AVRX Avalon Pharmaceuticals (MM)

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

þ		Quarterly Report Pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2007.

OR

o		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 001-32629

Registrant’s Telephone Number, Including Area Code: (301) 556-9900

     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 þ No o

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

Large accelerated filer o       Accelerated filer o       Non-accelerated filer þ

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

     As of October 31, 2007, 17,026,462 shares of Avalon Pharmaceuticals, Inc. common stock, par value $.01 per share, were outstanding.

 

 

AVALON PHARMACEUTICALS, INC.

		Page
PART I. FINANCIAL INFORMATION			4
Item 1. Financial Statements			4
Balance Sheets as of September 30, 2007 (unaudited) and December 31, 2006			4
Statements of Operations for the three and nine months ended September 30, 2007 and 2006 (unaudited)			5
Statements of Cash Flows for the nine months ended September 30, 2007 and 2006 (unaudited)			6
Notes to Financial Statements (unaudited)			7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			11
Item 3. Quantitative and Qualitative Disclosures About Market Risk			16
Item 4T. Controls and Procedures			16
PART II. OTHER INFORMATION			17
Item 6. Exhibits			17
SIGNATURES			18

FORWARD-LOOKING STATEMENTS

      From time to time in this interim quarterly report we may make statements that reflect our current expectations regarding our future results of operations, economic performance, and financial condition, as well as other matters that may affect our business. In general, we try to identify these forward-looking statements by using words such as “anticipate,” “believe,” “expect,” “estimate,” and similar expressions.

      All of these items involve significant risks and uncertainties. These and any of the other statements we make in this quarterly report that are forward-looking are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. We caution you that our actual results may differ significantly from the results we discuss in the forward-looking statements.

      We discuss some factors that could cause or contribute to such differences in the “Risk Factors” section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2006, and in Part II, Item 1A of our interim quarterly report on Form 10-Q for the quarter ended March 31, 2007. In addition, any forward-looking statements we make in this document speak only as of the date of this document, and we do not intend to update any such forward-looking statements to reflect events or circumstances that occur after that date.

PART I. FINANCIAL INFORMATION

See accompanying notes.

AVALON PHARMACEUTICALS, INC.
NOTES TO FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)

1. Basis of Presentation

     The financial statements included in this report have been prepared, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures, normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles, have been condensed or omitted pursuant to such rules and regulations. These financial statements should be read in conjunction with the audited financial statements and the related notes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006.

     In the opinion of our management, any adjustments contained in the accompanying unaudited financial statements as of and for the three and nine months ended September 30, 2007 and 2006 are of a normal recurring nature and are necessary to present fairly our financial position, results of operations and cash flows. Interim results are not necessarily indicative of results for the full fiscal year.

2. Organization

     Avalon Pharmaceuticals, Inc. (“Avalon,” or the “Company”), was incorporated on November 10, 1999, under the laws of the state of Delaware. Avalon is a biopharmaceutical company using proprietary technology, AvalonRx ^® , to discover and develop novel therapeutics.

3. Recent Accounting Pronouncements

     In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 159, The Fair Value for Financial Assets and Financial Liabilities. This Statement permits entities to choose to measure financial assets and liabilities, with certain exceptions, at fair value at specified election dates. A business entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. This Statement is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The Company has not determined the impact, if any, SFAS No. 159 will have on its financial statements.

     On September 15, 2006 the FASB issued SFAS No. 157, Fair Value Measurements. The Statement provides guidance for using fair value to measure assets and liabilities. This Statement references fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity would transact such sale or transfer. The Statement applies whenever other standards require (or permit) assets or liabilities to be measured at fair value. The Statement does not expand the use of fair value in any new circumstances. It is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The adoption of SFAS No. 157 is not expected to have a material impact on the Company’s financial statements.

4. Summary of Significant Accounting Policies

Use of Estimates

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

Cash and Cash Equivalents

     The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Cash equivalents consist primarily of money market funds and commercial paper. The Company maintains cash balances with financial institutions in excess of insured limits. The Company does not anticipate any losses with such cash balances.

