expenses that we have incurred related to the Merger;

•

The market price of our common stock could decline following an announcement that the Merger has been abandoned to the extent that the current market price reflects a premium based on the assumption that the Merger will be completed;

•

The fact that the Merger was not completed may be viewed negatively by current and potential investors, analysts and contract partners, which may cause a decline in the trading price of our common stock and harm our ability to enter into collaboration, manufacturing, supply and other agreements crucial to our business;

•

Matters relating to the Merger have required substantial commitments of time and resources by our management, which could otherwise have been devoted to other opportunities that might have been beneficial to us;

•

If the Merger Agreement is terminated under certain circumstances, we may be obligated to pay a termination fee of $17.0 million to Merck; and

•

We may not be able to develop and implement a strategy for the future growth and development of the our business that would generate a return similar to or better than the return which would be generated by the Merger.

While the Merger Agreement is in effect, we are subject to restrictions on our business activities.

While the Merger Agreement is in effect, we are subject to restrictions on our business activities and must generally operate our business in the ordinary course consistent with past practice, subject to certain exceptions. These restrictions could prevent us from pursuing attractive business opportunities that arise prior to the completion of the Merger and are generally outside the ordinary course of business, which could have been favorable to our operations and stockholders. As a result, if the Tender Offer and the proposed Merger are not completed, our results of operations and competitive position may be adversely affected.

Several lawsuits have been filed and additional lawsuits may be filed against us and the members of our Board of Directors relating to the Merger.

Various putative class action lawsuits have been filed that name us, the members of our Board of Directors, Merck and Monarch as defendants. All of the lawsuits are brought by purported holders of our common stock, both individually and on behalf of a putative class of our stockholders, alleging that our Board of Directors breached its fiduciary duties in connection with the Tender Offer and the Merger by purportedly failing to maximize stockholder value, and that we, Merck, and Monarch aided and abetted the alleged breaches. All of the lawsuits seek equitable relief, including, among other things, to enjoin consummation of the Tender Offer and the Merger, rescission of the Merger Agreement and an award of all costs, including reasonable attorneys’ fees. In addition, one complaint alleges our Board of Directors breached its fiduciary duty to disclose material information and another complaint alleges (i) we, our Board of Directors and Merck disseminated false and misleading statements relating to, among other things, the sales process of us in violation of §14(e) of the Exchange Act and (ii) certain control person liability under § 20(a) of the Exchange Act against us, the Board of Directors and Merck.

One of these lawsuits has been voluntarily dismissed by plaintiffs, and four have been consolidated in Delaware. All parties to this consolidated Delaware Chancery Court action have executed a Memorandum of Understanding pursuant to which the parties will negotiate a definitive settlement agreement, to be approved by the Delaware Court of Chancery and conditioned upon consummation of the Merger, whereby the parties will certify conditionally the consolidated Delaware Chancery Court action as a class action and move to dismiss all claims. One lawsuit is pending in North Carolina, where all defendants have filed motions seeking to dismiss the complaint. The court has not ruled on this motion. The court has denied plaintiffs’ emergency motion for expedited discovery and set a briefing schedule under which plaintiffs’ motion for a preliminary injunction will be fully briefed by May 9, 2011, and the court will hold a preliminary injunction hearing on May 10, 2011.

While we believe that the claims made in these lawsuits are without merit and intend to defend such claims vigorously, there can be no assurance that we will prevail in our defense. Further, it is possible that additional claims beyond those that have already been filed will be brought by the current plaintiffs or by others in an effort to enjoin the Tender Offer or Merger or seek monetary relief from us. An unfavorable resolution of any such litigation surrounding the Tender Offer or Merger could delay or prevent the consummation of either the Tender Offer or Merger. In addition, the cost to us of defending the litigation, even if resolved in our favor, could be substantial. Such litigation could also substantially divert the attention of our management and our resources in general. We are unable to estimate the outcome of the litigation.

The announcement and pendency of our agreement to be acquired by Merck, through Monarch, could adversely affect our business, financial results and operations.

As a result of our entering into the Merger Agreement, our employees may become concerned about the future of the business and about their future role with us until Merck’s strategies with regard to us are announced and executed. This may adversely affect our ability to retain key management, research and development, manufacturing and other personnel. As a result, there may be delays before we can achieve pre-transaction levels of activity in various functions, including marketing and sales, which may have an adverse effect on our future commercial financial performance. Also, as a result of our execution of the Merger Agreement and the announcement of the Tender Offer, third parties may be unwilling to enter into material agreements with us.

Risks Related to Product Commercialization

Failure to adequately market and commercialize AzaSite will negatively impact our revenues.

The commercial success of AzaSite will depend on a number of factors, including:

•

Acceptance by patients and physicians;

•

Effectiveness of our sales and marketing efforts;

•

Ability to differentiate AzaSite relative to our competitors’ products;

•

Ability to further develop clinical information to support AzaSite;

•

Market satisfaction with existing alternative therapies;

•

Perceived efficacy relative to other available therapies;

•

Disease prevalence;

•

Cost of treatment;

•

Pricing and availability of alternative products, including generic or over-the-counter products;

•

Marketing and sales activities of competitors;

•

Shifts in the medical community to new treatment paradigms or standards of care;

•

Relative convenience and ease of administration;

•

Adequate production and supply of commercial product and samples; and

•

Our ability to enter into managed care and governmental agreements on favorable terms.

We are responsible for all aspects of the commercialization of this product, including the determination of formularies upon which AzaSite is listed, manufacturing, distribution, marketing and sales. The determination of formularies upon which AzaSite is listed, the discounts and pricing under such formularies, as well as the amount of time it takes for us to obtain favorable formulary status under various plans, will impact our commercialization efforts. Additionally, inclusion on certain formularies requires significant price concessions through rebate programs that impact the level of revenue that we receive. The need to give price concessions can be particularly acute where competing products are listed on the same formulary, such as the area of bacterial conjunctivitis. If AzaSite is not successfully commercialized, our revenues will be limited.

Under our agreement with InSite Vision, we are obligated to make pre-determined minimum annual royalty payments to InSite Vision. To the extent annual royalty payments actually paid to InSite Vision on our sales of AzaSite are less than the minimum annual royalty amounts established under our agreement with InSite Vision, we are obligated to pay the difference. In the event we are required to make annual minimum royalty payments, our profits with respect to AzaSite, if any, will be decreased or any losses with respect to the product will be increased. Such circumstances may result in us ceasing our commercialization of AzaSite and terminating our agreement with InSite Vision. Based on actual net sales from AzaSite during the fourth quarter of 2010 and first quarter of 2011 and our expectation of net sales from AzaSite in the second and third quarters of 2011, we anticipate incurring a shortfall of the minimum royalty due to InSite Vision at the end of September 30, 2011.

Under our agreement with the manufacturer of AzaSite, we are required to purchase a minimum number of units of AzaSite annually, regardless of our ability to sell AzaSite. If we are unable to sell the quantities of AzaSite that we are required to purchase, our inventory of the product will increase and the shelf life of the inventory will be adversely impacted. In such circumstances, we may be required to make price concessions to sell short-dated product or write-off and dispose of expired product, which may have an adverse affect on our AzaSite profitability.

If a generic version of AzaSite is approved, sales of AzaSite will be adversely affected

Notwithstanding our exclusive license to the InSite Patents and exclusive sublicense to the Pfizer Patent pursuant to the InSite License Agreement, we only have step-in rights with respect to the initiation, prosecution and control of any patent infringement lawsuits under certain circumstances.

If the applicable parties are not ultimately successful in a patent infringement lawsuit against Sandoz, the FDA may grant final approval of an ANDA to Sandoz with respect to a generic form of azithromycin ophthalmic solution prior to the expiration dates of the respective patents, and our sales of AzaSite will be likely adversely impacted. An adverse outcome in any such legal action could result in one or more generic versions of azithromycin ophthalmic solution being launched before the expiration of the US Patents. After the introduction of a generic competitor, a significant percentage of the prescriptions written for a product generally may be filled with the generic version, resulting in a loss in sales of the branded product, including for indications for which the generic version has not been approved for marketing by the FDA. Generic competition often results in decreases in the prices at which branded products can be sold, particularly when there is more than one generic available in the marketplace. In addition, legislation enacted in the United States allows for, and in a few instances in the absence of specific instructions from the prescribing physician mandates, the dispensing of generic products rather than branded products where a generic equivalent is available. As a result, the introduction of a generic version of azithromycin ophthalmic solution could have a material adverse affect on our ability to successfully execute our business strategy, to maximize the value of AzaSite and therefore could have a material negative impact on our financial condition and results of operations.

