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, 2008.

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

AVALON PHARMACEUTICALS, INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware		52-2209310
(State or Other Jurisdiction of		(I.R.S. Employer Identification No.)
Incorporation or Organization)
20358 Seneca Meadows Parkway
Germantown, Maryland		20876
(Address of Principal Executive Offices)		(Zip Code)

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, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o		Accelerated filer o		Non-accelerated filer   o (Do not check if a smaller reporting company)		Smaller reporting company 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 November 12, 2008, 20,428,475 shares of Avalon Pharmaceuticals, Inc. common stock, par value $.01 per share, were outstanding.

 

 

AVALON PHARMACEUTICALS, INC.

		Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements			1
Balance Sheets as of September 30, 2008 (unaudited) and December 31, 2007			1
Statements of Operations for the three and nine months ended September 30, 2008 and 2007 (unaudited)			2
Statements of Cash Flows for the nine months ended September 30, 2008 and 2007 (unaudited)			3
Notes to Financial Statements (unaudited)			4
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			12
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
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1

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, 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

Item 1. Financial Statements

AVALON PHARMACEUTICALS, INC.

BALANCE SHEETS

(in thousands, except share amounts)

		September 30,				December 31,
		2008				2007
		(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	2,749			$	6,276
Short-term marketable securities			4,318				15,558
Accounts receivable			8				200
Interest receivable			57				190
Prepaid expenses			397				743
Deposits			—				102
Total current assets			7,529				23,069
Restricted cash and marketable securities			4,358				5,275
Property and equipment, net			6,309				7,325
Long-term marketable securities			—				1,416
Deferred financing costs, net			212				220
Total assets		$	18,408			$	37,305
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	1,583			$	1,063
Accrued expenses and other current liabilities			945				1,207
Deferred revenue and customer advances			884				1,204
Current portion of long-term debt			1,200				1,211
Total current liabilities			4,612				4,685
Deferred rent			416				446
Long-term debt, net of current portion			4,800				6,000
Stockholders’ equity:
Series C Junior Participating Preferred stock, $0.01 par value, 300,000 shares authorized, no shares issued and outstanding			—				—
Common stock, $0.01 par value; 60,000,000 shares authorized; 17,037,928 and 17,026,462 shares issued and outstanding at September 30, 2008 and December 31, 2007, respectively			170				170
Additional capital			150,587				150,331
Other comprehensive income			(14	)			50
Accumulated deficit			(142,163	)			(124,377	)
Total stockholders’ equity			8,580				26,174
Total liabilities and stockholders’ equity		$	18,408			$	37,305

See accompanying notes.

AVALON PHARMACEUTICALS, INC.

STATEMENTS OF OPERATIONS

(in thousands, except share and per share amounts)

(Unaudited)

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
Revenues		$	124			$	—			$	311			$	809
Costs and expenses:
Research and development			3,994				3,531				12,863				11,708
General and administrative			2,153				2,197				5,567				6,468
Total costs and expenses			6,147				5,728				18,430				18,176
Loss from operations			(6,023	)			(5,728	)			(18,119	)			(17,367	)
Other income (expense):
Interest income			98				470				559				1,187
Interest expense			(97	)			(155	)			(305	)			(486	)
Other			63				8				79				107
Total other income (expense), net			64				323				333				808
Net loss		$	(5,959	)		$	(5,405	)		$	(17,786	)		$	(16,559	)
Net loss per share — basic and diluted		$	(.35	)		$	(.32	)		$	(1.04	)		$	(1.13	)
Weighted average number of shares — basic and diluted			17,037,830				17,015,319				17,033,705				14,716,327

See accompanying notes.

AVALON PHARMACEUTICALS, INC.

STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

		Nine Months Ended
		September 30,
		2008				2007
Operating activities
Net loss		$	(17,786	)		$	(16,559	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation			1,261				1,552
Non-cash interest expense			159				163
Amortization of premium on investments			(153	)			(496	)
Stock based compensation			256				1,281
Changes in operating assets and liabilities:
Prepaid expenses			346				235
Accounts receivable and other assets			427				875
Accounts payable			520				(628	)
Accrued expenses and other current liabilities			(262	)			(30	)
Deferred revenue and customer advances			(319	)			(326	)
Deferred rent			(29	)			(17	)
Net cash used in operating activities			(15,580	)			(13,950	)
Investing activities
Proceeds from the sale and maturities of marketable securities			22,906				26,290
Purchases of marketable securities			(9,245	)			(35,239	)
Purchases of property and equipment			(245	)			(403	)
Net cash provided by (used in) investing activities			13,416				(9,352	)
Financing activities
Principal payments on debt			(1,211	)			(1,482	)
Proceeds from issuance of common stock			—				28,413
Deferred financing costs			(152	)			(147	)
Net cash provided by (used in) financing activities			(1,363	)			26,784
Net (decrease) increase in cash and cash equivalents			(3,527	)			3,482
Cash and cash equivalents at beginning of period			6,276				3,099
Cash and cash equivalents at end of period		$	2,749			$	6,581

See accompanying notes.

AVALON PHARMACEUTICALS, INC.

NOTES TO FINANCIAL STATEMENTS

SEPTEMBER 30, 2008

(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, 2007.

     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, 2008 and 2007 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. Liquidity Risks and Management’s Plans

     The accompanying financial statements have been prepared on a going-concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. Since inception, Avalon Pharmaceuticals, Inc. (the “Company” or “Avalon”) has incurred, and continues to incur, significant losses from operations. As described below in Note 3, the Company recently entered into an Agreement and Plan of Merger and Reorganization, dated October 27, 2008 (the “Merger Agreement”), with Clinical Data, Inc., a Delaware corporation (“Clinical Data”), and API Acquisition Sub II, LLC, a Delaware limited liability company and an indirect wholly-owned subsidiary of Clinical Data (“API”). The Merger Agreement provides that, upon the terms and subject to the conditions set forth in the Merger Agreement, API will be merged with and into Avalon, with Avalon continuing as the surviving corporation and a subsidiary of Clinical Data (the “Merger”). Management estimates that its existing capital resources will be sufficient to fund the Company’s current operations through the end of the first quarter of 2009, prior to which time the Merger with Clinical Data is expected to close.

     If the Merger does not close by the end of the first quarter of 2009, the Company’s ability to continue as a going concern would be dependent on management’s ability to raise additional capital sufficient to meet the Company’s obligations on a timely basis, and to ultimately attain profitability. In light of the proposed Merger, the Company’s management does not expect to seek to raise additional capital. Should the Merger not close or if the closing is delayed beyond the end of the first quarter of 2009, there is no assurance that the Company would be able to raise capital sufficient to enable the Company to continue its operations significantly beyond the end of the first quarter of 2009.

     In the event the Company were unable to successfully raise additional capital in such circumstances, the Company will not have sufficient cash flows and liquidity to finance its business operations as currently contemplated. Accordingly, in such circumstances the Company would be compelled to reduce general and administrative expenses and delay research and development projects and the purchase of scientific equipment and supplies until it were able to obtain sufficient financing.

     Failure to close the Merger or raise additional capital would significantly limit the Company’s ability to continue as a going concern. The balance sheets do not include any adjustments relating to recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue in existence.

3. Subsequent Events

     On October 27, 2008, the Company entered into the Merger Agreement with Clinical Data and API. The Merger Agreement provides that API will be merged with and into the Company, with the Company continuing as the surviving corporation and an indirect wholly-owned subsidiary of Clinical Data. As a condition to Clinical Data and Avalon entering into the Merger Agreement, on October 27, 2008, the parties entered into a number of other arrangements including a private placement of securities, a license agreement and a secured loan arrangement.

Merger Agreement

     Pursuant to the terms of the Merger Agreement, Clinical Data will acquire all of the outstanding shares of Avalon’s common stock for consideration consisting of Clinical Data common stock and certain contingent rights to acquire additional shares of Clinical Data common stock. Shares of Avalon common stock held by Clinical Data and its subsidiaries, will be cancelled without consideration at the closing (the “Closing”). Upon the closing of the Merger, each outstanding share of Avalon common stock shall be converted into a right to receive 0.0470 shares of Clinical Data common stock and a contingent value right (a “CVR”) to receive an additional fraction of a share of Clinical Data common stock upon the achievement of defined milestones.

