Paratek Pharmaceuticals
Annual Report 2009

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Table of Contents UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549Form 10-K xxAnnual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934For the fiscal year ended: December 31, 2009or ¨¨Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934Commission file number: 000-51967TRANSCEPT PHARMACEUTICALS, INC.(Exact name of registrant as specified in its charter) Delaware 33-0960223(State or other jurisdiction ofincorporation or organization) (I.R.S. EmployerIdentification No.)1003 W. Cutting Blvd., Suite #110Point Richmond, California 94804(510) 215-3500(Address, including zip code, and telephone number, including area code, of registrant’s principal executive office)Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of exchange on which registeredCommon Stock, par value $0.001 per share NASDAQ Global MarketSecurities registered pursuant to Section 12(g) of the Act:NoneIndicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No xIndicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes ¨ No xIndicate 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 1934during 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 filingrequirements for the past 90 days. Yes x No ¨Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data Filerequired to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorterperiod that the registrant was required to submit and post such files). Yes ¨ No ¨.Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, tothe best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment tothis Form 10-K. ¨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. Large accelerated filer ¨ Accelerated filer ¨ Non-accelerated filer x Smaller reporting company ¨ (Do not check if a smallerreporting company)Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No xThe aggregate market value of the common stock of the registrant held by non-affiliates of the registrant on June 30, 2009, the last business day of theregistrant’s second fiscal quarter was: $30,755,586.As of March 26, 2010 there were 13,413,391 shares of the registrant’s common stock outstanding.Documents incorporated by reference: Items 10, 11, 12, 13, and 14 of Part III incorporate information by reference from the Proxy Statement to be filedwith the Commission within 120 days of the end of our fiscal year pursuant to General Instruction G(3) to Form 10-K. Table of ContentsTABLE OF CONTENTS Item No. Page No.PART I 1. Business 3 1A. Risk Factors 30 1B. Unresolved Staff Comments 49 2. Properties 49 3. Legal Proceedings 50 4. Reserved 50PART II 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 51 6. Selected Financial Data 53 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 54 7A. Quantitative and Qualitative Disclosures About Market Risk 68 8. Financial Statements and Supplementary Data 69 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 99 9A(T). Controls and Procedures 99 9B. Other Information 100PART III 10. Directors, Executive Officers and Corporate Governance 101 11. Executive Compensation 101 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 101 13. Certain Relationships and Related Transactions, and Director Independence 102 14. Principal Accountant Fees and Services 102PART IV 15. Exhibits and Financial Statement Schedules 103EXHIBIT INDEX 103SIGNATURES 107 Table of ContentsSpecial Note Regarding Forward-Looking StatementsThis report contains forward-looking statements that are based upon current expectations within the meaning of the Private Securities LitigationReform Act of 1995. Transcept Pharmaceuticals, Inc., or Transcept, intends that such statements be protected by the safe harbor created thereby. Forward-looking statements involve risks and uncertainties and actual Transcept results and the timing of events may differ significantly from those results discussedin the forward-looking statements. Examples of such forward-looking statements include, but are not limited to, statements about or relating to: • expectations regarding plans to conduct a highway driving study and modify the Intermezzo package presentation, and the sufficiency of suchplans, to support the potential resubmission of a New Drug Application, or NDA, with the U.S. Food and Drug Administration, or FDA, forIntermezzo; • expectations regarding our ability to resubmit the NDA for Intermezzo, the expected timing of any such resubmission, and the expected timingof FDA review of any such resubmission; • the potential for Intermezzo to be the first sleep aid approved specifically for use for middle of the night awakenings; • expected activities and responsibilities of us and Purdue Pharmaceutical Products L.P., or Purdue, under our United States License andCollaboration Agreement, or the Collaboration Agreement; • our potential receipt of revenue under the Collaboration Agreement, including milestone and royalty revenue; • the satisfaction of conditions under the Collaboration Agreement with Purdue required for continued commercialization, and the payment ofpotential milestone payments, royalties and fulfillment of other Purdue obligations under the Collaboration Agreement; • the potential benefits of, and markets for, Intermezzo and other product candidates; • our plans for the manufacturing of Intermezzo, including the manufacture of validation batches; • potential competitors and competitive products; • expectations with respect to our ability to carry out plans to promote Intermezzo to psychiatrists in the United States through our co-promoteoption, if exercised, under the Collaboration Agreement, including development of a potential sales and marketing capability and the requiredsize of our sales force; • guidance with respect to expected cash, cash equivalents and marketable securities, research and development expenses, and general andadministrative expenses; • our ability to satisfy liquidity requirements for at least the next twelve months; • losses, costs, expenses, expenditures and cash flows, including the period of time over which we expect to recognize the revenue associated withthe up-front payment under the Collaboration Agreement; • capital requirements and our needs for additional financing; • the ability and degree to which we may obtain and maintain market exclusivity from the FDA for Intermezzo under Section 505(b)(2) of theFederal Food and Drug Cosmetic Act; • future payments under lease obligations and equipment financing lines; • our ability to obtain and maintain patent protection for Intermezzo without violating the intellectual property rights of others; and • expected future sources of revenue and capital. 1®®®®®®®®® Table of ContentsTranscept undertakes no obligation to, and expressly disclaims any obligation to, revise or update the forward-looking statements made herein or therisk factors whether as a result of new information, future events or otherwise. Forward-looking statements involve risks and uncertainties, which are morefully discussed in the “Risk Factors” section and elsewhere in this Annual Report, including, but not limited to, those risks and uncertainties relating to: • whether additional data exists or can be generated from existing or new clinical studies to demonstrate sufficiently to the FDA that Intermezzowould not present an unacceptable risk of residual effects, including residual effects that impair next day driving ability; • our ability to sufficiently demonstrate to the FDA that we can reduce inadvertent dosing errors of Intermezzo in the middle of the night or thatsuch dosing errors will not lead to unacceptable next day residual effects; • the potential for delays in or the inability to complete commercial partnership relationships, including additional marketing alliances forIntermezzo outside the United States; • positive results in our clinical trials may not be sufficient to obtain FDA regulatory approval of Intermezzo or to grant marketing exclusivity forIntermezzo under Hatch-Waxman; • potential termination of the Collaboration Agreement by Purdue; • our satisfaction of conditions under the Collaboration Agreement with Purdue required for Purdue to carry out its obligations under suchagreement; • difficulties or delays in building a sales organization in connection with any exercise of our co-promote option to psychiatrists under theCollaboration Agreement; • physician or patient reluctance to use Intermezzo, if approved; • changing standards of care and the introduction of products by competitors, including generic products whose introduction could reduce ourroyalty rates under the Collaboration Agreement, or alternative therapies for the treatment of indications we target; • unexpected adverse side effects or inadequate therapeutic efficacy of our product candidates that could slow or prevent product approval orapproval for particular indications; • inability to obtain additional financing, if necessary; • the uncertainty of protection for our intellectual property, through patents, trade secrets or otherwise; • potential infringement of the intellectual property rights or trade secrets of third parties; and • other difficulties or delays in development, testing, obtaining regulatory approval for, and undertaking production and marketing of our productcandidates.Intermezzo, Bimucoral, and Transcept Pharmaceuticals, Inc. are registered and unregistered trademarks of ours in the United States and otherjurisdictions. Other trademarks and trade names referred to in this Annual Report on Form 10-K are the property of their respective owners. 2®®®®®®®®TM Table of ContentsPART I Item 1.BusinessMerger of Novacea, Inc. and Transcept Pharmaceuticals, Inc.Transcept Pharmaceuticals, Inc., or Transcept, was incorporated in Delaware in 2001 as Novacea, Inc., or Novacea. Novacea previously traded on theNASDAQ Global Market under the ticker symbol “NOVC.” On January 30, 2009, Novacea completed a business combination, or merger, with a privatelyheld company, Transcept Pharmaceuticals, Inc., or TPI, pursuant to which TPI became a wholly owned subsidiary of Novacea and the corporate name ofNovacea was changed to “Transcept Pharmaceuticals, Inc.” Prior to the merger, Novacea substantially ended its business of developing novel therapies forthe treatment of cancer. Following the closing of the merger, the business conducted by TPI became the primary business of the combined entity and thatbusiness now operates through a wholly-owned subsidiary now known as Transcept Pharma, Inc. After the merger, former TPI stockholders, option holdersand warrant holders as of January 30, 2009 owned approximately 61% of Transcept common stock on a fully-diluted basis. After the merger, the stockholders,option holders and warrant holders of Novacea prior to the merger owned approximately 39% of the Transcept common stock on a fully-diluted basis. Undergenerally accepted accounting principles in the United States, the merger is treated as a “reverse merger” under the purchase method of accounting. Foraccounting purposes, TPI is considered to have acquired Novacea.Trading of Transcept Pharmaceuticals, Inc. securities on the NASDAQ Global Market under the ticker symbol “TSPT” commenced on February 2,2009.In this Annual Report, “Transcept,” “the Company,” “we,” “our” and “us” refers to the public company formerly known as Novacea and now known asTranscept Pharmaceuticals, Inc., and, as successor to the business of TPI, includes activities taking place with respect to the business of TPI prior to themerger of TPI and Novacea, as applicable.OverviewTranscept Pharmaceuticals, Inc. is a specialty pharmaceutical company focused on the development and commercialization of proprietary products thataddress important therapeutic needs in neuroscience. Our most advanced product candidate, Intermezzo (zolpidem tartrate sublingual tablet), is a sublinguallow dose formulation of zolpidem that we are developing for use in the middle of the night at the time a patient awakens and has difficulty returning to sleep.We submitted an NDA to the FDA on September 30, 2008. On October 28, 2009, we received a Complete Response Letter from the FDA regarding ourNDA indicating that the NDA was not approved. The FDA stated in its Complete Response Letter that it believes we submitted substantial evidence of theeffectiveness of Intermezzo for its proposed indication. However, the FDA also noted that the intended use of Intermezzo in the middle of the nightrepresents a unique insomnia indication and dosing strategy for which safety has not been previously established and that we had not adequatelydemonstrated to the FDA that Intermezzo can be reliably used safely.Our proposed label for Intermezzo indicates that Intermezzo should only be taken when patients have at least four hours remaining in bed beforebeing active again. In its Complete Response Letter, the FDA recognized that the Intermezzo data we submitted did not indicate significant next dayresidual effects at four hours. However, the FDA requested additional data demonstrating that Intermezzo, when taken as directed in the middle of the night,would not present an unacceptable risk of residual effects, with particular reference to next day driving ability. Based on communications with the FDA, weplan to conduct a pre-approval highway driving study to assess the effect of Intermezzo on next morning driving ability beginning at approximately threehours and four hours after dosing Intermezzo in the middle of the night. 3®®®®®®®®®® Table of ContentsIn the Complete Response Letter, the FDA also expressed two concerns regarding the possibility of patient dosing errors in the middle of the night thatcould lead to next day residual effects with particular reference to next day driving ability. Specifically, the FDA asked us to address methods to avoidinadvertent re-dosing in a single night and inadvertent dosing with less than four hours of bedtime remaining. To address these concerns, we plan to changeour originally proposed Intermezzo packaging from a multi-dose unit package to a bedside, single unit-dose package with revised patient instructionsdesigned to reduce the possibility of inadvertent patient dosing errors.In communications with the FDA, we discussed our proposed new packaging and how to assess its adequacy to address FDA concerns regarding thepotential for inadvertent dosing errors. The FDA indicated that the revised packaging appeared to reduce the potential for inadvertently taking more than onedose in a single night, but expressed continuing concern about the risk of inadvertent dosing with less than four hours of time remaining in bed. The FDAagreed that our plan to conduct a highway driving study is a reasonable way to measure potential next day driving impairment from dosing Intermezzo withfour hours or less remaining in bed. The FDA and Transcept also discussed whether a pre-approval patient use study might help to define patient ability toproperly follow instructions under actual conditions of use. We have no current plans to conduct a patient use study because of the challenges andlimitations of such a study, and have submitted to the FDA our position in this regard. The FDA indicated that it would consider our position as part of theoverall resubmission of the Intermezzo NDA. We also plan to include data from on-going studies of patient comprehension of label instructions in ourplanned resubmission.According to IMS Health, an independent market research firm, the number of prescriptions filled in the United States to treat insomnia grew fromapproximately 54 million in 2004 to approximately 79 million in 2009. Data from a major study from the Stanford Sleep Epidemiology Center published in2008 indicate that middle of the night awakening is the most common form of insomnia in the United States and affects approximately one-third of thepopulation at least three times each week. Data from a study published in Population Health Management in 2010, based on information from the UnitedStates National Health and Wellness Survey to evaluate the economic and humanistic burden of chronic insomnia characterized by nighttime awakenings,indicate that this condition was associated with a significant negative impact in health care utilization, health-related quality of life and work productivity.Despite the prevalence of middle of the night awakening, there is no sleep aid currently approved for use specifically in the middle of the night when patientsawaken and have difficulty returning to sleep.On July 31, 2009, we entered into the Collaboration Agreement with Purdue that provides Purdue with an exclusive license to commercializeIntermezzo in the United States. We retained an option to co-promote Intermezzo to psychiatrists in the United States. We also granted Purdue and anassociated company the right to negotiate for the commercialization of Intermezzo in Mexico and Canada, respectively, and we retained rights tocommercialize Intermezzo in the rest of the world. We plan to develop and market Intermezzo through one or more development and marketing alliances inmajor markets outside the United States.We have incurred net losses since inception as we have devoted substantially all of our resources to research and development, including contractmanufacturing and clinical trials. As of December 31, 2009, we had cash, cash equivalents, and marketable securities of $88.9 million, including workingcapital of $74.3 million, and an accumulated deficit of $86.9 million.Our ability to generate near term revenue is dependent upon the receipt of milestone and royalty payments under our Collaboration Agreement withPurdue, which are dependent upon the regulatory approval by the FDA of Intermezzo. To achieve profitable operations, we must successfully develop andcommercialize Intermezzo or we may need to identify, develop and commercialize future product candidates. Even if approved, our products may notachieve market acceptance and will face competition from both generic and branded pharmaceutical products. 4®®®®®®®®®® Table of ContentsWe believe that Intermezzo is positioned to be the first commercially available sleep aid specifically for use in the middle of the night when patientsawaken and have difficulty returning to sleep. Intermezzo has been uniquely designed for this indication and employs the following product features: • Known active agent. The active pharmaceutical ingredient in Intermezzo is zolpidem tartrate, cited by IMS Health as the most commonlyprescribed agent for the treatment of insomnia in the United States, with over one billion zolpidem tablets prescribed in 2009 in the UnitedStates. Approved in 1992 as the active ingredient in Ambien, a branded prescription sleep aid, zolpidem has a well established record of safetyand efficacy. • Rapid bioavailability. We believe that rapid bioavailability, the delivery of the active pharmaceutical ingredient into systemic circulation, is akey product feature for a sleep aid intended to be used in the middle of night. Intermezzo is formulated as a sublingual tablet, or a dosage formthat dissolves under the tongue, using our proprietary technology to facilitate more rapid absorption as compared to swallowed zolpidem tabletformulations, such as Ambien. • Low dose. We expect Intermezzo to be commercially available in doses that are 65% and 72% lower than the comparable doses of Ambien andAmbien CR, a controlled release version of Ambien, respectively. In Phase 3 clinical studies, patients who took this low dose returned to sleeprapidly and, about four hours after taking their medication in the middle of the night, showed no evidence of next day residual effects ascompared to placebo. We believe that Intermezzo 1.75 mg and 3.5 mg doses are the lowest doses of zolpidem that have been reported to inducesleep in a manner statistically superior to placebo.Our Business StrategyOur goal is to become a leading developer and marketer of pharmaceutical products that fill important therapeutic needs in the field of neuroscience.Our efforts to achieve this goal are driven by the following key strategies: • Obtain FDA approval for Intermezzo. We are working to resolve the issues identified in the Complete Response Letter to our NDA. We plan toresubmit the Intermezzo NDA in the late fourth quarter of 2010 after we generate and analyze additional data from our planned highway drivingstudy. We expect that our resubmitted Intermezzo NDA will result in a six-month review period at the FDA under the Prescription Drug User FeeAct, or PDUFA. • Maximize the market opportunity for Intermezzo through marketing alliances. We granted Purdue an exclusive license to commercializeIntermezzo in the United States. We also granted Purdue and an associated company the right to negotiate for the commercialization ofIntermezzo in Mexico and Canada, respectively. We retained rights to commercialize Intermezzo in the rest of the world and have an activeeffort underway to enter into one or more development and marketing alliances with established pharmaceutical companies in major marketsoutside the United States. • Develop a specialty commercial organization focused on neuroscience. If Intermezzo is approved in the United States, we plan to build a salesteam focused on psychiatrists in the United States to co-promote Intermezzo. Our collaboration agreement with Purdue gives us the option to co-promote Intermezzo to psychiatrists in the United States as early as the first anniversary of commercial launch of Intermezzo. For the 12 monthsended December 31, 2009, IMS Health reports that approximately 5,700 psychiatrists wrote 66% of all insomnia prescriptions written bypsychiatrists. Transcept believes it can begin to promote to this prescribing audience with a sales force of 50 to 60 representatives that couldexpand to 100 representatives depending on revenue results. • Develop a product pipeline to address unmet needs in the field of neuroscience. We completed two single blind exploratory clinical studies toexamine the use of low doses of ondansetron for the treatment of obsessive-compulsive disorder, or OCD. We believe the exploratory results wereencouraging and are evaluating product development strategies to pursue this opportunity. 