Pursuant to an arrangement between InSite Vision and Sandoz, Sandoz is the sole manufacturer of the active pharmaceutical ingredient used in the manufacture of AzaSite. As a result, Sandoz has information and experience that may be useful to it in the manufacture of a generic form of AzaSite. Moreover, Sandoz may be able to bring pressure on any litigation, including any settlement discussions resulting therefrom, which could potentially adversely impact the manufacture of the active pharmaceutical ingredient for AzaSite and, as a result, the manufacture and distribution of AzaSite.

In addition to the foregoing, if we are required to enforce our step-in rights with respect to such patents, any legal action taken to defend our rights relating to AzaSite will likely be costly, time consuming and distracting to management.

If Restasis is not successfully commercialized by Allergan, our revenues will be negatively impacted.

Allergan is responsible for commercializing Restasis. Accordingly, our revenues on the net sales of Restasis are dependent on the actions and success of Allergan, over whom we have no control.

The manufacture and sale of Restasis is protected in the United States by a formulation patent that expires in May 2014. While a formulation patent may afford certain limited protection, a competitor may attempt to gain FDA approval for a cyclosporine product using a different formulation. Furthermore, following the expiration of the formulation patent in 2014, a generic form of Restasis could be introduced into the market. If and when Restasis experiences competition from a cyclosporine product, including generics, our revenues attributable to Restasis may be significantly impacted.

Other factors that could affect the commercialization of Restasis include:

•

Extent and effectiveness of Allergan’s sales and marketing efforts;

•

Satisfaction with existing alternative therapies, including generic or over-the-counter products;

•

Perceived efficacy relative to other available therapies;

•

Changes in, or the levels of, third-party reimbursement of product costs;

•

Coverage and reimbursement under Medicare Part D, state government sponsored plans and commercial plans;

•

Cost of treatment;

•

Development and FDA approval of competing dry eye products; and

•

Shifts in the medical community to new treatment paradigms or standards of care.

Our agreement with Allergan to co-promote Elestat is no longer in effect, and our revenues from future sales of Elestat will be nominal.

Our Elestat co-promotion agreement with Allergan has been terminated as a result of the launch, on May 2, 2011, of the first generic epinastine product after expiration of the FDA exclusivity period covering Elestat in the United States. As a consequence, our co-promotion agreement with Allergan has been terminated, including the right to co-promote Elestat. The loss of substantially all revenue from Elestat sales will adversely impact our future results of operations and cash flows.

We rely on third parties to distribute and sell our products and those third parties may not perform.

We are dependent on third parties to perform or assist us in the distribution or sale of AzaSite. We rely on the services of a single source, third-party distributor to deliver AzaSite to our customers. In addition to the physical storage and distribution of AzaSite, this third-party distributor maintains and provides us with information and data with regard to our AzaSite inventory, orders, billings and receivables, chargebacks and returns, among others, on which our accounting estimates are based. If third parties do not successfully carry out their contractual duties in maximizing the commercial potential of our products, we may be required to hire or expand our own staff and sales force to compete successfully, which may not be possible. If third parties do not perform, or assist us in performing these functions, or if there is a delay or interruption in the distribution of our products, it could have an adverse effect on product revenue, accounting estimates and our overall operations.

We depend on three pharmaceutical wholesalers for the vast majority of our AzaSite sales in the United States, and the loss of any of these wholesalers could negatively impact our revenues.

The prescription drug wholesaling industry in the United States is highly concentrated, with a vast majority of all sales made by three major full-line companies: Cardinal Health, McKesson Corporation and AmerisourceBergen. Greater than 85% of our AzaSite revenues come from sales to these three companies. The loss of any of these wholesalers could have a negative impact on our commercialization of AzaSite.

It is also possible that these wholesalers, or others, could decide to change their policies and fees in the future. This could result in or cause us to incur higher product distribution costs, lower margins or the need to find alternative methods of distributing our products. Such alternative methods may not be economically or administratively feasible.

If Diquas is not successfully commercialized by Santen in Japan, any royalty revenues with respect to the sales of such product may be limited.

In December 2010, Santen launched Diquas in Japan. Santen is solely responsible for commercializing Diquas. Accordingly, royalty revenues on the net sales of Diquas are dependent on the successful commercialization efforts of Santen, over whom we have no control. Factors that could affect the commercialization of Diquas in Japan include:

•

The production of sufficient quantities of the product in order to facilitate the launch of the product and adequately supply the market;

•

Perceived efficacy relative to other available therapies;

•

Development and regulatory approval of competing dry eye products;

•

The extent and effectiveness of Santen’s sales and marketing efforts;

•

Recent natural disasters in Japan, including earthquakes and tsunami, and the related impact on Japanese society and business; and

•

Satisfaction with existing alternative therapies, including generic or over-the-counter products.

Risks Related to Manufacture and Supply

If we are unable to contract with third parties for the manufacture of active pharmaceutical ingredients required for preclinical testing, for the manufacture of drug products for clinical trials or for the large-scale manufacture of any approved products, we may be unable to develop or commercialize our drug products.

The manufacturing of sufficient quantities of new products or product candidates is a time-consuming and complex process. We have no experience or capabilities to conduct the manufacture of any of our products or product candidates. In order to successfully commercialize AzaSite and continue to develop our product candidates, we need to contract or otherwise arrange for the necessary manufacturing services. There are a limited number of manufacturers

that operate under the FDA’s cGMP regulations capable of manufacturing for us or our collaborators. We depend upon third parties for the manufacture of API, finished drug products for clinical trials, and for the manufacture of AzaSite. We expect to depend upon third parties for the large-scale manufacture of commercial quantities of any other approved product. This dependence may adversely affect our ability to develop and deliver such products on a timely and competitive basis. Similarly, our dependence on our partners to arrange for their own supplies of finished drug products may adversely affect our operations and revenues. If we, or our partners, are unable to engage or retain third-party manufacturers on a long-term basis or on commercially acceptable terms, our products may not be commercialized as planned, and the development of our product candidates could be delayed.

Reliance on a single party to manufacture and supply either finished product or the bulk active pharmaceutical ingredients for a product or product candidates could adversely affect us.

Under our agreements with Allergan, Allergan is responsible for the manufacture and supply of Restasis. Allergan relies upon an arrangement with a single third party for the manufacture and supply of API for Restasis. Allergan then completes the manufacturing process to yield finished product.

Under our supply agreement with InSite Vision, InSite Vision is responsible for supplying us with azithromycin, the API used in AzaSite. InSite Vision, in turn, relies upon an arrangement with a single third party, Sandoz, for the manufacture and supply of such API. We are responsible for producing the finished product form of AzaSite, which is currently manufactured by a single party. There can be no assurance that such manufacturer will be able to, or will desire to, continue to produce sufficient quantities of finished product in a timely manner to support the commercialization of AzaSite. Sandoz has submitted to the FDA an ANDA requesting approval to market and sell a generic version of AzaSite.

In the event a third-party manufacturer is unable to supply Allergan or InSite Vision (as the case may be), if such supply is unreasonably delayed, or if Allergan or our finished product contract supplier are unable to complete the manufacturing cycle, sales of the applicable product could be adversely impacted, which would result in a reduction in any applicable product revenue. In addition, if Allergan or the third-party manufacturers do not maintain cGMP compliance, the FDA could require corrective actions or take enforcement actions that could affect production and availability of the applicable product, thus adversely affecting sales.

It would be time consuming and costly to identify and qualify new sources for manufacture of APIs or finished products. If our vendors were to terminate our arrangement or fail to meet our supply needs we might be forced to delay our development programs and/or be unable to supply products to the market, which could delay or reduce revenues and result in loss of market share.

Risks Related to Product Development

If the FDA does not conclude that our product candidates meet statutory requirements for safety and efficacy, we will be unable to obtain regulatory approval for marketing in the United States.

We have to conduct significant development activities, non-clinical and clinical tests and obtain regulatory approval before our product candidates can be commercialized. Product candidates that may appear to be promising at early stages of development may not successfully reach the market for a number of reasons. The results of preclinical and clinical testing of our product candidates under development may not necessarily indicate the results that will be obtained from later or more extensive testing. Additionally, companies in the pharmaceutical and biotechnology industries, including us, have suffered significant setbacks in advanced clinical trials, even after obtaining promising results in earlier clinical trials. Our ongoing clinical trials might be delayed or halted for various reasons, including:

•

The measure of efficacy of the drug is not statistically significant compared to placebo;

•

Patients experience severe side effects or serious adverse events during treatment;

•

Patients experience medical problems that may or may not relate to the drug being studied;

•

Patients do not enroll in the clinical trials at the rate we expect;

•

We decide to modify the drug or the clinical trial protocol during testing;

•

Our commercial partners, or future commercial partners, delay, amend or change our development plan or strategy; and

•

We allocate our limited financial and other resources to other clinical programs.