Marketable Securities

     Marketable securities consist primarily of U.S Treasury and agency debt securities with various maturities. Management classifies the Company’s marketable securities as available-for-sale. Such securities are stated at market value, with the unrealized gains and losses included as accumulated other comprehensive income (loss). Realized gains and losses and declines in value judged to be other-than-temporary on securities available for sale, if any, are included in operations. A decline in the market value of any available-for-sale security below cost that is deemed to be other-than-temporary results in a reduction in fair value. The impairment is charged to earnings, and a new cost basis for the security is established. Dividend and interest income are recognized when earned. The cost of securities sold is calculated using the specific identification method.

Revenue Recognition

     Revenues are recognized when there is persuasive evidence that an arrangement exists, delivery has occurred, the price is fixed and determinable, and collection is reasonably assured. Payments received in advance of work performed are recorded as deferred revenue and recognized ratably over the performance period. Milestone payments are recognized as revenue in an amount commensurate with the level of effort expended when the milestone is achieved, the contract partner acknowledges completion of the milestone, no further performance obligations exist as defined in the agreements, collection is reasonably assured and substantive effort was necessary to achieve the milestone. During the first nine months of 2007, the Company recognized revenue from work performed and expenses incurred on its collaboration agreement with Novartis, and recognized no revenue from its other collaboration agreements.

Research and Development Costs

     The Company expenses its research and development costs as incurred.

Restricted Cash and Investments

     In accordance with the terms of a financing arrangement with the Maryland Industrial Development Financing Authority (MIDFA) and Manufacturers and Traders Trust Company (M&T Bank), in order to finance the build out of the Company’s corporate headquarters and research facility located in Germantown, Maryland, the Company established an investment account which is pledged as collateral for a letter of credit. The issuer of the letter of credit, M&T Bank, maintains the investment account. M&T Bank’s security interest in the account cannot exceed the minimum required cash collateral amount, which as of September 30, 2007 was defined as an adjusted market value of $4.9 million. This collateral agreement defines adjusted market value as the product of the fair market value of each permitted investment by a defined percentage ranging from 60% to 100%, depending on the nature of the permitted investment. The minimum cash collateral amount automatically decreases each April 1, as specified in the collateral agreement.

Comprehensive Income

     SFAS No. 130, Reporting Comprehensive Income, requires the presentation of comprehensive income or loss and its components as part of the financial statements. For the nine months ended September 30, 2007 and 2006, the Company’s net loss plus its unrealized gains (losses) on available-for-sale securities reflects comprehensive income (loss).

Stock-Based Compensation

     The Company accounts for share-based payments in accordance with the provisions of FASB Statement No. 123(R), “Share-Based Payment,” using the modified-prospective-transition method.

     The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing fair value model. The following weighted-average assumptions were used for options granted during the three months ended September 30, 2007 and 2006, and a discussion of our methodology for developing each of the assumptions used in the valuation model follows:

Dividend Yield— The Company has never declared or paid dividends and has no plans to do so in the foreseeable future.

Expected Volatility— Volatility is a measure of the amount by which a financial variable such as a share price has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period. Due to the Company’s limited trading history, there had been inadequate data to calculate historical volatility of our stock. Prior to June 30, 2007, the Company used an average volatility of similar companies in the pharmaceutical industry. Beginning with the three months ended September 30, 2007 the Company uses an average of the volatility of its own stock and the average volatility of similar companies in the pharmaceutical industry.

Risk-Free Interest Rate— This is the U.S. Treasury rate for the week of each option grant during the quarter having a term that most closely resembles the term of the option.

Expected Life of the Option Term— This is the period of time that the options granted are expected to remain unexercised. Options granted during the quarter have a maximum term of ten years. The Company has adopted SAB 107’s simplified method for estimating the expected term of stock options.

Forfeiture Rate— This is the estimated number of stock options granted that are expected to be forfeited or cancelled on an annual basis before becoming fully vested. The Company estimates the forfeiture rate based on past turnover data.

      Stock Compensation Plans

     The Company adopted the Avalon Pharmaceuticals, Inc. 1999 Stock Incentive Plan (the “1999 Plan”) to provide for the granting of stock awards, such as stock options, restricted common stock, and stock appreciation rights to employees, directors and other individuals as determined by the Board of Directors. The Company terminated the 1999 Plan as to future awards effective upon the closing of the Company’s initial public offering in October 2005. As of September 30, 2007, the Company had reserved 451,117 shares of common stock to accommodate the exercise of outstanding options granted under the 1999 Plan.