5®®®®®®®®®®®®®®®®®®®®®® Table of Contents • Identify and evaluate strategic product licensing opportunities. We are seeking additional development stage and marketed pharmaceuticalproduct licensing opportunities in order to leverage the specialty marketing infrastructure that we plan to build in support of Intermezzo.The Intermezzo OpportunityOverview of the insomnia marketAccording to IMS Health, an independent market research firm, the number of prescriptions filled in the United States to treat insomnia grew fromapproximately 54 million in 2004 to approximately 79 million in 2009.Middle of the night awakening: the most common insomnia symptomThe 2003 National Sleep Foundation, or NSF, “Sleep in America” poll of the U.S. population between the ages of 55 and 84 described waking upduring the night as the most prevalent insomnia symptom, affecting 33% of respondents. Based on the 2005 NSF poll data, we estimate that middle of thenight awakening is 50% more common than difficulty going to sleep at bedtime among the general population. The 2009 NSF poll found that 46% ofrespondents described being “awake a lot during the night.”Based on a study published in 2008 of nearly 9,000 individuals, the Stanford Sleep Epidemiology Research Center has estimated that about one-thirdof adults in the United States experience middle of the night awakenings at least three times each week. The study concluded that more than 90% of thosesubjects who reported middle of the night awakenings reported that this insomnia symptom persisted for at least six months. In the Stanford study, fewer than25% of this middle of the night awakening group reported difficulty going to sleep at bedtime.Data from a study published in Population Health Management in 2010, based on information from the United States National Health and WellnessSurvey to evaluate the economic and humanistic burden of chronic insomnia characterized by nighttime awakenings, indicate that this condition wasassociated with a significant negative impact in health care utilization, health-related quality of life and work productivity.The FDA has not previously approved any sleep aid specifically for use in the middle of the night when patients awaken and have difficulty returningto sleep. The most commonly prescribed sleep aids are formulated at doses that are sufficiently high to produce seven to eight hours of sleep. Such seven toeight hour products can be used at bedtime to prevent a middle of the night awakening. However, their prolonged duration of action makes them unsuitablefor use in the middle of the night when an awakening occurs, as this may increase the risk of residual sedative effects the following morning.Middle of the night awakenings typically do not occur every night, thus bedtime use of a high dose sleep aid to prevent an awakening requires that thepatient either predict which night an awakening might occur, or take a seven to eight hour product every night. The result is that patients may use their sleepaid more often than necessary, and at a higher dose than necessary, as compared to a fast-acting, low dose sleep aid that would be used only on the nights andat the time when an awakening actually occurs.Intermezzo—potential to be the first sleep aid approved specifically for use in the middle of the night when patients awaken and have difficultyreturning to sleepWe believe that Intermezzo, if approved, will be the first sleep aid approved specifically for use in the middle of the night when patients awaken andhave difficulty returning to sleep. In clinical trials, the unique Intermezzo characteristics of rapid bioavailability and low dose enabled patients to return tosleep quickly and, about four hours after taking their medication in the middle of the night, showed no evidence of the residual effects that have beenreported when seven to eight hour zolpidem products were taken in the middle of the night. 6®®®®® Table of ContentsIntermezzo is a sublingual tablet utilizing a proprietary formulation intended to enhance the absorption of the active sleep medication, zolpidem.Zolpidem is the most frequently prescribed sleep aid in the United States, with, according to IMS Health, over one billion tablets prescribed in 2009 in theUnited States. We believe that Intermezzo contains the lowest dose of zolpidem that has been reported to induce sleep in a manner statistically superior toplacebo, and is expected to be available in doses that are 65% and 72% lower than the comparable doses of Ambien and Ambien CR, respectively.Intermezzo: Bimucoral TechnologyIntermezzo differs from previous formulations of zolpidem through its combination of lower dose and sublingual route of administration, and isdesigned to be the first sleep aid approved specifically for use in the middle of the night when patients awaken and have difficulty returning to sleep. TheIntermezzo sublingual dosage form is formulated to rapidly deliver zolpidem to allow patients to return to sleep quickly. In order to permit patients to takeIntermezzo in the middle of the night and yet potentially awaken four hours later without hangover effects, Intermezzo employs a significantly reducedzolpidem dose of 3.5 mg for adults under age 65 and 1.75 mg for those patients over age 65. We believe they are the lowest doses of zolpidem reported to beeffective in inducing sleep in a manner that demonstrates statistical superiority to placebo.Intermezzo utilizes Bimucoral technology, a patented bicarbonate-carbonate binary buffer system, or a chemical combination that modifies the pH ofsaliva, to convert water-soluble zolpidem tartrate into its fat-soluble free-base form, which is more readily absorbed through the tissues of the mouth. Webelieve that this formulation facilitates rapid absorption, leading to measurable zolpidem blood levels within five minutes after administration of a 3.5 mgIntermezzo tablet. Data from a comparative bioavailability study indicated that 10 to 20 minutes after dosing, zolpidem exposure, as delivered byIntermezzo, was notably higher than that produced by a swallowed 10 mg zolpidem tablet. This occurred despite the fact that the 10 mg swallowedformulation contains nearly three times the Intermezzo 3.5 mg dose. Data from this study demonstrating enhanced bioavailability, as demonstrated by thearea under the curve, is illustrated below:Bioavailability comparison study (n=33):Intermezzo 3.5 mg vs. Ambien 10 mg (n=33) 7®®®®®®®®®®®®®®®®® Table of ContentsIntermezzo Clinical Development ProgramThe Intermezzo clinical development program that supported the filing of the NDA for Intermezzo in September 2008 consisted of a total of 12studies. Four studies were early stage bioavailability trials and utilized prototype formulations. These were completed prior to the submission of theinvestigational new drug application, or IND, in April 2005. Eight additional studies were conducted, including two Phase 3 clinical trials that were includedin the Intermezzo NDA submission.The basis for clinical trial dose selection was initially provided by a pharmacokinetic and pharmacodynamic study, which demonstrated rapidbioavailability and also indicated that sedation reached peak levels within 20 minutes after dosing, as measured with the Digit Symbol Substitution Test, orDSST, a standard objective test of cognitive function to measure impairment. Despite this rapid effect, sedation levels returned to baseline within about threehours by most measures, suggesting that patients may be able to awaken without residual sedative effects four hours after taking a middle of the night dose ofIntermezzo.The clinical safety and efficacy of Intermezzo are supported by two Phase 3 clinical studies. The first Phase 3 trial was a double-blind crossover studyconducted in sleep laboratories in 82 patients. This study analyzed both the objective and subjective effects of Intermezzo on middle of the nightawakenings. The second Phase 3 trial was a double-blind parallel group outpatient study in 294 patients which analyzed subjective outcomes when patientsused Intermezzo as needed at home at the time they awakened and had difficulty returning to sleep.In both of these clinical trials, Intermezzo met its primary clinical endpoint by enabling patients to return to sleep after a middle of the nightawakening more rapidly than placebo. After going back to sleep, patients tended to remain asleep longer than those on placebo and awoke without evidenceof residual effects as compared to placebo.Pivotal Phase 3 sleep laboratory studyThe Phase 3 sleep laboratory clinical trial was designed as an 82 patient randomized, double-blind, placebo controlled, three-way crossover study toevaluate the safety and efficacy of Intermezzo 1.75 mg and 3.5 mg when taken for a scheduled middle of the night awakening in subjects with insomniacharacterized by difficulty returning to sleep. The study was conducted in five U.S. clinical sites and each treatment period consisted of two consecutivenights of dosing followed by a 5 to 12 day washout period. The first period consisted of two baseline nights in the sleep laboratory, followed by randomizedtwo night treatment periods using placebo and Intermezzo 1.75 mg and 3.5 mg. 8®®®®®®®®®®® Table of ContentsThe figure below compares the time to sleep onset measured in the objective Phase 3 sleep laboratory study as produced by Intermezzo 1.75 mg and3.5 mg compared to placebo. The left hand bar graph compares sleep onset time in all patients in the study and demonstrates that 3.5 mg Intermezzo returnedpatients to sleep in the middle of the night approximately 23 minutes faster than placebo. The right hand bar graph examines only those patients whosemiddle of the night awakenings were particularly prolonged, in that they experienced awakenings during the baseline observation period that lasted morethan an hour. Despite the more prolonged middle of the night awakenings in this patient subset, the 3.5 mg Intermezzo dose returned these patients to sleepapproximately 28 minutes faster than placebo. All of these differences were statistically significant.Phase 3 Sleep Laboratory Study (n=82)Placebo vs. Intermezzo 1.75 mg and 3.5 mgObjective Latency to Persistent Sleep following a middle of the night awakening 9®®®® Table of ContentsAs the following figure shows, patients in the Phase 3 sleep laboratory study, when treated with either the 1.75 mg or 3.5 mg Intermezzo dose, weremore likely to fall asleep within 10 to 20 minutes than when these same patients received placebo. On the baseline nights, with one exception, no patientshad returned to sleep within 20 minutes. However, on the subsequent treatment nights when patients were given Intermezzo 3.5 mg, 75% of the samepatients returned to sleep at or before the 20 minute time point.Phase 3 Sleep Laboratory Study (n=82)Baseline and placebo vs. Intermezzo 1.75 mg and 3.5 mg:Proportion of patients asleep vs. time following a middle of the night awakening 10®®® Table of ContentsIn the placebo-controlled sleep laboratory study, neither Intermezzo dose produced residual hangover effects the morning after dosing. Residualhangover effects were measured objectively by the DSST and a subjective assessment of morning sleepiness and alertness utilizing a visual analog scale, orVAS. Results of the study are noted below.Phase 3 Sleep Laboratory Study (n=82)Residual effects of Intermezzo 1.75 mg and 3.5 mg vs. placeboDSST (objective) and VAS (subjective) scores 11®® Table of ContentsPivotal Phase 3 outpatient studyThe Phase 3 outpatient clinical trial was designed as a 294-patient randomized, double-blind, placebo controlled study to evaluate the safety andefficacy of Intermezzo 3.5 mg for use as-needed for the treatment of insomnia when a middle of the night awakening is followed by difficulty returning tosleep. The study was conducted in 25 U.S. clinical sites and the study duration included a two week baseline period, followed by a 28 day double-blindtreatment period.The Phase 3 outpatient study confirmed the positive results of the Phase 3 sleep laboratory study: Intermezzo improved time to sleep onset after amiddle of the night awakening by 18 minutes versus placebo, a difference that was statistically significant. The figure below compares the patient-reportedtime to sleep onset with Intermezzo 3.5 mg as compared to that of placebo and at baseline.Phase 3 Outpatient Study, Placebo vs. Intermezzo 3.5 mg (n=294)Latency to Sleep Onset (LSO) 4 week average 12®®®®MOTN Table of ContentsEach morning after awakening during the Phase 3 outpatient study patients reported their level of sleepiness on a nine-point scale. As the followinggraph shows, patients taking Intermezzo 3.5 mg reported feeling less sleepy and more alert than patients taking placebo, a difference that was statisticallysignificant.Phase 3 Outpatient Study (n=294)Next day sleepiness/alertness scores, 4-week average(0 to 9 scale: 0 = sleepiness, 9 = awake and alert)Intermezzo Regulatory Review in the United StatesOverviewOn September 30, 2008, we submitted an NDA to the FDA to seek approval of Intermezzo in the United States for use in the middle of the night at thetime a patient awakens and has difficulty returning to sleep.On October 28, 2009, we received a Complete Response Letter from the FDA regarding our NDA indicating that the NDA was not approved. The FDAstated in its Complete Response Letter that it believes we submitted substantial evidence of the effectiveness of Intermezzo for its proposed indication.However, the FDA noted that the intended use of Intermezzo in the middle of the night represents a unique insomnia indication and dosing strategy forwhich safety has not been previously established and that we had not adequately demonstrated to the FDA that Intermezzo can be reliably used safely.Our proposed label for Intermezzo indicates that Intermezzo should only be taken when patients have at least four hours remaining in bed beforebeing active again. In its Complete Response Letter, the FDA recognized that the Intermezzo data we submitted did not indicate significant next dayresidual effects at four hours, as measured by both the DSST and next day patient questionnaires. However, the FDA requested additional data demonstratingthat Intermezzo, when taken as directed in the middle of the night, would not present an unacceptable risk of residual effects, with particular reference tonext day driving ability.The FDA also expressed two concerns regarding the possibility of patient dosing errors in the middle of the night that could lead to next day residualeffects with particular reference to next day driving ability. Specifically, 13®®®®®®®®®® Table of Contentsthe FDA asked us to address methods to avoid inadvertent dosing with less than four hours of bedtime remaining and inadvertent re-dosing in a single night.On January 20, 2010, we met with the FDA to discuss the Complete Response Letter. In the briefing document submitted prior to the January 20, 2010meeting, we proposed a new Intermezzo bedside unit-dose package and patient instructions designed to reduce the possibility of inadvertent patient dosingerrors. The FDA indicated in the meeting that the revised packaging appeared to reduce the potential for inadvertently taking more than one dose in a singlenight. However, the FDA expressed continuing concern that the revised packaging may not adequately address the risk of inadvertent dosing with less thanfour hours of time remaining in bed, with particular regard to the possibility of impaired driving.On January 20, 2010, we also reviewed with the FDA the types of data that could support the evaluation of the proposed packaging and instructions,including data from pre-approval assessments of patient understanding of dosing instructions and a potential patient use study of the new Intermezzopackaging.On February 16, 2010, we proposed to the FDA to conduct a pre-approval highway driving study to assess the effect of Intermezzo on driving abilitybeginning at approximately three hours and four hours post-dosing to further understand the safety of dosing Intermezzo in the middle of the night. We alsosubmitted additional supportive analyses of data from a 2005 Phase 1 Intermezzo pharmacokinetic and pharmacodynamic study that measured cognitiveeffects through a battery of commonly recognized tests conducted at different time points up to five hours after dosing. As requested by the FDA, we alsoprovided information on the challenges and limitations of pre-approval patient use studies, and submitted a plan to assess and optimize patientunderstanding of the new packaging and patient instructions.On March 24, 2010, we had a teleconference with the FDA during which the FDA agreed that the proposal we submitted on February 16, 2010, toconduct a highway driving study, is a reasonable way to measure potential next day driving impairment as a result of dosing Intermezzo in the middle of thenight with four hours or less remaining in bed. During the teleconference, the FDA also indicated that it would consider, as part of the overall resubmission ofthe Intermezzo NDA, our position on the challenges and limitations of a pre-approval patient use study. Such a study would seek to define patient ability toproperly follow instructions under actual conditions of use. We have no current plans to conduct a patient use study because of the challenges andlimitations of such a study. We submitted our position in this regard to the FDA on February 16, 2010 and currently plan to resubmit such position with theresubmission of the Intermezzo NDA.We plan to resubmit the Intermezzo NDA in the late fourth quarter of 2010 after we generate and analyze additional data from our planned highwaydriving study. Because our planned resubmission will include additional clinical data, our resubmitted Intermezzo NDA will result in a six-month reviewperiod at the FDA under the PDUFA.Planned Highway Driving StudyWe plan to conduct a pre-approval highway driving study to assess the effect of Intermezzo on next morning driving ability beginning atapproximately three hours and four hours after dosing Intermezzo in the middle of the night. We believe this study will help to further characterize the safetyprofile of dosing Intermezzo with four hours or less remaining in bed. The study will assess the potential residual effect of Intermezzo on driving ability bytracking the deviation of subjects’ lateral position on the road over a one-hour driving period. The study is expected to assess the performance of 36 patientsin a single center, double-blind, randomized, placebo-controlled crossover study design. We plan to conduct the study at the Maastricht University in theNetherlands, a leading center of research on the effects of drugs and alcohol on driving performance. Key comparisons to be analyzed in the study throughtheir affect on subjects’ driving ability are: • Intermezzo 3.5mg verses placebo, 4 hours post-dose; • Intermezzo 3.5mg verses placebo, 3 hours post-dose; and • Zopiclone 7.5mg verses placebo (positive control). 14®®®®®®®®®®®®®®®® Table of ContentsPhase 1 Safety StudyThe Phase 1 study conducted in 2005 from which additional analyses were submitted to the FDA in February 2010, was conducted during the daytimein 24 normal healthy volunteers aged 21 to 44. Although not a measure of the presence or absence of potential driving impairment, the study did measurecognitive effects through a battery of commonly recognized objective and subjective measures of cognitive function. The tests included the Digit SymbolSubstitution Test, or DSST, a standard objective test of cognitive function; a visual analog scale, or VAS, for subjective assessment of alertness; the WordRecall test, a generally accepted test of the effect of sedative hypnotics on memory; Choice Reaction Time, or CRT, a test that measures response time, lapsesand errors, and is generally accepted as a test of performance on tasks that require sustained attention; and the Symbol Copying Test, or SCT, which is similarto DSST but without visual, search, memory or coding demands.The Phase 1 study demonstrated that sedative activity was statistically different from placebo as early as 20 minutes in every test except SCT. SCT wasnot statistically different from placebo at any time-point. Scores returned to baseline at 2.5 hours or less as measured by DSST, VAS, Word Recall, CRT-response time and CRT-lapses. The CRT-error test scores were inconsistent. They were significantly different from placebo at 20 minutes and 3 hours afterdosing, but not at hours 1, 1.5, 2.0, 2.5 and 4. Consistent with our proposed label for Intermezzo, these results suggest that patients may be able to awakenwithout residual sedative effects four hours after taking a middle of the night dose of Intermezzo.CommercializationCollaboration with PurdueOn July 31, 2009, we entered into the Collaboration Agreement with Purdue to commercialize Intermezzo in the United States. Under the terms of ourCollaboration Agreement: • On August 4, 2009, Purdue paid us a $25.0 million non-refundable license fee; • We are obligated to seek FDA approval of Intermezzo and to continue development of Intermezzo at our expense until FDA approval; and • If Purdue elects not to terminate our collaboration after its review of an FDA approval of Intermezzo: • Purdue is obligated to pay us up to $30.0 million, which amount is reduced by $2.0 million for each 30 day period that our receipt of anNDA approval for Intermezzo is delayed beyond June 30, 2010; • We are obligated to transfer the Intermezzo NDA to Purdue and Purdue is obligated to assume the expense associated with maintainingthe NDA and further development of Intermezzo in the United States, including any expense associated with post-approval studies; • Purdue is obligated to commercialize Intermezzo in the United States at its expense; • Purdue is obligated to pay us tiered double-digit base royalties on net sales of Intermezzo in the United States ranging up to the mid-twenty-percent level; • Purdue is obligated to pay us $10.0 million if either of two formulation patents are listed in the FDA’s Approved Drug Products withTherapeutic Equivalence Evaluations, or Orange Book; and • Purdue is potentially obligated to pay us up to an additional $80.0 million upon meeting certain intellectual property milestones andupon the achievement of certain net sales targets for Intermezzo in the United States.We retained an option to co-promote Intermezzo to psychiatrists in the United States as early as the first anniversary of commercial launch ofIntermezzo and as late as 55 months after commercial launch. Upon entry into the market under the co-promotion option, we would receive an additionaldouble-digit royalty from Purdue 15®®®®®®®®®®®®®® Table of Contentson sales generated by psychiatrists in the United States. This royalty is in addition to the base royalty on total United States net sales, and is set according tothe time interval between initiation of sales of Intermezzo in the United States and the time that we initiate our sales efforts in the market under the co-promote option.Purdue has the right to terminate the collaboration agreement at any time upon 180 days notice and after review of any final FDA approved label forIntermezzo. Our co-promote option may also be terminated by Purdue upon our acquisition by a third party or in the event of entry of generic competition toIntermezzo. The royalty payments discussed above are subject to reduction in connection with, among other things, the entry of generic competition toIntermezzo. The collaboration agreement expires on the later of 15 years from the date of first commercial sale in the United States or the expiration of patentclaims related to Intermezzo. The collaboration agreement is also subject to termination by Purdue in the event of FDA or governmental action thatmaterially impairs Purdue’s ability to commercialize Intermezzo or the occurrence of a serious event with respect to the safety of Intermezzo. Thecollaboration agreement may also be terminated by us upon Purdue commencing an action that challenges the validity of Intermezzo related patents. Wealso have the right to terminate the collaboration agreement immediately if Purdue is excluded from participation in federal healthcare programs. Thecollaboration agreement may also be terminated by either party in the event of a material breach or insolvency of the other party.We granted Purdue and an associated company the right to negotiate for the commercialization of Intermezzo in Mexico and Canada, respectively,and retained rights to commercialize Intermezzo in the rest of the world.Sales and MarketingIn our collaboration agreement with Purdue, we retained an option to co-promote Intermezzo to psychiatrists in the United States. We can exercise thisoption to enter the market as early as the first anniversary of the commercial launch of Intermezzo in the United States. Upon entry into the market under theco-promotion option, we would receive an additional double-digit royalty from Purdue on sales generated by psychiatrists in the United States.Our co-promote option with Purdue provides us with the potential to develop our own United States specialty sales and marketing capabilities focusedon the promotion of Intermezzo to psychiatrists and other products that address unmet needs in the field of neuroscience. To achieve our goal of developingour own sales and marketing infrastructure, we must first obtain FDA approval of Intermezzo, in-license another product opportunity or develop and obtainapproval for another product. To achieve commercial success in marketing and selling Intermezzo in the United States, we must work with our partner,Purdue, to effectively integrate our sales and marketing infrastructure and implement our sales and marketing efforts.For the 12 months ended December 31, 2009, IMS Health reports that approximately 5,700 psychiatrists wrote 66% of all insomnia prescriptionswritten by psychiatrists. Transcept believes it can begin to promote to this prescribing audience with an initial sales force of 50 to 60 representatives thatcould expand to 100 representatives depending on revenue results.Intermezzo Commercialization Outside the United StatesWe have not yet applied for regulatory approval to sell Intermezzo in any country other than the United States. We plan to market and sell ourproducts that receive regulatory approval outside the United States through pharmaceutical companies that are established in their respective markets. Wegranted Purdue and an associated company the right to negotiate for the commercialization of Intermezzo in Mexico and Canada, respectively. We retainedrights to commercialize Intermezzo and our other potential products in the rest of the world. We have an active effort underway to enter into one or moredevelopment and marketing alliances to develop and commercialize Intermezzo with established pharmaceutical companies in major markets outside theUnited States. 