Changes in regulatory policy or new regulations as well as clinical investigator misconduct could also result in delays or rejection of our applications for approval of our product candidates. Clinical investigator misconduct that raises questions about the integrity of data in one or more applications (e.g., fraud, bribery, omission of a material fact, gross negligence) could be used by the FDA as grounds to suspend substantive scientific review of any or all pending marketing applications until the data in question have successfully undergone a validity assessment. Product candidates that fail validity assessments must be withdrawn from FDA review or, if the drug is an approved, marketed product, such product must be removed from the market.

Additionally, the introduction of our products in foreign markets will subject us to foreign regulatory clearances, the receipt of which may be unpredictable, uncertain and may impose substantial additional costs and burdens which we or our partners in such foreign markets may be unwilling or unable to fund. As with the FDA, foreign regulatory authorities must be satisfied that adequate evidence of safety and efficacy of the product has been presented before marketing authorization is granted. The foreign regulatory approval process includes all of the risks associated with obtaining FDA marketing approval. Approval by the FDA does not ensure approval by other regulatory authorities, nor does approval by any foreign regulatory authority ensure approval by the FDA.

Since there may be no regulatory precedents for our clinical candidates, conducting clinical trials and obtaining regulatory approval may be difficult, expensive and prolonged, which would delay any commercialization of our products.

To complete successful clinical trials, our product candidates must demonstrate safety and provide substantial evidence of efficacy. The FDA generally evaluates efficacy based on the statistical significance of a product candidate meeting predetermined clinical endpoints. The design of clinical trials to establish meaningful endpoints is done in collaboration with the FDA prior to the commencement of clinical trials. We establish these endpoints based on guidance from the FDA, including FDA guidance documents applicable to establishing the efficacy, safety and tolerability measures required for approval of products. Depending upon the disease our product candidate is designed to treat, the FDA may not have established guidelines for the design of our clinical trials and may take longer than average to consider our product candidates for approval. The FDA could change its view on clinical trial design and establishment of appropriate standards for efficacy, safety and tolerability and require a change in clinical trial design, additional data or even further clinical trials before granting approval of our product candidates. We could encounter delays and increased expenses in our clinical trials if the FDA concludes that the endpoints established for a clinical trial do not adequately predict a clinical benefit.

We have initiated a Phase 2 development program to evaluate the use of AzaSite for the treatment of blepharitis. The FDA has not published guidelines on the approval of a product for the treatment of blepharitis. Furthermore, to date, no prescription product has been approved by the FDA for the treatment of blepharitis. The FDA may require that we evaluate the product in relation to different primary and/or secondary clinical endpoints than those being used presently. This may require us to undertake additional Phase 2 clinical trials, which could lead to increased costs and program delays.

We may need to develop alternate dosing regimens for our product candidates.

In order to achieve broad market acceptance of our product candidates, we may need to develop, alone or with others, alternate dosing regimens and methods for administering our products. If the number of doses, or the method of dosing, is not convenient, patients may not use our product. Furthermore, if patients use our products at a dosing level that is less than the dosing level tested in our clinical trials, the drug may not be efficacious or may be less efficacious. In such cases, the patient may look for alternative therapies.

Clinical trials may take longer to complete and cost more than we expect, which would adversely affect our ability to commercialize product candidates and achieve profitability.

The number and type of studies that may be required by the FDA, or other regulatory authorities, for a particular compound are based on the compound’s clinical profile compared to existing therapies for the targeted patient population. While all new compounds require standard regulated phases of testing, the actual type and scope of testing can vary significantly among different product candidates and as a result, creates additional complexity when estimating program costs. Factors that affect the costs of a clinical trial include:

•

The number of patients required to participate in clinical trials to demonstrate statistical significance for a drug’s safety and efficacy and the number and geographical location of clinical trial sites necessary to enroll such patients;

•

The time required to enroll the targeted number of patients in clinical trials, which may vary depending on the size and availability of the relevant patient population, the nature of the protocol, the proximity of patients to clinical sites, the eligibility criteria for the clinical trial, the perceived benefit to the clinical trial participants and approval of the Institutional Review Board;

•

Appropriate identification of optimal treatment regimens;

•

Adequate supplies of drug product;

•

Monitoring and auditing; and

•

The number and type of required laboratory tests supporting clinical trials.

Delays in patient enrollment can result in increased costs and longer development times. Even if we successfully complete clinical trials, we may not receive regulatory approval for the product candidate. In addition, if the FDA or foreign regulatory authorities require additional clinical trials, we could face increased costs and significant development delays.

Additionally, ongoing development programs and associated costs are subject to frequent, significant and unpredictable changes due to a number of factors, including:

•

Data collected in preclinical or clinical trials may prompt significant changes, delays or enhancements to an ongoing development program;

•

Commercial partners and the underlying contractual agreements may require additional or more involved clinical or preclinical activities;

•

The FDA or other regulatory authorities may direct the sponsor to change or enhance its ongoing development program based on developments in the testing of similar compounds or related compounds;

•

Unexpected regulatory requirements, changes in regulatory policy or review standards, or interim reviews by regulatory agencies may cause delays or changes to development programs;

•

Unexpected and serious adverse events, reactions, or experiences of clinical trial participants may cause delays or changes to the development programs and could result in a clinical hold, which would stop the clinical trial until the FDA determined that the trial or development program could be resumed; and

•

Anticipated manufacturing costs may change significantly due to necessary changes in manufacturing processes, variances from anticipated manufacturing process yields or changes in the cost and/or availability of starting materials, and other costs to ensure the manufacturing facility is in compliance with cGMP requirements and is capable of consistently producing the product candidate in accordance with established specifications submitted to the FDA.

The occurrence of any of these factors may result in significant disparities in total costs required to complete the respective development programs.

If we fail to reach milestones or to make annual minimum payments or otherwise breach our obligations under our license agreements, our licensors may terminate our agreements with them and seek additional remedies.

If we fail to meet payment obligations, performance milestones relating to the timing of regulatory filings, development and commercial diligence obligations, fail to make milestone payments in accordance with applicable provisions, or fail to pay the minimum annual payments under our respective licenses, our licensors may terminate the applicable license. As a result, our development of the respective product candidate or commercialization of the product would cease.

Risks Related to Governmental Regulation

Failure to comply with all applicable regulations, including those that require us to obtain and maintain governmental approvals for our product candidates, may result in fines, corrective actions, administrative sanctions and restrictions, including the withdrawal of a product from the market.

Pharmaceutical companies are subject to significant regulation by a number of local, state, and federal governmental agencies, including the FDA. Such regulations and their authorizing statutes are amended from time to time. There are laws and regulations that govern areas including financial controls, clinical trials, testing, manufacturing, labeling, safety, packaging, shipping, distribution, post-approval safety surveillance, marketing, and promotion of pharmaceuticals, including those governing interactions with prescribers and health care professionals in a position to prescribe, recommend, or arrange for the provision of our products. Failure to comply with applicable regulatory requirements could, among other things, result in warning letters, fines, corrective actions, administrative sanctions, suspensions or delays of product manufacture or distribution or both, product recalls, delays in marketing activities and sales, withdrawal of marketing approvals, and civil or criminal sanctions including seizure of product, court-ordered injunctions, and possible exclusion from eligibility for federal government contracts and reimbursement of our products by Medicare, Medicaid, and other third-party payors. Senior management and the executives of an FDA-regulated company, such as ours, can be individually criminally prosecuted for violations of the Food, Drug, and Cosmetic Act and, unlike typical criminal actions, the government is not required to show an intent to violate the law. Successful criminal prosecutions can lead to debarment from providing any services to a drug company in any capacity. If this occurred, the reputation of the company could suffer, sales could decrease, formularies could refuse to include our drug products, and/or our revenues could be reduced and result in loss of market share.

After initial regulatory approval, the manufacturing and marketing of drugs, including our products, are subject to continuing FDA and foreign regulatory requirements and oversight. The FDA requires drug manufacturers and distributors to monitor the safety of a drug after it is approved and marketed. We are required to document and investigate reports of adverse events and report serious adverse events to the FDA. Additionally, the FDA encourages health professionals to report significant adverse events associated with products. The FDA may require additional clinical studies, known as Phase 4 studies, to evaluate product safety effects. In addition to studies required by the FDA after approval, we may conduct our own Phase 4 studies to explore the use of the approved drug product for treatment of new indications or to broaden our knowledge of the product. The subsequent discovery of previously unknown problems with a product’s safety or efficacy as a result of these studies or as reported in their prescribed use may result in the implementation of an FDA-required risk evaluation and mitigation strategy known as REMS, restrictions through labeling changes, or withdrawal of the product from the market.