     Effective upon the closing of the Company’s initial public offering in October 2005, the Company adopted the Avalon Pharmaceuticals, Inc. 2005 Omnibus Long-Term Incentive Plan (the “2005 Plan”) to provide for the granting of stock awards, such as stock options, restricted common stock, stock units, dividend equivalent rights, stock appreciation rights and unrestricted common stock, and other performance and annual incentive awards to employees, directors and other individuals as determined by the Board of Directors. At the inception of the 2005 Plan, 989,738 shares were reserved for issuance under the 2005 Plan. The number of shares available for issuance under the 2005 Plan was increased from 989,738 to 1,581,582 in June 2006 and to 2,381,582 in June 2007. Additionally, shares that become available due to forfeiture of outstanding awards under the 1999 Plan are available for awards under the 2005 Plan. As of September 30, 2007, the Company had reserved 2,375,543 shares of common stock to accommodate the exercise of outstanding option grants under the 2005 Plan and for future grants under the 2005 Plan.

     Generally, stock options are granted with an exercise price that equals the fair market value of the Company’s common stock on the grant date. Options typically have a life of ten years and vest over periods ranging from one to five years. Options generally expire 90 days after an employee terminates employment with the Company.

     Shares of common stock issued to non-employee directors as part of their annual director compensation for the three and nine month periods ended September 30, 2007 were 6,832 and 20,137, respectively. The fair market value of these shares, on the date of grant, was approximately $29,000 and $85,200, respectively.

     The total intrinsic value of stock options exercised during the three and nine month periods ended September 30, 2007 was approximately $29,600 and $59,105, respectively. The weighted-average grant-date fair value of equity awards granted during the three and nine month periods ended September 30, 2007 was $2.85 and $2.98, respectively. The total fair value of stock options which vested during the three and nine month periods ended September 30, 2007 was approximately $360,300 and $951,700, respectively. There were 1,438,242 fully vested stock options outstanding at September 30, 2007. These stock options had a weighted average remaining life of 7.17 years.

     Cash received from the exercise of stock options under all share-based payment arrangements for the three months ended September 30, 2007 was $44,000. Due to the valuation allowance on all deferred tax assets, the Company recorded no tax benefit for stock compensation expense recognized during the three months ended September, 2007. As of September 30, 2007, there was approximately $947,700 of total unrecognized compensation costs related to non-vested employee stock options. That cost is expected to be recognized over a weighted average period of 2.45 years.

Basic and Diluted Net Loss Attributable to Common Stockholders Per Common Share

     Basic net loss attributable to common stockholders per common share excludes dilution for potential common stock issuances and is computed by dividing net loss by the weighted-average number of common shares outstanding for the period. Diluted net loss per common share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. Stock options and warrants were not considered in the computation of diluted net loss per common share for the periods presented, as their effect is antidilutive.

5. Stockholders Equity

Preferred Stock

     In April 2007, the Company entered into a Rights Agreement (the “Rights Agreement”) between the Company and American Stock Transfer & Trust Company, as Rights Agent. In connection with the adoption of the Rights Agreement, the Board of Directors of the Company declared a dividend distribution of one right (“Right”) for each outstanding share of common stock, par value $0.01 per share of the Company, payable to stockholders of record on May 10, 2007. Each Right, when exercisable, entitles the registered holder to purchase from the Company one one-thousandth of one share of Series C Junior Participating Preferred Stock at a price of $60.00 per one one-thousandth share, subject to adjustment. The description and terms of the Rights are set forth in the Rights Agreement.

     Initially, the Rights will be attached to all certificates representing shares of common stock then outstanding, and no separate certificates evidencing the Rights will be distributed. The Rights will separate from the common stock and a distribution of Rights Certificates will occur upon the earlier to occur of (i) 10 days following a public announcement that a person or group of affiliated or associated persons has acquired beneficial ownership of 20% or more of the outstanding shares of common stock or (ii) 10 business days following the commencement of, or the first public announcement of the intention to commence, a tender offer or exchange offer the consummation of which would result in the beneficial ownership by a person of 20% or more of the outstanding shares of common stock. (the earlier of such dates being called the “Distribution Date”).