16®®®®®®®®®®®®®®®®®®®® Table of ContentsExploratory Clinical Development ProgramsWe are seeking additional product opportunities that can be of importance in the field of neuroscience. In this regard, we are evaluating drug productconcepts for the treatment of OCD in patients who do not respond to conventional therapeutics. Our strategy is to augment the therapeutic effects offluoxetine and other similar selective serotonin reuptake inhibitors (SSRI) in OCD patients by promoting down-regulation of dopamine with ondansetron,currently marketed as Zofran by GlaxoSmithKline, to provide more effective treatments to control OCD in patients who are resistant to conventionaltherapies. We have completed two single blind exploratory clinical studies to examine the use of a range of low doses of ondansetron in the treatment of thisdisorder. These studies have yielded initial results that we and our advisors believe to be encouraging and we are currently evaluating product developmentstrategies to pursue this opportunity.In-LicensingWe have an in-licensing effort underway to identify and secure licenses to patents and development rights relating to the use of existing drugs in thefield of neuroscience, and to identify and secure the rights to one or more approved products that can be effectively sold by the specialty sales and marketingteam that we plan to build.CompetitionIf Intermezzo receives FDA marketing approval, it will compete against well-established products currently used in the treatment of insomnia, bothbranded and generic. Potentially competitive products include branded formulations of zolpidem, such as Ambien and Ambien CR marketed by Sanofi-Aventis, generic formulations of zolpidem, Lunesta, marketed by Dainippon-Sumitomo Pharma Co., Ltd., Rozerem, marketed by Takeda PharmaceuticalsCompany Limited, Sonata, marketed by King Pharmaceuticals, Inc. and generic forms of this product, and a number of other pharmaceutical agents,including antidepressants and antipsychotics, that are prescribed off-label. None of the currently marketed sleep aids that have FDA approval are specificallyapproved for use in the middle of the night when patients awaken and have difficulty returning to sleep. However, many of these products can be used toprevent middle of the night awakenings by prophylactic use at bedtime.The market for prescription sleep products has evolved significantly over the last 30 years. Until about 30 years ago, the market was dominated bybarbiturate sedative-hypnotics such as Seconal and Nembutal. These were superseded by the benzodiazepine class of sedative-hypnotics includingDalmane, Restoril and Halcion. Zolpidem, which is a selective modulator of GABA receptor and is a member of the non-benzodiazepine class of sleepaids, was introduced in the United States in 1993 under the Ambien brand, and, according to IMS Health, rapidly achieved the dominant position in theprescription sleep aid market. The patent for Ambien expired in April 2007, and shortly thereafter the FDA approved the generic manufacture of zolpidemby multiple pharmaceutical companies. The pricing of generically manufactured zolpidem is significantly lower than branded formulations of zolpidem andother non-generic sleep aids. Combined sales of generic zolpidem products accounted for approximately 45% of the U.S. prescription market for sleep aids.According to IMS Health, over one billion branded and generic zolpidem tablets were prescribed in the United States in 2009. An extended release version ofzolpidem was launched successfully as Ambien CR in 2005, and, according to IMS Health, held a 7.9% U.S. prescription market share in December 2009.Other branded prescription sleep aids include Lunesta (eszopiclone), marketed by Dainippon-Sumitomo Pharma Co., Ltd., which was approved inDecember 2004 by the FDA and launched in the first quarter of 2005, and Rozerem (ramelteon), which is marketed by Takeda Pharmaceuticals CompanyLimited. According to IMS Health, in December 2009, Lunesta held a 6.3% U.S. prescription market share and Rozerem held a 0.8% U.S. prescriptionmarket share.There exist a number of other agents that are used to treat insomnia. These include Sonata, a short-acting sleep aid marketed by King Pharmaceuticals,Inc., which lost patent protection in June 2008. Although not 17®®®®®TM®®®®TM®A®®®®®®®® Table of Contentsapproved or promoted for the treatment of middle of the night awakenings, some physicians prescribe Sonata off-label for this purpose. Edluar, for whichOrexo AB received marketing approval in March 2009, was launched in the U.S. market by Meda Pharmaceutals, Inc. in September 2009. Edluar employsthe same 5mg and 10mg zolpidem doses as generic Ambien and is designed to be used in the same manner at bedtime to produce seven to eight hours ofsleep. There are also a number of other pharmaceutical agents including antidepressants and antipsychotics that are not approved for the treatment ofinsomnia but are frequently prescribed off-label owing to their ancillary sedative effects. For example, the antidepressant generic trazadone is widelyprescribed off-label for the treatment of insomnia.In addition to current products for the treatment of insomnia, a number of new prescription products may enter the insomnia market over the nextseveral years. These may include the following: • Zolpimist, an orally administered spray containing zolpidem, received marketing approval from the FDA in December 2008. Zolpimistemploys the same 5mg and 10mg zolpidem doses as generic Ambien and is designed to be used in the same manner at bedtime to produce sevento eight hours of sleep. In November 2009, the developers of Zolpimist™, NovaDel Pharma, Inc., announced it had licensed the U.S. andCanadian marketing rights for Zolpimist to ECR Pharmaceuticals Company, Inc., a wholly owned subsidiary of Hi-Tech Pharmacal Co., Inc.ECR Pharmaceuticals Company, Inc. stated in its press release announcing the agreement that it intends to launch Zolpimist in the first half of2010. NovaDel Pharma, Inc. also recently announced that it commenced development of a low-dose version of Zolpimist™ for the treatment ofmiddle-of-the-night awakenings with the intent to enter such product candidate into clinical trials. • Tasimelteon (VEC-162), a melatonin agonist being developed by Vanda Pharmaceuticals Inc., received an orphan designation from the FDA inJanuary 2010 for treatment of non-24 hour sleep/wake disorder in blind individuals without light perception. • Silenor, a low dose doxepin formulation intended for use at bedtime, for which Somaxon Pharmaceuticals, Inc. announced FDA approval inMarch 2010 for the treatment of both transient (short term) and chronic (long term) insomnia characterized by difficulty with sleep maintenancein both adults and elderly patients. In clinical trials, Silenor demonstrated maintenance of sleep into the 7th and 8th hours of the night, with nomeaningful evidence of next day residual effects. In March 2010, Somaxon announced that it is focused on seeking a U.S. commercialpartnership, building a U.S. commercial presence and preparing to launch Silenor in the second half of 2010. • Indiplon, another agent that belongs to the GABA receptor modulator class of compounds, and which has not been approved by the FDA, isbeing developed by Neurocrine Biosciences, Inc. for the treatment of sleep initiation insomnia and middle of the night dosing. The potentialapproval of indiplon pursuant to an NDA submitted by Neurocrine Biosciences, Inc. has been delayed and the regulatory future of this product isuncertain. • Almorexant, an orexin receptor agonist, is being co-developed by GlaxoSmithKline plc and Actelion Pharmaceuticals, Inc. for the treatment ofinsomnia. In December 2009, Actelion announced positive efficacy results from the first Phase 3 study of almorexant and that certain safetyobservations required further evaluation in another Phase 3 study. • SKP-1041, a controlled-release zaleplon formulation is being developed by Somnus Therapeutics Inc. targeting treatment of middle of the nightawakenings with a formulation that is administered at bed time. • MK-4305, an orexin antagonist, is in Phase 3 trials and is being developed by Merck & Co., Inc. for the treatment of insomnia. • AZ-007, an inhaled version of zaleplon, is being developed by Alexza Pharmaceuticals, Inc. for the treatment of insomnia. AlexzaPharmaceuticals has commented publicly that they are evaluating AZ-007 for its suitability to treat middle of the night awakenings. 18®TMTM®TMTM®TMTM®®A Table of ContentsThere are a variety of other drugs intended as sleep aids under earlier stages of development. With the exceptions of indiplon and a possible newformulation of Zolpimist, as noted above, we believe that all of these product candidates are intended to be taken at bedtime, and are not being developedfor the as-needed treatment of middle of the night awakenings at the time they occur.ManufacturingWe do not have or intend to develop internal clinical supply or commercial manufacturing capabilities for Intermezzo, or other product candidates.We entered into an agreement with Patheon Inc., or Patheon, for the manufacture of Intermezzo tablets. We have also entered into agreements with PlantexUSA, Inc., or Plantex, as the sole source supplier of a special form of zolpidem tartrate, a specially manufactured form of the active pharmaceutical ingredientof Intermezzo, and with SPI Pharma, Inc., or SPI, as a supplier of buffered soda and Pharmaburst, a spray dried sugar, key excipients used in Intermezzo. Wehave agreements with Anderson Packaging Inc., or Anderson, and Sharp Corporation, or Sharp, for packaging of Intermezzo and have entered intoagreements with Mikart, Inc., or Mikart, to qualify them as a backup commercial supplier of finished product and as a backup commercial supplier of a keyIntermezzo excipient. All of these supply and manufacturing agreements contain customary commercial terms for pharmaceutical companies regardingforecasting, payment, pricing, ordering, current good manufacturing practices, or cGMP, compliance and quality. All such agreements provide for us to payfor supplies within 30 days of being invoiced upon their shipment, and, except for the agreements with Mikart as described below, none of these agreementscontain minimum purchase requirements. Other than the agreements with Sharp and Patheon, all agreements set forth four quarters of forecasting, with thefirst such quarter’s forecast being a binding firm order. The agreements with Sharp and Patheon contain similar forecasting provisions, except that the Sharpagreement sets forth a 12-month rolling forecast, with the first three months of such forecast being a binding firm order, and the Patheon agreement sets forth18-month, non-binding forecasting, but with a requirement that firm orders be separately placed three months prior to expected delivery. A further descriptionof the termination provisions and certain other terms is set forth below.When we entered into the collaboration agreement with Purdue we amended our supply agreements with Patheon, Plantex, SPI, and Sharp effectiveupon notice to be provided to such manufacturers that the NDA for Intermezzo has been transferred from us to Purdue. Once such notice has been delivered,these amendments allow Purdue to enter into direct supply agreements with such manufacturers for product supplied and sold in the United States. Inconnection with any termination of the Purdue collaboration agreement, the territory changes set forth in the amendments also terminate, and all supplyarrangements for the U.S. territory return to Transcept.Manufacturing Services Agreement with PatheonIn October 2006, we entered into the Manufacturing Services Agreement with Patheon. Under the agreement, we are required to obtain Intermezzotablets from Patheon, provided that we retain the ability to qualify a secondary supplier for a portion of its supply requirements from that secondary supplier.The initial term of the Manufacturing Services Agreement expires in December 2014, but is automatically renewed for three year periods, subject to 24 monthprior notice of an election not to renew. The agreement may be terminated prior to the end of term by either party for breach or insolvency of the other party,and by us on 30 days’ notice in the event of regulatory prevention from, or six month notice for a determination by us to cease, commercialization ofIntermezzo, or upon 24 months’ prior notice for any business reason.Supply Agreement with PlantexIn March 2006, we entered into the Supply Agreement with Plantex. Under the agreement, we are required to obtain specially manufactured zolpidemtartrate from Plantex, provided that we retain the ability to qualify a secondary supplier for a portion of its supply requirements from that secondary supplier.The initial term of the Supply Agreement expires on the earlier to occur of five years from the launch of Intermezzo or ten years from 19TM®®®®®®®®®®® Table of Contentsthe date of the agreement. The agreement may be terminated prior to the end of the term by either party for breach or insolvency of the other party, and maybe terminated by Plantex upon 24 months’ prior notice if Plantex discontinues production of a special form of zolpidem tartrate.Agreements with SPIIn June 2006, we entered into a Supply and License Agreement with SPI for the manufacture and supply of Pharmaburst, a key excipient used in themanufacture of Intermezzo. SPI is our sole supplier of Pharmaburst. The term of the Supply and License Agreement expires in June 2016. This agreementmay be terminated prior to the end of the term by either party for breach or insolvency of the other party.In July, 2007, we entered into a Supply Agreement with SPI for the manufacture and supply of buffered soda, a key excipient used in the manufactureof Intermezzo. Under the Supply Agreement, we obtained a license to patent rights for buffered soda, are required to obtain a large portion of our supply ofbuffered soda from SPI and are permitted to obtain up to a certain portion of alternative supply of buffered soda from a secondary supplier. A furtherdescription of the license under the Supply Agreement is in the section entitled “Business—Intellectual Property and Proprietary Technology.” The initialterm of the Supply Agreement expires on the earlier to occur of the 10 anniversary of commercial sale of Intermezzo or the 13 anniversary of the date of theagreement. This agreement may be terminated prior to the end of the term by either party for breach or insolvency of the other party, and may be terminatedby SPI on 90 days’ notice if minimum annual purchase requirements are not met, or upon 12 months’ notice with each such termination not being effectiveuntil the third anniversary of certain qualifications of an alternative supplier. We have made minimum annual purchase requirements under the agreementthrough 2010.Packaging and Supply Agreement with AndersonIn September 2006, we entered into a Packaging and Supply Agreement with Anderson. We plan to amend this agreement or enter into a packaging andsupply agreement with a new supplier because we plan to change the packaging of Intermezzo from a multi-dose unit package to a bedside, single unit-dosepackage. The initial term of the Packaging and Supply Agreement expires on the fifth anniversary of the execution of the agreement, and thereafterautomatically renews for one year periods unless one year prior notice is given by either party of an intent not to renew. This agreement may be terminatedprior to the end of the term by either party for breach or insolvency of the other party.Packaging and Supply Agreement with SharpIn June 2008, we entered into a Packaging and Supply Agreement with Sharp. We plan to amend this agreement or enter into a packaging and supplyagreement with a new supplier because we plan to change the packaging of Intermezzo from a multi-dose unit package to a bedside, single unit-dosepackage. The initial term of the Packaging and Supply Agreement expires in June 2018, and is renewable for three year terms upon our mutual agreementwith Sharp prior to 180 days before the end of the then current term. This agreement may be terminated prior to the end of the term by either party for breachor insolvency of the other party.Agreements with MikartIn January 2008, we entered into a Supply and Sublicense Agreement with Mikart. Pursuant to the terms of the Supply and Sublicense Agreement, wegranted to Mikart a non-exlusive sublicense in accordance with the terms of the Supply Agreement between us and SPI described above to allow Mikart toact as a back-up supplier of buffered soda. Such agreement requires us to purchase at least two batches of buffered soda (a total of approximately 420kilograms) from Mikart within 24 months following the initial commercial sale of Intermezzo, with the first such batch required to be purchased within 12months of such date. The term of the Supply and Sublicense Agreement expires on the earlier to occur of the 10 anniversary of the first commercial sale ofIntermezzo or the 13 anniversary of the date of the agreement. This agreement may be terminated prior 20®®®®th®th®®®th®th Table of Contentsto the end of the term by either party for breach by the other party. In addition, we can terminate the agreement upon 45 days’ prior notice to Mikart, andpayment to Mikart of a termination fee, at any time after the second anniversary of the first commercial sale of Intermezzo.In August 2008, we entered into a Manufacturing and Supply Agreement with Mikart for back-up supply of manufactured Intermezzo tablets. Withinthe first 12 months after the FDA qualifies and approves Mikart as a supplier of Intermezzo tablets, such agreement requires us to purchase at least threebatches of tablets from Mikart, with any individual batch either containing 1.75 mg of zolpidem (in which case a batch means 500,000 tablets) or 3.5 mg ofzolpidem (in which case a batch means 1,500,000 tablets). We and Mikart may also mutually agree on an alternate number of Intermezzo tablets constitutinga batch for purposes of such agreement. The term of the Manufacturing and Supply Agreement expires on the 10 anniversary of FDA qualification andapproval of Mikart as a supplier of Intermezzo tablets, but is automatically renewed for three year periods, subject to 18-month prior notice of an election notto renew. This agreement may be terminated prior to the end of the term by either party for breach by the other party, or by us if the FDA does not qualifyMikart as a supplier of Intermezzo tablets.Manufacturers and suppliers of our product candidates are subject to current cGMP requirements, U.S. Drug Enforcement Administration, or DEA,regulations and other rules and regulations prescribed by foreign regulatory authorities. We depend on third party suppliers and manufacturers for continuedcompliance with cGMP requirements and applicable foreign standards. We identified alternates for certain of the above-listed suppliers and plans to havesuch alternate suppliers qualified by the FDA and other regulatory authorities after potential approval of the Intermezzo NDA.Government RegulationPrescription drug products are subject to extensive regulation by the FDA, including regulations that govern the testing, manufacturing, safety,efficacy, labeling, storage, record keeping, distribution, import, export, advertising and promotion of such products under the Federal Food Drug andCosmetic Act, or FFDCA, and its implementing regulations, and by comparable agencies and laws in foreign countries. Failure to comply with applicableFDA or other regulatory requirements may result in a variety of administrative or judicially imposed sanctions, including FDA refusal to approve pendingapplications, suspension or termination of clinical trials, Warning Letters, civil or criminal penalties, recall or seizure of products, partial