The FDA periodically inspects drug manufacturing facilities to ensure compliance with applicable cGMP regulations. Failure to comply with statutory and regulatory requirements subjects the manufacturer to possible legal or regulatory action, such as suspension of manufacturing, seizure of product or court-ordered injunction, which could include mandatory recall of a product, and consent decrees that could be in place for up to five years or more until the government is satisfied with the company’s corrective and preventive actions to ensure compliance. Under a consent decree, a company is typically required to submit to third-party inspections, additional FDA reporting requirements, additional corrective actions, limitations on doing business in certain states, and disgorgement of any profits as a result of the wrongful conduct alleged by the government, all of which could significantly affect the cost of doing business and the company’s reputation, reduce revenues, and result in a loss of market share. Before taking such actions, the FDA may first issue one or more notices of compliance deficiencies. Such notices include inspectional observations on Form FDA-483, warning letters, and other untitled written correspondence; however, the FDA may also take action without such notice in situations of egregious noncompliance or where public safety is at risk. The FDA may also request us to take actions voluntarily or we may initiate actions ourselves such as recalls or suspension of manufacturing to ensure compliance with cGMP regulations.

Additional authority to take post-approval actions was given to the FDA under the FDA Amendments Act of 2007. The FDA is authorized to revisit and change its prior determinations if new information raises questions about our product’s safety profile. The FDA is authorized to impose additional post-marketing requirements, such as development of a risk evaluation and mitigation strategy which could include additional monitoring of post-approval adverse events, providing additional patient safety information, and adding warnings, precautions, and other safety information to the labeling. Failure to implement such requirements could result in corrective actions, fines, withdrawal of marketing approval, or any combination of such actions.

In its regulation of drug product advertising and promotional activities, the FDA may issue correspondence to pharmaceutical companies alleging that their advertising, promotional materials or activities are false or misleading and requesting corrective actions to remove and mitigate claims made in such materials. Pharmaceutical advertising and promotional activity must be true, fairly balanced between benefits and risks, provide adequate risk information, and be within the labeled indications. Drug manufacturers are prohibited from promoting unapproved, investigational drug products, and any approved and marketed drug product for a use that is not on the approved labeling; however, healthcare professionals are free to use the product for any use that, in the judgment of the healthcare professional, may be appropriate for any individual patient. The FDA and the HHS Office of the Inspector General (“OIG”) have the power to impose a wide array of sanctions on companies for advertising practices that are found to be false or misleading, do not include adequate risk information, or promote an unapproved or off-label use and, if we were to receive correspondence from the FDA or the OIG alleging such practices, it may be necessary for us to:

•

Incur substantial expenses, including fines, penalties, legal fees and costs to conform to the FDA’s limits on such promotion;

•

Change our methods of marketing, promoting and selling products;

•

Take corrective action, which could include placing advertisements or sending letters to physicians correcting statements made in previous advertisements or promotions; or

•

Disrupt the distribution of products and halt or suspend sales until we are in compliance with the FDA’s interpretation of applicable laws and regulations.

Medicare prescription drug coverage legislation and legislative or regulatory reform of the health care system may affect our or our partners’ ability to sell products profitably.

In both the United States and some foreign jurisdictions, there have been a number of legislative and regulatory changes to the health care system that could affect our ability to sell our products profitably. In the United States, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 established a voluntary Medicare outpatient prescription drug benefit under Part D of the Social Security Act. The program, which went into effect January 1, 2006, is administered by the Centers for Medicare & Medicaid Services within the HHS and is implemented and operated by private sector Part D plan sponsors. Each participating drug plan is permitted by regulation to develop and establish its own unique drug formulary that may exclude certain drugs from coverage and impose prior authorization and other coverage restrictions, and negotiate payment levels with drug manufacturers that may be lower than reimbursement levels available through private health plans or other payers. Moreover, beneficiary co-insurance requirements can vary, which could influence which products are recommended by physicians and selected by patients. The federal government continues to issue guidance and regulations regarding the obligations of Part D sponsors under the program, and a number of changes to the Part D program were included in recently-enacted health reform legislation, as discussed below.

We are responsible for contracting with Part D plan sponsors with respect to AzaSite. There is no assurance that any drug that we co-promote or sell will be covered by drug plans participating under the Medicare Part D program or, if covered, what the terms of any such coverage will be, or that the drugs will be reimbursed at amounts that reflect current or historical payment levels. Our results of operations could be materially adversely affected by the reimbursement changes associated with the Medicare prescription drug program or by changes in the formularies or

price negotiations with Part D drug plans. To the extent that private insurers or managed care programs follow Medicare coverage and payment developments, the adverse effects of lower Medicare payment may be magnified by private insurers adopting similar lower payment.

Our products also can be impacted by state and federal legislative and regulatory changes in Medicaid reimbursement policy and in mandated levels of Medicaid drug rebates paid by pharmaceutical manufacturers. Many states are facing serious budgetary pressures that could lead to adoption of additional cost-containment measures, including provisions aimed at reducing Medicaid drug prices. Medicaid drug pricing policies also have been subject to periodic revision by Congress, including as part of federal health reform efforts, as discussed below. Further, on February 3, 2011, the HHS announced that it is undertaking a national survey of pharmacies to create a national database of actual acquisition costs that states can use to determine state-specific pharmaceutical reimbursement rates; the data will be available to states later this year. There can be no assurances that new state and federal policies will not lower Medicaid reimbursement levels for our products.

In March 2010, Congress passed significant health reform legislation, the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act (collectively, “ACA”). The legislation is designed to expand access to affordable health insurance through subsidies, Medicaid expansion, and insurance market reforms (including the development of new health benefit exchanges), financed in part through reduced federal health care spending and various taxes and fees.

Among many other things, the ACA makes a number of significant changes affecting pharmaceutical manufacturers. With regard to Medicaid drug pricing, the ACA provides for increases to the minimum Medicaid rebate percentages from 15.1% to 23.1%, increased “additional rebates” for new formulations of brand name drugs, the establishment of a maximum rebate amount, and the extension of Medicaid rebates to Medicaid managed care organization utilization. In addition, the ACA broadens the definition of “average manufacturer price,” or AMP, which in turn may have the effect of increasing Medicaid rebate and Public Health Service section 340B drug discount program payment obligations. The ACA also provides that federal upper limits for multiple source drugs available for purchase by retail community pharmacies on a nationwide basis must be set at no less than 175% of the weighted average (based on utilization) of the most recently reported monthly AMP, using a smoothing process. The payments included in the calculation of AMP were further modified by the Education Jobs and Medicaid Assistance Act, which was enacted on August 10, 2010.

With regard to the Medicare Part D program, the ACA also requires drug manufacturers to provide a 50% discount on brand-name prescriptions filled in the Medicare Part D “coverage gap” beginning in 2011. The legislation also provided a $250 payment to Part D beneficiaries who reach the coverage gap during 2010, and mandates the gradual elimination of the coverage gap, beginning in 2011 and finishing in 2020. Moreover, the ACA reduces Part D premium subsidies for higher-income beneficiaries, expands medication therapy management requirements, and makes a number of other revisions to Part D program requirements. In addition, the ACA: extends the 340B program to additional entities, expands oversight of the 340B program, and increases manufacturer reporting requirements; creates an Independent Payment Advisory Board to develop recommendations to reduce Medicare spending under certain circumstances, with such recommendations to go into effect automatically unless Congress adopts alternative savings; expands public disclosure requirements regarding drug manufacturer financial arrangements with physicians; and establishes a licensure pathway for generic versions of biologics. Further, beginning in 2011, manufacturers and importers of branded prescription drugs and biologics will be assessed an annual fee ($2.5 billion in 2011 and increasing amounts in subsequent years up to $4.1 billion in 2018 and $2.8 billion annually thereafter), with individual company allocations to be determined by the Secretary of the Treasury, based generally on market share. The IRS recently extended the deadline for filing sales information, and has not yet made preliminary fee calculations for individual manufacturers. There can be no assurances that implementation of the new health reform legislation will not have an adverse impact on revenues, as well as reimbursement and/or coverage of our products.