     If the Merger Agreement is terminated under specified circumstances, Avalon may be required to pay Clinical Data a termination fee of $300,000 and reimburse Clinical Data up to $100,000 for its expenses associated with the Merger Agreement.

Rights Plan Amendment

     On October 27, 2008, the Company amended its Rights Agreement dated April 26, 2007 to render it inapplicable to the Merger, the transactions contemplated by the Merger Agreement, and the private placement described below.

Private Placement

     In connection with the execution of the Merger Agreement, Avalon entered into a Securities Purchase Agreement with Clinical Data for the sale of Company common stock and common stock purchase warrants in a private placement for a total purchase price of $237,338. Pursuant to the Securities Purchase Agreement, Clinical Data purchased a total of 3,390,547 shares of the Company’s common stock at a purchase price of $0.07 per share. In addition, the Company issued a common stock purchase warrant exercisable into 1,695,273 shares of common stock. The exercise price of the warrant is $0.86 per share, subject to adjustment for dilutive events. The warrant is not exercisable for six months after issuance and may not be exercised to the extent that the aggregate number of shares of Avalon’s common stock held by Clinical Data following exercise of the warrant (including shares of Avalon common stock otherwise held by Clinical Data) would exceed 19.9% of the outstanding stock of the Company unless the issuance of any additional shares is first approved by a vote of Avalon’s stockholders in accordance with the rules of the NASDAQ Stock Market.

          Avalon also entered into a Registration Rights Agreement with Clinical Data contemporaneously with entering into the Securities Purchase Agreement. Pursuant to the Registration Rights Agreement, Avalon agreed to register for resale the shares of common stock issued in the private placement and the shares of common stock issuable upon exercise of the warrant. The Registration Rights Agreement requires Avalon to file the registration statement by November 26, 2008 or Clinical Data shall be entitled to a liquidated damages payment in the amount of 1.5% of the total purchase price of the shares issued in the private placement for each month the registration statement remains unfiled after the deadline. In the event the registration statement is not declared effective by the SEC by the earlier of (i) 90 days after the termination of the Merger Agreement (or 120 days after termination in the event the registration statement is subject to review by the SEC) or (ii) within 5 days following notice from the SEC that the registration statement is no longer subject to review (the “Effectiveness Deadline”), Clinical Data shall be entitled to a liquidated damages payment in the amount of 1.5% of the total purchase price for each month (pro rated for any lesser period) after the Effectiveness Deadline during which such registration statement has not been declared effective by the SEC.

License Agreement

     In connection with the execution of the Merger Agreement, the Company entered into a license agreement with Clinical Data pursuant to which Avalon granted Clinical Data a royalty-free, fully-paid, worldwide, perpetual, irrevocable, sublicensable and exclusive license to AvalonRx ^® , Avalon’s proprietary drug-development platform, in exchange for a one time payment of $1,000,000. The license is subject to certain exceptions pursuant to which Avalon retained the right to utilize AvalonRx ^® to fulfill its obligations under its existing collaboration agreements and to continue development of AVN 944 and certain of its existing development programs.

Secured Loan

     In connection with the execution of the Merger Agreement, Avalon entered into a Note Purchase Agreement (the “Note Purchase Agreement”) with Clinical Data pursuant to which Clinical Data made a loan to Avalon evidenced by a term note (the “Term Note”) in the principal amount of $3,000,000 (the “Secured Loan”). The term note bears interest at a fixed rate of seven percent per annum and matures on March 31, 2009 unless accelerated pursuant to its terms. The Company has the right to prepay the term note, together with any accrued interest, at any time without penalty. The maturity of the term note accelerates if there is a default under the terms of the Note Purchase Agreement or related documents, including any default, breach or termination of the license agreement or of the Merger Agreement (other than a termination of the Merger Agreement as a result of a failure to obtain the approval by Avalon’s stockholders of the Merger). The Term Note is secured by collateral consisting of certain intellectual property rights of Avalon.