or total suspensionof production or withdrawal of a product from the market.FDA approval is required before any new unapproved drug, including a new use or new dosage form of a previously approved drug, can be marketed inthe United States. All applications for FDA approval must contain, among other things, information relating to safety and effectiveness, pharmaceuticalformulation, stability, manufacturing, processing, packaging and labeling.New Drug ApprovalA new drug approval by the FDA generally involves, among other things: • completion of extensive preclinical laboratory and animal testing in compliance with FDA good laboratory practice, or GLP, regulations; • submission to the FDA of an IND to conduct human clinical testing, which must become effective before human clinical trials may begin; • performance of adequate and well-controlled human clinical trials to establish the safety and efficacy of the proposed drug product for eachindication; • satisfactory completion of an FDA pre-approval inspection of the facility or facilities at which the product is produced to assess compliance withFDA cGMP, regulations; and • submission to and approval by the FDA of an NDA. 21®®®®th®®® Table of ContentsThe preclinical and clinical testing and approval process requires substantial time, effort and financial resources, and we cannot be certain that anyapprovals for our product candidates or any indications will be granted on a timely basis, if at all.Preclinical tests include laboratory evaluation of product chemistry, formulation and stability, as well as studies to evaluate toxicity in animals. Theresults of preclinical tests, together with manufacturing information and analytical data, are submitted as part of an IND to the FDA. The IND automaticallybecomes effective 30 days after acceptance by the FDA, unless the FDA, within the 30 day time period, raises concerns or questions about the conduct of theclinical trial, including concerns that human research subjects will be exposed to unreasonable health risks. In such a case, the IND sponsor and the FDA mustresolve any outstanding concerns before the clinical trial can begin. The submission of an IND may not result in FDA authorization to commence a clinicaltrial. Further, an independent institutional review board, or IRB, for each medical center proposing to conduct the clinical trial must review and approve theplan for any clinical trial before it commences at that center and it must monitor the study until completed. The FDA, the IRB, or the sponsor may suspend aclinical trial at any time on various grounds, including a finding that the subjects or patients are being exposed to an unacceptable health risk. Clinicaltesting also must satisfy extensive Good Clinical Practice, or GCP, regulations, including regulations for obtaining informed consent by each patient.For purposes of an NDA submission and approval, human clinical trials are typically conducted in the following four sequential phases, which mayoverlap: • Phase 1: Studies are initially conducted in a limited population to test the product candidate for initial safety, dose tolerance, absorption,metabolism, distribution and excretion in healthy humans or, on occasion, in patients. • Phase 2: Studies are generally conducted in a limited patient population to identify adverse effects and safety risks, to determine initial efficacyof the product for specific targeted indications and to determine dose tolerance and optimal dosage. Multiple Phase 2 clinical trials may beconducted by the sponsor to obtain additional information prior to beginning larger, more expensive and time consuming Phase 3 clinical trials.In some cases, a sponsor may decide to run what is referred to as a “Phase 2b” evaluation, which is a second, confirmatory Phase 2 trial that could,in limited situations, be accepted by the FDA and serve as one of the pivotal trials in the approval of a product candidate if the study is positive. • Phase 3: These are commonly referred to as pivotal studies. When Phase 2 evaluations demonstrate that a dose range of the product is effectiveand has an acceptable safety profile, Phase 3 trials are undertaken in larger patient populations in the target indication to further evaluate dosage,to provide substantial evidence of clinical efficacy and to further test for safety in an expanded and diverse patient population, often at multiple,geographically-dispersed clinical trial sites. • Phase 4: In many cases, the FDA incorporates into the approval of an NDA the sponsor’s agreement to conduct additional clinical trials to furtherassess a drug’s safety and effectiveness after NDA approval. Such post approval trials are typically referred to as Phase 4 studies.Controlled clinical trials conducted for our drug candidates must be included in a clinical trials registry database that is available and accessible to thepublic through the internet. Failure to properly participate in the clinical trial database registry could result in significant civil monetary penalties.The submission of an NDA is no guarantee that the FDA will find it complete and accept it for filing. The FDA reviews all NDAs submitted before itaccepts them for filing. It may refuse to file the application and request additional information rather than accept the application for filing, in which case, theapplication must be resubmitted with the supplemental information. After the application is deemed filed by the FDA, agency staff of the FDA will review anNDA to determine, among other things, whether a product is safe and efficacious for its intended use. 22 Table of ContentsWe submitted an NDA to the FDA on September 30, 2008. On October 28, 2009, we received a Complete Response Letter from the FDA regarding ourNDA indicating that the NDA was not approved. We are working to resolve the issues identified in the Complete Response Letter. We plan to resubmit theIntermezzo NDA after we generate and analyze any additional data from our planned highway driving study. The resubmission of an NDA after the receipt ofa Complete Response Letter indicating that an NDA is not approved can be considered either a Class I resubmission in connection with which the goal of theFDA is to respond in two months after resubmission or a Class II resubmission in connection with which the goal of the FDA is to respond in six months afterresubmission. A Class I resubmission is an application resubmitted after deficiencies in the final printed labeling, draft labeling, safety updates, stabilityupdates, phase IV commitments, assay validation data, final release testing on the last 1-2 manufacturing lots (used to support approval), minor reanalysis ofdata previously submitted to the application or other minor clarifying information. A Class II resubmission is an application resubmitted after otherdeficiencies not under a Class I resubmission including items that require an advisory committee meeting. We believe that the planned resubmission of theIntermezzo NDA will be considered a Class II submission because of the planned inclusion of the results of a new clinical study.In 1992, under the Prescription Drug User Fee Act, or PDUFA, the FDA agreed to specific goals for improving the drug review time and created a two-tiered system of review times—Standard Review and Priority Review. Standard Review is applied to a drug that offers at most, only minor improvement overexisting marketed therapies. The 2007 amendments to PDUFA set a goal that a Standard Review of an NDA be accomplished within a ten-month timeframe. APriority Review designation is given to drugs that offer major advances in treatment, or provide a treatment where no adequate therapy exists. The goal of theFDA for completing a Priority Review is six months. The FDA strives to, and usually does, meet these review goals, but is not legally required to do so inevery case. For example, the review of the Intermezzo NDA was a Standard Review. The review process is often significantly extended by FDA requests foradditional information or clarification. The FDA has substantial discretion in the approval process and may disagree with an applicant’s interpretation of thedata submitted in its NDA. As part of this review, the FDA may refer the application to an advisory committee for review, evaluation and recommendation asto whether the application should be approved. The FDA is not bound by the recommendation of an advisory committee, but it generally follows suchrecommendations. The FDA may deny approval of an NDA if the applicable regulatory criteria are not satisfied, or it may require additional clinical data oradditional pivotal Phase 3 clinical trials. Even if such data are submitted, the FDA may ultimately decide that the NDA does not satisfy the criteria forapproval. Data from clinical trials may be subject to different interpretation, and the FDA may interpret data differently than we do.Under new legislation in 2007 that granted significant new powers to the FDA, many of which are aimed at improving the safety of drug productsbefore and after approval, the FDA may determine that a risk evaluation and mitigation strategy, or REMS, is necessary to ensure that the benefits of a newproduct outweigh its risks. If required, a REMS may include various elements, such as publication of a medication guide, patient package insert, acommunication plan to educate healthcare providers of the drug’s risks, limitations on who may prescribe or dispense the drug, or other measures that theFDA deems necessary to assure the safe use of the drug.Once the NDA is approved, the FDA may withdraw product approval if ongoing regulatory requirements are not met or if safety problems occur afterthe product reaches the market. In addition, the FDA may require testing, including Phase 4 studies, and surveillance programs to monitor the effect ofapproved products which have been commercialized, and the FDA has the power to prevent or limit further marketing of a product based on the results ofthese post-marketing programs. Drugs may be marketed only for the approved indications and in accordance with the provisions of the approved label.Further, if there are to be any material modifications to the drug, including changes in indications, labeling, or manufacturing processes or facilities, we willlikely be required to submit and obtain FDA approval of a new or supplemental NDA, which may require us to develop additional data or conduct additionaland extensive preclinical studies and clinical trials. 23®®® Table of ContentsSection 505(b)(2) New Drug ApplicationsAs an alternate path to FDA approval for modifications of products previously approved by the FDA, an applicant may submit an NDA underSection 505(b)(2) of the FFDCA. Section 505(b)(2) was enacted as part of the Drug Price Competition and Patent Term Restoration Act of 1984, also knownas the Hatch-Waxman Act. This statutory provision permits the filing of an NDA where at least some of the information required for approval comes fromstudies not conducted by or for the applicant, and for which the applicant has not obtained a right of reference from the owner of the data. The Hatch-Waxman Act permits the applicant to rely upon the FDA findings of safety and effectiveness of a drug that has obtained FDA approval based on preclinical orclinical studies conducted by others. In addition to relying on prior FDA findings of safety and effectiveness for a referenced drug product, the FDA mayrequire companies to perform additional preclinical or clinical studies to support approval of the modification to the referenced product. We submitted theinitial NDA for Intermezzo under Section 505(b)(2). Our initial NDA relied on the extensive information that has been collected for immediate releasezolpidem products, which contain the approved active drug agent that is incorporated in Intermezzo. To the extent that a Section 505(b)(2) application relieson a prior FDA finding of safety and effectiveness of a previously approved product, the applicant is required to certify to the FDA concerning any patentslisted for the referenced product in the FDA publication called “Approved Drug Products with Therapeutic Equivalence Evaluations,” otherwise known asthe “Orange Book.” Specifically, the applicant must certify in the application that: • there is no patent information listed for the reference drug; • the listed patent has expired for the reference drug; • the listed patent for the reference drug has not expired, but will expire on a particular date and approval is sought after patent expiration; or • the listed patent for the reference drug is invalid, unenforceable, or will not be infringed by the manufacture, use or sale of the product for whichthe 505(b)(2) NDA is submitted.In the Intemezzo NDA, we made appropriate certification based on the listed and unexpired patents, if any, for the referenced drug product. Currently,there are no unexpired patents for immediate release zolpidem products listed in the Orange Book.In the event that one or more patents is listed in the Orange Book for the referenced product, including patents listed after we submitted the NDA forIntermezzo, we may also be required to evaluate the applicability of these patents to Intermezzo and submit additional patent certifications. A paragraph IIIcertification, stating that a listed patent has not expired, but will expire on a particular date, may delay the approval of Intermezzo until the expiration of thepatent. A paragraph IV certification, stating that a listed patent is invalid, unenforceable, or not infringed by Intermezzo may require us to notify the patentowner and the holder of the NDA for the referenced product of the existence of the Intermezzo NDA, and may result in patent litigation against us and theentry of a 30-month stay of FDA ability to issue final approval to the Intermezzo 505(b)(2) NDA.If we obtain FDA approval for Intermezzo, we could obtain three years of Hatch-Waxman marketing exclusivity for the product. Under this form ofexclusivity, the FDA would be precluded from approving a marketing application for a duplicate of Intermezzo, a product candidate that the FDA views ashaving the same conditions of approval as Intermezzo, for example, the same indication, the same route of delivery and/or other conditions of use, or a505(b)(2) NDA submitted to FDA with Intermezzo as the reference drug, for a period of three years from the date of Intermezzo approval, although the FDAmay accept and commence review of such applications. This form of exclusivity may not prevent the FDA from approving an NDA that relies only on its owndata to support the change or innovation. Further, if another company obtains approval for a product candidate for the same conditions of approval that weare studying for Intermezzo before Intermezzo were to receive approval, the Intermezzo approval could be blocked until the other company’s three-yearHatch-Waxman marketing exclusivity expires. 24®®®®®®®®®®®®®®®®® Table of ContentsManufacturing cGMP RequirementsWe and our contract manufacturers are required to comply with applicable FDA manufacturing requirements contained in the FDA cGMP regulations.cGMP regulations require, among other things, quality control and quality assurance as well as the corresponding maintenance of records anddocumentation. The manufacturing facilities for active pharmaceutical ingredients, or APIs, and finished drug products must meet cGMP requirements to thesatisfaction of the FDA, and pass a pre-approval inspection before we can use them to manufacture our products. We and our third-party manufacturers arealso subject to periodic inspections of facilities by the FDA and other authorities, including inspection of the procedures and operations used in the testingand manufacture of our products to assess continued compliance with applicable regulations.The API used to manufacture some of our product candidates originates outside the United States. The FDA could increase its diligence with regard toforeign sourced materials and manufacturing processes which may result in increased costs of maintaining foreign manufacturing and could lengthen or delaythe regulatory review process required to gain approval for our product candidates.Failure to comply with statutory and regulatory requirements subjects a manufacturer to possible legal or regulatory action, including adversepublicity, Warning Letters, the seizure or recall of products, injunctions, consent decrees placing significant restrictions on or suspending manufacturingoperations, and civil and criminal penalties. Adverse patient experiences with the product received by us must be reported to the FDA and could result in theimposition of market restriction through labeling changes or in product removal. Product approvals may be withdrawn if compliance with regulatoryrequirements is not maintained or if problems concerning safety or efficacy of the product occur following approval.Other Regulatory RequirementsWith respect to post-market product advertising and promotion, the FDA imposes a number of complex regulations on entities that advertise andpromote pharmaceuticals, which include, among others, standards for direct-to-consumer advertising, industry-sponsored scientific and educationalactivities, and promotional activities involving the internet, as well as a prohibition on off-label promotion. The FDA has very broad enforcement authorityunder the FFDCA, and failure to abide by these regulations can result in penalties, including the issuance of a Warning Letter directing entities to correctdeviations from FDA standards, a requirement that future advertising and promotional materials be pre-cleared by the FDA, and state and federal civil andcriminal investigations and prosecutions. Numerous other laws, not administered by the FDA, also apply to the promotion of pharmaceuticals, allegedviolations of which may also result in state and federal civil and criminal investigation and prosecutions.We are also subject to various laws and regulations regarding laboratory practices, the experimental use of animals, and the use and disposal ofhazardous or potentially hazardous substances in connection with our activities. In each of these areas, as above, the FDA and other agencies have broadregulatory and enforcement powers, including the ability to levy fines and civil penalties, suspend or delay issuance of approvals, seize or recall products,and withdraw approvals, any one or more of which could have a material adverse effect on us.DEA RegulationZolpidem, the active pharmaceutical ingredient in Intermezzo, is classified as a schedule IV controlled substance by the DEA. As a result,manufacturing of zolpidem is subject to regulation by the DEA. Controlled substances are those drugs that appear on one of five schedules promulgated andadministered by the DEA under the Controlled Substances Act, or CSA. The CSA governs, among other things, the distribution, record keeping, handling,security, and disposal of controlled substances. We, as well as our third-party suppliers who handle zolpidem, must be registered by the DEA in order toengage in these activities, and are subject to periodic and ongoing inspections by the DEA and similar state drug enforcement authorities to assess ongoingcompliance 25® Table of Contentswith DEA regulations. Any failure by us or our third party suppliers to comply with these regulations could lead to a variety of sanctions, including therevocation, or a denial of renewal, of DEA registration, injunctions, or civil or criminal penalties and loss of supply.Third-Party Reimbursement and Pricing ControlsIn the United States and elsewhere, sales of pharmaceutical products depend in significant part on the availability of coverage and reimbursement toproviders and the consumer from third-party payors, such as government and private insurance plans. Third-party payors are increasingly challenging theprices charged for medical products and services. Our products may not be considered cost effective, and coverage and reimbursement may not be availableor sufficient to allow sales of our products on a competitive and profitable basis.In the United States, there have been, and we expect that there will continue to be, a number of federal and state proposals to implement similargovernmental pricing control. While we cannot predict whether such legislative or regulatory proposals will be adopted, the adoption of such proposalscould have a material adverse effect on our business, financial condition and profitability.MedicareTwo principal payors in the United States are Medicaid and Medicare. We expect that in the United States many patients who are treated withIntermezzo will be Medicare beneficiaries. The Centers for Medicare and Medicaid Services, or CMS, is the agency within the Department of Health andHuman Services that administers both Medicare and Medicaid. CMS has the authority not to cover particular products or services if it determines that theyare not “reasonable and necessary” for the treatment of Medicare beneficiaries. CMS may make a national coverage determination, or NCD, for a product,which establishes on a nationwide basis the indications that will be covered, and any restrictions or limitations. However, for most new drugs that are eligiblefor payment, CMS does not create an NCD, and we do not plan to request one. Nevertheless, CMS or a third party may request an NCD independently. If suchrequest is made, we cannot assure investors that such NCD will contain favorable coverage terms.If there is no NCD, the local Medicare contractors that are responsible for administering the program on a state or regional basis have the discretion todeny coverage and reimbursement for the drug or issue a local coverage determination, or LCD. These LCDs can include both coverage criteria for the drugand frequency limits for the administration of the drug. Overturning restrictive LCDs in the various regions can be a time-consuming and expensive process.Effective January 1, 2006, Congress enacted a prescription drug benefit known as Medicare Part D. CMS contracts with numerous managed care plansand drug benefit plans to deliver the drug benefit. These plans develop formularies that determine which products are covered and at what co-pay level. IfMedicare coverage for Intermezzo is available, CMS will reimburse through Part D. While CMS evaluates Part D plans’ proposed formularies for potentiallydiscriminatory practices, the plans have considerable discretion in establishing formularies, establishing tiered co-pay structures and placing priorauthorization and other restrictions on the utilization of specific products. Moreover, Part D plan sponsors are permitted and encouraged to negotiate rebateswith manufacturers. Revenue for Intermezzo will be substantially affected by its formulary status on Part D plans and the rebates that Part D plan sponsors areable to negotiate.MedicaidMedicaid is a federal and state entitlement program that pays for medical assistance for certain individuals and families with low incomes and resourcesand who meet other eligibility requirements. Medicaid became law in 1965 and is jointly funded by the federal and state governments (including the Districtof Columbia and the territories) to assist states in furnishing medical assistance to eligible needy persons. Medicaid is the largest source of funding formedical and health-related services for the indigent population of the United States. 