In addition to federal health reform legislation, a number of states have adopted or are considering measures to contain state health care costs and institute other health care coverage and delivery reform, which could impact our reimbursement levels and require us to develop state-specific marketing and sales approaches. Further, a number of states require disclosure of financial arrangements with physicians, marketing expenditures, and the like, and other states may do so in the future; our failure to comply with these as well as the federal disclosure requirements could have an adverse impact.

Congress also has enacted the American Recovery and Reinvestment Act, which included a major expansion of federal efforts to compare the effectiveness of different medical treatments, including pharmaceuticals, which eventually could impact Medicare and private payer coverage and payment policies. This comparative effectiveness initiative was expanded by the ACA, and can include studies regarding the comparative clinical effectiveness of drugs. The federal government may consider additional proposals that could lead to coverage or reimbursement constraints and restrictions on access to certain products. We cannot predict the outcome of such initiatives, and it is difficult to predict the impact on our business of future legislative and regulatory changes.

We are subject to “fraud and abuse” and similar government laws and regulations, and a failure to comply with such laws and regulations, or an investigation into our compliance with such laws and regulations, or a failure to prevail in any litigation related to noncompliance, could harm our business.

We are subject to multiple state and federal laws pertaining to health care fraud and abuse. Pharmaceutical pricing, sales, and marketing programs and arrangements, and related business practices in the health care industry generally are under increasing scrutiny from federal and state regulatory, investigative, prosecutorial, and administrative entities. Many health care laws, including the federal and state anti-kickback laws and federal and state statutory and common law false claims laws, have been construed broadly by the courts and permit government entities to exercise considerable discretion. Further, the ACA contains a number of provisions strengthening the scope of the federal laws, including making a violation under the federal anti-kickback law a predicate action for violation of the federal False Claims Act and expanding the authority for Medicaid exclusions. The ACA also provides that a person need not have actual knowledge of the anti-kickback law, among others, or a specific intent to commit a violation of the law, to be found in violation of it. The ACA further applies the False Claims Act to payments made through new health benefits exchanges if the payments include any federal funds. In the event that government entities believed that wrongdoing had occurred, such entities could institute civil, administrative, or criminal proceedings which, if instituted and resolved unfavorably, could subject us to substantial fines, penalties, and injunctive and administrative remedies, including exclusion from government reimbursement programs. The adverse outcome of a government investigation also could prompt other government entities to commence investigations, or cause those entities or private parties to bring civil actions against us. We cannot predict whether investigations or enforcement actions would affect our marketing or sales practices. Any such result could have a material adverse impact on our results of operations, cash flows, financial condition, and our business. Such investigations and enforcement actions could be costly, divert management’s attention from our business, and result in damage to our reputation. We cannot guarantee that measures that we have taken to prevent violations, including our corporate compliance program, will protect us from future violations, lawsuits or investigations by governmental entities or private whistleblowers. If any such actions are instituted against us, and we are not successful in defending ourselves or asserting our rights, those actions could have a significant negative impact on our business, including the imposition of significant fines or other sanctions.

Failure to adequately ensure compliance with applicable laws and regulations may subject us to whistleblower and government actions.

In recent years, pharmaceutical companies have been the targets of extensive whistleblower actions in which the person bringing the action alleges violations of the federal civil False Claims Act or its state equivalent, including allegations that manufacturers aided and abetted in the submission of false claims. These actions have focused on such areas as pricing practices, off-label product promotion, manufacturing deficiencies, sales and marketing practices, and improper relationships with physicians and other health care professionals, among others. The ACA eliminates a number of jurisdictional bars to bringing a false claims action, and therefore may make it easier for whistleblowers to bring successful actions. If our relationships with health care professionals and/or our promotional or other activities are found not to comply with applicable laws, regulations or guidelines, we may be subject to warnings from, or investigative or enforcement action by, regulatory and other federal or state governmental authorities. The potential ramifications are far-reaching if there are areas identified as out of compliance by regulatory agencies and governmental authorities including, but not limited to, significant financial penalties, manufacturing and clinical trial

consent decrees, commercialization restrictions, exclusion from government programs, product recalls or seizures, the imposition of corporate integrity agreements and deferred prosecution agreements, or other restrictions and litigation. Furthermore, there can be no assurance that we will not be subject to a whistleblower or other state or federal investigative or enforcement action at some time in the future. Even an unsuccessful challenge to our operations or activities could prove costly and divert management’s attention.

Risks Associated with Our Business and Industry

If we do not receive timely regulatory approvals of our product candidates and successfully launch such products, we may need substantial additional funds to support our expanding capital requirements.

We have used substantial amounts of cash to fund our research and development and commercial activities. Our operating expenses were approximately $38.8 million for the three months ended March 31, 2011 and approximately $142.2 million for the year ended December 31, 2010. Our cash, cash equivalents and investments totaled approximately $77.8 million on March 31, 2011. Based on current operating plans, we expect our cash and investments to provide liquidity beyond 2011.

We expect that our capital and operating expenditures will continue to exceed our revenue over the next several years as we conduct our research and development, licensing, acquisition and/or commercial activities. Many factors will influence our future capital requirements, including:

•

The number, breadth and progress of our research and development programs;

•

The level of activities relating to commercialization of our products;

•

The ability to attract collaborators for our products and establish and maintain those relationships;

•

The receipt or payment of milestone payments under our current collaborative agreements and any future collaborations;

•

Progress by our collaborators with respect to the development of product candidates;

•

Competing technological and market developments;

•

The timing and terms of any business development activities;

•

The costs involved in defending any litigation claims against us;

•

The costs involved in responding to government, the Financial Industry Regulatory Authority, Inc., or other applicable investigations against us; and

•

The costs involved in enforcing patent claims and other intellectual property rights.

In addition, our capital requirements will depend upon:

•

The level of net sales generated for AzaSite;

•

The receipt of revenue from Allergan on net sales of Restasis;

•

The timing of the introduction of a generic form of Elestat;

•

The receipt of revenue from wholesalers and other customers on net sales of AzaSite;

•

The ability to obtain approval from the FDA for our product candidates; and

•

Payments from existing and future collaborators.

In the event that we do not receive timely regulatory approvals, we may need substantial additional funds to support our on-going operations, including business development, product commercialization and co-promotion efforts as well as continue our development activities associated with our product candidates. We may seek such additional funding through public or private equity offerings and debt financings. Additional financing may not be available when needed and/or such financing may not be on terms favorable to us or our stockholders. Our stockholders’ ownership will be diluted if we raise additional capital by issuing equity securities. If we are required to raise funds through future collaborations and licensing arrangements, we may have to give up rights to our technologies or product candidates or grant licenses on unfavorable terms. If adequate funds are not available, we would have to scale back or terminate product development and we may not be able to successfully commercialize any product candidate.

Our revenues are based, in part, upon Allergan’s revenue recognition policy and other accounting policies over which we have limited or no control.

During the fiscal quarter ended March 31, 2011, we recognized co-promotion revenue based on Allergan’s net sales of Elestat and royalty revenue based on Allergan’s net sales of Restasis, as defined in the agreements and as reported to us by Allergan. Accordingly, our co-promotion and royalty revenues are based upon Allergan’s revenue recognition policy and other accounting policies, over which we have limited or no control, and the underlying terms of our agreements. Allergan’s filings with the SEC indicate that Allergan maintains disclosure controls and procedures in accordance with applicable laws, which are designed to provide reasonable assurance that the information required to be reported by Allergan in its Exchange Act filings is reported timely and in accordance with applicable laws, rules and regulations. We are not entitled to review Allergan’s disclosure controls and procedures. We are unable to provide complete assurance that Allergan will not revise reported revenue amounts in the future. If Allergan’s reported revenue amounts were inaccurate, it could have a material impact on our financial statements, including financial statements for prior periods.

Revenues in future periods could vary significantly and may not cover our operating expenses.

Our revenues may fluctuate from period to period due in part to:

•

The introduction of a generic form of Elestat;

•

Fluctuations in future sales of AzaSite and Restasis due to competition, disease prevalence, manufacturing difficulties, reimbursement and pricing under commercial or government plans, or other factors that affect the sales of a product;

•

Deductions from gross sales relating to estimates of sales returns, credits and allowances, normal trade and cash discounts, managed care sales rebates and other allocated costs;

•

The duration of market exclusivity of AzaSite and Restasis;

•

The timing of approvals, if any, for other possible future products;

•

The progress toward and the achievement of developmental milestones by us or our partners;

•

The initiation of new contractual arrangements with other companies; and

•

The failure or refusal of a collaborative partner to pay royalties or milestone payments.

