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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
     
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 000-51329
 
XenoPort, Inc.
(Exact name of registrant as specified in its charter)
 
     
Delaware   94-3330837
     
(State or other jurisdiction of   (IRS Employer
incorporation or organization)   Identification No.)
3410 Central Expressway, Santa Clara, California 95051
 
(Address of principal executive offices)      (Zip Code)
(408) 616-7200
(Registrant’s telephone number, including area code)
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. þ Yes     o No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
             
Large accelerated filer þ   Accelerated filer o   Non-accelerated filer o   Smaller reporting company o
        (Do not check if a smaller reporting company)    
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes      þ No
Total number of shares of common stock outstanding as of October 15, 2008: 25,261,653.
 
 

 


 

XENOPORT, INC.
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XenoPort and Transported Prodrug are trademarks of XenoPort, Inc.
Solzira, Requip and Requip XL are trademarks of GlaxoSmithKline.
       
 EX-31.1
 EX-31.2
 EX-32.1

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PART I. FINANCIAL INFORMATION
Item 1. Unaudited Financial Statements
XENOPORT, INC.
BALANCE SHEETS
(Unaudited)
                 
    September 30,     December 31,  
    2008     2007  
    (In thousands)  
Current assets:
               
Cash and cash equivalents
  $ 21,730     $ 17,961  
Short-term investments
    103,359       142,180  
Accounts receivable
    1,972       1,392  
Prepaids and other current assets
    5,023       2,682  
 
           
Total current assets
    132,084       164,215  
Property and equipment, net
    11,123       6,791  
Restricted investments
    1,812       1,771  
Other assets
    100       100  
 
           
Total assets
  $ 145,119     $ 172,877  
 
           
Current liabilities:
               
Accounts payable
  $ 5,028     $ 1,647  
Accrued compensation
    4,510       3,923  
Accrued preclinical and clinical costs
    6,245       8,726  
Other accrued liabilities
    2,168       2,809  
Deferred revenue
    11,154       8,117  
Current portion of equipment financing obligations
    19       176  
Current portion of liability for early exercise of employee stock options
    41       132  
 
           
Total current liabilities
    29,165       25,530  
Deferred revenue
    19,911       20,328  
Deferred rent and other
    999       1,455  
Noncurrent portion of equipment financing obligations
          5  
Noncurrent portion of liability for early exercise of employee stock options
          22  
Commitments and contingencies Stockholders’ equity:
               
Common stock, $0.001 par value; 60,000 shares authorized; 25,251 and 24,989 shares issued and outstanding at September 30, 2008 and December 31, 2007, respectively
    25       25  
Additional paid-in capital
    314,830       301,084  
Accumulated other comprehensive income
    66       491  
Accumulated deficit
    (219,877 )     (176,063 )
 
           
Total stockholders’ equity
    95,044       125,537  
 
           
Total liabilities and stockholders’ equity
  $ 145,119     $ 172,877  
 
           
The accompanying notes are an integral part of these interim financial statements.

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XENOPORT, INC.
STATEMENTS OF OPERATIONS
(Unaudited)
                                 
    Three Months     Nine Months  
    Ended September 30,     Ended September 30,  
    2008     2007     2008     2007  
    (In thousands, except per share amounts)  
Revenues:
                               
Collaboration revenue
  $ 4,863     $ 35,425     $ 31,381     $ 88,061  
 
                       
Total revenues
    4,863       35,425       31,381       88,061  
 
                       
Operating expenses:
                               
Research and development
    23,709       16,788       60,869       54,514  
General and administrative
    6,537       4,459       18,485       13,053  
 
                       
Total operating expenses
    30,246       21,247       79,354       67,567  
 
                       
Income (loss) from operations
    (25,383 )     14,178       (47,973 )     20,494  
Interest income
    909       2,208       3,934       6,141  
Interest and other expense
    (29 )     (44 )     (165 )     (145 )
 
                       
Income (loss) before income taxes
    (24,503 )     16,342       (44,204 )     26,490  
Income tax provision (benefit)
    (390 )     748       (390 )     748  
 
                       
Net income (loss)
  $ (24,113 )   $ 15,594     $ (43,814 )   $ 25,742  
 
                       
Basic net income (loss) per share
  $ (0.96 )   $ 0.63     $ (1.74 )   $ 1.04  
 
                       
Diluted net income (loss) per share
  $ (0.96 )   $ 0.60     $ (1.74 )   $ 1.00  
 
                       
Shares used to compute basic net income (loss) per share
    25,215       24,856       25,135       24,720  
 
                       
Shares used to compute diluted net income (loss) per share
    25,215       26,156       25,135       25,818  
 
                       
The accompanying notes are an integral part of these interim financial statements.

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XENOPORT, INC.
STATEMENTS OF CASH FLOWS
(Unaudited)
                 
    Nine Months  
    Ended September 30,  
    2008     2007  
    (In thousands)  
Operating activities
               
Net income (loss)
  $ (43,814 )   $ 25,742  
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
               
Depreciation and amortization
    1,944       1,396  
Accretion of investment discounts, net
    (1,284 )     (4,585 )
Stock-based compensation expense
    10,433       6,528  
Change in assets and liabilities:
               
Accounts receivable
    (580 )     (1,990 )
Prepaids and other current and noncurrent assets
    (2,341 )     (719 )
Accounts payable
    3,381       (113 )
Accrued compensation
    587       311  
Accrued preclinical and clinical costs
    (2,481 )     (2,559 )
Other accrued liabilities
    (641 )     219  
Deferred revenue
    2,620       12,939  
Deferred rent and other
    (456 )     (172 )
 
           
Net cash provided by (used in) operating activities
    (32,632 )     36,997  
 
           
Investing activities
               
Purchases of investments
    (165,485 )     (215,950 )
Proceeds from sales of investments
    79,719        
Proceeds from maturities of investments
    125,446       189,178  
Change in restricted investments
    (41 )     (58 )
Purchases of property and equipment
    (6,276 )     (3,443 )
 
           
Net cash provided by (used in) investing activities
    33,363       (30,273 )
 
           
Financing activities
               
Proceeds from issuance of common stock and warrants
    3,206       2,783  
Repurchases of common stock
    (6 )     (32 )
Proceeds from repayment of promissory notes from a stockholder
          33  
Payments on equipment financing obligations
    (162 )     (425 )
 
           
Net cash provided by (used in) financing activities
    3,038       2,359  
 
           
Net increase (decrease) in cash and cash equivalents
    3,769       9,083  
Cash and cash equivalents at beginning of period
    17,961       14,857  
 
           
Cash and cash equivalents at end of period
  $ 21,730     $ 23,940  
 
           
 
Supplemental schedule of noncash investing and financing activities
               
 
Vesting of common stock from early exercises of stock options
  $ 113     $ 240  
 
           
The accompanying notes are an integral part of these interim financial statements.

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XENOPORT, INC.
NOTES TO FINANCIAL STATEMENTS
(Unaudited)
1. Organization and Summary of Significant Accounting Policies
     Nature of Operations
     XenoPort, Inc., or the Company, was incorporated in the state of Delaware on May 19, 1999. The Company is a biopharmaceutical company focused on developing a portfolio of internally discovered product candidates that utilize the body’s natural nutrient transporter mechanisms to improve the therapeutic benefits of drugs. The Company’s development efforts are currently focused on potential treatments of central nervous system disorders. Its facilities are located in Santa Clara, California.
     Basis of Preparation
     The accompanying financial statements as of September 30, 2008 and for the three and nine months ended September 30, 2008 and 2007 are unaudited. These unaudited financial statements have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly the Company’s financial position as of September 30, 2008 and results of operations for the three and nine months ended September 30, 2008 and 2007, and cash flows for the nine months ended September 30, 2008 and 2007. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from these estimates. The results of operations for the three and nine months ended September 30, 2008 are not necessarily indicative of the results to be expected for the year ending December 31, 2008 or for any other interim period or any other future year. For more complete financial information, these financial statements, and the notes hereto, should be read in conjunction with the audited financial statements for the year ended December 31, 2007 included in the Company’s annual report on Form 10-K, filed with the Securities and Exchange Commission, or SEC, on February 22, 2008.
     Revenue Recognition
     Revenue arrangements are accounted for in accordance with the provisions of SEC Staff Accounting Bulletin, or SAB, No. 104, Revenue Recognition, and Emerging Issues Task Force, or EITF, No. 00-21, Revenue Arrangements with Multiple Deliverables. A variety of factors are considered in determining the appropriate method of revenue recognition under these arrangements, such as whether the various elements can be considered separate units of accounting, whether there is objective and reliable evidence of fair value for these elements and whether there is a separate earnings process associated with a particular element of an agreement. Specifically, the Company accounts for each of these typical elements as follows:
    Up-front, licensing-type fees. Up-front, licensing-type payments are assessed to determine whether or not the licensee is able to obtain any stand-alone value from the license. Where this is not the case, the Company does not consider the license deliverable to be a separate unit of accounting, and the revenue is deferred with revenue recognition for the license fee being assessed in conjunction with the other deliverables that constitute the combined unit of accounting.
 
    Milestones. Milestones are assessed on an individual basis, and revenue is recognized from these milestones when earned, as evidenced by acknowledgment from collaborators, provided that (i) the milestone event is substantive and its achievability was not reasonably assured at the inception of the agreement, (ii) the milestone represents the culmination, or progress towards the culmination, of an earnings process and (iii) the milestone payment is non-refundable. Where separate milestones do not meet these criteria, the Company typically defaults to a performance-based model, with revenue recognition following delivery of effort as compared to an estimate of total expected effort. Milestones that are received after all substantive deliverables have occurred are considered to be bonus payments and are recognized upon receipt of the cash, assuming all of the other revenue recognition criteria are met.
 
    Collaborative research payments. Generally, the payments received are based on a contractual cost per full-time equivalent employee working on the project and are recognized as the services are performed over the related funding periods for each agreement.

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     Where there are multiple deliverables combined as a single unit of accounting, revenues are deferred and recognized over the longest period over which the Company remains obligated to perform services or deliver product. The specific methodology for the recognition of the revenue (e.g., straight-line or according to specific performance criteria) is determined on a case-by-case basis according to the facts and circumstances applicable to a given contract. For contracts with specific performance criteria, the Company utilizes the performance-based expected revenue method of revenue recognition, which requires that the Company estimate the total amount of costs to be expended for a given unit of accounting and then recognize revenue equal to the portion of costs expended to date. The estimated total costs to be expended are necessarily subject to revision from time-to-time as the underlying facts and circumstances change.
     Payments received in excess of revenues recognized are recorded as deferred revenue until such time as the revenue recognition criteria have been met.
     The Company’s collaboration agreements also include potential payments for commercial product supply, product royalties and sharing of operating profits. To date, no revenues have been received from these sources.
     Clinical Trials
     The Company accrues and expenses the costs for clinical trial activities performed by third parties based upon estimates of the percentage of work completed over the life of the individual study in accordance with agreements established with contract research organizations and clinical trial sites. The Company determines the estimates through discussions with internal clinical personnel and external service providers as to progress or stage of completion of trials or services and the agreed upon fee to be paid for such services. Costs of setting up clinical trial sites for participation in the trials are expensed immediately as research and development expenses. Clinical trial site costs related to patient enrollment are accrued as patients are entered into the trial and reduced by any initial payment made to the clinical trial site when the first patient is enrolled. Nonrefundable advance payments for research and development goods or services are recognized as expense as the related goods are delivered or the related services are provided in accordance with the provisions of EITF No. 07-03, Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities, or EITF 07-03. The Company adopted EITF 07-03 effective January 1, 2008, and there was no material impact on the Company’s financial position or results of operations upon adoption.
     Fair Value Measurements
     Effective January 1, 2008, the Company adopted the provisions of Statement of Financial Accounting Standards, or SFAS, No. 157, Fair Value Measurements, or SFAS 157. SFAS 157 defines fair value and provides guidance for using fair value to measure assets and liabilities. SFAS 157 applies whenever other standards require or permit assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. SFAS 157 also requires expanded disclosure of the effect on earnings for items measured using unobservable data, establishes a fair value hierarchy that prioritizes the inputs used to measure fair value and requires separate disclosure by level within the fair value hierarchy. There was no material impact on the Company’s financial position or results of operations upon adoption of SFAS 157.
     As defined in SFAS 157, fair value is the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the measurement date. The Company utilizes market data or assumptions that the Company believes market participants would use in pricing assets or liabilities, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated or generally unobservable. The Company applies the market approach valuation technique for fair value measurements on a recurring basis and maximizes the use of observable inputs and minimizes the use of unobservable inputs.
     Income Taxes
     Income tax expense (benefit) is accounted for in accordance with SFAS No. 109, Accounting for Income Taxes, or SFAS 109. Income tax expense has been provided using the liability method. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities as measured by the enacted tax rates that will be in effect when these differences reverse. The Company provides a valuation allowance against net deferred tax assets if, based upon the available evidence, it is more-likely-than-not that the deferred tax assets will not be realized.

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     Effective January 1, 2007, the Company adopted the provisions of Financial Accounting Standards Board, or FASB, Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109, or FIN 48. FIN 48 specifies how tax benefits for uncertain tax positions are to be recognized, measured and derecognized in financial statements; requires certain disclosures of uncertain tax matters; specifies how reserves for uncertain tax positions should be classified on the balance sheet; and provides transition and interim-period guidance, among other provisions.
     At the date of adoption of FIN 48, the Company had no unrecognized tax benefits and expected no significant changes in unrecognized tax benefits in the next 12 months.
     The Company’s policy is to recognize interest and penalties related to the underpayment of income taxes as a component of income tax expense. To date, there have been no interest or penalties charged to the Company in relation to the underpayment of income taxes.
     Recent Accounting Pronouncements
     In December 2007, the EITF reached a consensus on EITF No. 07-01, Accounting for Collaborative Arrangements Related to the Development and Commercialization of Intellectual Property, or EITF 07-01. EITF 07-01 discusses the appropriate income statement presentation and classification for the activities and payments between the participants in arrangements related to the development and commercialization of intellectual property. The required disclosure related to these arrangements is also specified. EITF 07-01 is effective for fiscal years beginning after December 15, 2008. As a result, EITF 07-01 is effective for the Company in the first quarter of fiscal 2009. The Company does not expect the adoption of EITF 07-01 to have a material impact on either its financial position or results of operations.
2. Collaboration Agreements
     In December 2005, the Company entered into a license agreement with Astellas Pharma Inc. for exclusive rights in Japan, Korea, the Philippines, Indonesia, Thailand and Taiwan (collectively referred to as the Astellas territory) to develop and commercialize the Company’s most advanced product candidate, XP13512, also known as ASP8825 in the Astellas territory. The Company received an initial license payment of $25,000,000 in December 2005, which has been deferred and is being recognized on a straight-line basis over a period that approximates the expected patent life of XP13512. The Company has received milestone payments of $15,000,000 to date and is eligible to receive potential clinical and regulatory milestone payments totaling up to an additional $45,000,000. In addition, the Company is entitled to receive percentage-based royalties on any sales of XP13512 in the Astellas territory. In the three months ended September 30, 2007, the Company recognized revenue of $379,000, representing amortization of the up-front license payment under this agreement. In the nine months ended September 30, 2007, the Company recognized revenue of $7,046,000, representing amortization of the up-front license payment and the first milestone payment as well as recognition of the second milestone payment under this agreement. In the three and nine months ended September 30, 2008, the Company recognized revenue of $379,000 and $1,137,000, respectively, representing amortization of the up-front license payment under this agreement. At September 30, 2008, $20,707,000 of revenue was deferred under this agreement, of which $1,515,000 was classified within current liabilities and the remaining $19,192,000 was recorded as a noncurrent liability. In addition, the agreement also requires Astellas to source all product from the Company under a specified supply agreement, and Astellas may request the Company to conduct development activities. Under the supply arrangement and requested development activities, the Company recorded a net offset to research and development expenses of $263,000 and $130,000 in the three months ended September 30, 2008 and 2007, respectively, and $1,608,000 and $5,973,000 in the nine months ended September 30, 2008 and 2007, respectively.
     In February 2007, the Company entered into an exclusive collaboration with Glaxo Group Limited, or GSK, to develop and commercialize XP13512, known in the United States by the trade name Solzira, in all countries of the world excluding the Astellas territory (collectively referred to as the GSK territory). In March 2007, GSK made an up-front, non-refundable license payment of $75,000,000. In addition, GSK has agreed to make additional payments of up to $275,000,000 upon the achievement of additional clinical and regulatory milestones, of which $65,000,000 has been received to date, including milestone payments of $8,000,000 and $25,000,000 received in March and April 2008, respectively, and up to $290,000,000 upon the achievement of specified XP13512 sales levels. Under the terms of the agreement, GSK is responsible for all future development costs, with the exception of specified development costs that the Company will assume in connection with the development of XP13512 for restless legs syndrome in the United States, and GSK is solely responsible for the manufacturing of XP13512 to support its development and commercialization within the GSK territory. Under the terms of the agreement, the Company is entitled to receive royalties based upon a percentage of sales of XP13512 in the GSK territory for a specified period of time, unless the Company elects the option to co-promote XP13512 in the United States. In the event that the Company elects the co-promotion option for XP13512, the Company would share marketing