26®®® Table of ContentsWe expect Intermezzo to be eligible for reimbursement under Medicaid and, therefore, subject to rebates under the Medicaid Drug Rebate Programestablished by the Omnibus Budget Reconciliation Act of 1990. Under the Medicaid Drug Rebate Program, we would pay a rebate to each participating stateagency for each unit of product reimbursed by Medicaid. The basic amount of the rebate for each product is the greater of 15.1% of the Average ManufacturerPrice (AMP) of that product, or the difference between AMP and the best price available from us to any non-excluded customer. The rebate amount alsoincludes an inflation adjustment if AMP increases faster than a specified inflation index. The rebate amount is calculated quarterly based on our reports of itscurrent AMP and best price for each of its products to CMS. AMPs and best price may be recalculated after they are initially submitted based on theavailability of additional data or because of additional analysis of prices that have been reported.Several state Medicaid programs have implemented Preferred Drug Lists, or PDLs, and more states may adopt this practice. Products placed on a stateMedicaid program’s PDL are not subject to restrictions on their utilization by Medicaid patients, such as the need to obtain authorization prior to prescribing.If Intermezzo is not included on Medicaid PDLs, use of it in the Medicaid program may be adversely affected. In some states that have adopted PDLs, wemay be required to provide substantial supplemental rebates to state Medicaid authorities in order for Intermezzo to be included on the PDL.Pharmaceutical manufacturers, as a condition of participation in the Medicaid Drug Rebate Programs, must enter into an agreement with the Secretaryof the Department of Health and Human Services to participate in the 340B program, enacted by the Public Health Service, or PHS, Act. Under the 340Bprograms pharmaceutical manufacturers are required to extend discounts based on the Medicaid rebate to a variety of health care entities referred to ascovered entities. These covered entities include health care providers that receive health services grants from the PHS, as well as certain hospitals that serve adisproportionate share of Medicare and Medicaid beneficiaries.Section 603 of the Veteran’s Health Care Act of 1992 requires manufacturers of covered drugs to enter into a master agreement with the Secretary of theDepartment of Veteran Affairs, or VA, in order to have their drugs covered under Medicaid. The master agreement requires the manufacturer to make itsproducts available for federal procurement by listing them on the Federal Supply Schedule. In addition, the master agreement requires the manufacturer toenter into a Pharmaceutical Pricing Agreement, or PPA, with the VA. Under the PPA, the manufacturer agrees to sell its drugs to the “Big Four” federalagencies—the VA, the Department of Defense, the PHS and the Coast Guard—at or below a Federal Ceiling Price, which is set at 76% of a calculation calledthe Non-Federal Average Manufacturer Price (non-FAMP), minus an additional discount.Another source of reimbursement for drug products is state Pharmaceutical Assistance Programs, or SPAPs. Many of these programs were created bystates to aid low-income elderly or persons with disabilities who do not qualify for Medicaid. We would pay rebates to some SPAPs and, if they areconsidered qualified programs by CMS, the prices we provided these entities would be excluded from our Medicaid best price.Private Insurance ReimbursementCommercial insurers usually offer pharmacy benefits. If private insurers decide to cover Intermezzo, they will reimburse for the drug in a variety ofways, depending on the insurance plan’s policies, employer and benefit manager input and contracts with their physician network. Private insurers tend toadopt reimbursement methodologies for a product similar to those adopted by Medicare. Revenue for Intermezzo may be materially and adversely affected ifprivate payors make unfavorable reimbursement decisions or delay making favorable reimbursement decisions.The continuing efforts of government and third-party payors to contain or reduce the costs of health care through various means may reduce potentialrevenues we may receive from sales of Intermezzo, if approved. These payors’ efforts could decrease the price that we receive for products it may sell,including Intermezzo. In 27®®®®®®® Table of Contentsaddition, third-party insurance coverage may not be available to patients for our products at all, especially in light of the availability of low-cost genericzolpidem therapeutics, regardless of the fact that such products are not designed or approved to treat middle of the night awakenings. Third-party payorscould also impose conditions that must be met by patients prior to providing coverage for use of our products. For instance, insurers may establish a priorauthorization procedure or “step-edit” system that requires a patient to utilize a lower price alternative product prior to becoming eligible to purchase ahigher price product that may be better targeted to the condition being treated. There can be no assurance that third-party payors will not similarly require apatient to first use generic zolpidem or other sleep aids prior to being eligible for insurance coverage of Intermezzo use.If government and third-party payors do not provide adequate coverage and reimbursement levels for our products, or if price controls or step-editsystems are enacted, our product royalties or revenues will suffer.Intellectual Property and Proprietary TechnologyOur success will depend in part on our ability to protect Intermezzo and future products and product candidates by obtaining and maintaining a strongproprietary position both in the United States and in other countries. To develop and maintain our proprietary position, we will rely on patent protection,regulatory protection, trade secrets, know-how, continuing technological innovations and licensing opportunities.The active ingredient and many of the inactive ingredients in Intermezzo have been known and used for many years and, therefore, are no longersubject to patent protection. Accordingly, our patents and applications are directed to the particular formulations and methods of use of zolpidem, the activepharmaceutical ingredient in Intermezzo. There can be no assurance that our issued patents that cover the formulation of Intermezzo will prevent othersfrom marketing formulations using the same active and inactive ingredients in similar but different formulations. Issued patents and currently pending patentapplications that cover Intermezzo have claims that are directed to both formulation and methods of use and are summarized below: • Formulations of zolpidem. We have two issued U.S. patents, one pending U.S. patent application and 15 corresponding foreign patents orapplications. Patents have been granted in China, New Zealand, Singapore, and South Africa. • Methods of use of zolpidem. We have seven pending U.S. patent applications and 13 foreign patents or applications. A patent has been granted inSouth Africa. • Buffered soda. We have one pending U.S. patent application, which is co-owned with SPI pursuant to the Supply Agreement between us and SPI,covering the compositions containing buffered soda and their method of use, which we refer to as Bimucoral technology. Under the SupplyAgreement, we have a royalty-free, fully paid-up exclusive license with respect to this patent application, with a right to grant sublicenses, forproducts incorporating both buffered soda and zolpidem. This license survives the termination of the Supply Agreement.In addition to the applications directed to Intermezzo, we filed patent applications for various other formulations and methods of use of drugsincluding pilocarpine, ondansetron, and ondansetron in combination with atypical antipsychotic drugs. We currently have no plans to pursue developmentof products relating to the pilocarpine patent application, but are evaluating opportunities relating to ondansetron alone or in combination with atypicalantipsychotic drugs. These applications are summarized below. • One pending U.S. patent application relating to compositions and methods of use of pilocarpine • Three pending U.S. patent applications relating to compositions and methods of use of ondansetron and ondansetron in combination withatypical antipsychoticsThe patent positions of pharmaceutical companies are generally uncertain and involve complex legal, scientific and factual questions. In addition, thecoverage claimed in a patent application can be significantly reduced before the patent is issued. Consequently, we do not know whether any of our patentapplications will 28®®®®®®®® Table of Contentsresult in the issuance of patents or, if any of our issued patents will provide significant proprietary protection or will be circumvented or challenged andfound to be unenforceable or invalid. In limited instances, patent applications in the United States and certain other jurisdictions are maintained in secrecyuntil patents issue, and since publication of discoveries in the scientific or patent literature often lags behind actual discoveries, we cannot be certain of thepriority of inventions covered by pending patent applications. Moreover, we may have to participate in interference proceedings declared by the U.S. Patentand Trademark Office to determine priority of invention or in opposition proceedings in a foreign patent office, any of which could result in substantial costto us, even if the eventual outcome is favorable. There can be no assurance that a court of competent jurisdiction would hold the patents, if issued, valid. Anadverse outcome could subject us to significant liabilities to third parties, require disputed rights to be licensed from third parties or require us to cease usingsuch technology. To the extent we determine it to be prudent, we intend to bring litigation against third parties that we believe are infringing its patents.We also rely on trade secret protection for our confidential and proprietary information. No assurance can be given that others will not independentlydevelop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets or disclose such technology or that wecan meaningfully protect our trade secrets. However, we believe that the substantial costs and resources required to develop technological innovations willhelp us protect our products.We require our employees, consultants and members of our scientific advisory board to execute confidentiality agreements upon the commencement ofemployment, consulting or collaborative relationships with us. These agreements provide that all confidential information developed or made known duringthe course of the relationship with us be kept confidential and not disclosed to third parties except in specific circumstances. In the case of employees, theagreements provide that all inventions resulting from work performed for us, utilizing the property or relating to our business and conceived or completed bythe individual during employment shall be our exclusive property to the extent permitted by applicable law. There can be no assurance, however, that theseagreements will provide meaningful protection or adequate remedies for our trade secrets in the event of unauthorized use or disclosure of such information.EmployeesAs of March 15, 2010, we had 29 employees, 6 of whom hold Ph.D., Pharm.D., or equivalent degrees. A total of 12 employees were engaged in researchand development, 3 were in sales and marketing, and 14 were in administration and finance. None of our employees are represented by a labor union orsubject to a collective bargaining agreement. We have not experienced any work stoppages and we consider our relations with our employees to besatisfactory.Available InformationAvailability of Reports. We are a reporting company under the Securities Exchange Act of 1934, as amended, or the 1934 Act, and file reports, proxystatements and other information with the Securities and Exchange Commission, or SEC. The public may read and copy any of our filings at the SEC’s PublicReference Room at 100 F Street N.E., Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling theSEC at 1-800-SEC-0330. Because we make filings with the SEC electronically, you may access this information at the SEC’s Internet site: www.sec.gov. Thissite contains reports, proxies and information statements and other information regarding issuers that file electronically with the SEC.Web Site Access. Our Internet web site address is www.transcept.com. We make available, free of charge at the “Investors” portion of our web site,annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant toSection 13(a) or 15(d) of the 1934 Act as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Reports ofbeneficial ownership filed pursuant to Section 16(a) of the 1934 Act are also available on our web site. Information in, or that can be accessed through, thisweb site is not part of this annual report on Form 10-K. 29 Table of ContentsItem 1A.Risk FactorsInvesting in our common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below and allinformation contained in this report before you decide to purchase our common stock. If any of the possible adverse events described below actually occurs,we may be unable to conduct our business as currently planned and our financial condition and operating results could be harmed. In addition, the tradingprice of our common stock could decline due to the occurrence of any of the events described below, and you may lose all or part of your investment.In the following discussion, references to “Transcept,” the “Company,” “we,” “us” and “our” refer to the public company formerly known asNovacea, Inc. and now known as Transcept Pharmaceuticals, Inc., and (as successor to the business of the private company formerly known as TransceptPharmaceuticals, Inc., or TPI, that is now the wholly owned subsidiary of Transcept following the merger of TPI and Novacea) also relates to activitiestaking place with respect to, and the financial information of, the business of TPI prior to the merger of TPI and Novacea.We have had a brief operating history that may make it difficult for you to evaluate the potential success of our business and we have a history of incurringlosses.We were founded in January 2001 under our former name Novacea, Inc., and in January 2009 underwent a merger with TPI, a private company foundedin 2002 whose business is currently conducted by us. Our operations to date have been limited to organizing and staffing, acquiring, developing andsecuring technology and undertaking preclinical studies and clinical trials. We have not yet demonstrated the ability to obtain regulatory approval andmanufacture marketed products to the U.S. Food and Drug Administration, or FDA. We have also not demonstrated the ability to meet and adhere to otherregulatory standards applicable to an FDA approved product, to conduct sales and marketing activities or to support commercialization efforts of acollaboration partner, such as our collaboration partner in the United States, Purdue Pharmaceutical Products L.P., or Purdue. Consequently, any predictionsyou make about our future success or viability may not be as accurate as they would be if we had a longer operating history.Furthermore, our business is not profitable and has incurred losses in each year since the inception of TPI in 2002. Our net loss for the years endedDecember 31, 2009, 2008 and 2007 was $21.8 million, $20.0 million and $20.4 million, respectively. As of December 31, 2009, we had an accumulateddeficit of $86.9 million. We expect to continue to incur losses for the foreseeable future unless Intermezzo is approved by the FDA and we receive milestoneand royalty revenue from our collaboration with Purdue that exceed our expenses. For the foreseeable future, we expect our accumulated deficit to increase aswe continue our research, development, regulatory and pre-approval and pre-commercialization efforts with respect to Intermezzo (both in support of ourcollaboration partner in the United States and potential collaboration partners worldwide) and with respect to other product candidates. If Intermezzo or ourother product candidates do not gain regulatory approval, are not commercialized or do not achieve market acceptance, we may not be able to generate anyrevenue. We cannot assure you that we will ever be profitable even if Intermezzo or any other product candidate is commercialized or that we can sustainprofitability, even if achieved. If we fail to achieve and maintain profitability, or if we are unable to fund our continuing losses, investors could lose all orpart of their investment.Our success depends substantially on our ability to obtain regulatory approval in the United States for our lead product candidate, Intermezzo, and toovercome issues presented by the FDA in response to our New Drug Application.Our success depends substantially on obtaining regulatory approval for our most advanced product candidate, Intermezzo, for use as needed for thetreatment of insomnia when a middle of the night awakening is followed by difficulty returning to sleep, or middle of the night awakening. Regulatoryapproval to market pharmaceutical products in the United States requires the completion of extensive non-clinical and clinical evaluations of a productcandidate, referred to as clinical trials, to demonstrate substantial evidence of both safety 30®®®®®® Table of Contentsand efficacy of the candidate, as well as development of manufacturing processes that demonstrate the ability to reliably and consistently produce thecandidate under current Good Manufacturing Practice, or cGMP, regulations. Each of these elements requires pharmaceutical development companies toexercise certain judgments concerning applicable regulatory requirements and to predict what the regulatory authority will ultimately deem acceptable.There can be no assurance that the results of the clinical trials or manufacturing processes for Intermezzo will satisfy the regulatory requirements forapproval. A failure to meet these requirements would significantly delay or prevent approval of Intermezzo and seriously harm our ability to generaterevenue.In September 2008, we submitted a New Drug Application, or NDA, to the FDA for Intermezzo. On October 28, 2009, we received a CompleteResponse Letter from the FDA formally responding to our Intermezzo NDA. The Complete Response Letter indicated that the FDA did not believe weadequately demonstrated that Intermezzo could be reliably used safely. The NDA was therefore not approved.In the Complete Response Letter, the FDA noted that we are seeking to gain approval of Intermezzo in a unique insomnia indication for which safetyhas not previously been established, specifically, the as needed treatment for difficulty returning to sleep after a middle of the night awakening. The FDA’sComplete Response Letter noted that data presented in the Intermezzo NDA indicated no significant residual effects four hours after dosing, as measured byboth the Digit Symbol Substitution Test, a commonly used test to measure the impairment of patients taking sedative hypnotics, and next day patientquestionnaires. However, the FDA requested additional data demonstrating that Intermezzo, when taken as directed in the middle of the night, would notpresent an unacceptable risk of residual effects, with particular reference to a patient’s ability to drive the next morning.The FDA also expressed two concerns in the Complete Response Letter regarding the possibility of patient dosing errors in the middle of the night thatcould lead to next day residual effects, with particular reference to next day driving ability. Specifically, the FDA asked us to address methods to avoidinadvertent dosing with less than four hours of bedtime remaining, and inadvertent re-dosing of Intermezzo in a single night.We plan to conduct a highway driving study to measure the potential for next day driving impairment from dosing Intermezzo in the middle of thenight with four hours or less remaining in bed. This study is designed to evaluate the effects of Intermezzo when dosed in a manner that is consistent with theproposed label wherein dosing occurs with at least four hours remaining in bed, and when Intermezzo is dosed in a manner that is inconsistent with theproposed label with at least three hours remaining in bed. We believe the general risks of study design and execution are heightened by the fact that, to ourknowledge, this is the first study of residual effects on driving ability to be conducted in support of FDA approval of a new sleep agent. Therefore commonlyaccepted protocols, study endpoints and statistical evaluation methodologies have not been established. Thus, we cannot assure you that our planned studywill generate results that will be sufficient to demonstrate the safety of Intermezzo. Additional studies in support of the NDA, if later determined to berequired, may also or alternatively include studies to assess other measurements of drug safety.We also need to determine how best to demonstrate to the FDA that Intermezzo would be used in a manner consistent with the proposed label byminimizing inadvertent dosing errors. We have discussed with the FDA our proposed change in packaging from a multi-dose unit package to a bedside,single unit-dose package with instructions designed to reduce inadvertent dosing errors. We have also discussed with the FDA how to assess the adequacy ofthe proposed new packaging to address FDA concerns regarding the potential for inadvertent dosing errors. The FDA expressed continuing concern about therisk of inadvertently dosing with less than four hours of time remaining in bed. If an evaluation of a new product presentation is required in support of FDAapproval of Intermezzo, there also can be no assurance that we will be able to effectively design or carry out such evaluation in a cost-effective manner, or atall, or that the FDA will find any data arising from such evaluation to be supportive of our efforts to gain approval for Intermezzo. Accordingly, if the FDAbelieves that our new single unit-dose package with revised instructions does not adequately reduce inadvertent dosing errors, our planned resubmission ofthe Intermezzo NDA could be denied and our business would be materially harmed. 