Inventory levels of AzaSite held by wholesalers can also cause our operating results to fluctuate unexpectedly. Although we attempt to monitor wholesaler inventory of our products, we rely upon information provided by third parties to quantify the inventory levels maintained by wholesalers. In addition, we and the wholesalers may not be effective in matching inventory levels to end-user demand. Significant differences between actual and estimated inventory levels and product demand may result in (1) inadequate or excessive (i) inventory production, (ii) product supply in distribution channels, or (iii) product availability at the retail level, and (2) unexpected increases or decreases in orders from our major customers. Any of these events may cause our revenues to fluctuate significantly from quarter to quarter, and in some cases may cause our operating results for a particular quarter to be below expectations.

If we continue to incur operating losses for a period longer than anticipated, or in an amount greater than anticipated, we may be unable to continue our operations.

We have experienced significant losses since inception. We incurred net losses of approximately $17.6 million for the three months ended March 31, 2011 and approximately $35.4 million for the year ended December 31, 2010. As of March 31, 2011, our accumulated deficit was approximately $453.5 million. We currently expect to incur operating losses over the next several years. We expect that losses will fluctuate from quarter to quarter. Such fluctuations will be affected by the timing and level of the following:

•

Commercialization activities to support AzaSite;

•

Revenues from Restasis;

•

Regulatory approvals of our product candidates;

•

Patient demand for our products and any licensed products;

•

Payments to and from licensors and corporate partners;

•

Research and development activities;

•

Investments in new technologies and product candidates; and

•

The costs involved in defending any litigation claims against, or government investigations of, us.

To achieve and sustain profitable operations, we must, alone or with others, develop successfully, obtain regulatory approval for, manufacture, introduce, market and sell our products. The time frame necessary to achieve market success is long and uncertain. We may not generate sufficient product revenues to become profitable or to sustain profitability. If the time required to achieve profitability is longer than we anticipate, we may not be able to continue our operations.

Recent stock market and credit market conditions have been extremely volatile and unpredictable. It is difficult to predict whether these conditions will continue or worsen, and, if so, whether the conditions would impact us and whether such impact could be material.

We have exposure to many different industries and counterparties, including commercial banks, investment banks and customers (which include wholesalers, managed care organizations and governments) that may be unstable or may become unstable in the current economic environment. Any such instability may impact these parties’ ability to fulfill contractual obligations to us or they might limit or place burdensome conditions upon future transactions with us. Customers may also reduce spending during times of economic uncertainty. Also, it is possible that suppliers may be negatively impacted. If such events were to occur, there could be a resulting material and adverse impact on our operations and results of operations.

We may decide to access the equity or debt markets to meet capital or liquidity needs. However, the recent constriction and volatility in these markets may restrict our future flexibility to do so when such needs arise. Further, recent economic conditions have resulted in severe downward pressure on the stock and credit markets, which could reduce the return available on invested corporate cash, which if severe and sustained could have a material and adverse impact on our results of operations and cash flows.

Our dependence on collaborative relationships may lead to delays in product development, lost revenues and disputes over rights to technology.

Our business strategy depends to some extent upon the formation of research collaborations, licensing and/or marketing arrangements. We currently have collaboration agreements with several companies, including Allergan, InSite Vision and Santen. The termination of any collaboration will result in the loss of any unmet development or commercial milestone payments, may lead to delays in product development and disputes over technology rights, and may reduce our ability to enter into collaborations with other potential partners. In the event we breach an agreement with a collaborator, the collaborator is entitled to terminate our agreement with them in the event we do not cure the breach within a specified period of time, which is typically 60 or 90 days from the notice date. If we do not maintain our current collaborations, or establish additional research and development collaborations or licensing arrangements, it will be difficult to develop and commercialize potential products. Any future collaborations or licensing arrangements may not be on terms favorable to us.

Our current or any future collaborations or licensing arrangements ultimately may not be successful. Under our current strategy, and for the foreseeable future, we do not expect to develop or market products outside North America without a collaborative partner or outside our therapeutic areas of focus.

It may be necessary in the future for us to obtain additional licenses to avoid infringement of third-party patents. Additionally, we may enter into license arrangements with other third parties as we build our product portfolio. We do not know the terms on which such licenses may be available, if at all.

We will continue to depend on collaborators and/or contractors for research and development, manufacturing and marketing of our potential products. Our agreements with collaborators typically allow them some discretion in electing whether to pursue such activities. If any collaborator were to breach or terminate its agreement with us or otherwise fail to conduct collaborative activities in a timely and successful manner, the clinical development or commercialization of product candidates or research programs would be delayed or terminated. Any delay or termination in clinical development or commercialization would delay or eliminate potential product revenues relating to our product candidates.

Disputes may arise in the future over the ownership of rights to any technology developed with collaborators. These and other possible disagreements between us and our collaborators could lead to delays in the collaborative development or commercialization of products. Such disagreements could also result in litigation or require arbitration to resolve.

Failure to hire and retain key personnel may hinder our product development programs and our business efforts.

We depend on the principal members of our management and scientific staff, including Adrian Adams, our President and Chief Executive Officer and a director, and Thomas R. Staab, II, our Chief Financial Officer and Treasurer. If these people leave us, we may have difficulty conducting our operations. Our future success will depend in part on our ability to attract, hire or appoint, and retain additional personnel skilled or experienced in the pharmaceutical industry. There is significant competition for such qualified personnel and we may not be able to attract and retain such personnel.

We may not be able to successfully compete with other biotechnology companies and pharmaceutical companies.

The biotechnology and pharmaceutical industries are intensely competitive and subject to rapid and significant technological change. There are many companies seeking to develop products for the same indications that we are working on. Our competitors in the United States and elsewhere are numerous and include, among others, major multinational pharmaceutical and chemical companies and specialized biotechnology firms.

Most of these competitors have greater resources than we do, including greater financial resources, larger research and development staffs and more experienced marketing and manufacturing organizations. In addition, most of our competitors have greater experience than we do in conducting clinical trials and obtaining FDA and other regulatory approvals. Accordingly, our competitors may succeed in obtaining FDA or other regulatory approvals for product candidates more rapidly than we do. Companies that complete clinical trials, obtain required regulatory approvals, and commence commercial sale of their drugs before we do may achieve a significant competitive advantage, including patent and FDA marketing exclusivity rights that would delay our ability to market products. Drugs resulting from our research and development efforts, or from our joint efforts with our collaborative partners, may not compete successfully with competitors’ existing products or products under development.

Our competitors may also develop technologies and drugs that are safer, more effective, or less costly than any we are developing or which would render our technology and future drugs obsolete and non-competitive.

If our intellectual property protection is inadequate, the development and any possible sales of our product candidates could suffer or competitors could force our products completely out of the market.

Our business and competitive position depends on our ability to continue to develop and protect our products and processes, proprietary methods and technology and to prevent others from infringing on our patents, trademarks and other intellectual property rights. Upon the expiration or loss of patent protection for a product, we or our applicable collaborative partners may lose a significant portion of sales of that product in a short period of time as other companies manufacture generic forms of the previously protected product or manufacture similar products at lower cost, without having had to incur significant research and development costs in formulating the product.

Therefore, our future financial success may depend in part on our and our partners obtaining patent protection for technologies incorporated into our products. We cannot be assured that such patents will be issued, or that any existing or future patents will be of commercial benefit. In addition, it is impossible to anticipate the breadth or degree of protection that any such patents will afford, and we cannot be assured that any such patents will not be successfully challenged in the future. If we are unsuccessful in obtaining or preserving patent protection, or if any of our products rely on unpatented proprietary technology, we cannot be assured that others will not commercialize products substantially identical to those products. We also believe that the protection of our trademarks is an important factor in product recognition and in our ability to maintain or increase market share. If we do not adequately protect our rights in our various trademarks from infringement, their value to us could be lost or diminished, seriously impairing our competitive position. Moreover, the laws of certain foreign countries do not protect our intellectual property rights to the same extent as the laws of the United States.

Certain of our patents are use patents containing claims covering methods of treating disorders and diseases by administering therapeutic chemical compounds. Use patents may provide limited protection for commercial efforts in the United States, but may afford a lesser degree of protection, if any, in other countries due to their patent laws. Besides our use patents, we have patents and patent applications covering compositions (new chemical compounds), pharmaceutical formulations and processes for manufacturing our new chemical compounds. Many of the chemical compounds included in the claims of our use patents and process applications were known in the scientific community prior to our patent applications. None of our composition patents or patent applications covers these previously known chemical compounds, which are in the public domain. As a result, competitors may be able to commercialize products that use the same previously known chemical compounds used by us for the treatment of disorders and diseases not covered by our use patents. Such competitors’ activities may reduce our revenues.