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and commercialization costs and would be entitled to a share of operating profits from sales of XP13512 in the United States, and would also be entitled to receive payments on details that the Company performs on Requip XL, GSK’s product for Parkinson’s disease in the United States. Subject to U.S. Food and Drug Administration, or FDA, approval of the new drug application, or NDA, for Solzira for the treatment of moderate-to-severe primary restless legs syndrome, the Company would co-promote XP13512 in the United States to those same prescribers. The Company has concluded that the up-front license payment does not have value to GSK on a stand-alone basis without the benefit of the specified development activities that the Company will perform in connection with XP13512 and that $65,000,000 of milestones payable for clinical trial and pre-clinical activities were either not sufficiently substantive or not sufficiently at risk to be accounted for using the “when-earned” model. Accordingly, these milestones and the up-front payment were combined into a separate unit of accounting that is being recognized over the best estimate of the development period to commercialization of the product during which time delivery of substantially all of the efforts required for the completion of the Company’s contractual responsibilities under the GSK agreement is expected to occur. In the three months ended September 30, 2008 and 2007, the Company recognized revenue of $4,484,000 and $35,046,000, respectively, and in the nine months ended September 30, 2008 and 2007, the Company recognized revenue of $24,744,000 and $81,015,000, respectively, under this agreement. At September 30, 2008, $10,358,000 of revenue was deferred under this agreement, of which $9,639,000 was classified within current liabilities and the remaining $719,000 was recorded as a noncurrent liability.
     In October 2007, the Company entered into an exclusive license agreement for the development and commercialization of XP21510 in the United States with Xanodyne Pharmaceuticals, Inc., including for the potential treatment of women diagnosed with menorrhagia. In exchange for these rights, the Company is entitled to receive up-front, non-refundable cash payments totaling $12,000,000, of which $6,000,000 was paid to the Company upon execution of the agreement and the remaining $6,000,000 is due on the 12-month anniversary of the execution date. The Company is eligible to receive aggregate cash payments of up to $130,000,000 upon the achievement of certain development, regulatory and commercial milestones with respect to XP21510, of which $1,000,000 was received in April 2008, as well as aggregate cash payments of up to $5,000,000 upon the achievement of certain development, regulatory and commercial milestones with respect to Xanodyne’s tranexamic acid product candidate, known as XP12B, which has generated positive preliminary data in two Phase 3 clinical trials. In addition, the Company is entitled to receive tiered, double-digit royalty payments on potential future sales of XP21510 in the United States for a specified period of time, as well as escalating single-digit royalties on potential future sales of XP12B. In the three and nine months ended September 30, 2008, the Company recognized revenue of $0 and $5,500,000, respectively, representing the Company’s completion of the transfer of manufacturing and supply responsibilities to Xanodyne and recognition of the first milestone payment with respect to XP21510 under this agreement. At September 30, 2008, no revenue was deferred under this agreement.
3. Net Income (Loss) Per Share
     Basic net income (loss) per share is calculated by dividing the net income (loss) by the weighted-average number of common shares outstanding for the period less the weighted-average number of unvested common shares subject to repurchase, without consideration for potential common shares. Diluted net income (loss) per share is computed by dividing the net income (loss) by the weighted-average number of common shares outstanding for the period less the weighted-average number of unvested common shares subject to repurchase and dilutive potential common shares for the period determined using the treasury-stock method. For purposes of this calculation, restricted stock units, options to purchase stock and warrants are considered to be potential common shares and are only included in the calculation of diluted net income (loss) per share when their effect is dilutive.

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    Three Months     Nine Months  
    Ended September 30,     Ended September 30,  
    2008     2007     2008     2007  
    (In thousands, except per share amounts)  
Numerator:
                               
Net income (loss)
  $ (24,113 )   $ 15,594     $ (43,814 )   $ 25,742  
 
                       
Denominator:
                               
Weighted-average common shares outstanding
    25,226       24,962       25,161       24,855  
Less: Weighted-average unvested common shares subject to repurchase
    (11 )     (106 )     (26 )     (135 )
 
                       
Denominator for basic net income (loss) per share
    25,215       24,856       25,135       24,720  
 
                       
Dilutive effect of:
                               
Restricted stock units and options to purchase common stock
          1,285             1,081  
Warrants outstanding
          15             17  
 
                       
Denominator for diluted net income (loss) per share
    25,215       26,156       25,135       25,818  
 
                       
Basic net income (loss) per share
  $ (0.96 )   $ 0.63     $ (1.74 )   $ 1.04  
 
                       
Diluted net income (loss) per share
  $ (0.96 )   $ 0.60     $ (1.74 )   $ 1.00  
 
                       
Outstanding dilutive securities not included in the computation of diluted net income (loss) per share as they had an antidilutive effect:
                               
Restricted stock units and options to purchase common stock
    3,557       234       3,557       934  
Warrants outstanding
    21             21        
 
                       
 
    3,578       234       3,578       934  
 
                       
4. Comprehensive Income (Loss)
     The Company displays comprehensive income (loss) and its components as part of the annual statement of stockholders’ equity. Comprehensive income (loss) is comprised of net income (loss) and unrealized gains and losses on available-for-sale securities. Total comprehensive income (loss) was as follows:
                                 
    Three Months     Nine Months  
    Ended September 30,     Ended September 30,  
    2008     2007     2008     2007  
    (In thousands)  
Net income (loss)
  $ (24,113 )   $ 15,594     $ (43,814 )   $ 25,742  
Change in unrealized gain (loss) on available-for-sale securities
    49       190       (425 )     297  
 
                       
 
  $ (24,064 )   $ 15,784     $ (44,239 )   $ 26,039  
 
                       
5. Cash and Cash Equivalents, Short-Term Investments and Restricted Investments
     The following are summaries of cash and cash equivalents, short-term investments and restricted investments (in thousands):
                                 
            Gross     Gross        
            Unrealized     Unrealized     Estimated  
    Cost     Gains     Losses     Fair Value  
As of September 30, 2008:
                               
Cash
  $ 5,033     $     $     $ 5,033  
Money market funds
    10,496                   10,496  
U.S. government agencies
    54,291             (59 )     54,232  
Corporate debt securities
    55,203       185       (60 )     55,328  
Certificate of deposit
    1,812                   1,812  
 
                       
 
  $ 126,835     $ 185     $ (119 )   $ 126,901  
 
                       
Reported as:
                               
Cash and cash equivalents
                          $ 21,730  
Short-term investments
                            103,359  
Restricted investments
                            1,812  
 
                             
 
                          $ 126,901  
 
                             
As of December 31, 2007:
                               
Cash
  $ 1,770     $     $     $ 1,770  
Money market funds
    10,104                   10,104  
Corporate debt securities
    147,776       527       (36 )     148,267  
Certificate of deposit
    1,771                   1,771  
 
                       
 
  $ 161,421     $ 527     $ (36 )   $ 161,912  
 
                       
Reported as:
                               
Cash and cash equivalents
                          $ 17,961  
Short-term investments
                            142,180  
Restricted investments
                            1,771  
 
                             
 
                          $ 161,912  
 
                             

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     At September 30, 2008 and December 31, 2007, the contractual maturities of all investments held were less than 12 months.
     The Company recognized $0 and $445,000 in the three and nine months ended September 30, 2008, respectively, of gross realized gains on sales of short-term investments based on the specific identification method. No gross realized gains or losses were recognized in the same periods in 2007.
     The Company’s available-for-sale investments, which include cash equivalents and short-term investments, are measured at fair value using the following inputs (in thousands):
                                 
            Fair Value Measurements at Reporting Date Using  
            Quoted Prices in     Significant        
            Active Markets     Other     Significant  
    Total As of     for Identical     Observable     Unobservable  
    September 30,     Assets     Inputs     Inputs  
Description   2008     (Level 1)     (Level 2)     (Level 3)  
 
                       
Money market funds
  $ 10,496     $ 10,496     $     $  
U.S. government agencies
    54,232             54,232        
Corporate debt securities
    55,328             55,328        
 
                       
Total
  $ 120,056     $ 10,496     $ 109,560     $  
 
                       
6. Stock-Based Compensation
     Details of the Company’s employee non-cash stock-based compensation are as follows:
                                 
    Three Months     Nine Months  
    Ended September 30,     Ended September 30,  
    2008     2007     2008     2007  
    (In thousands)  
Research and development
  $ 2,116     $ 1,254     $ 5,669     $ 3,712  
General and administrative
    1,747       1,071       4,764       2,798  
 
                       
 
  $ 3,863     $ 2,325     $ 10,433     $ 6,510  
 
                       
7. Commitments
     On February 29, 2008, the Company entered into a lease for approximately 59,000 square feet of office space in a building at 3400 Central Expressway, Santa Clara, California, or the 3400 Lease. The term of the 3400 Lease runs for 60 months.
     Also on February 29, 2008, the Company amended its lease with respect to the Company’s current office space at 3410 Central Expressway, Santa Clara, California, or, as amended, the 3410 Lease. This amendment extends the term of the 3410 Lease for approximately two years from the original expiration date of December 10, 2011, so that the 3410 Lease will expire in 2013, on the same date as the 3400 Lease.
     The Company has the option to extend both the 3410 Lease and 3400 Lease for two additional terms of five years each. Subject to certain restrictions, if the lessor proposes to rent the remaining office space of the building at 3400 Central Expressway not covered by the 3400 Lease within one year from the commencement date of the 3400 Lease, the Company has a right of first refusal on leasing such additional space.

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     In 2004, the Company entered into a sublease agreement to sublease a portion of its facilities that were not in use at that time. The sublease agreement was subsequently terminated in January 2007. The Company recognizes rent expense evenly over the lease term and recorded the monthly sublease income as an offset to rent expense. The Company began recognizing rent expense on the 3400 Lease in May 2008. In the three months ended September 30, 2008 and 2007, the Company recognized rent expense of $1,110,000 and $916,000, respectively, and in the nine months ended September 30, 2008 and 2007, the Company recognized rent expense, net of sublease income in 2007, of $3,019,000 and $2,703,000, respectively. Deferred rent of $1,756,000 and $1,696,000 at September 30, 2008 and December 31, 2007, respectively, represents the difference between rent expense recognized and actual cash payments related to the Company’s operating lease.
     At September 30, 2008, future minimum payments under all non-cancelable operating leases were as follows (in thousands):
         
Year ending December 31:
       
Remaining 2008
  $ 994  
2009
    5,328  
2010
    5,498  
2011
    5,547  
2012
    3,723  
2013
    2,639  
 
     
Total minimum lease payments
  $ 23,729  
 
     
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
     This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the “safe harbor” created by those sections. Forward-looking statements are based on our management’s beliefs and assumptions and on information currently available to our management. In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “project,” “predict,” “potential” and similar expressions intended to identify forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results, performance, time frames or achievements to be materially different from any future results, performance, time frames or achievements expressed or implied by the forward-looking statements. We discuss many of these risks, uncertainties and other factors in this Quarterly Report on Form 10-Q in greater detail under the heading “Risk Factors.” Given these risks, uncertainties and other factors, you should not place undue reliance on these forward-looking statements. Also, these forward-looking statements represent our estimates and assumptions only as of the date of this filing. You should read this Quarterly Report on Form 10-Q completely and with the understanding that our actual future results may be materially different from what we expect. We hereby qualify our forward-looking statements by these cautionary statements. Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.
Overview
     We are a biopharmaceutical company focused on developing a portfolio of internally discovered product candidates that utilize the body’s natural nutrient transporter mechanisms to improve the therapeutic benefits of drugs. Our most advanced product candidate, XP13512, known in the United States by the trade name Solzira, is being developed for the treatment of a number of central nervous system, or CNS, disorders. In September 2008, our collaborative partner Glaxo Group Limited, or GSK, submitted a new drug application, or NDA, to the U.S. Food and Drug Administration, or FDA, requesting approval of Solzira for the treatment of moderate-to-severe primary restless legs syndrome, or RLS. RLS is a common, under-diagnosed neurological condition that frequently manifests itself as a sleep disorder. GSK is also evaluating XP13512 in Phase 2 clinical trials for the treatment of post-herpetic neuralgia, or PHN, painful diabetic neuropathy, or PDN, and migraine prophylaxis. Our collaborative partner Astellas Pharma Inc. is evaluating XP13512, which is known as ASP8825 in the Astellas territory, in a Phase 2 clinical trial in Japan for the treatment of RLS. We are evaluating our second product candidate, XP19986, for the potential treatment of gastroesophageal reflux disease, or GERD, and for the potential treatment of spasticity in separate Phase 2 clinical trials. We plan to initiate an exploratory Phase 2 clinical trial of XP19986 in patients with acute back spasms in the fourth quarter of 2008. We are evaluating our third product candidate, XP21279, for the potential treatment of Parkinson’s disease.

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     Our innovative product candidates, which we refer to as Transported Prodrugs, are created by modifying the chemical structure of currently marketed drugs, referred to as parent drugs, and are designed to correct deficiencies in the oral absorption, distribution and/or metabolism of the parent drug. Our current portfolio of proprietary product candidates includes the following:
     XP13512.  XP13512 is a Transported Prodrug of gabapentin. We have licensed to Astellas exclusive rights to develop and commercialize XP13512 in the Astellas territory and have an exclusive collaboration with GSK to develop and commercialize XP13512 in all countries of the world other than the Astellas territory. Under the terms of our collaboration with GSK, we may elect to co-promote XP13512 in the United States.
    XP13512 for RLS.  XP13512 is currently being evaluated for the treatment of RLS in a Phase 3 clinical program in the United States and in a Phase 2 clinical trial in Japan. RLS is characterized by an irresistible urge to move one’s legs, usually accompanied by unpleasant sensations or pain in the legs. We have announced top-line data from three RLS Phase 3 clinical trials that demonstrated statistically significant improvements compared to placebo on the primary endpoints of these trials and that XP13512 was generally well-tolerated. In September 2008, GSK submitted to the FDA an NDA requesting approval of Solzira for the treatment of moderate-to-severe primary RLS. GSK has also recently initiated a Phase 3b polysomnography clinical trial to evaluate the potential sleep benefits of XP13512 in patients with RLS.
 
    XP13512 for Neuropathic Pain.  We are developing XP13512 as a potential treatment for neuropathic pain. We have shown in a Phase 2a clinical trial that XP13512 is effective for the management of PHN, a chronic type of neuropathic pain that can follow the resolution of shingles. XP13512 is being studied by our partner Astellas for the treatment of PDN, a chronic type of neuropathic pain that results from diabetes. Based on the results of a planned interim analysis of the clinical data, although no safety concerns were noted, Astellas recently terminated its Phase 2 clinical trial of XP13512 as a potential treatment for PDN due to difficulty in demonstrating a statistically significant advantage of XP13512 over placebo under the current clinical trial design. Our partner GSK has initiated a neuropathic pain program that includes two Phase 2 clinical trials designed to show the safety and efficacy of XP13512 in the management of PHN, as well as a Phase 2 clinical trial designed to show the safety and efficacy of XP13512 in the treatment of PDN.
 
    XP13512 for Migraine Prophylaxis.  XP13512 is a potential treatment for migraine, a neurological disorder characterized by recurrent headache attacks that are usually accompanied by various combinations of symptoms, including nausea and vomiting, as well as distorted vision and sensitivity to light and sound. Migraine prophylaxis treatments are designed to reduce the frequency and severity of migraine attacks. GSK recently initiated a Phase 2b clinical trial designed to show the safety and efficacy of XP13512 as a potential treatment for prophylaxis of migraine.
     XP19986.  XP19986 is a Transported Prodrug of R-baclofen. We have retained all rights to this product candidate.
    XP19986 for GERD.  We are developing XP19986 for the treatment of GERD, a digestive system disorder caused primarily by transient relaxations of the lower esophageal sphincter, which is a combination of muscles that controls the junction between the esophagus and the stomach. GERD is characterized by the frequent, undesirable passage of stomach contents into the esophagus that results in discomfort and potential damage to the lining of the esophagus. We have successfully completed a Phase 2a clinical trial indicating that single doses of XP19986 were well-tolerated and produced statistically significant reductions in the number of reflux episodes in patients with GERD. We are currently conducting a second Phase 2 clinical trial of XP19986 in patients with GERD symptoms.
 