Loan Default

     On October 29, 2008, Avalon received notice from Manufacturers and Traders Trust Company (“M&T Bank”) regarding the occurrence of an event of default related to its letter of credit with M&T Bank upon the Company’s entry into the Merger Agreement and the Secured Loan. As a result of the default, M&T Bank declared all outstanding amounts under the letter of credit to be immediately due and payable. On October 30, 2008 the Company made a payment of $6,062,489 to M&T Bank which constituted all amounts due under the letter of credit. This payment was inclusive of $6,000,000 in principal, $34,508 of accrued interest, and $27,981 for related fees and expenses. As a result of this payment, Avalon has no continuing obligations under the letter of credit or its financing arrangement with the Maryland Industrial Development Financing Authority (“MIDFA”).

4. Restructuring

     On August 13, 2008 the Company restructured its operations to focus on the pre-clinical and clinical development of its Beta-catenin inhibitor program and on its existing collaborations, such as with Merck. The Company curtailed its other development programs and is evaluating the clinical data from its AVN944 development program to assess strategies for further development of AVN944. In connection with the restructuring of its operations, the Company reduced its workforce by approximately one third, or 19 employees. The Company recorded restructuring charges related to these actions of $928,000 in the third quarter of 2008. Details of the restructuring charge and amounts paid and accrued are set forth in the table below.

		Three Months
		Ended 9/30/08								As of 9/30/08
		Restructuring				Amount				Restructuring
		Charges				Paid				Accrual
Severance		$	830				($562	)		$	268
Benefits			55				(11	)			45
Taxes & Other			43				(21	)			22
		$	928				($594	)		$	334

5. Organization

     Avalon 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.

6. Recent Accounting Pronouncements

     In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 provides guidance for using fair value to measure assets and liabilities. It also responds to investors’ requests for expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value and the effect of fair value measurements on earnings. SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value, and does not expand the use of fair value in any new circumstances. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company has adopted the provisions of SFAS 157 as of January 1, 2008, for financial instruments. Although the adoption of SFAS 157 did not materially impact its financial condition, results of operations or cash flow, the Company is now required to provide additional disclosures as part of its financial statements. SFAS 157 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include:

	•		Level 1, defined as observable inputs such as quoted prices in active markets for identical assets;
	•		Level 2, defined as observable inputs other than level 1 prices such as quoted prices for similar assets; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities; and
	•		Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.

     The Company’s cash equivalents, short-term, long-term and restricted marketable securities are subject to fair value measurements. The inputs used in measuring the fair value of these instruments are considered to be level 2 in accordance with the SFAS 157 hierarchy.

     In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115 (“SFAS 159”). SFAS 159 expands the use of fair value accounting but does not affect existing standards that require assets or liabilities to be carried at fair value. Under SFAS 159, a company may elect to use fair value to measure accounts and loans receivable, available-for-sale and held-to-maturity securities, equity method investments, accounts payable, guarantees and issued debt. Other eligible items include firm commitments for financial instruments that otherwise would not be recognized at inception and non-cash warranty obligations where a warrantor is permitted to pay a third party to provide the warranty goods or services. If the use of fair value is elected, any upfront costs and fees related to the item must be recognized in earnings and cannot be deferred, such as debt issuance costs. The fair value election is irrevocable and generally made on an instrument-by-instrument basis, even if a company has similar instruments that it elects not to measure based on fair value. At the adoption date, unrealized gains and losses on existing items for which fair value has been elected are reported as a cumulative adjustment to beginning retained earnings. Subsequent to the adoption of SFAS 159, changes in fair value are recognized in earnings. SFAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The adoption of SFAS No. 159 did not have a material impact on our financial position or results of operations.

     In June 2007, the FASB ratified EITF 07-03, Accounting for Nonrefundable Advance Payments for Goods or Services Received for Use in Future Research and Development Activities (“EITF 07-03”). EITF 07-03 requires that nonrefundable advance payments for goods or services that will be used or rendered for future research and development activities be deferred and capitalized and recognized as an expense as the goods are delivered or the related services are performed. EITF 07-03 is effective, on a prospective basis, for financial statements issued for fiscal years beginning after December 15, 2007. The adoption of EITF 07-03 did not have a material impact on our financial statements.

7. 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, agency and corporate 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

     Revenue is recognized when there is persuasive evidence that an agreement 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 when milestones, as defined in the contract, are achieved. During the first nine months of 2008, the Company recognized revenue from work performed on its collaboration agreement with Novartis, and recognized no revenue from its other collaboration agreements.