     Until the Distribution Date, (i) the Rights will be evidenced by the common stock certificates, and will be transferred with and only with the common stock certificates, (ii) new common stock certificates issued after May 10, 2007 upon transfer or new issuance of the common stock will contain a notation incorporating the Rights Agreement by reference, and (iii) the surrender for transfer of any certificates for common stock outstanding will also constitute the transfer of the Rights associated with the common stock represented by such certificate.

     The Rights are not exercisable until the Distribution Date and will expire at the close of business on May 10, 2017, unless such date is extended, the Rights Agreement is terminated, or the Rights are earlier redeemed or exchanged by the Company as described below. The Rights will not be exercisable by a holder in any jurisdiction where the requisite qualification to the issuance to such holder, or the exercise by such holder, of the Rights has not been obtained or is not obtainable.

     As soon as practicable following the Distribution Date, separate certificates evidencing the Rights will be mailed to holders of record of the common stock as of the close of business on the Distribution Date and, thereafter, the separate Rights Certificates alone will evidence the Rights. Except as otherwise determined by the Board of Directors of the Company, only shares of common stock issued prior to the Distribution Date will be issued with Rights.

     In the event that a person becomes the beneficial owner of 20% or more of the then outstanding shares of common stock, except pursuant to an offer for all outstanding shares of common stock which the Directors determine to be fair to and otherwise in the best interests of the Company and its stockholders, each holder of a Right will have the right to exercise the Right by purchasing, for an amount equal to the Purchase Price, common stock (or, in certain circumstances, cash, property or other securities of the Company) having a value equal to two times such amount. Notwithstanding any of the foregoing, following the occurrence of the events set forth in this paragraph, all Rights that are beneficially owned by any acquiring person will be null and void.

Common Stock

     In January 2007, the Company raised $10.0 million through a private placement of 3,000,000 shares of its common stock to seventeen accredited institutional investors. The proceeds from this financing are being used to fund the Company’s lead oncology drug, AVN944, and the continued development of additional pipeline programs using the Company’s proprietary technology AvalonRx ^® . Offering expenses of $499,000 were netted against gross proceeds and recorded to additional capital.

     In May 2007, the Company raised $20.0 million in gross proceeds through a private placement of 3,838,772 shares of its common stock to twenty accredited institutional investors. The investors also received warrants to purchase up to 959,693 shares of common stock at an exercise price of $6.00 per share. The warrants will expire in five years. The proceeds from this financing are being used to fund the Company’s lead oncology drug, AVN944, and the continued development of additional pipeline programs using the Company’s proprietary technology AvalonRx ^® . Offering expenses of $1.3M were netted against gross proceeds and recorded to additional capital.

6. Related Party Transactions

     The Company paid one member of the board of directors consulting fees totaling $79,200 for the nine months ended September 30,2007 and two members of the board of directors consulting fees totaling $92,100 for the nine months ended September 30, 2006.

7. Income Taxes

     For the nine month periods ended September 30, 2007, and 2006, there is no current provision for income taxes and the deferred tax benefit has been entirely offset by valuation allowances. The difference between the amounts of income tax benefit that would result from applying domestic federal statutory income tax rates to the net loss and the net deferred tax assets is related to certain nondeductible expenses, state income taxes, and the change in the valuation allowance.

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

      The following discussion and analysis of our results of operations, financial condition and liquidity and capital resources should be read in conjunction with our unaudited consolidated financial statements and related notes contained in this Quarterly Report on Form 10-Q , as well as the audited financial statements and related notes for the fiscal year ended December 31,2006 and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contained in our Annual Report on Form 10-K , for the fiscal year ended December 31, 2006.

Overview

     We are a biopharmaceutical company focused on the discovery, development and commercialization of first-in-class cancer therapeutics. Our lead product candidate, AVN944, an IMPDH inhibitor, is in Phase II clinical development. We have preclinical programs to develop inhibitors of the Beta-catenin and Aurora/Centrosome pathways, discovery programs for inhibitors of the Survivin and Myc pathways, and partnerships with Merck, MedImmune, ChemDiv, Medarex and Novartis. We use AvalonRx ^® , our proprietary platform which is based on large-scale biomarker identification and monitoring, to discover and develop therapeutics for pathways that have historically been characterized as “undruggable.”