31®®®®®®®®®®®®®®®®® Table of ContentsThe FDA also discussed with us whether a pre-approval patient use study might help to define patient ability to properly follow instructions underactual conditions of use. We have no current plans to conduct a patient use study because of the challenges and limitations of such a study and havesubmitted to the FDA our position in this regard. Problems with pre-approval use studies include the inability to replicate actual in-use conditions and studysubjects’ altering their behavior because they are under observation. The risks associated with designing and conducting such an evaluation are heightenedby the fact that recognized standards for such evaluations have not been established. The FDA indicated that it would consider our position on the challengesand limitations of a pre-approval use study as part of the overall resubmission of the Intermezzo NDA. The FDA may not agree with our proposal and mayrequire us to conduct such a use study. If we are required to conduct a pre-approval patient use study, notification of such requirement may not be deliveredto us until after review of our resubmitted NDA for Intermezzo. If the FDA does not agree with our proposal to not conduct a use study, approval of aresubmitted Intermezzo NDA could be denied and our business would be materially harmed.Our proposed driving study has been designed, in part, to characterize the effect on driving of dosing Intermezzo with at least three hours remaining inbed, which is in a manner that is inconsistent with the proposed label that requires patients dose with at least four hours remaining in bed. We believe theFDA will consider the adequacy of our new proposed packaging to minimize dosing errors in the context of the data from our proposed highway drivingstudy that may reflect the presence or absence of impairment of driving ability from residual effects of Intermezzo. However, even if our study shows theabsence of residual effect on driving ability when Intermezzo is dosed with three hours remaining in bed, the FDA may still request that we demonstrate theextent to which patients use Intermezzo in the middle of the night in a manner inconsistent with the proposed label.If our proposed new packaging is not acceptable to the FDA, we may need to develop a new presentation of the proposed product that may include newdosing instructions, packaging and/or dispensing methods for Intermezzo designed to maximize the likelihood that Intermezzo would be taken as directed.Any such new presentation could make Intermezzo a less attractive commercial product and more costly to produce. There can be no assurance that we willbe able to identify a new product presentation that will address the FDA’s concerns regarding inadvertent mis-dosing of Intermezzo by patients to a degreesufficient to warrant FDA approval of Intermezzo. We cannot assure you that any such new presentation, if identified or developed, will be cost-effective oreasy to manufacture, and if the Intermezzo NDA is approved after meeting FDA requirements, that such new presentation will not make Intermezzo a lesscommercially attractive product.Additionally, despite the FDA’s statement in the Complete Response Letter finding that that we presented substantial evidence of effectiveness ofIntermezzo, there can also be no assurance that the FDA will not come to a different interpretation of our previously submitted clinical trial data, includingdata from our two pivotal Phase 3 clinical trials that served as the basis for our Intermezzo NDA, or otherwise alter its view and conclude that Intermezzo isnot sufficiently effective to warrant approval.Because the FDA has not approved a pharmaceutical product specifically to treat middle of the night awakening, there can be no assurance that theFDA will approve this new indication within the insomnia category. While we expect to continue our efforts to obtain and to follow FDA guidance in order toobtain approval of Intermezzo, the FDA may not agree that any new data or trial results we submit will be sufficient to support Intermezzo approval or mayreconsider its guidance, require more clinical trials or otherwise require additional data or studies to justify a new middle of the night awakening indicationin the insomnia market.In addition, we have limited experience in preparing, submitting and prosecuting regulatory filings, including NDAs and other applications necessaryto gain regulatory approvals. Unless we receive regulatory approval from the FDA, Intermezzo cannot be commercialized in the United States. Significantdelay or the inability to commercialize Intermezzo in the United States would significantly harm our business and financial prospects. 32®®®®®®®®®®®®®®®®®®®®® Table of ContentsOur clinical trials may fail to demonstrate adequately the safety and efficacy of our product candidates, which could prevent or delay regulatory approvaland commercialization.Before obtaining regulatory approvals for the commercial sale of our product candidates, we must demonstrate through lengthy, complex andexpensive preclinical testing and clinical trials that the product candidate is both safe and effective for use in each target indication. The results obtained incompleted clinical trials and non-clinical studies may not be predictive of results from ongoing or future trials. Our trial results may be negatively affected byfactors that had not been fully anticipated prior to commencement of the trial. Such trials may fail to demonstrate efficacy in the treatment of the intendeddisorder or may fail to demonstrate that a product candidate is safe when used as directed or even when misused. The outcome of earlier trials may not bepredictive of the outcome of later trials. For example, we previously conducted a Phase 1 pharmacokinetic and pharmacodynamic study of Intermezzo thatdemonstrated rapid bioavailability and also indicated that sedation levels returned to baseline within about three hours by most measures, suggesting thatpatients may be able to awaken without residual sedative effects four hours after taking a middle of the night dose of Intermezzo. These study results shouldnot in any way be construed as predictive of the outcome of any future studies, including, without limitation, a repeat of the same or similar studies or theplanned study to assess the effect of Intermezzo on study subjects’ ability to drive or to be predictive of the sufficiency of current or future data that may begenerated to support FDA approval of Intermezzo for its intended indication. Actual results of any future studies may differ materially from past studies dueto various risks and uncertainties, including, but not limited to, • identical study designs evaluating identical endpoints may produce different study results; • different study designs intended to measure the same or similar endpoints may produce different results; • different studies in different or progressively larger patient populations could reveal more frequent, more severe or additional side effects thatwere not seen in earlier studies; and • the unpredictable nature of clinical trials generally.Although we seek to design our clinical trial protocols to address known factors that may negatively affect results, there can be no assurance thatprotocol designs will be adequate or that factors that we may or may not be aware of or anticipate will not have a negative effect on the results of our clinicaltrials. Once a study has commenced, we may voluntarily suspend or terminate the study if at any time we believe that there is an unacceptable safety risk topatients.Further, side effects could interrupt, delay or halt clinical trials of our product candidates and could result in the FDA or other regulatory authoritiesstopping further development of or denying approval of our product candidates. Based on results at any stage of clinical trials, we may decide to repeat orredesign a trial, modify our regulatory strategy or even discontinue development of one or more of our product candidates.If our product candidates are not shown to be both safe and effective in clinical trials, the resulting delays in developing other compounds andconducting associated non-clinical testing and clinical trials, as well as the potential need for additional financing, would have a material adverse effect onour business, financial condition and results of operations.Delays in the commencement or completion of clinical testing could result in increased costs to us and delay our ability to generate revenue.We do not know whether future clinical trials will begin on time or be completed on schedule, if at all. The commencement and completion of clinicaltrials can be disrupted for a variety of reasons, including difficulties in: • addressing issues raised by the FDA or other regulatory authorities regarding safety, design, scope and objectives of clinical studies; • recruiting and enrolling patients to participate in a clinical trial; 33®®®® Table of Contents • obtaining regulatory approval to commence a clinical trial; • reaching agreement on acceptable terms with prospective clinical research organizations and trial sites; • manufacturing sufficient quantities of a product candidate; and • obtaining institutional review board approval to conduct a clinical trial at a prospective site.A clinical trial may also be suspended or terminated by us or the FDA or other regulatory authorities due to a number of factors, including: • failure to conduct the clinical trial in accordance with regulatory requirements or in accordance with our clinical protocols; • inspection of the clinical trial operations or trial site by the FDA or other regulatory authorities resulting in the imposition of a clinical hold; • unforeseen safety issues; or • inadequate patient enrollment or lack of adequate funding to continue the clinical trial.The general risks of study design and execution applicable to our planned highway driving study are heightened by the fact that, to our knowledge,this is the first study of residual effects on driving ability to be conducted in support of FDA approval of a new sleep agent in that standards for evaluation ofsuch a study have not been established.In addition, changes in regulatory requirements and guidance may occur and we may need to amend clinical trial protocols to reflect these changes,which could impact the cost, timing or successful completion of a clinical trial. If we experience delays in the commencement or completion of our clinicaltrials, the commercial prospects for our product candidates and our ability to generate product revenue will be harmed. Many of the factors that cause, or leadto, a delay in the commencement or completion of clinical trials may also lead to the denial of regulatory approval of a product candidate.Our success depends on meeting the conditions for approval and market exclusivity under Section 505(b)(2) of the Federal Food, Drug and Cosmetic Act,or FFDCA.We are seeking approval for Intermezzo under Section 505(b)(2) of the FFDCA, enacted as part of the Drug Price Competition and Patent RestorationAct of 1984, otherwise known as the Hatch-Waxman Act, which permits applicants to rely in part on clinical and non-clinical data generated by third parties.Specifically, we are relying in part on third party data with respect to zolpidem, which is the active ingredient in Intermezzo and the previously approvedinsomnia products Ambien and Ambien CR. There can be no assurance that the FDA will not require us to conduct additional non-clinical or clinicalstudies or otherwise obtain new supplementary data with respect to some or all of the data upon which we may rely prior to approving an Intermezzo NDA.Our NDA also relies on prior FDA findings of safety and effectiveness of previously-approved products, and we have made certifications in our NDAunder Section 505(b)(2) requirements based on the listed patents in the FDA publication “Approved Drug Products with Therapeutics EquivalenceEvaluations,” or the Orange Book, for certain of these referenced products. Currently, there are no unexpired patents for immediate release zolpidem productslisted in the Orange Book. In the event that one or more patents is listed in the Orange Book for the referenced product after our submission of additionalinformation in support of our NDA for Intermezzo, we may also be required to evaluate the applicability of these patents to Intermezzo and submitadditional certifications. A paragraph III certification, stating that a listed patent has not expired, but will expire on a particular date, may delay the approvalof Intermezzo until the expiration of the patent. A paragraph IV certification, stating that a listed patent is invalid, unenforceable, or not infringed byIntermezzo may require us to notify the patent owner and the holder of the NDA for the referenced product of the existence of the Intermezzo NDA, and mayresult in patent litigation against us and the entry of a 30-month stay of FDA ability to issue final approval of the 505(b)(2) NDA for Intermezzo. 34®®®®®®®®®®® Table of ContentsOur success also relies, in part, on obtaining Hatch-Waxman marketing exclusivity in connection with any approval of our NDA for Intermezzo. Suchexclusivity protection would preclude the FDA from approving a marketing application for a duplicate of Intermezzo, a product candidate that the FDAviews as having the same conditions of approval as Intermezzo (for example, the same indication, the same route of delivery and/or other conditions of use),or a 505(b)(2) NDA submitted to the FDA with Intermezzo as the reference product, for a period of three years from the date of Intermezzo approval,although the FDA may accept and commence review of such applications. This form of exclusivity may not prevent FDA approval of an NDA that relies onlyon its own data to support the change or innovation. Similarly, if, prior to approval of the Intermezzo NDA, another company obtains approval for a productcandidate under, in the view of the FDA, the same conditions of approval that we are seeking for Intermezzo, Intermezzo could be blocked until the othercompany’s three-year Hatch-Waxman marketing exclusivity expires.We are dependent upon the efforts of Purdue for commercializing Intermezzo in the United States, and will be dependent on the efforts of othercollaboration partners if we enter into additional strategic collaborations outside the United States.The success of sales of Intermezzo in the United States will be dependent on the ability of Purdue to successfully launch and commercializeIntermezzo, if approved by the FDA, pursuant to the Collaboration Agreement we signed in July 2009. The terms of the Collaboration Agreement providethat Purdue has the ability to terminate such arrangement for any reason at any time upon 180 days notice and within 10 business days after review ofdocumentation we receive from the FDA in connection with any approval of Intermezzo in the United States. Thus, for example, even if the measures takento address FDA concerns on the safety of Intermezzo are successful to obtain FDA approval, Purdue may determine that such measures, or the outcome of anyclinical trials from such measures, have made Intermezzo a less attractive commercial product for Purdue and terminate our collaboration. If theCollaboration Agreement is terminated, our business and our ability to generate revenue from sales of Intermezzo will be substantially harmed and we willbe required to develop our own sales and marketing organization or enter into another strategic collaboration in order to commercialize Intermezzo in theUnited States. Such efforts may not be successful and, even if successful, would require substantial time and resources to carry out.The manner in which Purdue launches Intermezzo, including the timing of launch and potential pricing, will have a significant impact on the ultimatesuccess of Intermezzo in the United States, and the success of the overall commercial arrangement with Purdue. If launch of commercial sales of Intermezzoin the United States by Purdue is delayed or prevented, our revenue will suffer and our stock price will decline. Further, if launch and resulting sales ofIntermezzo are not deemed successful, our stock price will decline. The outcome of Purdue commercialization efforts could also have an effect on investors’perception of potential sales of Intermezzo outside of the United States, which could also cause a decline in our stock price and may make it more difficult toenter into strategic collaborations outside the United States.The Collaboration Agreement provides for Purdue to be responsible for conducting any post-approval studies of Intermezzo, both if such studies arerequired or requested in connection with FDA approval of Intermezzo. The planning and execution of these studies will be primarily the responsibility ofPurdue, and may not be carried out in accordance with our preferences, or could yield results that are detrimental to Purdue’s sales of Intermezzo in theUnited States or detrimental to our efforts to develop or commercialize Intermezzo outside the United States.Our ability to receive any significant revenue from our product candidates covered by a strategic collaboration, such as our Collaboration Agreementwith Purdue, will be dependent on the efforts of the collaboration partner and may result in lower levels of income than if we marketed or developed ourproduct candidates entirely on our own. The collaboration partner may not fulfill its obligations or carry out marketing activities for our product candidatesas diligently as we would like. We could also become involved in disputes with our partner, which could lead to delays in or termination ofcommercialization programs and 35®®®®®®®®®®®®®®®®®®®®®®®®® Table of Contentstime-consuming and expensive litigation or arbitration. If a collaboration partner terminates or breaches its agreement, or otherwise fails to complete itsobligations in a timely manner, the chances of successfully developing or marketing our product candidates would be materially and adversely affected.We are seeking to enter into additional strategic collaborations for the development and commercialization of Intermezzo outside the United States.We may not be able to enter into additional collaborations on acceptable terms, if at all. Our establishment of Purdue as our commercial partner forIntermezzo in the United States could also limit the potential collaboration options we have outside the United States or could render potential collaboratorsless inclined to enter into an agreement with us because of such relationship. Further, we have granted Purdue and an associated company an option tonegotiate with us for a license to commercialize Intermezzo in Mexico and Canada. While these options and subsequent negotiation periods continue, weare prevented from negotiating with and being able to enter into commercialization agreements with other potential strategic partners for development orcommercialization of Intermezzo in such countries.If we choose to exercise our co-promotion option and are unable to establish a sales and marketing infrastructure in the United States, our potentialrevenues could be substantially harmed.In order to commercialize Intermezzo or any other product candidates successfully, we must enter into and maintain strategic collaborations toperform, and/or acquire or internally develop a sales, marketing and distribution infrastructure. We have entered into a strategic collaboration forcommercialization of Intermezzo in the United States with Purdue and may develop our own sales force and marketing infrastructure for Intermezzo to co-promote Intermezzo to psychiatrists in the United States. However, we have no experience in building a sales and marketing organization. If we exercise ourco-promotion option and are unable to develop our own sales, marketing and distribution infrastructure to effectively commercialize Intermezzo , our abilityto generate additional revenue from potential sales of Intermezzo to psychiatrists would be substantially harmed.The development of sales, marketing and distribution infrastructure is difficult and time consuming, and requires substantial financial and otherresources. Factors that may hinder our efforts to develop an internal sales, marketing and distribution infrastructure include: • inability to recruit, retain and effectively manage adequate numbers of effective sales and marketing personnel; • the inability of sales personnel to obtain access to or convince 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 withmore extensive product lines; and • unforeseen delays, costs and expenses associated with creating a sales and marketing organization.We may require substantial additional funding and may be unable to raise capital when needed.We have no current source of product revenue. We have a limited operating history and have not yet commercialized any products. We had cash, cashequivalents and marketable securities of $88.9 million at December 31, 2009. We expect our negative cash flows from operations to continue for theforeseeable future as we determine and undertake activities to support the planned resubmission of the Intermezzo NDA, pursue the regulatory approval andcommercialization of Intermezzo internationally and develop other product candidates. We do not know how long it will take to obtain regulatory approvalof Intermezzo, or if such approval is obtainable. We also expect negative cash flows beyond any potential regulatory approval and product launch ofIntermezzo. As a result, we will need to generate significant revenues to pay these costs and achieve profitability. We do not know whether or when we willbecome profitable because of the significant uncertainties with respect to our ability to gain regulatory approval of Intermezzo and generate revenues fromthe sale of our products and from our existing and potential future collaborations. 