Research and Development Costs

     Expenditures, other than advance payments for research and development, subject to the provisions of EITF 07-03, are expensed as incurred.

Restricted Cash and Investments

     In accordance with the terms of a financing arrangement with MIDFA and 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, 2008 was defined as an adjusted market value of $4.3 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. On October 30, 2008 the Company paid off the related debt and the restrictions on this collateral were removed. See Note 3 above.

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, 2008 and 2007, 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 .

     The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing fair value model and recognized as compensation expense over the vesting period of the award using the accelerated attribution method. The following weighted-average assumptions were used for options granted during the three months ended September 30, 2008 and 2007, and a discussion of our methodology for developing each of the assumptions used in the valuation model follows:

		Three Months				Three Months
		Ended				Ended
		September 30,				September 30,
		2008				2007
Dividend yield			0.00	%			0.00	%
Expected volatility			65.5	%			70.5	%
Risk-free interest rate			3.45	%			5.00	%
Expected life of the option term (in years)			7.0				6.0
Forfeiture rate			4.2	%			4.2	%

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. Since June 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 expected life of the option term.

Expected Life of the Option Term— This is the period of time that the options granted are expected to remain unexercised. The expected term is based upon management’s consideration of the historical life of options, the vesting period of the option granted and the contractual period of the option granted.

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, 2008, the Company had reserved 447,456 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 shares to 1,581,582 shares in June 2006 and from 1,581,582 shares to 2,381,582 shares 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, 2008, the Company had reserved 2,879,204 shares of common stock to accommodate the exercise of outstanding option grants under the 1999 Plan and 2005 Plan and for future grants under the 1999 Plan and 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 six months 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, 2008 were 4,487 and 11,466 shares, respectively. The fair market value of these shares, on the date of grant, was approximately $5,833 and $26,041, respectively.

     The weighted-average grant-date fair value of equity awards granted during the three and nine month periods ended September 30, 2008 was $.37 and $.69, respectively. The total fair value of stock options which vested during the three and nine month periods ended September 30, 2008 was approximately $151,000 and $757,000, respectively. There were 1,698,076 fully vested stock options outstanding at September 30, 2008. These stock options had a weighted average remaining life of 6.49 years.

										Weighted-
						Weighted-				Average				Aggregate
						Average				Remaining				Intrinsic
						Exercise				Contractual				Value
		Shares				Price				Term				(in thousands)
Outstanding at June 30, 2008			2,120,483			$	4.02
Granted			401,900				.80
Exercised			—				—
Forfeited or expired			58,212				3.07
Outstanding at September 30, 2008			2,464,171				3.52
Vested and expected to vest at September 30, 2008			2,360,676			$	4.16				6.49			$	—
Exercisable at September 30, 2008			1,698,076			$	4.16				6.49			$	—

     No stock options were exercised during the nine months ended September 30, 2008. 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 30, 2008. As of September 30, 2008, unamortized stock-based compensation expenses of approximately $521,000 remains to be recognized over a weighted average period of 2.3 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.

8. Debt

     In February 2008, the Company entered into an amendment to the letter of credit with M&T Bank supporting the Company’s financing with MIDFA to extend the expiry of the letter of credit agreement to April 8, 2013. In addition, the amendment removed the Company’s financial covenant obligations under the letter of credit regarding the maintenance of (i) a minimum ratio of current assets to current liabilities and (ii) a minimum tangible net worth. On October 30, 2008 the Company paid off all amounts owed under the letter of credit and retired the letter of credit. As a result of this payment, Avalon has no continuing obligations under the letter of credit or its financing arrangement with MIDFA. See Note 3 above.

9. 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.

          In connection with the Company’s proposed merger with Clinical Data, the Company and American Stock Transfer & Trust Company entered into Amendment No. 1 to the Rights Agreement for the purpose of amending the Rights Agreement to render it inapplicable to the Merger, the transactions contemplated by the Merger Agreement, and the private placement described in Note 3.

10. Related Party Transactions

     The Company paid one member of the board of directors consulting fees totaling $41,000 for the nine months ended September 30, 2008.