    XP19986 for Spasticity.  We are developing XP19986 as a potential treatment for spasticity, a condition in which certain muscles are continuously contracted, causing stiffness or tightness of muscles that interferes with movement or speech. Racemic baclofen, which contains both R-baclofen and S-baclofen, is currently approved in the United States for the treatment of spasticity resulting from multiple sclerosis, spinal cord injury and other spinal cord diseases. We believe that spasticity patients may benefit from XP19986 due to less frequent dosing and a more desirable pharmacokinetic profile than racemic baclofen. We are currently conducting a Phase 2 clinical trial of XP19986 in spinal cord injury patients with spasticity.
 
    XP19986 for Acute Back Spasms.  We plan to develop XP19986 as a potential treatment for the relief of discomfort from acute painful musculoskeletal conditions associated with acute back spasms. These acute back spasms are involuntary and, frequently, painful contractions of the muscles of the lower back.
     XP21279.  XP21279 is a Transported Prodrug of levodopa, or L-Dopa, that we are developing for the treatment of Parkinson’s disease, a neurological disorder that occurs primarily in the elderly, characterized by tremor, rigidity and loss of reflexes. In March

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2008, we announced positive results from a Phase 1 clinical trial of XP21279 that demonstrated that XP21279 produced a more sustained exposure of L-Dopa compared to oral L-Dopa dosed in the same healthy subjects and that XP21279 was well-tolerated in this first trial in humans. We are currently conducting a Phase 1 clinical trial designed to assess the pharmacokinetics, safety and tolerability of two new formulations of XP21279 compared to oral L-Dopa. We have retained all rights to this product candidate.
     XP20925.  XP20925 is a Transported Prodrug of propofol that is in preclinical development for the treatment of acute migraine as an abortive therapy for individual migraine episodes as they occur. We have commenced preclinical development activities to support the potential filing of an investigational new drug application, or IND, for XP20925. We have retained all rights to this product candidate.
     XP21510.  XP21510 is a Transported Prodrug of tranexamic acid. Tranexamic acid is a man-made derivative of the naturally occurring amino acid lysine and works to inhibit, on a molecular basis, the breakdown of blood clots. It is approved in many countries in Europe and Asia for the treatment of women with menorrhagia, or heavy menstrual bleeding. We have licensed to Xanodyne Pharmaceuticals, Inc. exclusive rights to develop and commercialize XP21510 in the United States, including for the potential treatment of women diagnosed with menorrhagia.
     We were incorporated in May 1999 and commenced active operations in August 1999. To date, we have not generated any product revenues. We have funded our research and development operations primarily through sales of our preferred stock, our initial and follow-on public offerings, non-equity payments from our collaborators and government grants. We have received additional funding from capital lease financings and interest earned on investments. Prior to the three months ended June 30, 2007, we had incurred net losses since our inception. However, due to the recognition of revenues from up-front and milestone payments from our collaborations with GSK, Astellas and Xanodyne, we were profitable in the three-month periods ended June 30, September 30 and December 31, 2007. While recognition of these revenues resulted in a profitable year for 2007, we continue to expect to incur losses for the next several years as we expand our research and development activities and seek to advance our product candidates into later stages of development. We expect our research and development expenses to increase in the foreseeable future due to increasing headcount, investment in our preclinical development programs and XP19986 development costs, partially offset by decreasing expenses for our clinical program evaluating XP13512 for the treatment of RLS. Subject to regulatory approval of any of our product candidates, we expect to incur significant expenses associated with the establishment of a North American specialty sales force. Because of the numerous risks and uncertainties associated with drug development, we are unable to predict the timing or amount of increased expenses or when, or if, we will be able to achieve or sustain profitability. As of September 30, 2008, we had an accumulated deficit of approximately $219.9 million.
     From our inception in 1999 through 2001, our principal activities were focused on identifying and characterizing natural nutrient transporter mechanisms and developing the technology necessary to utilize them for the active transport of drugs. Beginning in 2002, our activities expanded to include the preclinical and clinical development of internally discovered product candidates based on this proprietary technology. In addition to our ongoing research program, the process of carrying out the development of our product candidates to later stages of development will require significant additional research and development expenditures, including preclinical testing, clinical trials, manufacturing development efforts and regulatory activities. We outsource a substantial portion of our preclinical studies, clinical trials and manufacturing activities to third parties to maximize efficiency and minimize our internal overhead.
     In December 2005, we entered into an agreement in which we licensed to Astellas exclusive rights to develop and commercialize XP13512 in Japan, Korea, the Philippines, Indonesia, Thailand and Taiwan (collectively referred to as the Astellas territory). We received an initial license payment of $25.0 million from Astellas. The terms of the agreement also specify clinical and regulatory milestone payments totaling up to a maximum of $60.0 million, including milestone payments of $15.0 million that we have received to date. We will receive royalties on any sales of XP13512 in the Astellas territory at a royalty rate in the mid-teens on a percentage basis. As of September 30, 2008, we had recognized an aggregate of $19.3 million of revenue pursuant to this agreement.
     In February 2007, we announced an exclusive collaboration with GSK to develop and commercialize XP13512 worldwide, excluding the Astellas territory (collectively referred to as the GSK territory). GSK made an up-front, non-refundable license payment to us of $75.0 million that we received in March 2007, and GSK has agreed to make additional payments of up to $275.0 million upon the achievement of clinical and regulatory milestones, of which $65.0 million has been received to date, including $8.0 million and $25.0 million received in March and April 2008, respectively, and up to $290.0 million upon the achievement of specified sales levels. Under the terms of the agreement, GSK is responsible for all future development costs, with the exception of specified development

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costs that we will assume in connection with the development of XP13512 for RLS in the United States. We are entitled to receive royalties based upon a percentage of sales of XP13512 in the GSK territory for a specified period of time, unless we elect the option to co-promote XP13512 in United States. In the event that we elect the co-promotion option for XP13512, we would share marketing and commercialization costs and would be entitled to a share of operating profits from sales of XP13512 in the United States, as well as receive payments on details we perform on Requip XL, GSK’s product for Parkinson’s disease in the United States. Subject to FDA approval of the new drug application, or NDA, for Solzira, we would co-promote XP13512 in the United States to those same prescribers. As of September 30, 2008, we had recognized an aggregate of $129.6 million of revenue pursuant to this agreement.
     In October 2007, we announced an exclusive license agreement for the development and commercialization of XP21510 in the United States by Xanodyne, including for the potential treatment of women diagnosed with menorrhagia. In exchange for these rights, we received up-front, non-refundable cash payments totaling $12.0 million, of which $6.0 million was paid to us upon execution of the agreement and the remaining $6.0 million was paid to us in October 2008. We are eligible to receive aggregate cash payments of up to $130.0 million upon the achievement of certain development, regulatory and commercial milestones with respect to XP21510, of which $1.0 million was received in April 2008, as well as aggregate cash payments of up to $5.0 million upon the achievement of certain development, regulatory and commercial milestones with respect to Xanodyne’s tranexamic acid product candidate, known as XP12B, that has generated positive preliminary data in two Phase 3 clinical trials. In addition, we are entitled to receive tiered, double-digit royalty payments on potential future sales of XP21510 in the United States for a specified period of time, as well as escalating single-digit royalties on potential future sales of XP12B. As of September 30, 2008, we had recognized an aggregate of $7.0 million of revenue pursuant to this agreement as we completed the transfer of manufacturing and supply responsibilities to Xanodyne and achieved the first milestone with respect to XP21510.
Critical Accounting Policies and Significant Judgments and Estimates
     Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States for financial information. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenues and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and judgments related to revenue recognition and clinical development costs. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies and significant judgments and estimates are detailed in our Annual Report on Form 10-K, with the exception of the following fair value measurements policy, which has been updated since the adoption of Statement of Financial Accounting Standards, or SFAS, No. 157, Fair Value Measurements, or SFAS 157.
     Fair Value Measurements
     Effective January 1, 2008, we adopted the provisions of SFAS 157, which defines fair value and provides guidance for using fair value to measure assets and liabilities. SFAS 157 applies whenever other standards require or permit assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. Accordingly, the carrying amounts of certain of our financial instruments, including cash equivalents and short-term investments, continue to be valued at fair value on a recurring basis. SFAS 157 also requires expanded disclosure of the effect on earnings for items measured using unobservable data, establishes a fair value hierarchy that prioritizes the inputs used to measure fair value and requires separate disclosure by level within the fair value hierarchy.
     As defined in SFAS 157, fair value is the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the measurement date. We utilize market data or assumptions that we believe market participants would use in pricing assets or liabilities, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated or generally unobservable. We apply the market approach valuation technique for fair value measurements and maximize the use of observable inputs and minimize the use of unobservable inputs. All of our cash equivalents and short-term investments are valued using quoted prices in active markets and are valued at Level 1 or Level 2 within the fair value hierarchy.

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Results of Operations
     Three and Nine Months Ended September 30, 2008 and 2007
     Revenues
     Our revenues consisted of the recognition of revenues from up-front and milestone payments from our collaborations with Astellas, GSK and Xanodyne.
                                                                 
    Three Months                     Nine Months        
    Ended                     Ended        
    September 30,     Change     September 30,     Change  
    2008     2007     $     %     2008     2007     $     %  
    (In thousands, except percentages)  
Revenues
  $ 4,863     $ 35,425     $ (30,562 )     (86 )%   $ 31,381     $ 88,061     $ (56,680 )     (64 )%
     The decrease in revenues for the three months ended September 30, 2008 compared to the same period in 2007 was the result of a $30.6 million decrease in revenues recognized under our GSK agreement.
     The decrease in revenues for the nine months ended September 30, 2008 compared to the same period in 2007 was the result of a $56.3 million decrease in revenues recognized under our GSK agreement and a $5.9 million decrease in revenues recognized under our Astellas agreement, offset by $5.5 million of revenue recognized under our Xanodyne agreement that was executed in October 2007.
     The decrease in revenues under our GSK agreement for the three and nine months ended September 30, 2008 generally reflects the decreased activities in our Phase 3 RLS program compared to the same periods in 2007.
     We expect revenues to fluctuate in the future primarily depending upon our progress against the deliverables specified in the terms of our collaboration with GSK, the timing of milestone-related activities under our Astellas, GSK and Xanodyne collaborations and the extent to which we enter into new collaborative agreements.
     Research and Development Expenses
     Research and development expenses consisted of costs associated with our research activities and drug discovery efforts, as well as costs associated with conducting preclinical studies and clinical trials, manufacturing development efforts and activities related to regulatory filings. Of the total research and development expenses for the three and nine months ended September 30, 2008 and 2007, the allocation of costs associated with research and preclinical and clinical development activities was as follows:
                                                                 
    Three Months                     Nine Months        
    Ended                     Ended        
    September 30,     Change     September 30,     Change  
    2008     2007     $     %     2008     2007     $     %  
    (In thousands, except percentages)  
Research and preclinical
  $ 6,116     $ 4,855     $ 1,261       26 %   $ 16,705     $ 14,119     $ 2,586       18 %
Clinical development
    17,593       11,933       5,660       47 %     44,164       40,395       3,769       9 %
 
                                                   
Total research and development
  $ 23,709     $ 16,788     $ 6,921       41 %   $ 60,869     $ 54,514     $ 6,355       12 %
 
                                                   
     The increase in research and development expenses in the three months ended September 30, 2008 compared to the same period in 2007 was principally due to the following:
    increased net costs for XP19986 of $3.2 million primarily due to increased clinical costs, partially offset by decreased toxicology costs;
 
    increased net costs for our preclinical development programs of $2.1 million due to increased manufacturing and toxicology costs; and
 
    increased personnel costs of $2.6 million resulting from increased headcount and increased non-cash stock-based compensation of $0.9 million; partially offset by

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    decreased net costs for XP13512 of $1.7 million due to decreased clinical costs, partially offset by increased manufacturing costs.
 
     The increase in research and development expenses in the nine months ended September 30, 2008 compared to the same period in 2007 was principally due to the following:
 
    increased net costs for XP19986 of $5.6 million primarily due to increased clinical and manufacturing costs, partially offset by decreased toxicology costs;
 
    increased net costs for our preclinical development programs of $4.9 million due to increased manufacturing and toxicology costs; and
 
    increased personnel costs of $6.8 million resulting from increased headcount and increased non-cash stock-based compensation of $2.0 million; partially offset by
 
    decreased net costs for XP13512 of $13.4 million due to decreased clinical costs.
     We expect our research and development expenses to increase in the foreseeable future due to increasing headcount and investment in our preclinical development programs and XP19986 development costs, partially offset by decreasing expenses for our clinical program evaluating XP13512 for the treatment of RLS. The timing and amount of these increases will primarily depend upon the costs related to our Phase 2 clinical trials in GERD, spasticity and acute back spasms for XP19986 and the outcomes of current or future clinical trials for XP19986 and XP21279, as well as the related expansion of our research and development organization, regulatory requirements, advancement of our preclinical programs and product candidate manufacturing costs.
     General and Administrative Expenses
     General and administrative expenses consisted principally of salaries and other related costs for personnel in executive, finance, accounting, business development, information technology, legal and human resources functions. Other general and administrative expenses included facility costs not otherwise included in research and development expenses, patent-related costs and professional fees for legal, consulting and accounting services.
                                                                 
    Three Months                     Nine Months        
    Ended                     Ended        
    September 30,     Change     September 30,     Change  
    2008     2007     $     %     2008     2007     $     %  
    (In thousands, except percentages)  
General and administrative
  $ 6,537     $ 4,459     $ 2,078       47 %   $ 18,485     $ 13,053     $ 5,432       42 %
     The increase in general and administrative expenses in the three months ended September 30, 2008 compared to the same period in 2007 was primarily due to increased personnel and related costs of $1.5 million, resulting from an increase in headcount and increased non-cash stock-based compensation of $0.7 million.
     The increase in general and administrative expenses in the nine months ended September 30, 2008 compared to the same period in 2007 was primarily due to increased personnel and related costs of $4.1 million, resulting from an increase in headcount and increased non-cash stock-based compensation of $2.0 million.
     We expect that general and administrative expenses will continue to increase in the future due to increasing headcount, expanded infrastructure and facilities and increasing consulting and legal services.
     Interest Income and Interest and Other Expense
     Interest income consisted of interest earned on our cash and cash equivalents and short-term investments.
                                                                 
    Three Months                     Nine Months        
    Ended                     Ended        
    September 30,     Change     September 30,     Change  
    2008     2007     $     %     2008     2007     $     %  
    (In thousands, except percentages)  
Interest income
  $ 909     $ 2,208     $ (1,299 )     (59 )%   $ 3,934     $ 6,141     $ (2,207 )     (36 )%
Interest and other expense
  $ 29     $ 44     $ (15 )     (34 )%   $ 165     $ 145     $ 20       14 %

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     The decrease in interest income in the three and nine months ended September 30, 2008 compared to the same periods in 2007 was primarily due to lower average short-term investment balances and interest rates.
     Income Taxes
     In the three and nine months ended September 30, 2008, we recorded $0.4 million of current income tax benefit due to the adoption of a provision in the Housing and Economic Recovery Act of 2008 that allows corporations to convert carry-forward research and development and Alternative Minimum Tax, or AMT, credits into a separate credit amount, which we plan to claim as a refund for cash in 2009. In the three and nine months ended September 30, 2007, we recorded $0.7 million of current income tax expense. The income tax expense recognized resulted from our full year forecasted effective tax rate of 2.8% related to U.S. federal and state AMT.
Liquidity and Capital Resources
                 
    As of   As of
    September 30,   December 31,
    2008   2007
    (In thousands)
Cash and cash equivalents and short-term investments
  $ 125,089     $ 160,141  
Working capital
    102,919       138,685  
Restricted investments
    1,812       1,771  
Current portion of equipment financing obligations
    19       176  
Noncurrent portion of equipment financing obligations
          5  
                 
    Nine Months
    Ended
    September 30,
    2008   2007
    (In thousands)
Cash provided by (used in):
               
Operating activities
  $ (32,632 )   $ 36,997  
Investing activities
    33,363       (30,273 )
Financing activities
    3,038       2,359  
Capital expenditures (included in investing activities above)
    (6,276 )     (3,443 )
     Due to our significant research and development expenditures and the lack of regulatory agency approvals to sell products, we have generated cumulative operating losses since we incorporated in 1999. As such, we have funded our research and development operations primarily through sales of our preferred stock, our initial and follow-on public offerings, non-equity payments from our collaborators and government grants. We have received additional funding from capital lease financings and interest earned on investments, each as described more fully below. At September 30, 2008, we had available cash and cash equivalents and short-term investments of $125.1 million. Our cash and investment balances are held in a variety of interest-bearing instruments, including U.S. government agencies, corporate debt securities and money market accounts. Cash in excess of immediate requirements is invested with regard to liquidity and capital preservation, and we seek to minimize the potential effects of concentration and degrees of risk.
     Net cash provided by (used in) operating activities was $(32.6) million and $37.0 million in the nine months ended September 30, 2008 and 2007, respectively. The net cash used in operating activities in the nine months ended September 30, 2008 primarily reflected our net loss, offset by non-cash stock-based compensation and non-cash changes in operating assets and liabilities. The net cash provided by operating activities for the nine months ended September 30, 2007 primarily reflected the net income for the period, as well as increases in deferred revenue and non-cash stock-based compensation, partially offset by net accretion of investment discounts.
     Net cash provided by (used in) investing activities was $33.4 million and $(30.3) million in the nine months ended September 30, 2008 and 2007, respectively. Cash provided by investing activities for the nine months ended September 30, 2008 was primarily related to the proceeds from sales and maturities of investments, offset by purchases of investments and capital expenditures. Cash used in investing activities for the nine months ended September 30, 2007 was primarily related to purchases of investments and to a lesser extent, purchases of property and equipment, partially offset by the proceeds from maturities of investments.