36®®®®®®®®®®®®®®® Table of ContentsIf the timing of potential product approval and launch is significantly delayed as a result of FDA or other regulatory approval delays, the CollaborationAgreement with Purdue is terminated or other factors arise, our cash, cash equivalents and marketable securities may prove insufficient to fund our operationsthrough the commercial launch of Intermezzo. Purdue is obligated to pay us up to $30.0 million if they elect to continue with our Collaboration Agreementafter an FDA approval of Intermezzo. This potential $30.0 million payment is reduced by $2.0 million for each 30-day period that our receipt of an NDAapproval for Intermezzo is delayed beyond June 30, 2010. Further, the development and potential regulatory approval of additional product candidates willlikely require additional funding which may not be available at and as of the time needed on commercially reasonable terms, if at all.We currently believe that our available cash, cash equivalents and marketable securities and interest income will be sufficient to fund our anticipatedlevels of operations for at least the next twelve months. However, our future capital requirements will depend on many factors, including: • the success of our ability to obtain FDA approval of Intermezzo and to develop and commercialize Intermezzo; • the scope and results of our efforts to respond to the Complete Response Letter received by the FDA on the Intermezzo NDA, including the cost,timing and results of any additional studies; • advancement of other product candidates into development; • potential acquisition or in-licensing of other products or technologies; • the timing of, and the costs involved in, obtaining regulatory approvals; • the cost of development and manufacturing activities; • the costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims and other patent-related costs, including litigationcosts and the results of such litigation; and • our ability to establish and maintain additional collaborative arrangements.Additional financing may not be available to us when we need it or it may not be available on favorable terms. If we are unable to obtain adequatefinancing on a timely basis, we may be required to significantly curtail one or more of our development, licensing or acquisition programs. We could berequired to seek funds through arrangements with collaborators or others that may require us to relinquish rights to some of our technologies, productcandidates or products which we would otherwise pursue on our own. If we raise additional funds by issuing equity securities, our then-existing stockholderswill experience dilution and the terms of any new equity securities may have preferences over our common stock.Intermezzo and our other product candidates may not achieve market acceptance even if we obtain regulatory approvals.Even if we receive regulatory approvals for the commercial sale of Intermezzo or our other product candidates, the commercial success of theseproduct candidates will depend upon, among other things, acceptance by physicians and patients. Market acceptance of, and demand for, any product that wedevelop and that are commercialized by us or our collaboration partner will depend on many factors, including: • the ability to provide acceptable evidence of safety and efficacy of Intermezzo or future products for their respective indications; • the ease of use of Intermezzo; • the existence of generic or branded competition for Intermezzo; • the ability to obtain adequate pricing and sufficient insurance coverage and reimbursement; • the availability, relative cost and relative efficacy and safety of alternative and competing treatments; 37®®®®®®®®®®® Table of Contents • the effectiveness of our or a collaboration partner’s sales, marketing and distribution strategies; and • the ability to produce commercial quantities sufficient to meet demand.If Intermezzo or our other product candidates fail to gain market acceptance, we may be unable to earn sufficient revenue to continue our business.We will face substantial competition from companies with established products.We plan to seek approval of Intermezzo for use as needed for the treatment of insomnia when a middle of the night awakening is followed by difficultyreturning to sleep, an indication that we believe represents an opportunity in the broader insomnia therapeutic market. The insomnia market is large, deeplycommercialized and characterized by intense competition among large, established pharmaceutical companies with well funded and staffed and experiencedsales and marketing organizations and far greater name recognition than us or our collaboration partner.If Intermezzo receives marketing approval, it will compete in this large market against well-established branded products with significant advertisingsupport, as well as with new market entrants and generic competitors selling zolpidem and other sleep aids at a fraction of the price at which we or ourcollaboration partner will most likely seek to sell Intermezzo.We believe that if Intermezzo is approved on a timely basis, and with the label we have requested from the FDA, it will be the first sleep aid approvedby the FDA specifically for use in the middle of the night when patients awaken and have difficulty returning to sleep. However, currently approved andmarketed seven to eight hour therapeutics can also treat this condition when used to deliver a prophylactic dose of a sleep aid at the beginning of the night.The most directly competitive approved products in the United States are Ambien and Ambien CR, marketed by Sanofi-Aventis, and generic forms ofzolpidem available from multiple manufacturers. Additionally, Zolpimist, an orally administered spray for which NovaDel Pharma, Inc. received marketingapproval from the FDA in December 2008, and Edluar, a sublingual tablet for which Orexo AB received marketing approval from the FDA in March 2009,employ the same 5mg and 10mg zolpidem doses as generic Ambien and are designed to be used in the same manner at bedtime to produce seven to eighthours of sleep. Zolpidem, in both its branded and generic forms, is the most widely-prescribed drug in the United States for treatment of insomnia.Additionally, Lunesta (eszopiclone), marketed by Dainippon-Sumitomo Pharma Co. Ltd. and Rozerem (ramelteon), marketed by TakedaPharmaceuticals Company Limited, can similarly treat middle of the night awakenings by providing a prophylactic dose at bed-time in order to avoid amiddle of the night awakening, and short duration products such as Sonata, which utilizes the active ingredient zaleplon and marketed by KingPharmaceuticals, Inc., have been used off-label for the as-needed treatment of middle of the night awakenings. In March 2010, Somaxon Pharmaceuticals, Inc.announced FDA approval Silenor, a low dose doxepin formulation intended for use at bedtime, for the treatment of both transient (short term) and chronic(long term) insomnia characterized by difficulty with sleep maintenance in both adults and elderly patients. In clinical trials, Silenor demonstratedmaintenance of sleep into the 7th and 8th hours of the night, with no meaningful evidence of next day residual effects. In March 2010, Somaxon announcedthat it is focused on seeking a U.S. commercial partnership, building a U.S. commercial presence and preparing to launch Silenor in the second half of 2010.In January 2010 Vanda Pharmaceuticals Inc. received an orphan indication from the FDA for VEC-162 (tasimelteon), a melatonin agonist similar toramelteon, for treatment of non-24 hour sleep/wake disorder in blind individuals without light perception. Vanda may seek additional broader insomniaindications for this product. Other drugs, such as the antidepressant generic trazadone, are also widely prescribed off-label for the treatment of insomnia. 38®®®®®®®TMTM®®®®®®® Table of ContentsOther companies may develop products to compete with Intermezzo.We are aware of several products currently in development which are seeking indication statements from the FDA for the treatment of middle of thenight awakenings. Neurocrine Biosciences, Inc. received an approvable letter, pending additional clinical and pre-clinical studies, from the FDA for itsproduct candidate, indiplon, proposed to be used for sleep initiation and middle of the night dosing. NovaDel Pharma, Inc. has announced that it commenceddevelopment of a low-dose version of Zolpimist™ for the treatment of middle-of-the-night awakenings with the intent to enter such product candidate intoclinical trials, and Somnus Therapeutics Inc. has indicated that it is similarly targeting treatment of middle of the night awakenings with development of itscontrolled-release zaleplon formulation, SKP-1041. Additionally, Alexza Pharmaceuticals, Inc. has commented publicly that they are evaluating AZ-007,immediate release Staccato zaleplon, for its ability to treat middle of the night awakenings.There are many other companies working to develop new products and other therapies to treat insomnia, including but not limited to Eli Lilly andCompany, Merck and Co., Inc., and GlaxoSmithKline plc in conjunction with Actelion Pharmaceuticals Ltd. Several of these products are in late stageclinical trials.Furthermore, new developments, including the development of other drug technologies and methods of treating conditions, occur in thebiopharmaceutical industry at a rapid pace. Any of these developments may negatively affect the commercial prospects of Intermezzo.Many potential competitors, either alone or together with their partners, have substantially greater financial resources, research and developmentprograms, clinical trial and regulatory experience, expertise in prosecution of intellectual property rights, and manufacturing, distribution and sales andmarketing capabilities than us or our collaboration partner. As a result of these factors, these competitors may: • develop product candidates and market products that are less expensive, safer, more effective or easier to use than our current product candidatesand contemplated future products; • commercialize competing products before Intermezzo or other product candidates can be launched; • initiate or withstand substantial price competition more successfully than we can; • have greater success in recruiting skilled scientific workers and experienced sales and marketing personnel from the limited pool of availabletalent; • more effectively negotiate third-party licenses and strategic collaborations; and • take advantage of acquisition or other opportunities more readily than us or our collaboration partner.Governmental and third-party payors may impose restrictions or reimbursement or pricing controls that could limit product revenue.The continuing efforts of government and third-party payors to contain or reduce the costs of health care through various means may reduce potentialrevenue we may receive from sales of Intermezzo, if approved. In particular, third-party insurance coverage may not be available to patients for Intermezzoor our other products, especially in light of the availability of low-cost generic zolpidem therapeutics, regardless of the fact that such products are notspecifically designed or indicated to specifically treat middle of the night awakening. Government and third-party payors could also impose price controlsand other conditions that must be met by patients prior to providing coverage for use of our products. For example, insurers may establish a “step-edit”system that requires a patient to utilize a lower price alternative product prior to becoming eligible for reimbursement of a higher price product. Ifgovernment and third-party payors do not provide adequate coverage and reimbursement levels for our products, or if price controls, prior authorization orstep-edit systems are enacted, our product revenue will suffer. 39®®®®® Table of ContentsNegative publicity and documented side effects concerning products used to treat patients in the insomnia market may harm commercialization ofIntermezzo or our other product candidates.Products containing zolpidem, the active ingredient in Intermezzo, are widely marketed. Zolpidem use has been linked to negative effects, such assleepwalking and amnesia, and has the potential to cause physical or psychological dependence. Furthermore, zolpidem is classified as a Schedule IVsubstance under the Comprehensive Drug Abuse and Prevention Control Act of 1970, and is subject to certain packaging, prescription and purchase volumelimitations. There can be no assurance that additional negative publicity or increased governmental controls on the use of zolpidem or other compounds usedin products for the insomnia market would not inhibit or prevent commercialization of Intermezzo or our other product candidates. Furthermore, negativepublicity concerning zolpidem and other hypnotic pharmaceuticals could cause the FDA to make approval of new products for the insomnia market moredifficult, by requiring additional or different non-clinical or clinical studies or taking other actions, out of safety or other concerns, or could lead to reducedconsumer usage of sleep aids, including zolpidem products and Intermezzo.Even if our product candidates receive regulatory approval, they will be subject to ongoing regulatory requirements and may face regulatory orenforcement action.Any product candidate for which we receive regulatory approval, together with related third-party manufacturing facilities and processes, post-approval clinical data, and advertising and promotional activities for the product, will be subject to significant review, oversight and ongoing and changingregulation by the FDA and other regulatory agencies. Failure to comply with regulatory requirements may subject us to administrative and judicially-imposed sanctions. These may include warning letters, adverse publicity, civil and criminal penalties, injunctions, product seizures or detention, productrecalls, total or partial suspension of production, and refusal to approve pending product marketing applications.Even if we receive regulatory approval to market a particular product candidate, the approval could be conditioned on our conducting additionalcostly post-approval studies or could limit the indicated uses included in our labeling. Moreover, the product may later cause adverse effects that limit orprevent its widespread use, force us to withdraw it from the market or impede or delay the ability to obtain regulatory approvals in additional countries.The FDA has also requested that all manufacturers of sedative-hypnotic pharmaceutical products modify their product labeling to include stronglanguage concerning potential risks. These risks include severe allergic reactions and complex sleep-related behaviors, which may include sleep-driving. TheFDA also recommended that pharmaceutical manufacturers conduct clinical studies to investigate the frequency with which sleep-driving and other complexbehaviors occur in association with individual drug products. We have not conducted such studies, and it is unclear how and to what extent, if any, theserequests and recommendations will affect Intermezzo or our other product candidates.If manufacturers supplying our product candidates fail to produce in the volumes and quality that are required on a timely basis, or to comply withstringent regulations applicable to pharmaceutical manufacturers, there may be delays in the development and commercialization of, or an inability tomeet demand for, our products, if any, and we may lose potential revenue.We do not manufacture Intermezzo, and we do not plan to develop the capacity to do so. We have a primary manufacturing and supply agreement withPatheon, Inc. to manufacture a commercial supply of Intermezzo. We also have agreements with Mikart, Inc. to qualify it as a backup commercial supplier offinished product, as well as a backup commercial manufacturer of a key excipient used in the manufacture of Intermezzo. We currently have arrangements touse Anderson Packaging, Inc. as a primary packager of Intermezzo and Sharp Corporation to supply sample packaging. We plan to amend our agreementswith Anderson and Sharp or enter into packaging and supply agreements with new suppliers if we determine to change the packaging of Intermezzo. We relyupon SPI Pharma, Inc. as a supplier for certain key excipients contained within Intermezzo, for one of such excipients, Pharmaburst, as the sole source, andupon Plantex USA, Inc. as 40®®®®®®®®®®®® Table of Contentsour sole source for a special form of zolpidem tartrate. These agreements have set terms of duration, some of which automatically renew for successive one orthree year periods. The first to expire among these agreements, the Packaging and Supply Agreement with Anderson Packaging, Inc., has a term that ends inSeptember of 2011, although such agreement automatically renews for one year periods thereafter. Purdue is similarly dependent on these manufacturers forthe commercial supply of Intermezzo and has entered into direct agreements with certain of such manufacturers in connection with entry into theCollaboration Agreement that would take effect soon after an FDA approval of Intermezzo if Purdue elects to continue with our collaboration. Any of therisks that we face with respect to these manufacturers are therefore similarly applicable to Purdue, and the realization of these risks by Purdue would have asignificant impact on Purdue commercialization efforts and our ability to generate revenue under the Collaboration Agreement.The manufacture of pharmaceutical products requires significant expertise and capital investment, including the development of advancedmanufacturing techniques and process controls. Manufacturers of pharmaceutical products often encounter difficulties in production, particularly in scalingup initial production. These problems include difficulties with production costs and yields, quality control, including stability of the product candidate andquality assurance testing, shortages of qualified personnel, as well as compliance with strictly enforced federal, state and foreign regulations. Third-partymanufacturers and key suppliers may not perform as agreed, may terminate their agreements, or may experience manufacturing difficulties due to resourceconstraints or as a result of labor disputes, unstable political environments at foreign facilities or financial difficulties. For example, a supplier with amanufacturing facility in Israel may face geopolitical risk that could prevent it from providing supplies from such facility. Additionally, third-partymanufacturers and key suppliers may become subject to claims of infringement of intellectual property rights of others, which could cause them to incursubstantial expenses, and, if such claims were successful, could cause them to incur substantial damages or cease production of our products or productcomponents. For example, SPI, the sole supplier of Pharmaburst, a key excipient used in Intermezzo, is the defendant in a lawsuit alleging patentinfringement that may involve Pharmaburst. In addition, several of our suppliers have only one facility qualified to supply key components of Intermezzo,and transferring such supply to an alternate site could take substantial time and resources. Any interruption of supply from such facilities could materiallyimpair our ability to manufacture and generate revenue from Intermezzo. These manufacturers and suppliers may also choose, or be required, to seek licensesfrom the claimant, which may not be available on acceptable terms or at all. If these manufacturers or key suppliers were to encounter any of these difficulties,or otherwise fail to comply with their contractual obligations, ability to launch Intermezzo or any other product candidate, if approved, would bejeopardized. Even if we were able to launch a product, these difficulties could cause increases in the prices we or our collaborators pay for supply of suchproduct and its components which could substantially hinder or prevent commercialization efforts.In addition, all manufacturers and suppliers of pharmaceutical products must comply with current Good Manufacturing Practice, or cGMP,requirements enforced by the FDA through its facilities inspection program. The FDA is likely to conduct inspections of third-party manufacturer and keysupplier facilities as part of its review of any of our NDAs. If third-party manufacturers and key suppliers are not in compliance with cGMP requirements, itmay result in a delay of approval, particularly if these sites are supplying single source ingredients required for the manufacture of Intermezzo. These cGMPrequirements include quality control, quality assurance and the maintenance of records and documentation. Furthermore, regulatory qualifications ofmanufacturing facilities are applied on the basis of the specific facility being used to produce supplies. As a result, if one of these manufacturers shiftsproduction from one facility to another, the new facility must go through a complete regulatory qualification process and be approved by regulatoryauthorities prior to being used for commercial supply. Manufacturers may be unable to comply with these cGMP requirements and with other FDA, state andforeign regulatory requirements. A failure to comply with these requirements may result in fines and civil penalties, suspension of production, suspension ordelay in product approval, product seizure or recall, or withdrawal of product approval. If the safety of any quantities supplied is compromised due to a third-party manufacturer or key supplier failure to adhere to applicable laws or for other reasons, we may not be able to obtain regulatory approval for our productcandidates and, even if such approval is obtained, any resulting products may not be successfully commercialized. 