     Since our inception, our operations have consisted primarily of developing AvalonRx ^® , utilizing our technology to seek to discover and develop novel cancer therapeutics, and the in-license and development of AVN944. During that period, we have generated limited revenue from collaborative partners, and have had no revenue from product sales. Our operations have been funded principally through the offering of equity securities and debt financings.

     We have never been profitable and, as of September 30, 2007, we had an accumulated deficit of $119.3 million. We had net losses of $16.6 million for the nine months ended September 30, 2007 and net losses of $17.1 million for the year ended December 31, 2006. We expect to incur significant and increasing operating losses for the foreseeable future as we advance our drug candidates from discovery through preclinical testing and clinical trials and seek regulatory approval and eventual commercialization. In addition to these increasing research and development expenses, we expect general and administrative costs to increase as we add personnel. We will need to generate significant revenues to achieve profitability, and we may never do so.

Financial Operations Overview

Revenue

     We have not generated any revenue from sales of commercial products and do not expect to generate any product revenue for the foreseeable future. To date, our revenue has consisted of collaboration revenue.

      Collaboration Revenue. Since inception, we have generated revenue solely in connection with our collaboration and pilot study agreements. Our collaborations with MedImmune and Novartis include upfront payments, research funding, and payments for the achievement of certain discovery and development related milestones. During the first nine months of 2007, we recognized revenue under our collaboration with Novartis and recognized no revenue from our other collaborations.

Research and Development Expense

     Research and development expense consists of expenses incurred in connection with developing and advancing our drug discovery technology and identifying and developing our drug candidates and supporting our collaborative relationships. These expenses consist primarily of salaries and related expenses, the purchase of laboratory supplies, access to data sources, facility costs, costs for preclinical development and expenses related to our in-license and clinical trials of AVN944. We charge all research and development expenses to operations as incurred.

     We expect our research and development costs to be substantial and to increase as we advance AVN944 through clinical trials and move other drug candidates into preclinical testing and clinical trials. Based on the results of our preclinical studies, we expect to selectively advance some drug candidates into clinical trials. We anticipate that we will select drug candidates and research projects for further development on an ongoing basis in response to their preclinical and clinical success and commercial potential. In January 2006, we initiated U.S. Phase I clinical trials of AVN944 in hematological cancers. In July 2007, we announced the initiation of a Phase II clinical trial in pancreatic cancer patients.

General and Administrative

     General and administrative expense consists primarily of salaries and related expenses for personnel in administrative, finance, business development and human resource functions. Other costs include legal costs of pursuing patent protection of our intellectual property and other fees for legal services.

Critical Accounting Policies and Significant Judgments and Estimates

Income Taxes

     In July 2006, the FASB issued FASB Interpretation Number 48, Accounting for Uncertainty in Income Taxes (“FIN48”). FIN No. 48 clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. In addition, FIN 48 scopes out income taxes from SFAS No. 5, Accounting for Contingencies . FIN 48 is effective for fiscal years beginning after December 15, 2006.

     We adopted the provisions of FASB Interpretation No. 48 Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109, on January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements if that position is more likely than not of being sustained by the taxing authority. The adoption of FIN 48 did not have an impact on our financial position or results of operations.

     We file income tax returns in the state of Maryland. With few exceptions, we are subject to U.S. federal, state and local income tax examinations by tax authorities for years after 1998. See our most recent Annual Report filed on Form 10-K for the year ended December 31, 2006 for a complete discussion of our critical accounting policies.

Stock-Based Compensation

     In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123, revised 2004, or SFAS 123(R), “ Share-Based Payment .” SFAS 123(R) supersedes Accounting Principles Board (“APB”) Opinion No. 25, “ Accounting for Stock Issued to Employees ”, and requires companies to recognize compensation expense, using a fair-value based method, for costs related to share-based payments, including those made pursuant to stock option and employee stock purchase plans.