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     Net cash provided by financing activities was $3.0 million and $2.4 million in the nine months ended September 30, 2008 and 2007, respectively. The net cash provided by financing activities for the nine months ended September 30, 2008 and 2007 reflected proceeds from issuance of common stock, partially offset by principal payments on equipment financing obligations.
     We believe that our existing capital resources and expected milestone payments, together with interest thereon, will be sufficient to meet our projected operating requirements into the second quarter of 2010. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we currently expect. Further, our operating plan may change, and we may need additional funds to meet operational needs and capital requirements for product development and commercialization sooner than planned. We currently have no credit facility or committed sources of capital other than potential milestones receivable under our collaborations. Our forecast of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement and involves risks and uncertainties, and actual results could vary as a result of a number of factors, including the factors discussed in “Risk Factors.” Because of the numerous risks and uncertainties associated with the development and commercialization of our product candidates, and the extent to which we enter into additional collaborations with third parties to participate in their development and commercialization, we are unable to estimate the amounts of increased capital outlays and operating expenditures associated with our current and anticipated clinical trials. Our future funding requirements will depend on many factors, including:
    the scope, rate of progress, results and cost of our preclinical testing, clinical trials and other research and development activities;
 
    the timing of potential receipt of FDA approval of Solzira and its potential commercialization;
 
    the cost of manufacturing clinical, and establishing commercial, supplies of our product candidates and any products that we may develop;
 
    the timing of any milestone payments under our collaborative arrangements;
 
    the number and characteristics of product candidates that we pursue;
 
    the cost, timing and outcomes of regulatory approvals;
 
    the cost and timing of establishing sales, marketing and distribution capabilities;
 
    the terms and timing of any other collaborative, licensing and other arrangements that we may establish;
 
    the timing, receipt and amount of sales, profit sharing or royalties, if any, from our potential products;
 
    the cost of preparing, filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights; and
 
    the extent to which we acquire or invest in businesses, products or technologies, although we currently have no commitments or agreements relating to any of these types of transactions.
     If we need to raise additional money to fund our operations, funding may not be available to us on acceptable terms, or at all. If we are unable to raise additional funds when needed, we may terminate or delay clinical trials for one or more of our product candidates, we may delay our establishment of sales and marketing capabilities or other activities that may be necessary to commercialize our product candidates or we curtail significant drug development programs that are designed to identify new product candidates. We may seek to raise any necessary additional funds through equity or debt financings, collaborative arrangements with corporate partners or other sources. To the extent that we raise additional capital through licensing arrangements or arrangements with collaborative partners, we may be required to relinquish, on terms that are not favorable to us, rights to some of our technologies or product candidates that we would otherwise seek to develop or commercialize ourselves. However, the credit markets and the financial services industry have recently been experiencing a period of unprecedented turmoil and upheaval characterized by the bankruptcy, failure, collapse or sale of various financial institutions and an unprecedented level of intervention from the United States federal government. These events have generally made equity and debt financing more difficult to obtain. To the extent that we raise additional capital through equity financings, dilution to our stockholders would result. Any debt financing or additional equity that we raise may contain terms that are not favorable to our stockholders or us.

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Off-Balance Sheet Arrangements
     We currently have no material off-balance sheet arrangements as defined in Regulation S-K 303(a)(4)(ii).
Contractual Obligations
     Our future contractual obligations at September 30, 2008 were as follows (in thousands):
                                         
    Payments Due by Period  
            Less                     Greater  
            Than     1-3     3-5     Than 5  
ContractualObligations   Total     1 Year     Years     Years     Years  
Equipment financing obligations
  $ 20     $ 20     $     $     $  
Operating lease obligations
    23,730       4,978       11,084       7,668        
 
                             
Total fixed contractual obligations
  $ 23,750     $ 4,998     $ 11,084     $ 7,668     $  
 
                             

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Recent Accounting Pronouncements
     In December 2007, the Emerging Issues Task Force, or EITF, reached a consensus on EITF No. 07-01, Accounting for Collaborative Arrangements Related to the Development and Commercialization of Intellectual Property, or EITF 07-01. EITF 07-01 discusses the appropriate income statement presentation and classification for the activities and payments between the participants in arrangements related to the development and commercialization of intellectual property. The required disclosure related to these arrangements is also specified. EITF 07-01 is effective for fiscal years beginning after December 15, 2008. As a result, EITF 07-01 is effective for us in the first quarter of fiscal 2009. We do not expect the adoption of EITF 07-01 to have a material impact on either our financial position or results of operations.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
     The primary objective of our investment activities is to preserve our capital to fund operations. We also seek to maximize income from our investments without assuming significant risk. To achieve our objectives, we maintain a portfolio of cash equivalents and investments in a variety of securities of high credit quality. As of September 30, 2008, we had cash and cash equivalents and short-term investments of $125.1 million consisting of cash and highly liquid investments deposited in highly rated financial institutions in the United States. A portion of our investments may be subject to interest rate risk and could fall in value if market interest rates increase. However, because our investments are short-term in duration, we believe that our exposure to interest rate risk is not significant and a 1% movement in market interest rates would not have a significant impact on the total value of our portfolio. We actively monitor changes in interest rates.
     We contract for the conduct of certain manufacturing activities with a contract manufacturer in Europe. We made payments in the aggregate amount of $2.2 million and $4.5 million during the nine months ended September 30, 2008 and 2007, respectively, to this European contract manufacturer. We are subject to exposure to fluctuations in foreign exchange rates in connection with these agreements. To date, the effect of the exposure to these fluctuations in foreign exchange rates has not been material, and we do not expect it to be material in the foreseeable future. We do not hedge our foreign currency exposures. We have not used derivative financial instruments for speculation or trading purposes.
Item 4. Controls and Procedures
     Evaluation of Disclosure Controls and Procedures
     Based on the evaluation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or Securities Exchange Act) required by Rules 13a-15(b) or 15d-15(b) under the Securities Exchange Act, our chief executive officer and chief financial officer have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective.
     Changes in Internal Control over Financial Reporting
     There were no changes in our internal control over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
     From time to time, we may be involved in litigation relating to claims arising out of our ordinary course of business. We are not currently a party to any material legal proceedings.

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Item 1A. Risk Factors
     The following risks and uncertainties may have a material adverse effect on our business, financial condition or results of operations. Investors should carefully consider the risks described below before making an investment decision. The risks described below are not the only ones we face. Additional risks not presently known to us or that we currently believe are immaterial may also significantly impair our business operations. Our business could be harmed by any of these risks. The trading price of our common stock could decline due to any of these risks, and investors may lose all or part of their investment.
     We have marked with an asterisk (*) those risk factors below that reflect substantive changes from the risk factors included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 22, 2008.
Risks Related to Our Business and Industry
     We have incurred cumulative operating losses since inception, we expect to continue to incur losses for the foreseeable future and we may never sustain profitability.*
     We have a limited operating history and have incurred cumulative losses of $219.9 million since our inception in May 1999. In the three and nine months ended September 30, 2008, we incurred net losses of $24.1 million and $43.8 million, respectively. Due to the recognition of revenues from up-front and milestone payments from our collaborations with Glaxo Group Limited, or GSK, Astellas Pharma Inc. and Xanodyne Pharmaceuticals, Inc., we were profitable in the three-month periods ended June 30 and September 30, 2007, and for the year ended December 31, 2007. However, while recognition of these revenues resulted in a profitable year for 2007, we continue to expect to incur losses for the next several years. We expect our research and development expenses to increase in the foreseeable future due to increasing headcount, investment in our preclinical development programs and XP19986 development costs, partially offset by decreasing expenses for our clinical program evaluating XP13512, known in the United States by the trade name Solzira, and by the designation ASP8825 in the Astellas territory, for the treatment of restless legs syndrome, or RLS. Subject to regulatory approval of any of our product candidates, we expect to incur significant expenses associated with the establishment of a North American specialty sales force. Annual losses have had, and will continue to have, an adverse effect on our stockholders’ equity.
     Because of the numerous risks and uncertainties associated with drug development, we are unable to predict the timing or amount of increased expenses or when, or if, we will be able to achieve or sustain profitability. Currently, we have no products approved for commercial sale and, to date, we have not generated any product revenues. We have financed our operations primarily through the sale of equity securities, non-equity payments from collaborative partners, capital lease and equipment financings and government grants. We have devoted substantially all of our efforts to research and development, including clinical trials. If we or our collaborative partners are unable to develop and commercialize any of our product candidates, if development is delayed or if sales revenue from any product candidate that receives marketing approval is insufficient, we may never become profitable. Even if we do become profitable, we may not be able to sustain or increase our profitability on a quarterly or annual basis.
     Our success depends substantially on our most advanced product candidates, which are still under development. If we or our collaborative partners are unable to bring any or all of these product candidates to market, or experience significant delays in doing so, our ability to generate product revenue and our likelihood of success will be harmed. *
     Our ability to generate product revenue in the future will depend heavily on the successful development and commercialization of our product candidates. In September 2008, GSK filed a new drug application, or NDA, with the U.S. Food and Drug Administration, or FDA, for our most advanced product candidate for the treatment of RLS. This product candidate is currently being evaluated in a Phase 3 clinical program for RLS in the United States, in a Phase 2 clinical trial for RLS in Japan and in Phase 2 clinical trials for neuropathic pain and migraine prophylaxis in the United States. Our other product candidates are either in Phase 1 or Phase 2 clinical development or in various stages of preclinical development. Any of our product candidates could be unsuccessful if it:
    does not demonstrate acceptable safety and efficacy in preclinical studies or clinical trials or otherwise does not meet applicable regulatory standards for approval;
 
    does not offer therapeutic or other improvements over existing or future drugs used to treat the same conditions;
 
    is not capable of being produced in commercial quantities at acceptable costs; or
 
    is not accepted in the medical community and by third-party payors.

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     We do not expect any of our current product candidates to be commercially available before the second half of 2009, if at all. If we or our collaborative partners are unable to make our product candidates commercially available, we will not generate substantial product revenues and we will not be successful. The results of our clinical trials to date do not provide assurance that acceptable efficacy or safety will be shown upon completion of future clinical trials.
     If we or our partners are not able to obtain required regulatory approvals, we or our partners will not be able to commercialize our product candidates, our ability to generate revenue will be materially impaired and our business will not be successful.*
     Our product candidates and the activities associated with their development and commercialization are subject to comprehensive regulation by the FDA and other agencies in the United States and by comparable authorities in other countries. In February 2007, we announced an exclusive collaboration with GSK to develop and commercialize XP13512 in all countries of the world other than the Astellas territory. Pursuant to the terms of our agreement, in September 2008, GSK filed an NDA with the FDA requesting approval of Solzira for the treatment of RLS, and GSK will lead the development and registration of XP13512 for all indications other than RLS in the United States and all indications in the remainder of GSK’s licensed territory. The inability to obtain FDA approval or approval from comparable authorities in other countries would prevent us and our collaborative partners from commercializing our product candidates in the United States or other countries. We or our collaborative partners may never receive regulatory approval for the commercial sale of any of our product candidates. Moreover, if the FDA requires that any of our product candidates be scheduled by the U.S. Drug Enforcement Agency, or DEA, we or our collaborative partners will be unable to begin commercial sale of that product until the DEA completes scheduling proceedings. If any of our product candidates is classified as a controlled substance by the DEA, we or our collaborative partners would have to register annually with the DEA and those product candidates would be subject to additional regulation.
     Neither we nor our collaborative partners have received regulatory approval to market any of our product candidates in any jurisdiction. We have only limited experience in preparing and filing the applications necessary to gain regulatory approvals. The process of applying for regulatory approval is expensive, often takes many years and can vary substantially based upon the type, complexity and novelty of the product candidates involved. The application process begins with the submission of an NDA that the FDA initially reviews and either accepts or rejects for filing. NDA submissions are complex electronic filings, which include vast compilations of data sets, integrated documents and data calculations. The FDA has substantial discretion in the submission process and may refuse to accept an NDA submission if there are errors or omissions relating to the electronic transmittal process, data entry, data compilation or formatting. If the FDA refuses to accept the Solzira NDA submission, the NDA approval process would be delayed until we and GSK could correct and refile the NDA submission with the FDA in a manner that is ultimately accepted by the FDA.
     Changes in the regulatory approval policy during the development period, changes in, or the enactment of additional, regulations or statutes or changes in regulatory review for each submitted product application may cause delays in the approval or rejection of an NDA. For example, the FDA recently announced that, due to staffing and resource limitations, it has given its managers discretion to miss certain timing goals for completing reviews of NDAs set forth under the Prescription Drug User Fee Act, or PDUFA. If the FDA were to miss a PDUFA timing goal for one of our product candidates, the development and commercialization of the product candidate could be delayed or impaired. In addition, the Food and Drug Administration Amendments Act of 2007, or FDAAA, mandates FDA advisory committee reviews of all new molecular entities as part of the NDA approval process, although the FDA maintains discretion under the FDAAA to approve NDAs for new molecular entities without advisory committee reviews in certain instances. Solzira is classified as a new molecular entity. The advisory committee review process can be a lengthy and uncertain process that could delay the FDA’s NDA approval process and delay or impair the development and commercialization of our product candidates.
     The FDA has substantial discretion in the approval process and may refuse to approve any application or decide that our or our collaborative partners’ data is insufficient for approval and require additional preclinical, clinical or other studies. For example, varying interpretations of the data obtained from preclinical and clinical testing could delay, limit or prevent regulatory approval of any of our product candidates. Even if the FDA or other regulatory agency approves a product candidate, the approval may impose significant restrictions on the indicated uses, conditions for use, labeling, advertising, promotion, marketing and/or production of such product and may impose ongoing requirements for post-approval studies, including additional research and development and clinical trials. The FDA and other agencies also may impose various civil or criminal sanctions for failure to comply with regulatory requirements, including withdrawal of product approval.
     We and our collaborative partners will need to obtain regulatory approval from authorities in foreign countries to market our product candidates in those countries. Neither we nor our collaborative partners have filed for final regulatory approval to market our product candidates in any foreign jurisdictions. Approval by one regulatory authority does not ensure approval by regulatory authorities in other jurisdictions. If we or our collaborative partners fail to obtain approvals from foreign jurisdictions, the geographic market for our product candidates would be limited.