11. Income Taxes

     For the nine month periods ended September 30, 2008, and 2007, 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, 2007 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, 2007.

Overview

     We are a biopharmaceutical company focused on the discovery, development and commercialization of first-in-class cancer therapeutics. 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, 2008, we had an accumulated deficit of $142.0 million. We had net losses of $17.8 million for the nine months ended September 30, 2008 and net losses of $21.7 million for the year ended December 31, 2007. We expect to incur significant 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. We will need to generate significant revenues to achieve profitability, and we may never do so.

     As of September 30, 2008, we had cash, cash equivalents and marketable securities of approximately $11.4 million. Of this amount, $4.4 million was held in a restricted account to serve as collateral for our long-term debt.

     We currently estimate that our existing capital resources will be sufficient to fund our current operations through the end of the first quarter of 2009, by which time our pending merger with a subsidiary of Clinical Data is expected to close. If our proposed merger does not close by the end of the first quarter of 2009, we would need to raise additional funds to continue operations and to repay our secured loan from Clinical Data. See “—Recent Developments” below. In light of the proposed merger, we do not expect to seek to raise additional capital. Should the merger not close or if the closing is delayed beyond the end of the first quarter of 2009, there is no assurance that we would be able to raise capital sufficient to enable us to continue our operations significantly beyond the end of the first quarter of 2009. In the event we were unable to successfully raise additional capital in such circumstances, we will not have sufficient cash flows and liquidity to finance our business operations as currently contemplated. Accordingly, in such circumstances we would be compelled to reduce general and administrative expenses and delay research and development projects and the purchase of scientific equipment and supplies until we were able to obtain sufficient financing.

Recent Developments

     On October 27, 2008, we entered into a merger agreement with Clinical Data, Inc., or Clinical Data, and API Acquisition Sub II, LLC, an indirect wholly-owned subsidiary of Clinical Data, or API. The merger agreement provides that, upon the terms and subject to the conditions set forth in the merger agreement, API will be merged with and into Avalon, with Avalon continuing as the surviving corporation and a subsidiary of Clinical Data. In connection with entering into the merger agreement with Clinical Data, we borrowed $3 million from Clinical Data under a secured loan to fund our short term on-going operations, entered into a license agreement with Clinical Data under which Clinical Data received an exclusive license (subject to certain exceptions) to AvalonRx ^® in exchange for a one time license fee of $1 million, and engaged in a private placement with Clinical Data of our common stock and warrants for a cash payment of $237,338 from Clinical Data. As a result of entering into the merger agreement and receiving the $3 million secured loan from Clinical Data, we were notified by Manufacturers and Traders Trust Company (M&T Bank) on October 29, 2008, that we were in default under the terms of its letter of credit to the Maryland Industrial Development Financing Authority (MIDFA). On October 30, 2008 we paid off all amounts due M&T Bank under the letter of credit and as a result, we have no further obligations under the letter of credit or our financing arrangement with MIDFA. See Note 3 to our unaudited financial statements set forth above in this Form 10-Q for a more detailed description of the merger agreement and the related transactions entered into by us with Clinical Data.

     On August 13, 2008 we restructured our operations to focus on the pre-clinical and clinical development of our Beta-catenin inhibitor program and on our existing collaborations, such as with Merck. We curtailed our other development programs and are evaluating the clinical data from our AVN944 development program to assess strategies for further development of AVN944. In connection with the restructuring of our operations, we reduced our workforce by approximately one third, or 19 employees. We recorded restructuring charges related to these actions of $928,000 in the third quarter of 2008.

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 Merck, AstraZeneca and Novartis include upfront payments, research funding, and/or payments for the achievement of certain discovery and development related milestones. During the first nine months of 2008, we recognized revenue from work performed 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. Other than for advance payments for research and development costs, subject to the provisions of EITF 07-03, we charge all research and development expenses to operations as incurred.

     We expect our research and development costs to be substantial as we advance our 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. We are currently conducting Phase I clinical trials for AVN944 in patients with hematological cancer and Phase IIa clinical trials for patients with pancreatic cancer. In August 2008, we announced that we had reached a likely maximum tolerated dose of AVN944 in both the ongoing Phase I clinical trial and in the Phase IIa trial. Management is currently assessing strategies for further development of AVN944.