     We adopted SFAS 123(R) on January 1, 2006 using the modified prospective transition method, which requires that stock-based compensation cost is recognized for all awards granted, modified or settled after the effective date as well as for all awards granted to employees prior to the effective date that remain unvested as of the effective date. Prior to the adoption, we disclosed such costs on a pro forma basis in the notes to our financial statements.

     For the nine months ended September 30, 2007, we recorded approximately $1.3 million of stock-based compensation expenses, of which $0.2 million was included in research and development expense and $1.1 million was included in general and administrative expense. Since we continue to operate in a net loss, the adoption of SFAS 123(R) had no impact for tax-related effects on cash flow from operations and cash flow from financing activities for the nine months ended September 30, 2007. As of September 30, 2007, unamortized stock-based compensation expenses of approximately $947,700 remains to be recognized over a weighted-average period of approximately 2.45 years. We amortize stock-based compensation expenses on a straight-line ratable basis over the vesting period.

     We estimated the fair value of stock options granted during the three months ended September 30, 2007 using the Black-Scholes option pricing model. The assumptions used under this model are as follows: (i) expected term of 6 years based on the simplified method for estimating the expected term of stock options; (ii) expected volatility of 70.5% based a combined average of the historical volatility of our common stock and an average historical volatility of similar companies in the pharmaceutical industry; (iii) weighted average risk-free interest rate of 5.00% based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected term of the option; and (iv) expected dividend yield of zero percent. In addition, under SFAS 123(R), the fair value of stock options granted is recognized as expense over the service period, net of estimated forfeitures. Based on historical data, we calculated a 4.20% annual forfeiture rate, which we believe is a reasonable assumption. However, the estimation of forfeitures 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.

     The Black-Scholes option pricing model requires the input of highly subjective assumptions. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models may not provide a reliable single measure of the fair value of our employee stock. In addition, management will continue to assess the assumptions and methodologies used to calculate estimated fair value of share-based compensation. Circumstances may change and additional data may become available over time, which result in changes to these assumptions and methodologies, and which could materially impact our fair value determination.

Results of Operations

Three Months Ended September 30, 2007 and 2006

      Revenue. No revenue was recognized during the three months ended September 30, 2007. Collaboration efforts during the quarter, related to our partnership agreements with Merck, Novartis and ChemDiv, may result in milestone or royalty payments in future periods.

      Research and Development. Research and development expenses increased by $109,000, or 3%, to $3.5 million for the three months ended September 30, 2007 from $3.4 million for the same period in 2006. The increase in research and development expenses was primarily attributable to increases in clinical trial costs related to our AVN944 drug candidate and salary expenses related to new hires.

     Research and development expenses consist of direct costs which include salaries and related costs of research and development personnel, and the costs of consultants, materials and supplies associated with research and development projects. Indirect research and development costs include facilities, depreciation, patents and other indirect overhead costs.

     During the remainder of 2007, and thereafter, research and development expenses may increase substantially as we continue development of our internal programs and clinical studies for our AVN944 drug program.

      General and Administrative. General and administrative expenses increased by $512,000 or 30%, to $2.2 million for the three months ended September 30, 2007, compared to $1.7 million for the three months ended September 30, 2006. This increase was primarily attributable to an increase in consulting costs and compensation expense related to stock options.

      Interest Income. Interest income increased by $145,000 or 44%, to $470,000 for the three months ended September 30, 2007, compared to $325,000 for the three months ended September 30, 2006. The increase in interest income is a result of higher average cash balances and higher average interest rates.

      Interest Expense. Interest expense decreased by $47,000 or 23%, to $155,000 for the three months ended September 30, 2007, compared to $202,000 for the three months ended September 30, 2006. The decrease in interest expense was primarily related to lower balances on our long term debt. This decrease was offset, in part, by higher average interest rates on our development bond financing.

      Other Income. Other income was $8,000 for the three months ended September 30, 2007, compared to $146,000 for the three months ended September 30, 2006. The decrease in other income was primarily related to the discontinuation of income from subletting part of our facility and the provision of shared services to subtenants during the first half of 2007.

Nine Months Ended September 30, 2007 and 2006

      Revenue. Total revenues for the nine months ended September 30, 2007 were $809,000, a decrease of $1.3 million from the same period in the prior year. All 2007 revenue was attributable to our collaboration agreement with Novartis and no revenue was recognized under our other collaboration agreements.