Third parties may challenge, invalidate or circumvent our patents and patent applications relating to our products, product candidates or technologies at any time. If we must defend a patent suit, or if we choose to initiate a suit to have a third-party patent declared invalid, or allege infringement of our patents, we may need to make considerable expenditures of money and expend considerable management time in litigation. We believe that there is significant litigation in the pharmaceutical and biotechnology industry regarding patent and other intellectual property rights. A patent does not provide the patent holder with freedom to operate in a way that infringes the patent rights of others. We may be accused of patent infringement at any time. A judgment against us in a patent infringement action could cause us to pay monetary damages, require us to obtain licenses, or prevent us from manufacturing or marketing the affected products. In addition, we may need to initiate litigation to enforce our proprietary rights against others. Initiation of litigation may result in considerable expenditures of money and management time and may result in our patents being declared invalid. Further, we may need to participate in interference proceedings in the U.S. Patent and Trademark Office, or USPTO, to determine the priority of invention of any of our technologies.

Our ability to develop sufficient patent rights in our pharmaceutical, biopharmaceutical and biotechnology products to support commercialization efforts is uncertain and involves complex legal and factual questions. For instance, the USPTO examiners may not allow our claims in examining our patent applications. If we have to appeal a decision to the USPTO’s Appeals Board for a final determination of patentability, we could incur significant legal fees. Lengthy and uncertain patent prosecutions, including the utilization of the appeals process, can add uncertainty, delay and expense to the process of obtaining intellectual property rights for our products, and as such may add delay and uncertainty to the development program for any such product.

Use of our products may result in product liability claims for which we may not have adequate insurance coverage.

Manufacturing, marketing and sale of our products or conducting clinical trials of our product candidates may expose us to liability claims from the use of those products and product candidates. Product liability claims could result in the imposition of substantial liability on us, a recall of products, or a change in the indications for which they may be used. Although we carry product liability insurance and clinical trial liability insurance, we, or our collaborators, may not maintain sufficient insurance to cover these potential claims. We do not have the financial resources to self-insure and it is unlikely that we will have these financial resources in the foreseeable future. If we are unable to protect against potential product liability claims adequately, we may find it difficult or impossible to continue to commercialize our products or the product candidates we develop. If claims or losses exceed our liability insurance coverage, there could be a resulting material adverse effect on our business.

Insurance coverage is increasingly more costly and difficult to obtain or maintain.

While we currently have insurance for our business, property, directors and officers, and our products, insurance is increasingly more costly and narrower in scope, and we may be required to assume more risk in the future. If we are subject to claims or suffer a loss or damage in excess of our insurance coverage, we will be required to share that risk in excess of our insurance limits. If we are subject to claims or suffer a loss or damage that is outside of our insurance coverage, we may incur significant uninsured costs associated with loss or damage that could have an adverse effect on our operations and financial position. Furthermore, any claims made on our insurance policies may impact our ability to obtain or maintain insurance coverage at reasonable costs or at all.

Risks Related to Our Stock

Our common stock price has been volatile and your investment in our stock may decline in value.

The market price of our common stock has been volatile. These fluctuations create a greater risk of capital losses for our stockholders as compared to less volatile stocks. Factors that have caused volatility and could cause additional volatility in the market price of our common stock include among others:

•

Announcements made by us concerning results of clinical trials with our product candidates;

•

Announcements regarding the commercialization of AzaSite;

•

Announcements regarding potential FDA approval (or lack thereof) of any of our product candidates;

•

Market acceptance and market share of AzaSite and Restasis;

•

The introduction of a generic form of Elestat;

•

Duration of market exclusivity of AzaSite and Restasis;

•

Volatility in other securities including pharmaceutical and biotechnology securities;

•

Changes in government regulations;

•

Regulatory actions and/or investigations;

•

Changes in the development priorities of our collaborators that result in changes to, or termination of, our agreements with such collaborators;

•

Developments concerning proprietary rights including patents by us or our competitors;

•

Variations in our operating results;

•

FDA approval of other treatments for the same indication as any one of our product candidates;

•

Business development activities; and

•

Litigation.

Extreme price and volume fluctuations occur in the stock market and in particular market sectors from time to time that may affect the prices of biotechnology companies. These extreme fluctuations are sometimes unrelated to the actual performance of the affected companies.

Warburg is able to exercise substantial control over our business.

Warburg Pincus Private Equity IX, L.P., or Warburg, holds 22,907,488 shares of our common stock, which represented approximately 28% of our outstanding common stock as of April 1, 2011. Warburg and its affiliates may acquire the lesser of: (x) 32.5% of our voting securities on a fully diluted basis and (y) 34.9% of our then outstanding voting securities, without triggering the provisions of our stockholder rights plan. Warburg has the right to designate one person for election to our Board of Directors for so long as Warburg owns a significant percentage of our securities. Pursuant to this right, Jonathan S. Leff serves as a Class C member of the Board of Directors. Pursuant to a Securities Purchase Agreement, dated July 17, 2007, for so long as Warburg owns at least 10% of the shares of

common stock issued upon the exchange of Exchangeable Preferred Stock it acquired in July 2007, it will have subscription rights to acquire a pro rata amount of future issuances of equity securities by us, subject to certain exceptions.

As an inducement to Merck and Monarch entering into the Merger Agreement, and in consideration thereof, Warburg, Merck and Monarch entered into a tender and support agreement, whereby Warburg agreed, among other things, to tender its shares in the Tender Offer for the offer price and support any and all corporate action necessary to consummate the Merger, including granting Merck a limited irrevocable proxy to vote the 22,907,488 shares of our common stock that are held by Warburg in furtherance of the foregoing. Among other things, the tender and support agreement provides that (i) Warburg, as of the date of such agreement, is the beneficial owner of 22,907,488 shares of our common stock, or the Covered Shares, (ii) Warburg will vote all of the Covered Shares in favor of the approval of the Merger and the approval and adoption of the Merger Agreement and against any alternative proposal, (iii) Warburg will not sell, transfer, gift or otherwise dispose of any of the Covered Shares (other than to an affiliate, subsidiary, partner or member of Warburg) or grant any proxies or powers of attorney with respect to any of the Covered Shares in contravention of the obligations under the tender and support agreement, and (iv) Warburg will not subject any Covered Shares to any pledges, liens or other encumbrances or arrangements. Warburg has also agreed not to take any action, in its capacity as a stockholder, that we are prohibited from taking pursuant to a specified section of the Merger Agreement. In furtherance of the agreement, Warburg has tendered its shares.

Additionally, Warburg granted Merck an irrevocable option to purchase Covered Shares at the offer price if (i) Monarch acquires shares pursuant to the Tender Offer and (ii) Warburg fails to tender into the Tender Offer all of the Covered Shares or withdraws the tender of any Covered Shares in breach of the tender and support agreement. Merck may exercise such option at any time within the 60 days following the date when the option first becomes exercisable.

As a result of the foregoing, Warburg is able to exercise substantial influence over our business, policies and practices.

Our existing principal stockholders hold a substantial amount of our common stock and may be able to influence significant corporate decisions, which may conflict with the interest of other stockholders.

As of April 1, 2011, our current 5% and greater stockholders (which includes Warburg) and their affiliates beneficially owned approximately 40% of our outstanding common stock. These stockholders, if they act together, may be able to influence the outcome of matters requiring approval of the stockholders, including the election of our directors and other corporate actions such as:

•

a merger or corporate combination with or into another company;

•

a sale of substantially all of our assets; and

•

amendments to our certificate of incorporation.

The decisions of these individual stockholders may conflict with our interests or those of our other stockholders.

Future sales and issuances of securities may dilute the ownership interests of our current stockholders and cause our stock price to decline.

Future sales of our common stock by current stockholders into the public market could cause the market price of our stock to fall. As of April 1, 2011, there were 83,292,192 shares of our common stock outstanding. We may from time to time issue securities in relation to a license arrangement, collaboration, merger or acquisition.

In addition, on October 6, 2010, we filed with the SEC a shelf registration statement on Form S-3. This shelf registration statement has been declared effective and allows us to sell up to $150 million of securities, including common stock, preferred stock, debt securities, depositary shares and securities warrants, from time to time at prices and on terms to be determined at the time of sale.

As of April 1, 2011, there were 12,986,465 stock options and restricted stock units outstanding and 8,005,279 shares available for issuance under our Amended and Restated 2010 Equity Compensation Plan and equity compensation grants outside such plan. The shares underlying existing stock options and restricted stock units and possible future stock options, stock appreciation rights and stock awards have been registered pursuant to registration statements on Form S-8.