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

Stock-Based Compensation

     We account for share-based payments in accordance with the provisions of FASB Statement No. 123(R), Share-Based Payment . For the nine months ended September 30, 2008, we recorded approximately $230,000 of stock-based compensation expenses, of which $87,000 was included in research and development expense and $143,000 was included in general and administrative expense. Since we continue to operate in a net loss, stock-based compensation expense 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, 2008. As of September 30, 2008, unamortized stock-based compensation expenses of approximately $521,000 remains to be recognized over a weighted-average period of approximately 2.3 years. We amortize stock-based compensation expenses on an accelerated basis over the vesting period.

     We estimated the fair value of stock options granted during the three months ended September 30, 2008 using the Black-Scholes option pricing model. The assumptions used under this model are as follows: (i) expected term of 7 years based upon management’s consideration of the historical life of options, the vesting period of the option granted and the contractual period of the option granted; (ii) expected volatility of 65.5% based on historical and peer volatility data; (iii) weighted average risk-free interest rate of 3.45% 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, 2008 and 2007

      Revenue. Total revenues for the three months ended September 30, 2008 were $124,000, compared with no revenues in the same period of the prior year. The reported revenues were attributable to our collaboration agreement with Novartis.

      Research and Development. Research and development expenses increased by $463,000, or 13%, to $4.0 million for the three months ended September 30, 2008 from $3.5 million for the same period in 2007. The increase in research and development expenses was primarily attributable to increases in clinical trial and product costs related to our AVN944 drug candidate and our pre-clinical drug candidate AVN316.

     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.

      General and Administrative. General and administrative expenses decreased by $44,000 or 2% when comparing the three months ended September 30, 2008 with the three months ended September 30, 2007. Lower stock compensation expense as well as lower costs for personnel and consultants were largely offset by a $928,000 restructuring charge. The restructuring charge included severance and related costs for the 19 employees who left Avalon when we restructured our operations in August of 2008.

      Interest Income. Interest income decreased by $372,000 or 79%, to $98,000 for the three months ended September 30, 2008, compared to $470,000 for the three months ended September 30, 2007. The decrease in interest income is due to lower balances of cash and investments and lower average interest rates.

      Interest Expense. Interest expense decreased by $58,000, or 37%, to $97,000 for the three months ended September 30, 2008, compared to $155,000 for the three months ended September 30, 2007. The decrease in interest expense was related to lower debt balances and lower average interest rates on debt.

      Other Income. Other income was $63,000 for the three months ended September 30, 2008, compared to $8,000 for the three months ended September 30, 2007. The increase in other income was primarily related to income from subletting part of our facility and the provision of shared services to subtenants.

Nine Months Ended September 30, 2008 and 2007

      Revenue. Total revenues for the nine months ended September 30, 2008 were $311,000, a decrease of $498,000 from the same period in the prior year. All 2007 and 2008 revenues were attributable to our collaboration agreement with Novartis.

      Research and Development. Research and development expenses increased by $1.2 million, or 10%, to $12.9 million for the nine months ended September 30, 2008 from $11.7 million for the same period in 2007. The increase in research and development expenses was primarily attributable to increases in clinical trial and product costs related to our AVN944 drug candidate and our pre-clinical drug candidate AVN316.

      General and Administrative. General and administrative expenses decreased by $901,000 or 14%, to $5.6 million for the nine months ended September 30, 2008, compared to $6.5 million for the nine months ended September 30, 2007. Lower costs for stock compensation, personnel and consultants were partially offset by a restructuring charge of $928,000 recorded in the third quarter of 2008.

      Interest Income. Interest income decreased by $628,000 or 53%, to $559,000 for the nine months ended September 30, 2008, compared to $1.2 million for the nine months ended September 30, 2007. The decrease in interest income is primarily due to lower balances of cash and investments and lower average interest rates.

      Interest Expense. Interest expense decreased by $181,000, or 37%, to $305,000 for the nine months ended September 30, 2008, compared to $486,000 for the nine months ended September 30, 2007. The decrease in interest expense was primarily related to lower debt balances and lower average interest rates on debt.