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     We depend on collaborations to complete the development and commercialization of some of our product candidates. These collaborations may place the development of our product candidates outside our control, may require us to relinquish important rights or may otherwise be on terms unfavorable to us.*
     In December 2005, we entered into a collaboration with Astellas for the development and commercialization of XP13512 in Japan and five other Asian countries. In February 2007, we entered into an exclusive collaboration with GSK to develop and commercialize XP13512 worldwide, excluding the Astellas territory. In October 2007, we entered into a collaboration with Xanodyne for the development and commercialization of XP21510 in the United States. We may enter into additional collaborations with third parties to develop and commercialize some of our other product candidates. Our dependence on Astellas and GSK for the development and commercialization of XP13512 and Xanodyne for the development and commercialization of XP21510 subjects us to, and dependence on future collaborators for development and commercialization of additional product candidates will subject us to, a number of risks, including:
    we may not be able to control the amount and timing of resources that our collaborators may devote to the development or commercialization of product candidates or to their marketing and distribution;
 
    collaborators may delay clinical trials, provide insufficient funding for a clinical trial program, stop a clinical trial or abandon a product candidate, repeat or conduct new clinical trials or require a new formulation of a product candidate for clinical testing;
 
    disputes may arise between us and our collaborators that result in the delay or termination of the research, development or commercialization of our product candidates or that result in costly litigation or arbitration that diverts management’s attention and resources;
 
    collaborators may experience financial difficulties;
 
    collaborators may not properly maintain or defend our intellectual property rights or may use our proprietary information in such a way as to invite litigation that could jeopardize or invalidate our proprietary information or expose us to potential litigation;
 
    business combinations or significant changes in a collaborator’s business strategy may also adversely affect a collaborator’s willingness or ability to complete its obligations under any arrangement;
 
    a collaborator could independently move forward with a competing product candidate developed either independently or in collaboration with others, including our competitors; and
 
    the collaborations may be terminated or allowed to expire, which would delay the development and may increase the cost of developing our product candidates.
     For example, pursuant to the terms of our agreement, GSK is responsible for all future development costs of XP13512, with the exception of specified development costs that we will assume in connection with the development of XP13512 for RLS in the United States. In September 2008, GSK filed an NDA for FDA approval of Solzira for RLS. In addition, GSK will lead the development and registration of XP13512 for all indications other than RLS in the United States and all indications in the remainder of GSK’s licensed territory. We cannot control the process for securing FDA approval of Solzira for RLS. We cannot control the amount and timing of resources that GSK or Astellas may devote to the development or commercialization of XP13512, or that Xanodyne may devote to the development and commercialization of XP21510, or to their respective marketing and distribution. In addition, GSK, Astellas or Xanodyne could independently direct their respective development and marketing resources to the development or commercialization of competitive products, which could delay or impair the commercialization of XP13512 or XP21510, as the case may be, and harm our business.

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     If we do not establish collaborations for our product candidates other than XP13512 and XP21510, we will have to alter our development and commercialization plans.*
     Our strategy includes selectively collaborating with leading pharmaceutical and biotechnology companies to assist us in furthering development and potential commercialization of some of our product candidates. We intend to do so especially for indications that involve a large, primary care market that must be served by large sales and marketing organizations. We face significant competition in seeking appropriate collaborators, and these collaborations are complex and time consuming to negotiate and document. We may not be able to negotiate additional collaborations on acceptable terms, or at all. We are unable to predict when, if ever, we will enter into any additional collaborations because of the numerous risks and uncertainties associated with establishing additional collaborations. If we are unable to negotiate additional collaborations, we may have to curtail the development of a particular product candidate, reduce or delay its development program or one or more of our other development programs, delay its potential commercialization or reduce the scope of our sales or marketing activities or increase our expenditures and undertake development or commercialization activities at our own expense. If we elect to increase our expenditures to fund development or commercialization activities on our own, we may need to obtain additional capital, which may not be available to us on acceptable terms, or at all. If we do not have sufficient funds, we will not be able to bring our product candidates to market and generate product revenues.
     We will need additional funding and may be unable to raise capital when needed, which would force us to delay, reduce or eliminate our product development programs or commercialization efforts.*
     We will need to raise additional capital to fund our operations and complete the development of our product candidates. If any product candidates receive regulatory approval for commercial sale, we may need to raise additional capital to fund our commercialization efforts. Our future funding requirements will depend on many factors, including:
    the scope, rate of progress, results and cost of our preclinical testing, clinical trials and other research and development activities;
 
    the timing of potential receipt of FDA approval of Solzira and its potential commercialization;
 
    the cost of manufacturing clinical and establishing commercial supplies of our product candidates and any products that we may develop;
 
    the timing of any milestone payments under our collaborative arrangements;
 
    the number and characteristics of product candidates that we pursue;
 
    the cost, timing and outcomes of regulatory approvals;
 
    the cost and timing of establishing sales, marketing and distribution capabilities;
 
    the terms and timing of any collaborative, licensing and other arrangements that we may establish;
 
    the timing, receipt and amount of sales, profit sharing or royalties, if any, from our potential products;
 
    the cost of preparing, filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights; and
 
    the extent to which we acquire or invest in businesses, products or technologies, although we currently have no commitments or agreements relating to any of these types of transactions.
     Until we can generate a sufficient amount of product revenues, if ever, we expect to finance future cash needs through public or private equity offerings, debt financings or corporate collaboration and licensing arrangements, as well as through interest income earned on cash balances. However, the credit markets and the financial services industry have recently been experiencing a period of unprecedented turmoil and upheaval characterized by the bankruptcy, failure, collapse or sale of various financial institutions and an unprecedented level of intervention from the United States federal government. These events have generally made equity and debt financing more difficult to obtain.
     If we raise additional funds by issuing equity securities, our stockholders may experience dilution. Any debt financing or additional equity that we raise may contain terms that are not favorable to our stockholders or us. To the extent that we raise additional capital

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through licensing arrangements or arrangements with collaborative partners, we may be required to relinquish, on terms that are not favorable to us, rights to some of our technologies or product candidates that we would otherwise seek to develop or commercialize ourselves.
     We believe that our existing capital resources and expected milestone payments, together with interest thereon, will be sufficient to meet our projected operating requirements into the second quarter of 2010. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we currently expect. Further, our operating plan may change, and we may need additional funds to meet operational needs and capital requirements for product development and commercialization sooner than planned. We currently have no credit facility or committed sources of capital other than potential milestones receivable under our collaborations.
     Additional funds may not be available when we need them on terms that are acceptable to us, or at all. If adequate funds are not available on a timely basis, we may:
    terminate or delay clinical trials for one or more of our product candidates;
 
    delay our establishment of sales and marketing capabilities or other activities that may be necessary to commercialize our product candidates; or
 
    curtail significant drug development programs that are designed to identify new product candidates.
     If our preclinical studies do not produce successful results or our clinical trials do not demonstrate safety and efficacy in humans, we will not be able to commercialize our product candidates.*
     To obtain the requisite regulatory approvals to market and sell any of our product candidates, we must demonstrate, through extensive preclinical studies and clinical trials, that the product candidate is safe and effective in humans. Preclinical and clinical testing is expensive, can take many years and has an uncertain outcome. A failure of one or more of our clinical trials could occur at any stage of testing. In addition, success in preclinical testing and early clinical trials does not ensure that later clinical trials will be successful, and interim results of a clinical trial do not necessarily predict final results. We may experience numerous unforeseen events during, or as a result of, preclinical testing and the clinical trial process, which could delay or prevent our or our collaborative partners’ ability to commercialize our product candidates, including:
    regulators or institutional review boards may not authorize us to commence a clinical trial at a prospective trial site;
 
    our preclinical testing or clinical trials may produce negative or inconclusive results, which may require us to conduct additional preclinical or clinical testing or to abandon projects that we expect to be promising;
 
    we may suspend or terminate our clinical trials if the participating patients are being exposed to unacceptable health risks;
 
    risks associated with clinical trial design may result in a failure of the clinical trial to show statistically significant results even if the product candidate is effective;
 
    regulators or institutional review boards may suspend or terminate clinical research for various reasons, including noncompliance with regulatory requirements; and
 
    the effects of our product candidates may not be the desired effects or may include undesirable side effects.
     As an example of an unforeseen event, after having been discharged from a Phase 1 clinical trial in which a single dose of XP13512 was administered almost two days earlier, a volunteer died of a self-inflicted gunshot wound following a domestic dispute. We do not believe that this incident was related to XP13512. However, any unforeseen event could cause us to experience significant delays in, or the termination of, clinical trials. Any such events would increase our costs and could delay or prevent our ability to commercialize our product candidates, which would adversely impact our financial results.

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     Any failure or delay in commencing or completing clinical trials for our product candidates could severely harm our business.*
     To date, we have not completed all of the clinical trials required for regulatory approval of any product candidate. The commencement and completion of clinical trials for our product candidates may be delayed or terminated as a result of many factors, including:
    delays in patient enrollment, which we have experienced in the past, and variability in the number and types of patients available for clinical trials;
 
    our inability or the inability of our collaborators or licensees to manufacture or obtain from third parties materials sufficient for use in preclinical studies and clinical trials;
 
    difficulty in maintaining contact with patients after treatment, resulting in incomplete data;
 
    poor effectiveness of product candidates during clinical trials;
 
    unforeseen safety issues or side effects; and
 
    governmental or regulatory delays and changes in regulatory requirements, policy and guidelines.
     For example, based on the results of a planned interim analysis of the clinical data, although no safety concerns were noted, Astellas recently terminated its Phase 2 clinical trial of XP13512 as a potential treatment for PDN due to difficulty in demonstrating a statistically significant advantage of XP13512 over placebo under the current clinical trial design. Any delay in commencing or completing clinical trials for our product candidates would delay commercialization of our product candidates and severely harm our business and financial condition. In addition, unforeseen safety issues or side effects could result from our collaborators’ current or future clinical trials, which could delay or negatively impact commercialization of our product candidates. It is also possible that none of our product candidates will complete clinical trials in any of the markets in which we or our collaborators intend to sell those product candidates. Accordingly, we or our collaborators would not receive the regulatory approvals needed to market our product candidates, which would severely harm our business and financial condition.
     We rely on third parties to conduct our clinical trials. If these third parties do not perform as contractually required or expected, we may not be able to obtain regulatory approval for, or commercialize, our product candidates.
     We do not have the ability to independently conduct clinical trials for our product candidates, and we must rely on third parties, such as contract research organizations, medical institutions, clinical investigators, collaborative partners and contract laboratories, to conduct our clinical trials. We have, in the ordinary course of business, entered into agreements with these third parties. Nonetheless, with the exception of XP21510 in the United States and XP13512 outside the United States for RLS and all other indications around the world, we are responsible for confirming that each of our clinical trials is conducted in accordance with its general investigational plan and protocol. Moreover, the FDA requires us to comply with regulations and standards, commonly referred to as good clinical practices, for conducting and recording and reporting the results of clinical trials to assure that data and reported results are credible and accurate and that the trial participants are adequately protected. Our reliance on third parties that we do not control does not relieve us of these responsibilities and requirements. For example, we need to prepare, and ensure our compliance with, various procedures required under good clinical practices, even though third-party contract research organizations have prepared and are complying with their own, comparable procedures. If these third parties do not successfully carry out their contractual duties or regulatory obligations or meet expected deadlines, if the third parties need to be replaced or if the quality or accuracy of the data they obtain is compromised due to the failure to adhere to our clinical protocols or regulatory requirements or for other reasons, our preclinical development activities or clinical trials may be extended, delayed, suspended or terminated, and we may not be able to obtain regulatory approval for, or successfully commercialize, our product candidates.
     If some or all of our patents expire, are invalidated or are unenforceable, or if some or all of our patent applications do not yield issued patents or yield patents with narrow claims, competitors may develop competing products using our intellectual property and our business will suffer.*
     Our success will depend in part on our ability to obtain and maintain patent and trade secret protection for our technologies and product candidates both in the United States and other countries. We cannot guarantee that any patents will issue from any of our pending or future patent applications. Alternatively, a third party may successfully circumvent our patents. Our rights under any issued patents may not provide us with sufficient protection against competitive products or otherwise cover commercially valuable products or processes.

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     The degree of future protection for our proprietary technologies and product candidates is uncertain because legal means afford only limited protection and may not adequately protect our rights or permit us to gain or keep our competitive advantage. For example:
    we might not have been the first to make the inventions covered by each of our pending patent applications and issued patents;
 
    we might not have been the first to file patent applications for these inventions;
 
    others may independently develop similar or alternative technologies or duplicate any of our technologies;
 
    it is possible that none of our pending patent applications will result in issued patents;
 
    any patents issued to us or our collaborators may not provide a basis for commercially viable products or may be challenged by third parties; or
 
    the patents of others may have an adverse effect on our ability to do business.
     Even if valid and enforceable patents cover our product candidates and technologies, the patents will provide protection only for a limited amount of time.
     Our and our collaborators’ ability to obtain patents is highly uncertain because, to date, some legal principles remain unresolved, there has not been a consistent policy regarding the breadth or interpretation of claims allowed in patents in the United States and the specific content of patents and patent applications that are necessary to support and interpret patent claims is highly uncertain due to the complex nature of the relevant legal, scientific and factual issues. Furthermore, the policies governing biotechnology patents outside the United States are even more uncertain. Changes in either patent laws or interpretations of patent laws in the United States and other countries may diminish the value of our intellectual property or narrow the scope of our patent protection.
     Even if patents are issued regarding our product candidates or methods of using them, those patents can be challenged by our competitors who can argue such patents are invalid and/or unenforceable. For example, in September 2008, a law firm on behalf of an undisclosed client filed an opposition against the patent grant of one of our European patent applications covering XP13512. Unlike in the United States, where an issued patent is presumed valid, in Europe, third parties have nine months following the grant of a patent in which to file an opposition during which there is no presumption of patent validity. As is often the case, this opposition was filed a few days prior to the expiration of the nine-month period, and, accordingly, the grant of the European patent will be subject to a full review. While we cannot predict the duration or result of this opposition proceeding, a corresponding U.S. patent was issued, and the most important of the prior art that was cited in the European opposition as a basis for challenging the issuance of the European patent covering XP13512 was cited to the U.S. Patent and Trademark Office during the prosecution of that issued U.S. patent. The possible revocation of the European patent or amendment of its granted claims would not preclude us from developing and commercializing XP13512 in Europe, but could increase the risk of competition. Patents also may not protect our product candidates if competitors devise ways of making these or similar product candidates without legally infringing our patents. The Federal Food, Drug and Cosmetic Act and FDA regulations and policies provide incentives to manufacturers to challenge patent validity and these same types of incentives encourage manufacturers to submit NDAs that rely on literature and clinical data not prepared for or by the drug sponsor.
     As of October 15, 2008, we held 35 U.S. patents and had 87 patent applications pending before the U.S. Patent and Trademark Office. For some of our inventions, corresponding non-U.S. patent protection is pending. Of the 35 U.S. patents that we hold, 25 patents are compound- and composition-related, having expiration dates from 2021 to 2026; four patents are synthesis-method related, having expiration dates from 2022 to 2025; one patent is proteomics methodology-related, having an expiration date in 2022; and five patents are screening methodology-related, having expiration dates from 2022 to 2025. Subject to possible patent term extension, the entitlement for which and the term of which we cannot predict, patent protection in the United States covering XP13512, our product candidate that is a Transported Prodrug of gabapentin, will expire no earlier than 2022. We believe that in all countries in which we hold or have licensed rights to patents or patent applications related to XP13512, the composition-of-matter patents relating to gabapentin have expired. For XP19986, our product candidate that is a Transported Prodrug of R-baclofen, two U.S. composition-of-matter patents have issued that will expire no earlier than 2025 and two synthesis method/chemical intermediate U.S. patents have issued that will expire no earlier than 2025. For XP21279, our product candidate that is a Transported Prodrug of L-dopa, one U.S. composition-of-matter patent has issued that will expire no earlier than 2025. For XP21510, our product candidate that is a Transported Prodrug of tranexamic acid, one U.S. composition-of-matter patent has issued that will expire no earlier than 2026. Although third parties may challenge our rights to, or the scope or validity of, our patents, to date, other than the European opposition

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described above, we have not received any communications from third parties challenging our patents or patent applications covering our product candidates.
     We also rely on trade secrets to protect our technology, especially where we do not believe that patent protection is appropriate or obtainable. However, trade secrets are difficult to protect. Our employees, consultants, contractors, outside scientific collaborators and other advisors may unintentionally or willfully disclose our confidential information to competitors. Enforcing a claim that a third party illegally obtained and is using our trade secrets is expensive and time-consuming, and the outcome is unpredictable. Failure to obtain or maintain trade secret protection could adversely affect our competitive business position.
     Our research and development collaborators may have rights to publish data and other information in which we have rights. In addition, we sometimes engage individuals or entities to conduct research that may be relevant to our business. The ability of these individuals or entities to publish or otherwise publicly disclose data and other information generated during the course of their research is subject to certain contractual limitations. In most cases, these individuals or entities are, at the least, precluded from publicly disclosing our confidential information and are only allowed to disclose other data or information generated during the course of the research after we have been afforded an opportunity to consider whether patent and/or other proprietary protection should be sought. If we do not apply for patent protection prior to such publication or if we cannot otherwise maintain the confidentiality of our technology and other confidential information, then our ability to receive patent protection or protect our proprietary information may be jeopardized.
     Third-party claims of intellectual property infringement would require us to spend significant time and money and could prevent us from developing or commercializing our products.*
     Our commercial success depends in part on not infringing the patents and proprietary rights of other parties and not breaching any licenses that we have entered into with regard to our technologies and products. Because others may have filed, and in the future are likely to file, patent applications covering products or other technologies of interest to us that are similar or identical to ours, patent applications or issued patents of others may have priority over our patent applications or issued patents. For example, we are aware of a family of third-party patent applications relating to prodrugs of gabapentin. We believe the applications have been abandoned in the United States, the European Patent Office, Canada, Australia and the United Kingdom. Additionally, we are aware of third-party patents relating to the use of baclofen in the treatment of gastroesophageal reflux disease, or GERD. If the patents are determined to be valid and construed to cover XP19986, the development and commercialization of XP19986 could be affected. With respect to the claims contained in these patent applications and patents, we believe that our activities do not infringe the patents at issue and/or that the third-party patent or patent applications are invalid. However, it is possible that a judge or jury will disagree with our conclusions regarding non-infringement and/or invalidity, and we could incur substantial costs in litigation if we are required to defend against patent suits brought by third parties or if we initiate these suits. Any legal action against our collaborators or us claiming damages and seeking to enjoin commercial activities relating to the affected products and processes could, in addition to subjecting us to potential liability for damages, require our collaborators or us to obtain a license to continue to manufacture or market the affected products and processes. Licenses required under any of these patents may not be available on commercially acceptable terms, if at all. Failure to obtain such licenses could materially and adversely affect our ability to develop, commercialize and sell our product candidates. We believe that there may continue to be significant litigation in the biotechnology and pharmaceutical industry regarding patent and other intellectual property rights. If we become involved in litigation, it could consume a substantial portion of our management and financial resources and we may not prevail in any such litigation.
     Furthermore, our commercial success will depend, in part, on our ability to continue to conduct research to identify additional product candidates in current indications of interest or opportunities in other indications. Some of these activities may involve the use of genes, gene products, screening technologies and other research tools that are covered by third-party patents. Court decisions have indicated that the exemption from patent infringement afforded by 35 U.S.C. § 271(e)(1) does not encompass all research and development activities associated with product development. In some instances, we may be required to obtain licenses to such third-party patents to conduct our research and development activities, including activities that may have already occurred. It is not known whether any license required under any of these patents would be made available on commercially acceptable terms, if at all. Failure to obtain such licenses could materially and adversely affect our ability to maintain a pipeline of potential product candidates and to bring new products to market. If we are required to defend against patent suits brought by third parties relating to third-party patents that may be relevant to our research activities, or if we initiate such suits, we could incur substantial costs in litigation. Moreover, an adverse result from any legal action in which we are involved could subject us to damages and/or prevent us from conducting some of our research and development activities.