      Research and Development. Research and development expenses increased by $1.8 million, or 18%, to $11.7 million for the nine months ended September 30, 2007 from $9.9 million for the same period in 2006. The increase in research and development expenses was primarily attributable to increases in clinical trial costs related to our AVN944 drug candidate, increases in laboratory supplies expense, and an increase in salaries and benefits expense related to new hires.

      General and Administrative. General and administrative expenses increased by $734,000 or 12%, to $6.5 million for the nine months ended September 30, 2007, compared to $5.7 million for the nine months ended September 30, 2006. This increase is primarily attributable to an increase in consulting costs and an increase in compensation expense related to stock options.

      Interest Income. Interest income increased by $192,000 or 19%, to $1,187 for the nine months ended September 30, 2007, compared to $995,000 for the nine months ended September 30, 2006. The increase in interest income is a result of interest earned on higher average cash balances and higher average interest rates.

      Interest Expense. Interest expense decreased by $140,000 or 22%, to $486,000 for the nine months ended September 30, 2007, compared to $626,000 for the nine months ended September 30, 2006. The decrease in interest expense was primarily related to lower balances on our long term debt. This decrease was offset, in part, by higher average interest rates on our development bond financing.

      Other Income. Other income decreased by $384,000 or 78%, to $107,000 for the nine months ended September 30, 2007, compared to $491,000 for the nine months ended September 30, 2006. The decrease in other income was primarily related to the discontinuation of income from subletting part of our facility and the provision of shared services to subtenants during the first half of 2007.

Liquidity and Capital Resources

     Our primary cash requirements are to:

	•		fund our research and development and clinical programs;
	•		obtain regulatory approvals;
	•		prosecute, defend and enforce any patent claims and other intellectual property rights;
	•		fund general corporate overhead; and
	•		support our debt service requirements and contractual obligations.

     Our cash requirements could change materially as a result of the progress of our research and development and clinical programs, licensing activities, business development activities, acquisitions, divestitures or other corporate developments.

     We have incurred operating losses since our inception and historically have financed our operations principally through public stock offerings, debt financings, private placements of equity securities, strategic collaborative agreements that include research and development funding and development milestones, and investment income.

     In evaluating alternative sources of financing we consider, among other things, the dilutive impact, if any, on our stockholders, the ability to leverage stockholder returns through debt financing, the particular terms and conditions of each alternative financing arrangement and our ability to service our obligations under such financing arrangements.

     As of September 30, 2007, we had cash, cash equivalents and marketable securities of approximately $33.4 million. Of this amount, $4.9 million is currently held in a restricted account to serve as collateral for our long-term debt. Our funds are currently invested in investment grade and United States government securities.

Sources and Uses of Cash

      Operating Activities. Net cash used in operating activities for the nine months ended September 30, 2007 was $14.0 million, compared to $8.8 million for the same period in fiscal 2006. During the first nine months of fiscal year 2007, our net loss of $16.6 million was reduced by non-cash charges of $2.6 million, primarily for stock compensation and depreciation and amortization. During the first nine months of fiscal year 2006, our net loss of $12.7 million was reduced by non-cash charges of $3.9 million, primarily associated with stock compensation, depreciation and amortization, offset by changes in our net operating assets and liabilities.

      Investing Activities. Net cash used in investing activities for the nine months ended September 30, 2007 was $9.4 million, compared to $2.4 million for the same period in 2006. Cash used in investing activities represents the amount used to purchase property and equipment and marketable securities, net of proceeds from the sale and maturity of marketable securities.

      Financing Activities. Net cash provided by financing activities for the nine months ended September, 2007 was $26.8 million, compared to $5.1 million for the same period in 2006. During the first nine months of 2007, $28.4 million was raised from issuance of common stock. This amount was offset by $1.5 million in repayments on debt.

Credit Arrangements

     In April 2003, we entered into a series of agreements with the Maryland Industrial Development Financing Authority, or MIDFA, and Manufacturers and Traders Trust Company, or M&T Bank, in order to finance improvements to our corporate office and research facility located in Germantown, Maryland. MIDFA sold development bonds in the amount of $12.0 million. The proceeds of the bond sale were put in trust to reimburse us for the costs we incurred for improvements to our facility. We are required to repay the trust $1.2 million annually for these borrowings. The borrowing bears interest at a variable rate and matures on April 8, 2013. The weighted-average interest rate during the nine months ended September, 2007 and 2006 was 5.42% and 5.10%, respectively.