      Other Income. Other income was $79,000 for the nine months ended September 30, 2008, compared to $107,000 for the nine months ended September 30, 2007. The decrease in other income was primarily related to lower income from subletting part of our facility and the provision of shared services to subtenants in the 2008 period.

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, 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, 2008, we had cash, cash equivalents and marketable securities of approximately $11.4 million. Of this amount, $4.4 million was held in a restricted account to serve as collateral for our long-term debt. In connection with entering into the merger agreement with Clinical Data, on October 27, 2008, we borrowed $3 million from Clinical Data under a secured loan to fund our short term on-going operations, entered into a license agreement with Clinical Data under which Clinical Data received an exclusive license (subject to certain exceptions) to AvalonRx ^® in exchange for a one time license fee of $1 million, and engaged in a private placement with Clinical Data of our common stock and warrants for a cash payment of $237,338 from Clinical Data. As a result of entering into the merger agreement and receiving the $3 million secured loan from Clinical Data, we were required under the terms of our letter of credit from M&T Bank to pay off all amounts due under the letter of credit. On October 30, 2008 we paid off all amounts due M&T Bank under the letter of credit and as a result, we have no further obligations under the letter of credit or our financing arrangement with MIDFA.

     As a result of our borrowing $3 million from Clinical Data and the receipt of other payments from Clinical Data in connection with the private placement and exclusive license grant of AvalonRx ^® to Clinical Data described above, we currently estimate that our existing capital resources will be sufficient to fund our current operations through the end of the first quarter of 2009, by which time our pending merger with a subsidiary of Clinical Data is expected to close. If our proposed merger does not close by the end of the first quarter of 2009, we would need to raise additional funds to continue operations and to repay our secured loan from Clinical Data. In light of the proposed merger, we do not expect to seek to raise additional capital. Should the merger not close or if the closing is delayed beyond the end of the first quarter of 2009, there is no assurance that we would be able to raise capital sufficient to enable us to continue our operations significantly beyond the end of the first quarter of 2009. In the event we were unable to successfully raise additional capital in such circumstances, we will not have sufficient cash flows and liquidity to finance our business operations as currently contemplated. Accordingly, in such circumstances we would be compelled to reduce general and administrative expenses and delay research and development projects and the purchase of scientific equipment and supplies until we were able to obtain sufficient financing.

Sources and Uses of Cash

      Operating Activities. Net cash used in operating activities for the nine months ended September 30, 2008 was $15.6 million, compared to $14.0 million for the same period in fiscal 2007. During the first nine months of fiscal year 2008, our net loss of $17.8 million was reduced by non-cash charges of $1.5 million, primarily for stock compensation, depreciation and amortization, while changes in our net operating assets and liabilities provided and additional $0.6 million in cash.

      Investing Activities. Net cash provided by investing activities for the nine months ended September 30, 2008 was $13.4 million, compared to net cash used in investing activities of $9.4 million for the same period in 2007. Proceeds from the sale and maturity of marketable securities were the primary source of cash from investing activities, providing $22.9 million in the first nine months of 2008 and $26.3 million in the comparable period of 2007. Cash used in investing activities principally represents the amount used to purchase marketable securities, net of proceeds from the sale and maturity of marketable securities.

      Financing Activities. Net cash used by financing activities for the nine months ended September 30, 2008 was $1.4 million, compared to $26.8 million of net cash provided by financing activities for the same period in 2007. Aggregate proceeds of $28.4 million from the issuance of common stock in two private placements was the principal source of net cash provided by financing activities during the first nine months of 2007.

Credit Arrangements

     In April 2003, we entered into a series of agreements with MIDFA and 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, on the first day of April, 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 30, 2008 and 2007 was 3.02% and 5.42% 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, 2008, that amount is $6,098,630, consisting of $6.0 million of principal and $98,630 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, 2013, 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.

     On October 30, 2008 we paid off all amounts due M&T Bank under the letter of credit and as a result, we have no further obligations under the letter of credit or our financing arrangement with MIDFA. See “Recent Developments” above.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

     Not applicable pursuant to the rules of the Securities and Exchange Commission relating to the disclosure requirements for a “smaller reporting company.”

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, 2008 (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

Item 6. Exhibits

Exhibit No.		Description
31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1		Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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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