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     If third parties do not manufacture our product candidates in sufficient quantities or at an acceptable cost, clinical development and commercialization of our product candidates would be delayed.*
     We do not currently own or operate manufacturing facilities for the production of clinical or commercial quantities of any of our product candidates. To date, we have relied on, and we expect to continue to rely on, a limited number of third-party compound manufacturers and active pharmaceutical ingredient, or API, formulators for the production of preclinical, clinical and commercial quantities of our product candidates. We do not have commercial supply agreements with any of these third parties, and our agreements with these parties are generally terminable at will by either party at any time. If, for any reason, these third parties are unable or unwilling to perform under our agreements or enter into new agreements, we may not be able to locate alternative manufacturers or formulators or enter into favorable agreements with them. Any inability to acquire sufficient quantities of our product candidates in a timely manner from these third parties could delay clinical trials and prevent us or our partners from developing and commercializing our product candidates in a cost-effective manner or on a timely basis.
     Under the terms of our collaboration with GSK, GSK is solely responsible for the manufacture of XP13512 to support its development and commercialization within its licensed territory. As a result, if GSK fails to manufacture sufficient quantities of XP13512, development and commercialization of this product candidate could be impaired or delayed in the GSK licensed territory. In addition, we will continue to be responsible for providing Astellas both clinical and commercial supplies of XP13512. Thus, we expect to continue to rely on a limited number of third-party manufacturers to meet our clinical and commercial supply obligations to Astellas for XP13512. We purchase substantial amounts of gabapentin, which is used to make XP13512, from Teva Pharmaceutical Industries, Ltd. pursuant to purchase orders issued from time to time. Teva’s sale of gabapentin is the subject of ongoing litigation brought by Pfizer Inc alleging infringement of a patent held by Pfizer. In September 2007, the Court of Appeals for the Federal Circuit overturned a July 2006 District Court ruling that was in favor of the generic gabapentin makers, including Teva, and the suit has been remanded to the District Court to continue with the trial. In the event that Teva decides not to sell gabapentin to us, or decides to sell gabapentin to us at a price that is not commercially attractive, or, as a result of this litigation, ceases producing gabapentin, we would not be able to manufacture XP13512 until an alternative supplier was qualified. This could impair our ability to meet our supply obligations to Astellas and delay their ability to commercialize this product candidate.
     We currently rely on Lonza Ltd. as the single source supplier of our current requirements of XP13512 API. We have agreed to purchase XP13512 API from Lonza under a manufacturing services and product supply agreement. In the event that Lonza terminates the agreement in response to a breach by us, we would not be able to manufacture the API until a qualified alternative supplier is identified. This could delay the development of, and impair the ability of us or Astellas to commercialize, this product candidate. In addition, our current agreement with Lonza does not provide for the entire supply of API that we require to support Astellas’ planned clinical trials or full-scale commercialization. However, the manufacturing services and product supply agreement obligates the parties to negotiate in good faith on the terms and conditions for Lonza to supply some or all of our total requirements for the commercial supply of XP13512 API. In the event that the parties cannot agree to the terms and conditions for Lonza to provide some or all of our API commercial supply needs, we would not be able to manufacture API until a qualified alternative supplier is identified. This could impair our ability to satisfy our contractual obligations to Astellas and could also delay or impair Astellas’ ability to develop and commercialize XP13512. Unless earlier terminated, our current agreement with Lonza expires in July 2009.
     In addition, we currently rely on Patheon Pharmaceuticals, Inc. as our single source supplier for XP13512 formulated in sustained-release tablets for clinical trials at specified transfer prices under a quotation agreed upon by the parties that forms a part of a master services agreement. In the event that Patheon terminates the agreement under specified circumstances, we would not be able to manufacture XP13512 sustained-release tablets until a qualified alternative supplier is identified. This could impair our ability to satisfy our contractual obligations to Astellas and could also delay or impair Astellas’ ability to develop and commercialize XP13512.
     We currently rely on Excella GmbH (formerly Heumann Pharma GmbH) as our single source supplier of R-baclofen, the active agent used to make XP19986, under purchase orders issued from time to time. We are aware of two alternative suppliers of R-baclofen, and we are in the process of qualifying them as alternative suppliers. In the event that Excella determines to not sell R-baclofen to us at a price that is commercially attractive, and if we were unable to qualify an alternative supplier of R-baclofen, this could delay the development of, and impair our ability to commercialize, this product candidate.
     We currently rely on Lonza as the single source supplier of our current worldwide requirements of XP19986 in API form under a manufacturing services and product supply agreement. Our current agreement with Lonza does not provide for the entire supply of the API necessary for our Phase 2 and Phase 3 clinical trials or for full-scale commercialization. In the event that the parties cannot agree to the terms and conditions for Lonza to provide some or all of our API clinical and commercial supply needs, we would not be able to manufacture API until a qualified alternative supplier is identified, which could also delay the development of, and impair our ability to commercialize, this product candidate.

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     We currently rely on Xcelience, LLC as our single source supplier for XP19986 formulated in sustained-release tablets for clinical trials at specified transfer prices under quotations agreed upon by the parties as a part of a master services agreement. We have identified a potential alternative supplier and are in the qualifying process. In the event that Xcelience terminates the agreement under specified circumstances, we would not be able to manufacture XP19986 sustained-release tablets until an alternative supplier is qualified. This could delay the development of, and impair our ability to commercialize, XP19986.
     We currently rely on Ajinomoto Company as our single source supplier of L-Dopa, which is used to make XP21279, under purchase orders issued from time to time. We are aware of several alternative suppliers of L-Dopa, and we believe at least one alternative manufacturer could potentially supply L-Dopa, in the event that Ajinomoto determines to not sell L-Dopa to us at a price that is commercially attractive. If we were unable to qualify an alternative supplier of L-Dopa, this could delay the development of, and impair our ability to commercialize, XP21279.
     We have purchased from Raylo Chemicals, Inc., a subsidiary of Gilead Sciences, Inc., all of our current worldwide requirements of XP21279 in API form through our initial Phase 1 clinical trial under a manufacturing services and product supply agreement. We have identified a potential alternative supplier for manufacture of XP21279 in API form, and we are in the process of qualifying it as an alternative supplier. If we were unable to qualify an alternative supplier of XP21279, this could delay the development of, and impair our ability to commercialize, this product candidate.
     UPM Pharmaceuticals, Inc. provided our requirements of XP21279 for clinical trials in the form of sustained-release tablets at specified transfer prices under price quotations agreed upon by the parties as a part of a master services agreement. We rely on UPM as a single source supplier for tablets of XP21279. We have identified a potential alternative supplier and are in the qualifying process. In the event that UPM terminates the agreement under specified circumstances, we would not be able to manufacture XP21279 sustained-release tablets until an alternative supplier is qualified. This could delay the development of, and impair our ability to commercialize, XP21279.
     If we are required to obtain alternate third-party manufacturers, it could delay or prevent the clinical development and commercialization of our product candidates.*
     We may not be able to maintain or renew our existing or any other third-party manufacturing arrangements on acceptable terms, if at all. If we are unable to continue relationships with Teva, Lonza or Patheon for XP13512, Excella, Lonza or Xcelience for XP19986 or Ajinomoto or UPM for XP21279, to continue relationships at an acceptable cost or if these suppliers fail to meet our requirements for these product candidates for any reason, we would be required to obtain alternative suppliers. Any inability to obtain qualified alternative suppliers, including an inability to obtain, or delay in obtaining, approval of an alternative supplier from the FDA, would delay or prevent the clinical development and commercialization of these product candidates, and could impact our ability to meet our supply obligations to Astellas.
     Any failure or delay in developing or manufacturing, or obtaining a qualified commercial supplier of, a new sustained-release tablet formulation of XP19986 could delay the clinical development and commercialization of this product candidate.
     Catalent Pharma Solutions, LLC (formerly Cardinal Health PTS, LLC) provided our requirements of XP19986 for our Phase 1 and Phase 2a clinical trials in the form of capsules containing controlled-release beads. However, we have developed new sustained-release tablet formulations of XP19986 to replace the Catalent capsules and have conducted clinical trials with these new tablet formulations. There can be no assurance that clinical trials with the sustained-release tablet formulations will replicate efficacy results from our earlier clinical trials with the capsule formulation. The failure to replicate these earlier clinical trials would delay our clinical development timelines. We have engaged Xcelience as a third-party manufacturer for the new sustained-release tablet formulations. Any inability to obtain a qualified commercial supplier, including an inability to obtain, or delay in obtaining, approval of a supplier from the FDA, would delay or prevent the clinical development and commercialization of this product candidate. We currently ship XP19986 using refrigerated containers. We anticipate that manufacturing improvements we will make will alleviate the need to ship this product candidate for commercial sale using refrigerated containers. If we are unable to achieve these manufacturing improvements, we may incur additional expenses and delays that could impair our ability to generate product revenue.
     Use of third-party manufacturers may increase the risk that we or our partners will not have adequate supplies of our product candidates.*
     Our current reliance, and our and our partners’ anticipated future reliance, on third-party manufacturers will expose us and our partners to risks that could delay or prevent the initiation or completion of clinical trials by us or our partners, the submission of

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applications for regulatory approvals, the approval of our products by the FDA or foreign regulatory authorities or the commercialization of our products or could result in higher costs or lost product revenues. In particular, our contract manufacturers:
    could encounter difficulties in achieving volume production, quality control and quality assurance or suffer shortages of qualified personnel, which could result in their inability to manufacture sufficient quantities of drugs to meet clinical schedules or to commercialize our product candidates;
 
    could terminate or choose not to renew manufacturing agreements, based on their own business priorities, at a time that is costly or inconvenient for us;
 
    could fail to establish and follow FDA-mandated current good manufacturing practices, or cGMPs, which are required for FDA approval of our product candidates, or fail to document their adherence to cGMPs, either of which could lead to significant delays in the availability of material for clinical study and delay or prevent marketing approval for our product candidates;
 
    could encounter financial difficulties that would interfere with their obligations to supply our product candidates; and
 
    could breach, or fail to perform as agreed under, manufacturing agreements.
     As an example, one of our third-party manufacturers previously released financial results indicating that its earnings were adversely affected due to certain circumstances at two of its manufacturing operations. If such financial difficulties interfere with its ability to satisfy its contractual obligations to supply our product candidates, there could be a delay in commencing or completing our or our collaborative partners’ clinical trials, which could also delay the development of, and impair our or our partners’ ability to commercialize, our product candidates.
     If we are not able to obtain adequate supplies of our product candidates, it will be more difficult to develop our product candidates and compete effectively. Our product candidates and any products that we may develop may compete with other product candidates and products for access to manufacturing facilities. For example, gabapentin is also marketed as generic gabapentin by Teva, one of our third-party manufacturers.
     In addition, the manufacturing facilities of Excella, Lonza, Teva and Ajinomoto are located outside of the United States. This may give rise to difficulties in importing our product candidates or their components into the United States or other countries as a result of, among other things, regulatory agency import inspections, incomplete or inaccurate import documentation or defective packaging.
     Safety issues with the parent drugs or other components of our product candidates, or with approved products of third parties that are similar to our product candidates, could give rise to delays in the regulatory approval process, restrictions on labeling or product withdrawal.*
     Discovery of previously unknown problems with an approved product may result in restrictions on its permissible uses, including withdrawal of the medicine from the market. The FDA approved gabapentin, the parent drug for our XP13512 product candidate, in 1993, and, to date, it has been used in at least 12 million patients. Baclofen, the R-isomer of which is the parent drug for our XP19986 product candidate, has been used since 1977. The FDA has not approved the R-isomer of baclofen for use in humans. The FDA approved levadopa, or L-Dopa, the parent drug for our XP21279, in 1967. The FDA has not approved oral tranexamic acid, which is the parent drug for our XP21510 product candidate, although it has been used in European countries and other countries for many years and is approved in intravenous form in the United States for tooth extractions in hemophiliacs. Although gabapentin, baclofen, L-Dopa and tranexamic acid have been used successfully in patients for many years, newly observed toxicities, or worsening of known toxicities, in patients receiving gabapentin, baclofen, L-Dopa or tranexamic acid could result in increased regulatory scrutiny of XP13512, XP19986, XP21279 and XP21510, respectively.
     Our product candidates are engineered to be broken down by the body’s natural metabolic processes and to release the parent drug and other metabolic substances. While these breakdown products are generally regarded as safe, it is possible that there could be unexpected toxicity associated with these breakdown products that will cause any or all of XP13512, XP19986, XP21279 and XP21510 to be poorly tolerated by, or toxic to, humans. Any unexpected toxicity of, or suboptimal tolerance to, our Transported Prodrugs would delay or prevent commercialization of these product candidates.