If some or all of such shares are sold or otherwise issued into the public market over a short period of time, our current stockholders’ ownership interests may be diluted and the value of all publicly traded shares is likely to decline, as the market may not be able to absorb those shares at then-current market prices. Additionally, such sales and issuances may make it more difficult for us to sell equity securities or equity-related securities in the future at a time and price that our management deems acceptable, or at all.

Our Rights Agreement, the provisions of our Change in Control Severance Benefit Plans, the anti-takeover provisions in our Amended and Restated Certificate of Incorporation, as amended, and Amended and Restated Bylaws, standstill agreements, and our right to issue preferred stock, may discourage a third party from making a take-over offer that could be beneficial to us and our stockholders and may make it difficult for stockholders to replace our Board of Directors and effect a change in our management if they desire to do so.

In October 2002, we entered into a Rights Agreement with Computershare Trust Company. The Rights Agreement could discourage, delay or prevent a person or group from acquiring 15% or more of our common stock. The Rights Agreement provides that if a person acquires 15% or more of our common stock without the approval of our Board of Directors, all other stockholders will have the right to purchase securities from us at a price that is less than its fair market value, which would substantially reduce the value of our common stock owned by the acquiring person. As a result, our Board of Directors has significant discretion to approve or disapprove a person’s efforts to acquire 15% or more of our common stock. In connection with the transaction with Warburg, we and Computershare entered into a First Amendment to Rights Agreement which provides that Warburg and its affiliates will be exempt from the definition of an “Acquiring Person” under the Rights Agreement, unless Warburg or certain of its affiliates becomes the beneficial owner of the lesser of: (x) 32.5% of our voting securities on a fully diluted basis and (y) 34.9% of our then outstanding voting securities. In addition to Warburg’s ability to exercise substantial control over our business, the First Amendment to Rights Agreement could further discourage, delay or prevent a person or group from acquiring 15% or more of our common stock. As part of the same transaction with Warburg, we entered into a standstill agreement, dated July 20, 2007, pursuant to which Warburg and certain of its affiliates agreed for three years not to increase their holdings of our common stock beyond the levels described above in the First Amendment to Rights Agreement. On August 4, 2009, we amended the standstill agreement to extend its term until August 4, 2012.

In connection with the Merger Agreement, we entered into a second amendment, or the Second Amendment, dated April 5, 2011, to the Rights Agreement. The Second Amendment, among other things, renders the Rights Agreement inapplicable to the Merger, the Tender Offer, the Top-Up Option, the Merger Agreement and the transactions, including the tender agreement. The Second Amendment provides that none of the approval, execution, delivery, performance or public announcement of the Merger Agreement, the execution of the tender agreement, nor the consummation or public announcement of the Merger, the Tender Offer, the Top-Up Option or any other transaction contemplated by the Merger Agreement, will result in either Merck or Monarch or any of their respective affiliates or associates being deemed an “Acquiring Person” or “Beneficial Owners” (as such terms are defined in the Second Agreement) or give rise to any event that would result in the occurrence of a “Share Acquisition Date” or a “Distribution Date” (as such terms are defined in the Rights Agreement).

Our employees are covered under Change in Control Severance Benefit Plans which provide severance benefits in the event they are terminated after a change in control. In addition, the Company’s Executive Employment Agreements with Mr. Adams, our President and Chief Executive Officer, and Mr. Koven, our Executive Vice President and Chief Administrative and Legal Officer, provide for severance benefits in the event of a change of control. These arrangements would increase the acquisition costs to a purchasing company that triggers the change in control provisions and as a result, may discourage, delay or prevent a change in control.

Our Amended and Restated Certificate of Incorporation and Amended and Restated Bylaws contain provisions which could discourage, delay or prevent a third party from acquiring shares of our common stock or replacing members of our Board of Directors. Our Amended and Restated Certificate of Incorporation allows our Board of Directors to issue shares of preferred stock. Our Board of Directors can determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. As a result, our Board of Directors could make it difficult for a third party to acquire a majority of our outstanding voting stock. Since management is appointed by the Board of Directors, any inability to effect a change in the Board of Directors may result in the entrenchment of management.

Our Amended and Restated Certificate of Incorporation also provides that the members of the Board will be divided into three classes. Each year, the terms of approximately one-third of the directors will expire. Our Amended and Restated Bylaws include director nomination procedures and do not permit our stockholders to call a special meeting of stockholders. The staggering of directors’ terms of office, the director nomination procedures and the inability of stockholders to call a special meeting may make it difficult for stockholders to remove or replace the Board of Directors should they desire to do so. The director nomination requirements include a provision that requires stockholders give advance notice to our Secretary of any nominations for director or other business to be brought by stockholders at any stockholders’ meeting. Our directors may be removed from our Board of Directors only for cause. These provisions may discourage, delay or prevent changes of control or management, either by third parties or by stockholders seeking to change control or management.

In the ordinary course of our business, from time to time we discuss possible collaborations, licenses and other transactions with various third parties, including pharmaceutical companies and biotechnology companies. When we deem it appropriate, we enter into standstill agreements with such third parties in relation to the discussions. These standstill agreements, several of which may be in force from time-to-time, typically prohibit such parties from acquiring our securities for a period of time.

We are also subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law. Under these provisions, if anyone becomes an “interested stockholder,” we may not enter a “business combination” with that person for three years without special approval, which could discourage a third party from making a take-over offer and could delay or prevent a change of control. For purposes of Section 203, “interested stockholder” means, generally, someone owning 15% or more of our outstanding voting stock or an affiliate of ours that owned 15% or more of our outstanding voting stock during the past three years, subject to certain exceptions as described in Section 203. In connection with our prior sale of stock to Warburg, we agreed to waive Warburg’s acquisition of securities from the provisions of Section 203 of the Delaware General Corporation Law.

Item 5. Other Information.

On April 22, 2011, we announced in a press release that we were indefinitely postponing our Annual Meeting of Stockholders, or the Annual Meeting, which had been scheduled for May 6, 2011, due to the recently announced Merger Agreement, tender offer and pending merger. In the event it becomes necessary to hold the Annual Meeting later this year, we will inform stockholders of the new meeting date.

Item 6. Exhibits.

See the Exhibit Index located at the end of this Report.

SIGNATURES

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


	Inspire Pharmaceuticals, Inc.

Date: May 10, 2011	By:	/s/ Adrian Adams
		Adrian Adams
		President & Chief Executive Officer
		(principal executive officer)

Date: May 10, 2011	By:	/s/ Thomas R. Staab, II
		Thomas R. Staab, II
		Chief Financial Officer & Treasurer
		(principal financial and chief accounting officer)

EXHIBIT INDEX


Exhibit No.		Description of Exhibit

2.1		Agreement and Plan of Merger, dated as of April 5, 2011, by and among the Company, Merck & Co. Inc. and Monarch Transaction Corp. (Incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on April 8, 2010).

3.1		Amended and Restated Certificate of Incorporation (Incorporated by reference to Exhibit 99.2 to the Company’s Current Report on Form 8-K filed on June 8, 2010).

3.2		Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on December 18, 2007).

4.1		Second Amendment to Rights Agreement (Incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed on April 8, 2010).

10.1		Executive Retention Bonus Agreement, dated as of March 22, 2011, by and between the Company and Adrian Adams.†

10.2		Executive Retention Bonus Agreement, dated as of March 22, 2011, by and between the Company and Andrew I. Koven.†

10.3		Executive Retention Bonus Agreement, dated as of March 22, 2011, by and between the Company and Thomas R. Staab, II.†

10.4		Executive Retention Bonus Agreement, dated as of March 22, 2011, by and between the Company and R. Kim Brazzell.†

10.5		Executive Retention Bonus Agreement, dated as of March 22, 2011, by and between the Company and Joseph M. Spagnardi.†

31.1		Certification of the President & Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934.*

31.2		Certification of the Chief Financial Officer & Treasurer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934.*

32.1		Certification of the President & Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.**

32.2		Certification of the Chief Financial Officer & Treasurer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.**

99.1		Tender and Support Agreement, dated as of April 5, 2011, by and among Parent, Merger Sub and Warburg Pincus Private Equity IX, L.P. (incorporated by reference to Exhibit 99.8 to Warburg Pincus Private Equity IX, L.P.’s Form 13 D/A filed with the SEC on April 6, 2011).

*	Filed herewith

**	Furnished herewith

†	Management contract or compensation plan or arrangement required to be filed as an exhibit to this Report.

Large accelerated filer

Accelerated filer

Non-accelerated filer

¨ (do not check if a smaller reporting company)

Smaller reporting company

INSPIRE PHARMACEUTICALS INC 10-Q