     In connection with the development bond financing, we entered into an agreement with M&T Bank to issue the trustee an irrevocable letter of credit to provide payment of the principal and interest of the bonds. The amount of the letter of credit changes annually, as principal payments are made. As of September 30, 2007, that amount is $7,318,356, consisting of $7.2 million of principal and $118,356 in interest, computed at 50 days at an assumed maximum rate of interest of 12% per annum. The letter of credit expires the earlier of April 8, 2008, or the date the bonds have been paid in full. In consideration of the letter of credit, we have granted M&T Bank a security interest in certain facility improvements, equipment and cash collateral held as restricted cash.

Operating Capital and Capital Expenditure Requirements

     Our future funding requirements will depend on many factors, including but not limited to:

	•		the size and complexity of our research and development programs;
	•		the scope and results of our preclinical testing and clinical trials;
	•		continued scientific progress in our research and development programs;
	•		the time and expense involved in seeking regulatory approvals;
	•		competing technological and market developments;
	•		acquisition, licensing and protection of intellectual property rights; and
	•		the cost of establishing manufacturing capabilities and conducting commercialization activities.

     Until we can generate a sufficient amount of product revenue to finance our cash requirements, which we may never do, we expect to finance future cash needs primarily through public or private equity offerings, debt financings or strategic collaborations. If we are successful in raising additional funds through the issuance of equity securities, investors likely will experience dilution, or the equity securities may have rights, preferences or privileges senior to those of the holders of our common stock. If we raise funds through the issuance of debt securities, those securities would have rights, preferences and privileges senior to those of our common stock. We do not know whether additional funding will be available on acceptable terms, or at all. If we are not able to secure additional funding when needed, we may have to delay, reduce the scope of, or eliminate one or more of our clinical trials or research and development programs. In addition, we may have to partner one or more of our drug candidate programs at an earlier stage of development, which would lower the economic value of those programs to our Company.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

     We are exposed to market risk from changes in interest rates. At September 30, 2007, we had $7.2 million of obligations which were subject to variable rates of interest under our development bond financing with MIDFA. If market interest rates increased 1% from the rate at September 30, 2007, our annual interest expense would increase approximately $72,000, assuming that obligations subject to variable interest rates remained constant.

     In addition, the value of our portfolio of cash equivalents and investments is subject to market risk from changes in interest rates.

     The primary objective of our investment activities is to preserve our capital for the purpose of funding operations while at the same time maximizing the income we receive from our investments without significantly increasing risk. To achieve these objectives, our investment policy allows us to maintain a portfolio of cash equivalents and investments in a variety of securities, including commercial paper, money market funds and corporate debt securities. As of September 30, 2007, we had cash and cash equivalents, short-term and long-term investments and restricted cash of $33.4 million as follows:

     We maintain an investment portfolio of investment grade government agency notes and corporate bonds. The securities in our investment portfolio are not leveraged, are classified as available-for-sale and are, due to their predominantly short-term nature, subject to minimal interest rate risk. We currently do not hedge interest rate exposure on our investment portfolio. As of September 30, 2007, securities totaling $19.8 million mature in the next 12 months and $2.1 million mature after September 30, 2008. While we do not believe that an increase in market rates of interest would have any significant negative impact on the realizable value of our investment portfolio, changes in interest rates affect the investment income we earn on our investments and, therefore, impact our cash flow and results of operations.

     We have operated in the United States and all revenues to date have been received in U.S. dollars. Accordingly, we have not had any material exposure to foreign currency rate fluctuations.

Item 4T. Controls and Procedures

      Disclosure Controls and Procedures: Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures, as of September 30, 2007 (the “Evaluation Date”). Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the Evaluation Date, our disclosure controls and procedures were effective.

      Changes in Internal Control over Financial Reporting: There have been no changes in our internal control over financial reporting during the quarter ended on the Evaluation Date that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

SIGNATURES

     Pursuant to the 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.

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