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     Additionally, problems with approved products marketed by third parties that utilize the same therapeutic target or belong to the same therapeutic class as the parent drug of our product candidates could adversely affect the development of our product candidates. For example, the product withdrawals of Vioxx from Merck & Co., Inc. and Bextra from Pfizer in 2005 due to safety issues has caused other drugs that have the same therapeutic target, such as Celebrex from Pfizer, to receive additional scrutiny from regulatory authorities. If either gabapentin or pregabalin, drugs from Pfizer that are marketed as Neurontin and Lyrica, respectively, encounters unexpected toxicity problems in humans, the FDA may delay or prevent the regulatory approval of XP13512 since it is believed to share the same therapeutic target as gabapentin and pregabalin. In 2005, the FDA requested that all makers of epilepsy drugs analyze their clinical trial data to determine whether these drugs increase the risk of suicide in patients. In January 2008, the FDA warned doctors that 11 antiepileptic drugs, or AEDs, including gabapentin, increased suicide-related risk in patients, especially epileptics. In July 2008, an advisory committee recommended to the FDA that warnings be added to the labels of all AEDs regarding an increased risk of suicide or suicidal thoughts. At this time, it is unclear if XP13512, as a compound that is believed to share the same therapeutic target as gabapentin and pregabalin, would, if approved by the FDA, require a similar warning in its label. Finally, if the FDA determines that a drug may present a risk of substance abuse, it can recommend to the DEA that the drug be scheduled under the Controlled Substances Act. While gabapentin is not a scheduled drug at the present time, pregabalin has been scheduled as a controlled substance. Since pregabalin is a scheduled drug, it is possible that the FDA may require additional testing of XP13512, the results of which could lead the FDA to conclude that XP13512 should be scheduled as well. Scheduled substances are subject to DEA regulations relating to manufacturing, storage, distribution and physician prescription procedures, and the DEA regulates the amount of a scheduled substance that is available for clinical trials and commercial distribution. Accordingly, any scheduling action that the FDA or DEA may take with respect to XP13512 may delay its clinical trial and approval process. Any failure or delay in commencing or completing clinical trials or obtaining regulatory approvals for our product candidates would delay commercialization of our product candidates and severely harm our business and financial condition.
     We may not be successful in our efforts to identify or discover additional Transported Prodrug candidates.
     An important element of our strategy is to identify, develop and commercialize Transported Prodrugs that improve upon the absorption, distribution and/or metabolism of drugs that have already received regulatory approval. Other than XP13512, XP19986 and XP21279, all of our research and development programs are at a preclinical stage. Research programs to identify new product candidates require substantial technical, financial and human resources. These research programs may initially show promise in identifying potential product candidates, yet fail to yield product candidates for clinical development for a number of reasons, including:
    the research methodology used may not be successful in identifying potential product candidates; or
 
    potential product candidates may, on further study, be shown to have inadequate efficacy, harmful side effects, suboptimal pharmaceutical profile or other characteristics suggesting that they are unlikely to be effective products.
     If we are unable to develop suitable product candidates through internal research programs or otherwise, we will not be able to increase our revenues in future periods, which could result in significant harm to our financial position and adversely impact our stock price.
     Our product candidates will remain subject to ongoing regulatory review, even if they receive marketing approval. If we or our collaborative partners fail to comply with continuing regulations, these approvals could be rescinded and the sale of our products could be suspended.
     Even if we or our collaborative partners receive regulatory approval to market a particular product candidate, the approval could be conditioned on conducting additional, costly, post-approval studies or could limit the indicated uses included in the labeling. Moreover, the product may later cause adverse effects that limit or prevent its widespread use, force us or our collaborative partners to withdraw it from the market or impede or delay our or our collaborative partners’ ability to obtain regulatory approvals in additional countries. In addition, the manufacturer of the product and its facilities will continue to be subject to FDA review and periodic inspections to ensure adherence to applicable regulations. After receiving marketing approval, the manufacturing, labeling, packaging, adverse event reporting, storage, advertising, promotion and record keeping related to the product will remain subject to extensive regulatory requirements.
     If we or our collaborative partners fail to comply with the regulatory requirements of the FDA and other applicable U.S. and foreign regulatory authorities or previously unknown problems with our products, manufacturers or manufacturing processes are discovered, we and our partners could be subject to administrative or judicially imposed sanctions, including:

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    restrictions on the products, manufacturers or manufacturing processes;
 
    warning letters;
 
    civil or criminal penalties or fines;
 
    injunctions;
 
    product seizures, detentions or import bans;
 
    voluntary or mandatory product recalls and publicity requirements;
 
    suspension or withdrawal of regulatory approvals;
 
    total or partial suspension of production; and
 
    refusal to approve pending applications for marketing approval of new drugs or supplements to approved applications.
     Because we have a number of product candidates and are considering a variety of target indications, we may expend our limited resources to pursue a particular candidate or indication and fail to capitalize on candidates or indications that may be more profitable or for which there is a greater likelihood of success.
     Because we have limited financial and managerial resources, we must focus on research programs and product candidates for the specific indications that we believe are the most promising. As a result, we may forego or delay pursuit of opportunities with other product candidates or other indications that later prove to have greater commercial potential. Our resource allocation decisions may cause us to fail to capitalize on viable commercial products or profitable market opportunities. In addition, we may spend valuable time and managerial and financial resources on research programs and product candidates for specific indications that ultimately do not yield any commercially viable products. If we do not accurately evaluate the commercial potential or target market for a particular product candidate, we may relinquish valuable rights to that product candidate through collaboration, licensing or other royalty arrangements in situations where it would have been more advantageous for us to retain sole rights to development and commercialization.
     The commercial success of any products that we or our partners may develop will depend upon the degree of market acceptance among physicians, patients, healthcare payors and the medical community.
     Any products that result from our product candidates may not gain market acceptance among physicians, patients, healthcare payors and the medical community. If these products do not achieve an adequate level of acceptance, we may not generate material product revenues and we may not become profitable. The degree of market acceptance of any products resulting from our product candidates will depend on a number of factors, including:
    demonstration of efficacy and safety in clinical trials;
 
    the prevalence and severity of any side effects;
 
    potential or perceived advantages over alternative treatments;
 
    perceptions about the relationship or similarity between our product candidates and the parent drug upon which each Transported Prodrug candidate was based;
 
    the timing of market entry relative to competitive treatments;
 
    the ability to offer product candidates for sale at competitive prices;
 
    relative convenience and ease of administration;

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    the strength of marketing and distribution support;
 
    sufficient third-party coverage or reimbursement; and
 
    the product labeling or product insert required by the FDA or regulatory authorities in other countries.
     If we are unable to establish sales and marketing capabilities or enter into additional agreements with third parties to market and sell our product candidates, we may be unable to generate product revenues.*
     We have a limited sales and marketing organization and have limited experience in the sales, marketing and distribution of pharmaceutical products. There are risks involved with establishing our own sales and marketing capabilities, as well as entering into arrangements with third parties to perform these services. Developing an internal sales force is expensive and time-consuming. On the other hand, if we enter into arrangements with third parties to perform sales, marketing and distribution services, as we have for XP13512 around the world and XP21510 in the United States, our product revenues will be lower than if we market and sell any products that we develop ourselves.
     Under the terms of our collaboration with GSK, we are entitled to a royalty based on a percentage of sales of XP13512 in the GSK territory for a specified period of time, unless we elect the option to co-promote XP13512 in the United States. In the event that we elect the co-promotion option for XP13512, we would share marketing and commercialization costs and would be entitled to a share of operating profits from sales of XP13512 in the United States, as well as receive payments on details we perform on Requip XL, GSK’s product for Parkinson’s disease in the United States. Subject to approval from the FDA of an NDA for Solzira, we would co-promote XP13512 in the United States to those same prescribers. If we elect the co-promotion option for XP13512, we plan to establish our own specialty sales force to sell and market our products. Under the terms of our collaboration with Xanodyne, we are entitled to a percentage of sales of XP21510 in the United States for a specified period of time and a specified percentage of sales of XP12B, Xanodyne’s formulation of tranexamic acid that has successfully completed two Phase 3 pivotal trials.
     Factors that may inhibit our efforts to commercialize our products include:
    our inability to recruit and retain adequate numbers of effective sales and marketing personnel;
 
    the inability of sales personnel to obtain access to or persuade adequate numbers of physicians to prescribe our products;
 
    the lack of complementary products to be offered by sales personnel, which may put us at a competitive disadvantage relative to companies with more extensive product lines; and
 
    unforeseen costs and expenses associated with creating an independent sales and marketing organization.
     Because of the numerous risks and uncertainties involved with establishing our own sales and marketing capabilities, we are unable to predict when we will establish our own sales and marketing capabilities. If we are not successful in recruiting sales and marketing personnel or in building a sales and marketing infrastructure, we will have difficulty commercializing our product candidates, which would adversely affect our business and financial condition.
     Our ability to generate revenue from any products that we may develop will depend on reimbursement and drug pricing policies and regulations.*
     Many patients may be unable to pay for any products that we or our collaborative partners may develop. In the United States, many patients will rely on Medicare, Medicaid, private health insurers and other third-party payors to pay for their medical needs. Our and our partners’ ability to achieve acceptable levels of reimbursement for drug treatments by governmental authorities, private health insurers and other organizations will have an effect on our and our partners’ ability to successfully commercialize, and attract additional collaborators to invest in the development of, our product candidates. We cannot be sure that reimbursement in the United States, Europe or elsewhere will be available for any products that we or our partners may develop, and any reimbursement that may become available may be decreased or eliminated in the future. Third-party payors increasingly are challenging prices charged for medical products and services, and many third-party payors may refuse to provide reimbursement for particular drugs when an equivalent generic drug is available. Although we believe any products that may result from our product candidates will represent an improvement over the parent drugs upon which they are based and be considered unique and not subject to substitution by a generic parent drug, it is possible that a third-party payor may consider our product candidate and the generic parent drug as equivalents and

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only offer to reimburse patients for the generic drug. Even if we show improved efficacy or improved convenience of administration with our product candidate, pricing of the existing parent drug may limit the amount we will be able to charge for our product candidate. If reimbursement is not available or is available only at limited levels, we or our partners may not be able to successfully commercialize our product candidates, and may not be able to obtain a satisfactory financial return on such products.
     The trend toward managed healthcare in the United States and the changes in health insurance programs, as well as legislative proposals to reform healthcare or reduce government insurance programs, may result in lower prices for pharmaceutical products, including any products that may result from our product candidates. In addition, any future regulatory changes regarding the healthcare industry or third-party coverage and reimbursement may affect demand for any products that we may develop and could harm our sales and profitability.
     In December 2003, the Medicare Prescription Drug Improvement and Modernization Act of 2003, or the 2003 Medicare Act, was enacted. Medicare beneficiaries are now eligible to obtain subsidized prescription drug coverage from a choice of private sector plans. Over 90 percent of Medicare beneficiaries now have coverage for prescription medicines. It remains difficult to predict the long-term impact of the 2003 Medicare Act on pharmaceutical companies. The use of pharmaceuticals has increased slightly among some patients as the result of the expanded access to medicines afforded by coverage under Medicare. However, such expanded utilization has been largely offset by increased pricing pressure and competition due to the enhanced purchasing power of the private sector plans that negotiate on behalf of Medicare beneficiaries and by an increase in the use of generic medicines in this population.
     If our competitors are able to develop and market products that are more effective, safer or less costly than any products that we may develop, our commercial opportunity will be reduced or eliminated. *
     We face competition from established pharmaceutical and biotechnology companies, as well as from academic institutions, government agencies and private and public research institutions. Our commercial opportunity will be reduced or eliminated if our competitors develop and commercialize products that are safer, more effective, have fewer side effects or are less expensive than any products that we may develop. In addition, significant delays in the development of our product candidates could allow our competitors to bring products to market before us and impair our ability to commercialize our product candidates.
     We estimate that we have at least three competitors in the neuropathic pain, migraine prophylaxis and RLS therapeutic areas, including Eli Lilly and Company, Johnson & Johnson and Pfizer. Competition for XP13512 could include: approved drugs that act on the same target as XP13512, such as pregabalin, Neurontin and generic gabapentin; anti-Parkinson’s disease products and product candidates, such as generic ropinirole from GSK and pramipexole from Boehringer Ingelheim GmbH, which are each approved for the treatment of moderate-to-severe RLS, and the rotigotine patch from Schwarz Pharma AG (member of the UCB group), which filed its NDA with the FDA in the fourth quarter of 2007 and is currently under FDA review for the treatment of moderate-to-severe RLS; antiepileptics, such as topiramate from Johnson & Johnson, which is approved for the prevention of migraines; and serotonin norepinephrine inhibitors, such as duloxetine from Eli Lilly, which is approved for the management of painful diabetic neuropathy. We are aware that generic gabapentin is marketed by Alpharma Inc., Pfizer, Teva and IVAX Corp, among others, and that it is prescribed off-label to treat a variety of conditions. We estimate that XP19986 could have several generic drug competitors in the spasticity area. There are several drugs approved for the treatment of spasticity, such as racemic baclofen, diazepam, dantrolene sodium and tizanidine, and many therapies in development, such as Fampridine-SR from Acorda Therapeutics, Inc. that could compete with XP19986. We estimate that we have at least five competitors in the GERD therapeutic area, including Wyeth, TAP Pharmaceutical Products Inc., Novartis, Addex Pharmaceuticals and AstraZeneca. We estimate that we have at least four competitors in the market for treating acute back spasms, including Amrix from Cephalon, Inc., Skelaxin from King Pharmaceuticals, Inc., Flexeril and generic cyclobenzaprine and Soma and generic carisoprodol. Competition for XP21279 could include generic L-Dopa/carbidopa drugs and other drugs approved for the treatment of Parkinson’s disease. These include a combination therapy of L-Dopa/carbidopa/entacapone (marketed in the United States by Novartis as Stalevo) and dopamine agonists (marketed by Boehringer-Ingelheim, GSK and UCB as Mirapex, Requip and Neupro, respectively). In addition, there may be other compounds of which we are not aware that are at an earlier stage of development and may compete with our product candidates. If any of those compounds are successfully developed and approved, they could compete directly with our product candidates.
     Many of our competitors have significantly greater financial resources and expertise in research and development, manufacturing, preclinical testing, conducting clinical trials, obtaining regulatory approvals and marketing approved products than we do. Established pharmaceutical companies may invest heavily to quickly discover and develop novel compounds that could make our product candidates obsolete. Smaller or early-stage companies may also prove to be significant competitors, particularly through collaborative arrangements with large and established companies. In addition, these third parties compete with us in recruiting and retaining qualified scientific and management personnel, establishing clinical trial sites and patient registration for clinical trials, as well as in

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acquiring technologies and technology licenses complementary to our programs or advantageous to our business. Accordingly, our competitors may succeed in obtaining patent protection, receiving FDA approval or discovering, developing and commercializing medicines before we do. We are also aware of other companies that may currently be engaged in the discovery of medicines that will compete with the product candidates that we are developing. In addition, in the markets that we are targeting, we expect to compete against current market-leading medicines. If we are not able to compete effectively against our current and future competitors, our business will not grow and our financial condition will suffer.
     Off-label sale or use of generic gabapentin products could decrease sales of XP13512 and could lead to pricing pressure if such products become available at competitive prices and in dosages that are appropriate for the indications for which we or our collaborative partners are developing XP13512.
     Physicians are permitted to prescribe legally available drugs for uses that are not described in the drug’s labeling and that differ from those uses tested and approved by the FDA. Such off-label uses are common across medical specialties. Various products are currently sold and used off-label for some of the diseases and conditions that we or our partners are targeting, and a number of companies are, or may be, developing new treatments that may be used off-label. The occurrence of such off-label uses could significantly reduce our or our partners’ ability to market and sell any products that we or our partners may develop.
     We believe that in all countries in which we hold or have licensed rights to patents or patent applications related to XP13512, the composition-of-matter patents relating to gabapentin have expired. Off-label prescriptions written for gabapentin could adversely affect our ability to generate revenue from the sale of XP13512, if approved for commercial sale. This could result in reduced sales and pricing pressure on XP13512, if approved, which in turn would reduce our ability to generate revenue and have a negative impact on our results of operations.
     Our investment portfolio may become impaired by further deterioration of the capital markets.*
     Our cash equivalent and short-term investment portfolio as of September 30, 2008 consisted of bonds of U.S. government agencies, corporate debt securities and money market mutual funds. We follow an established investment policy and set of guidelines to monitor, manage and limit our exposure to interest rate and credit risk. The policy sets forth credit quality standards and limits our exposure to any one issuer, as well as our maximum exposure to various asset classes.
     As a result of current adverse financial market conditions, investments in some financial instruments, such as structured investment vehicles, sub-prime mortgage-backed securities and collateralized debt obligations, may pose risks arising from liquidity and credit concerns. As of September 30, 2008, we had no direct holdings in these categories of investments and our indirect exposure to these financial instruments through our holdings in money market mutual funds was immaterial. As of September 30, 2008, we had no impairment charge associated with our short-term investment portfolio relating to such adverse financial market conditions. Although we believe our current investment portfolio has very little risk of impairment, we cannot predict future market conditions or market liquidity and can provide no assurance that our investment portfolio will remain unimpaired.
     If we fail to attract and keep senior management and key scientific personnel, we may be unable to successfully develop or commercialize our product candidates.*
     Our success depends on our continued ability to attract, retain and motivate highly qualified management, clinical and scientific personnel and on our ability to develop and maintain important relationships with leading clinicians. If we are not able to retain Drs. Ronald Barrett, Kenneth Cundy, Mark Gallop, David Savello and David Stamler, we may not be able to successfully develop or commercialize our product candidates. Competition for experienced scientists and development staff may limit our ability to hire and retain highly qualified personnel on acceptable terms. In addition, none of our employees have employment commitments for any fixed period of time and could leave our employment at will. We do not carry “key person” insurance covering members of senior management or key scientific personnel. If we fail to identify, attract and retain qualified personnel, we may be unable to continue our development and commercialization activities.
     We will need to hire additional employees in order to commercialize our product candidates. Any inability to manage future growth could harm our ability to commercialize our product candidates, increase our costs and adversely impact our ability to compete effectively.
     In order to commercialize our product candidates, we will need to expand the number of our managerial, operational, financial and other employees. We currently anticipate that we will need at least 150 additional employees by the time that XP13512 or XP19986 is initially commercialized, including at least 50 sales representatives. Because the projected timeframe of hiring these additional employees depends on the development status of our product candidates and because of the numerous risks and uncertainties associated with drug development, we are unable to project when we will hire these additional employees. The competition for qualified personnel in the pharmaceutical and biotechnology field is intense, and we may experience difficulties in recruiting, hiring and retaining qualified individuals.
     Future growth will impose significant added responsibilities on members of management, including the need to identify, recruit, maintain and integrate additional employees. Our future financial performance and our ability to commercialize our product candidates and compete effectively will depend, in part, on our ability to manage any future growth effectively.

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     If product liability lawsuits are brought against us, we will incur substantial liabilities and may be required to limit commercialization of any products that we may develop.
     We face an inherent risk of product liability exposure related to the testing of our product candidates in human clinical trials and will face an even greater risk if we commercially sell any products that we may develop. If we cannot successfully defend ourselves against claims that our product candidates or products that we may develop caused injuries, we will incur substantial liabilities. Regardless of merit or eventual outcome, liability claims may result in:
    decreased demand for any product candidates or products that we may develop;
 
    injury to our reputation;
 
    withdrawal of clinical trial participants;
 
    costs to defend the related litigation;
 
    substantial monetary awards to clinical trial participants or patients;
 
    loss of revenue; and
 
    the inability to commercialize any products that we may develop.
     We have product liability insurance that covers our clinical trials up to a $10.0 million annual aggregate limit. We intend to expand our insurance coverage to include the sale of commercial products if marketing approval is obtained for any products that we may develop. Insurance coverage is increasingly expensive, and we may not be able to maintain insurance coverage at a reasonable cost and we may not be able to obtain insurance coverage that will be adequate to satisfy any liability that may arise.
     If we use biological and hazardous materials in a manner that causes contamination or injury or violates laws, we may be liable for damages.
     Our research and development activities involve the use of potentially harmful biological materials as well as hazardous materials, chemicals and various radioactive compounds. We cannot completely eliminate the risk of accidental contamination or injury from the use, storage, handling or disposal of these materials. In the event of contamination or injury, we could be held liable for damages that result, and any liability could exceed our resources. We, the third parties that conduct clinical trials on our behalf and the third parties that manufacture our product candidates are subject to federal, state and local laws and regulations governing the use, storage, handling and disposal of these materials and waste products. The cost of compliance with these laws and regulations could be significant. The failure to comply with these laws and regulations could result in significant fines and work stoppages and may harm our business.
     Our facility is located in California’s Silicon Valley, in an area with a long history of industrial activity and use of hazardous substances, including chlorinated solvents. Environmental studies conducted prior to our leasing of the site found levels of metals and volatile organic compounds in the soils and groundwater at our site. While these constituents of concern predated our occupancy, certain environmental laws, including the U.S. Comprehensive, Environmental Response, Compensation and Liability Act of 1980, impose strict, joint and several liability on current operators of real property for the cost of removal or remediation of hazardous substances. These laws often impose liability even if the owner or operator did not know of, or was not responsible for, the release of such hazardous substances. As a result, while we have not been, we cannot rule out the possibility that we could in the future be held liable for costs to address contamination at the property beneath our facility, which costs could be material.
     Our facility is located near known earthquake fault zones, and the occurrence of an earthquake, extremist attack or other catastrophic disaster could cause damage to our facilities and equipment, which could require us to cease or curtail operations.
     Our facility is located near known earthquake fault zones and, therefore, is vulnerable to damage from earthquakes. In October 1989, a major earthquake struck this area and caused significant property damage and a number of fatalities. We are also vulnerable to damage from other types of disasters, including power loss, attacks from extremist organizations, fire, floods and similar events. If any disaster were to occur, our ability to operate our business could be seriously impaired. In addition, the unique nature of our research activities and of much of our equipment could make it difficult for us to recover from this type of disaster. We currently may not have adequate insurance to cover our losses resulting from disasters or other similar significant business interruptions, and we do not plan to purchase additional insurance to cover such losses due to the cost of obtaining such coverage. Any significant losses that are not recoverable under our insurance policies could seriously impair our business and financial condition.

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Risks Related to Ownership of our Common Stock
     Our stock price is volatile, and purchasers of our common stock could incur substantial losses.*
     The market prices for securities of biopharmaceutical companies in general have been highly volatile. The market price of our common stock may be influenced by many factors, including:
    adverse results or delays in our or our collaborative partners’ clinical trials;
 
    the timing of achievement of our clinical, regulatory, partnering and other milestones, such as the commencement of clinical development, the completion of a clinical trial, the filing for regulatory approval or the establishment of commercial partnerships for one or more of our product candidates;
 
    announcement of FDA approvability, approval or non-approval of our product candidates or delays in the FDA review process;
 
    actions taken by regulatory agencies with respect to our product candidates, our clinical trials or our sales and marketing activities;
 
    actions taken by regulatory agencies with respect to products or drug classes related to our product candidates;
 
    the commercial success of any of our products approved by the FDA or its foreign counterparts;
 
    changes in our collaborators’ business strategies;
 
    regulatory developments in the United States and foreign countries;
 
    changes in the structure of healthcare payment systems;
 
    any intellectual property matter involving us, including infringement lawsuits;
 
    actions taken by regulatory agencies with respect to our or our partners’ compliance with regulatory requirements;
 
    announcements of technological innovations or new products by us or our competitors;
 
    market conditions for equity investments in general, or the biotechnology or pharmaceutical industries in particular;
 
    changes in financial estimates or recommendations by securities analysts;
 
    sales of large blocks of our common stock;
 
    sales of our common stock by our executive officers, directors and significant stockholders;
 
    restatements of our financial results and/or material weaknesses in our internal controls; and
 
    the loss of any of our key scientific or management personnel.
     The stock markets in general, and the markets for biotechnology stocks in particular, have experienced extreme volatility that has often been unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the trading price of our common stock. In the past, class action litigation has often been instituted against companies whose securities have experienced periods of volatility in market price. Any such litigation brought against us could result in substantial costs, which would hurt our financial condition and results of operations, divert management’s attention and resources and possibly delay our clinical trials or commercialization efforts.

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     Failure to maintain effective internal controls in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 could have a material adverse effect on our stock price.
     Section 404 of the Sarbanes-Oxley Act of 2002 and the related rules and regulations of the SEC require annual management assessments of the effectiveness of our internal control over financial reporting and a report by our independent registered public accounting firm attesting to, and reporting on, the effectiveness of our internal control over financial reporting. If we fail to maintain the adequacy of our internal control over financial reporting, as such standards are modified, supplemented or amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 and the related rules and regulations of the SEC. If we cannot favorably assess, or our independent registered public accounting firm is unable to provide an unqualified attestation report on, the effectiveness of our internal control over financial reporting, investor confidence in the reliability of our financial reports may be adversely affected, which could have a material adverse effect on our stock price.
     Fluctuations in our operating results could cause our stock price to decline.*
     The following factors are likely to result in fluctuations of our operating results from quarter to quarter and year to year:
    adverse results or delays in our or our collaborative partners’ clinical trials;
 
    the timing and achievement of our clinical, regulatory, partnering and other milestones, such as the commencement of clinical development, the completion of a clinical trial, the filing for regulatory approval or the establishment of a commercial partnership for one or more of our product candidates;
 
    announcement of FDA approvability, approval or non-approval of our product candidates or delays in the FDA review process;
 
    actions taken by regulatory agencies with respect to our product candidates, our clinical trials or our sales and marketing activities;
 
    actions taken by regulatory agencies with respect to products or drug classes related to our product candidates;
 
    the commercial success of any of our products approved by the FDA or its foreign counterparts;
 
    changes in our collaborators’ business strategies;
 
    actions taken by regulatory agencies with respect to our or our partners’ compliance with regulatory requirements;
 
    regulatory developments in the United States and foreign countries;
 
    changes in the structure of healthcare payment systems;
 
    any intellectual property matter involving us, including infringement lawsuits; and
 
    announcements of technological innovations or new products by us or our competitors.
     Due to these fluctuations in our operating results, a period-to-period comparison of our results of operations may not be a good predictor of our future performance. For example, due to the recognition of revenues from up-front and milestone payments from our collaborations with Astellas, GSK and Xanodyne, we were profitable in the three-month periods ended June 30 and September 30, 2007, and for the year ended December 31, 2007. However, while recognition of these revenues resulted in a profitable year for 2007, we continue to expect to incur losses for the next several years. In any particular financial period, the actual or anticipated fluctuations could be below the expectations of securities analysts or investors and our stock price could decline.

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     Because a small number of existing stockholders own a large percentage of our voting stock, they may be able to exercise significant influence over our affairs, acting in their best interests and not necessarily those of other stockholders.*
     As of October 15, 2008, our executive officers, directors and holders of 5% or more of our outstanding common stock beneficially owned approximately 31.6% of our common stock. The interests of this group of stockholders may not always coincide with our interests or the interests of other stockholders. This concentration of ownership could also have the effect of delaying or preventing a change in our control or otherwise discouraging a potential acquiror from attempting to obtain control of us, which in turn could reduce the price of our common stock.
     Our stockholder rights plan and anti-takeover provisions in our charter documents and under Delaware law could make an acquisition of us, which may be beneficial to our stockholders, more difficult and may prevent attempts by our stockholders to replace or remove our current management.
     Provisions in our amended and restated certificate of incorporation and bylaws may delay or prevent an acquisition of us, a change in our management or other changes that stockholders may consider favorable. These provisions include:
    a classified board of directors;
 
    a prohibition on actions by our stockholders by written consent;
 
    the ability of our board of directors to issue preferred stock without stockholder approval, which could be used to make it difficult for a third party to acquire us;
 
    notice requirements for nominations for election to the board of directors; and
 
    limitations on the removal of directors.
     Moreover, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which prohibits a person who owns in excess of 15% of our outstanding voting stock from merging or combining with us for a period of three years after the date of the transaction in which the person acquired in excess of 15% of our outstanding voting stock, unless the merger or combination is approved in a prescribed manner.
     We have adopted a rights agreement under which certain stockholders have the right to purchase shares of a new series of preferred stock at an exercise price of $140.00 per one one-hundredth of a share, if a person acquires more than 15% of our common stock. The rights plan could make it more difficult for a person to acquire a majority of our outstanding voting stock. The rights plan could also reduce the price that investors might be willing to pay for shares of our common stock and result in the market price being lower than it would be without the rights plan. In addition, the existence of the rights plan itself may deter a potential acquiror from acquiring us. As a result, either by operation of the rights plan or by its potential deterrent effect, mergers and acquisitions of us that our stockholders may consider in their best interests may not occur.
     If there are large sales of our common stock, the market price of our common stock could drop substantially.*
     If our existing stockholders sell a large number of shares of our common stock or the public market perceives that existing stockholders might sell shares of our common stock, the market price of our common stock could decline significantly. As of October 15, 2008, we had 25,261,653 outstanding shares of common stock. Of these shares, up to 14,702,189 shares of common stock are tradable under Rule 144 under the Securities Act of 1933, as amended, or the Securities Act, subject in some cases to various vesting agreements and the volume limitations and manner of sale requirements under Rule 144, and the remainder of the shares outstanding as of October 15, 2008 have been registered under the Securities Act and are freely tradable.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Issuer Purchases of Equity Securities
None.
Item 3. Defaults Upon Senior Securities

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None.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
None.

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Item 6. Exhibits
     
Exhibit    
Number   Description of Document
3.1
  Amended and Restated Certificate of Incorporation (1)
 
   
3.2
  Amended and Restated Bylaws (1)
 
   
3.3
  Certificate of Designation of Series A Junior Participating Preferred Stock (2)
 
   
4.1
  Specimen Common Stock Certificate (3)
 
   
4.2
  Fifth Amended and Restated Investors Rights Agreement, dated December 16, 2004, by and among the Company and certain stockholders of the Company (4)
 
   
4.3
  Form of Right Certificate (5)
 
   
10.37
  Offer letter between the Company and David A. Stamler, M.D., effective July 14, 2008 (6)
 
   
10.38
  Change of Control Agreement between the Company and David A. Stamler, M.D., dated July 14, 2008 (6)
 
   
10.39
  New Hire Option Agreement between David A. Stamler, M.D., and the Company (6)
 
   
10.40
  New Hire Stock Unit Award between David A. Stamler, M.D., and the Company (6)
 
   
31.1
  Certification of the Chief Executive Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
   
31.2
  Certification of the Chief Financial Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
   
32.1
  Certification required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. §1350) (7)
 
(1)   Incorporated herein by reference to the same numbered exhibit of our quarterly report on Form 10-Q (File No. 000-51329) for the period ended June 30, 2005, as filed with the SEC on August 11, 2005.
 
(2)   Incorporated herein by reference to Exhibit 3.1 of our current report of Form 8-K, filed with the SEC on December 16, 2005.
 
(3)   Incorporated herein by reference to the same numbered exhibit of our registration statement on Form S-1, as amended (File No. 333-122156), as filed with the SEC on April 13, 2005.
 
(4)   Incorporated herein by reference to the same numbered exhibit of our registration statement on Form S-1 (File No. 333-122156), as filed with the SEC on January 19, 2005.
 
(5)   Incorporated herein by reference to Exhibit 4.1 of our current report of Form 8-K, filed with the SEC on December 16, 2005.
 
(6)   Incorporated herein by reference to the same numbered exhibit of our quarterly report on Form 10-Q (File No. 000-51329) for the period ended June 30, 2008, as filed with the SEC on August 7, 2008.
 
(7)   This certification accompanies the quarterly report on Form 10-Q to which it relates, is not deemed filed with the Securities and Exchange Commission and is not to be incorporated by reference into any filing of the Registrant under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended (whether made before or after the date of the Form 10-Q), irrespective of any general incorporation language contained in such filing.

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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.
         
  XenoPort, Inc.
(Registrant)
 
 
  /s/ Ronald W. Barrett    
November 6, 2008  Ronald W. Barrett   
  Chief Executive Officer and Director
(principal executive officer) 
 
 
     
  /s/ William G. Harris    
  William G. Harris   
November 6, 2008   Senior Vice President of Finance and
Chief Financial Officer
(principal financial and accounting officer) 
 
 
     
  /s/ Martyn J. Webster    
  Martyn J. Webster   
November 6, 2008  Vice President of Finance   
 

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EXHIBIT INDEX
     
Exhibit    
Number   Description of Document
3.1
  Amended and Restated Certificate of Incorporation (1)
 
   
3.2
  Amended and Restated Bylaws (1)
 
   
3.3
  Certificate of Designation of Series A Junior Participating Preferred Stock (2)
 
   
4.1
  Specimen Common Stock Certificate (3)
 
   
4.2
  Fifth Amended and Restated Investors Rights Agreement, dated December 16, 2004, by and among the Company and certain stockholders of the Company (4)
 
   
4.3
  Form of Right Certificate (5)
 
   
10.37
  Offer letter between the Company and David A. Stamler, M.D., effective July 14, 2008 (6)
 
   
10.38
  Change of Control Agreement between the Company and David A. Stamler, M.D., dated July 14, 2008 (6)
 
   
10.39
  New Hire Option Agreement between David A. Stamler, M.D., and the Company (6)
 
   
10.40
  New Hire Stock Unit Award between David A. Stamler, M.D., and the Company (6)
 
   
31.1
  Certification of the Chief Executive Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
   
31.2
  Certification of the Chief Financial Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
   
32.1
  Certification required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. §1350) (7)
 
(1)   Incorporated herein by reference to the same numbered exhibit of our quarterly report on Form 10-Q (File No. 000-51329) for the period ended June 30, 2005, as filed with the SEC on August 11, 2005.
 
(2)   Incorporated herein by reference to Exhibit 3.1 of our current report of Form 8-K, filed with the SEC on December 16, 2005.
 
(3)   Incorporated herein by reference to the same numbered exhibit of our registration statement on Form S-1, as amended (File No. 333-122156), as filed with the SEC on April 13, 2005.
 
(4)   Incorporated herein by reference to the same numbered exhibit of our registration statement on Form S-1 (File No. 333-122156), as filed with the SEC on January 19, 2005.
 
(5)   Incorporated herein by reference to Exhibit 4.1 of our current report of Form 8-K, filed with the SEC on December 16, 2005.
 
(6)   Incorporated herein by reference to the same numbered exhibit of our quarterly report on Form 10-Q (File No. 000-51329) for the period ended June 30, 2008, as filed with the SEC on August 7, 2008.
 
(7)   This certification accompanies the quarterly report on Form 10-Q to which it relates, is not deemed filed with the Securities and Exchange Commission and is not to be incorporated by reference into any filing of the Registrant under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended (whether made before or after the date of the Form 10-Q), irrespective of any general incorporation language contained in such filing.

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