41®®®®®®®®® Table of ContentsThere are no alternate manufacturers qualified at this time with respect to the commercial supply of Intermezzo, nor are there alternate manufacturersidentified or qualified with respect to the commercial supply of several of the key ingredients and packaging materials used in Intermezzo . If manufacturersare required to be changed, prior approval by the FDA and comparable foreign regulators will be required. In addition, we or Purdue would likely have toincur significant costs and expend significant efforts to educate the new manufacturer with respect to, or to help the new manufacturer independentlydevelop, the processes necessary for production. Manufacturing and supply switching costs in the pharmaceutical industry can be very high, and switchingmanufacturers or key suppliers can frequently take 12 to 18 months to complete, although in certain circumstances such a switch may be significantlydelayed or prevented by regulatory and other factors.Any of these factors could cause the delay or suspension of regulatory submissions, required regulatory approvals or commercialization of Intermezzoor any other product candidate that we develop, entail higher costs or result in an inability to effectively commercialize our products, if any are approved.Furthermore, if manufacturers fail to deliver the required commercial quantities of raw materials, including the active pharmaceutical ingredient, keyexcipients or finished product on a timely basis and at commercially reasonable prices, we or our strategic partners would be unable to meet demand for ourproducts and we would lose potential revenue.We rely on third parties to conduct our non-clinical and clinical trials. If these third parties do not perform as contractually required or otherwiseexpected, we may not be able to obtain regulatory approval for our product candidates.We do not currently conduct non-clinical and clinical trials on our own, and instead rely on third parties, such as contract research organizations,medical institutions, clinical investigators and contract laboratories, to assist us with our non-clinical and clinical trials. We, and our third parties, are alsorequired to comply with regulations and standards, commonly referred to as Good Clinical Practice, for conducting, recording and reporting the results ofclinical trials to assure that data and reported results are credible and accurate and that the trial participants are adequately protected. If these third parties donot successfully carry out their duties with regard to Intermezzo development or fail to successfully carry out their duties to us as they relate to meetingfuture regulatory obligations or expected deadlines, if the third parties need to be replaced, or if the quality or accuracy of the data these third partiesobtained during the development of Intermezzo or in the future is compromised due to the failure to adhere to our clinical protocols or regulatoryrequirements or for other reasons, our non-clinical development activities or clinical trials may be extended, delayed, suspended or terminated, and we maynot be able to obtain regulatory approval for our product candidates, including Intermezzo.We may face potential product liability exposure, and if successful claims are brought against us, we may incur substantial liability for a productcandidate and may have to limit such candidate’s commercialization.The use of our product candidates in clinical trials and the sale of any products for which we obtain marketing approval exposes us to the risk ofproduct liability claims. Product liability claims might be brought against us by consumers, health care providers, pharmaceutical companies or others sellingour products. If we cannot successfully defend ourselves against these claims, we will incur substantial liabilities. We are also obligated under certaincircumstances to indemnify suppliers and others with whom we have contractual relationships for product liability claims such entities might incur withrespect to our products and product candidates. Regardless of merit or eventual outcome, liability claims may result in: • decreased demand for our products; • impairment of our business reputation; • withdrawal of clinical trial participants; • costs of related litigation; • substantial monetary awards to patients or other claimants; 42®®®®®® Table of Contents • loss of revenue; and • the inability to commercialize our product candidates.Although we currently have product liability insurance coverage for our clinical trials with limits that we believe are customary and adequate toprovide us with coverage for foreseeable risks associated with our development efforts, this insurance coverage may not reimburse us or may be insufficient toreimburse us for the actual expenses or losses we may suffer. Moreover, insurance coverage is becoming increasingly expensive and, in the future, we may notbe able to maintain insurance coverage at a reasonable cost or in sufficient amounts to protect us against losses due to liability. We intend to expand ourinsurance coverage to include the sale of commercial products if we obtain marketing approval for Intermezzo, but we may be unable to obtain such productliability insurance on commercially reasonable terms.We depend on key personnel and if we are not able to retain them our business will suffer.We are highly dependent on the principal members of our management and scientific staff, including but not limited to Glenn A. Oclassen, ourPresident and Chief Executive Officer, and Nikhilesh N. Singh, Ph.D., our Senior Vice President and Chief Scientific Officer. The competition for skilledpersonnel among biopharmaceutical companies in the San Francisco Bay Area is intense and the employment services of our scientific, management andother executive officers may be terminated at-will. If we lose one or more of these key employees, our ability to implement and execute our business strategysuccessfully could be seriously harmed. Replacing key employees may be difficult and may take an extended period of time because of the limited number ofindividuals in the biopharmaceutical industry with the breadth of skills and experience required to develop, gain regulatory approval of and commercializeproducts successfully. We do not carry key man life insurance on any of our key personnel other than Dr. Singh.If we do not raise additional capital, we may be forced to delay, reduce or eliminate our development programs and commercialization efforts.Our future capital requirements will depend on, and could increase significantly as a result of, many factors, including: • the costs and timing of regulatory approval; • the need to conduct additional clinical trials; • the costs of establishing or contracting for sales and marketing capabilities, including potential costs of being required to engage in contractingfor replacements for such capabilities if an existing arrangement is terminated; • the rate of progress to begin and conduct and cost of our clinical trials and other development activities; • the extent to which we acquire or in-license new products, technologies or businesses; • the effect of competing technological and market developments; and • the costs of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights.We may need to seek additional funding through strategic collaborations or through public or private sales of our equity securities. In addition, wemay obtain equipment leases and may pursue opportunities to obtain debt financing in the future. There can be no assurance, however, that strategiccollaborations, additional equity or debt financing will be available on reasonable terms, if at all. If adequate funds are not available, we may be required todelay, reduce the scope of, or eliminate one or more of our then existing or planned development, commercialization or expansion activities. 43® Table of ContentsRaising additional funds by issuing securities or through licensing arrangements may cause dilution to existing stockholders, restrict our operations orrequire us to relinquish proprietary rights.To the extent that we raise additional capital by issuing equity securities, our existing stockholders’ ownership will be diluted. Any debt financing weenter into may involve covenants that restrict our operations. These restrictive covenants may include limitations on additional borrowing and specificrestrictions on the use of our assets, as well as prohibitions on our ability to create liens, pay dividends, redeem our stock or make investments. In addition, ifwe raise additional funds through licensing arrangements, it may be necessary to relinquish potentially valuable rights to potential products or proprietarytechnologies, or grant licenses on terms that are not favorable to us.The commercial success, if any, of Intermezzo depends, in part, on the rights we are seeking through certain patent applications.The potential commercial success of Intermezzo depends in part on two issued patents from the U.S. Patent and Trademark Office, or USPTO, coveringthe formulation of Intermezzo and patents that may issue covering methods of use of zolpidem. In addition, we have pending certain foreign equivalentpatent applications with respect to formulations and manufacture of zolpidem for use in treatment of middle of the night awakening, as well as applicationscovering combinations and methods of use of ondansetron in conjunction with atypical antipsychotic drugs. There can be no assurance that our pendingpatent applications and applications we may file in the future, or those applications we may license from third parties, will result in patents being issued in atimely manner, or at all. Even if patents issue, the claims in such patents may not issue in a form that will be advantageous to us, may not encompassIntermezzo or our other product candidates and their unique features, and may not provide us with proprietary protection or competitive advantages. Forinstance, competitors may be able to engineer around our formulation patent applications with alternate formulations that deliver therapeutic effects similarto potential products covered by our zolpidem formulation patent applications. Other drug companies may also be able to develop generic versions of ourproducts if we are unable to maintain our proprietary rights. For example, generic drug makers may attempt to introduce generic low dose zolpidem productssimilar to our products immediately after the expiration of Hatch-Waxman marketing exclusivity and prior to the expiration of patents that may be issuedrelating to Intermezzo . Furthermore, among other limitations, the method of use patent applications that have been filed to encompass Intermezzo arelimited in scope to certain uses of zolpidem, so potential competitors could develop similar products using active pharmaceutical ingredients other thanzolpidem. Any patents that have been allowed, we have obtained or do obtain may be challenged by re-examination, opposition, or other administrativeproceeding, or may be challenged in litigation, and such challenges could result in a determination that the patent is invalid.The active, and many of the inactive, ingredients in Intermezzo, including generically manufactured zolpidem, have been known and used for manyyears and, therefore, are no longer subject to patent protection. Accordingly, certain of our pending patent applications are directed to the particularformulations of these ingredients in our products, and their use. Although we believe our formulations and their use are patentable and provide a competitiveadvantage, even if such patents are issued, such patents may not prevent others from marketing formulations using the same active and inactive ingredients insimilar but different formulations. Moreover, if our patents were successfully challenged and ruled to be invalid, we would be exposed to a greater risk ofdirect competition.Failure to obtain effective patent protection for Intermezzo and our other product candidates would allow for products to be marketed by competitorsthat would undermine sales, marketing and collaboration efforts for our product candidates, and reduce or eliminate our revenue. In addition, both the patentapplication process and the process of managing patent disputes can be time consuming and expensive. 44®®®®®®®® Table of ContentsIf we are unable to maintain and enforce our proprietary rights, we may not be able to compete effectively or operate profitably.Our commercial success will depend, in part, on obtaining and maintaining patent protection, trade secret protection and regulatory protection of ourproprietary technology and information as well as successfully defending against third-party challenges to our proprietary technology and information. Wewill be able to protect our proprietary technology and information from use by third parties only to the extent that we have valid and enforceable patents,trade secrets or regulatory protection to cover them and we have exclusive rights to utilize them.Our commercial success will continue to depend in part on the patent rights we own, the patent rights we have licensed, the patent rights of oursuppliers and the patent rights we plan to obtain related to future products we may market. Our success also depends on our and our licensors’ and suppliers’ability to maintain these patent rights against third-party challenges to their validity, scope or enforceability. Further, we do not fully control the patentprosecution of the patents and patent applications we have licensed. There is a risk that licensors to us will not devote the same resources or attention to theprosecution of the licensed patent applications as we would if we controlled the prosecution of the patent applications, and the resulting patent protection, ifany, may not be as strong or comprehensive as if we had prosecuted the applications ourselves. The patent positions of biopharmaceutical companies can behighly uncertain and involve complex legal and factual questions for which important legal principles remain unresolved. No consistent policy regarding thebreadth of claims allowed in such companies’ patents has emerged to date in the United States. The patent situation outside the United States is even moreuncertain. Changes in either the patent laws or in interpretations of patent laws in the United States or other countries may diminish the value of ourintellectual property. Accordingly, we cannot predict the breadth of claims that may be allowed or enforced in our patents or in third-party patents. Forexample: • we or our licensors might not have been the first to make the inventions covered by pending patent applications and issued patents; • we or our licensors 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 or any pending patent applications of our licensors will result in issued patents; • our patents, if issued, and the issued patents of our licensors may not provide a basis for commercially viable products, or may not provide uswith any competitive advantages, or may be challenged and invalidated by third parties; • we may not develop additional proprietary technologies or product candidates that are patentable; or • the patents of others may have an adverse effect on our business.We also rely on trade secrets to protect our technology, especially where we do not believe patent protection is appropriate or obtainable. However,trade secrets are difficult to protect. While we seek to protect confidential information, in part, by confidentiality agreements with our employees,consultants, contractors, or scientific and other advisors, they may unintentionally or willfully disclose our information to competitors. If we were to enforce aclaim that a third party had illegally obtained and was using our trade secrets, it would be expensive and time consuming, and the outcome would beunpredictable. In addition, courts outside the United States are sometimes less willing to protect trade secrets.If we are not able to defend the patent or trade secret protection position of our technologies and product candidates, then we will not be able toexclude competitors from developing or marketing competing products, and we may not generate enough revenue from product sales, if any, to justify thecost of development of our product candidates and to achieve or maintain profitability. 45 Table of ContentsIf we are sued for infringing intellectual property rights of other parties, such litigation will be costly and time consuming, and an unfavorable outcomewould have a significant adverse effect on our business.Although we believe that we would have valid defenses to allegations that our current product candidates, production methods and other activitiesinfringe the valid and enforceable intellectual property rights of any third parties of which we are aware, we cannot be certain that a third party will notchallenge our position in the future. Other parties may own patent rights that might be infringed by our products or other activities, or other parties may claimthat their patent rights are infringed by excipients manufactured by others and contained in our products. For example, SPI, the sole supplier of Pharmaburst,a key excipient used in Intermezzo, is the defendant in a lawsuit that alleges that certain of SPI’s products infringe one or more patents of a third party.Although not specifically identified in the original complaint, subsequent press releases have indicated that Pharmaburst products allegedly infringe suchpatents. SPI has informed us that the third party’s patent rights are not infringed by Pharmaburst and that they intend to defend their rights vigorously.However, because Pharmaburst is a key excipient in Intermezzo, the interruption of supply of Pharmaburst through an injunction or through voluntarycessation of production could materially harm our ability to supply Intermezzo. There has been, and we believe that there will continue to be, significantlitigation and demands for licenses in the life sciences industry regarding patent and other intellectual property rights. Competitors or other patent holdersmay assert that our products and the methods we employ are covered by their patents. These parties could bring claims against us that would cause us to incursubstantial expenses and, if successful against us, could cause us to pay substantial damages or possibly prevent us from commercializing our productcandidates. Further, if a patent infringement suit were brought against us, we could be forced to stop or delay research, development, manufacturing or salesof the product or product candidate that is the subject of the suit.As a result of patent infringement claims, or in order to avoid potential claims, we may choose to seek, or be required to seek, a license from the thirdparty and would most likely be required to pay license fees or royalties or both. These licenses may not be available on acceptable terms, or at all. Even if wewere able to obtain a license, the rights may be non-exclusive, which would give competitors access to the same intellectual property. Ultimately, we couldbe prevented from commercializing a product, or be forced to cease some aspect of our business operations if, as a result of actual or threatened patentinfringement claims, we or our collaborators are unable to enter into licenses on acceptable terms. This could harm our business significantly.These risks of intellectual property infringement are similarly faced by our suppliers and collaborators, which could hinder or prevent them frommanufacturing or commercializing our products.We may incur substantial costs as a result of litigation or other proceedings relating to patent and other intellectual property rights.In the event a competitor infringes upon one of our patents or other intellectual property rights, litigation to enforce our intellectual property rights orto defend our patents against challenge, even if successful, could be expensive and time consuming and could require significant time and attention frommanagement. We may not have sufficient resources to enforce our intellectual property rights or to defend our patents against challenges from others.The pharmaceutical industry is characterized by extensive litigation and administrative proceedings over patent and other intellectual property rights.We could therefore become subject to litigation that could be costly, result in the diversion of management’s time and efforts, and require us to pay damages.Whether a product infringes a patent involves complex legal and factual issues, the determination of which is often uncertain. Our competitors may assert thatthey own U.S. or foreign patents containing claims that cover our products, components of our products, or the methods we employ in making or using ourproducts. In addition, we may become a party to an interference proceeding declared by the USPTO to determine the priority of inventions. Because patentapplications can take many years to issue, and in many instances, at least 18 months to publish, there may be applications now pending of which we areunaware, which may later result in issued patents that 46®®®®®®®® Table of Contentscontain claims that cover our products. There could also be existing patents, of which we are unaware, that contain claims that cover one or more componentsof our products. As the number of participants in our industry increases, the possibility of patent infringement claims against us also increases.Any interference proceeding, litigation, or other assertion of claims against us may cause us to incur substantial costs, could place a significant strainon our financial resources, divert the attention of management from our core business and harm our reputation. If the relevant patents were upheld as validand enforceable and we were found to infringe, we could be required to pay substantial damages and/or royalties and could be prevented from selling ourproducts unless we could obtain a license or were able to redesign our products to avoid infringement. Any such license may not be available on reasonableterms, if at all. If we fail to obtain any required licenses or make any necessary changes to our products or technologies, we may be unable to make, use, sell,or otherwise commercialize one or more of our products. In addition, if we are found to willfully infringe, we could be required to pay treble damages, amongother penalties.If we fail to comply with our obligations in the agreements under which we license rights to products or technology from third parties, we could loselicense rights that are important to our business.We are a party to a number of agreements that include technology licenses that are important to our business and expect to enter into additionallicenses in the future. For example, we hold licenses from SPI Pharmaceuticals, Inc. relating to key excipients used in the manufacture of Intermezzo. If wefail to comply with these agreements, the licensor may have the right to terminate the license, in which event we and our collaboration partners would not beable to market products covered by the license, including Intermezzo.We may be subject to damages resulting from claims that we or our employees have wrongfully used or disclosed alleged trade secrets of former employers.Many of our employees were previously employed at universities or other biotechnology or pharmaceutical companies, including competitors orpotential competitors. Although no claims against us are currently pending, we may be subject to claims that these employees or we ourselves haveinadvertently or otherwise used or disclosed trade secrets or other proprietary information of former employers. Litigation may be necessary to defend againstthese claims. If we fail in defending such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights or personnel. Aloss of key research personnel or their work product could hamper or prevent our or a collaboration partner’s ability to develop or commercialize certainpotential products, which could severely harm our business. Even if we are successful in defending against these claims, litigation could result in substantialcosts and be a distraction to management.If our agreements with employees, consultants, advisors and corporate partners fail to protect our intellectual property, proprietary information or tradesecrets, it could have a significant adverse effect on us.We have taken steps to protect our intellectual property and proprietary technology by entering into confidentiality agreements and intellectualproperty assignment agreements with our employees, consultants, advisors and corporate partners. However, such agreements may not be enforceable or maynot provide meaningful protection for our trade secrets or other proprietary information in the event of unauthorized use or disclosure or other breaches of theagreements, and we may not be able to prevent such unauthorized disclosure. Monitoring unauthorized disclosure is difficult, and we do not know whetherthe steps we have taken to prevent such disclosure are, or will be, adequate. Furthermore, the laws of some foreign countries may not protect our intellectualproperty rights to the same extent as do the laws of the United States. 47®® Table of ContentsOur stock price is expected to be volatile.The market price of our common stock could be subject to significant fluctuations. Market prices for securities of early-stage pharmaceutical,biotechnology and other life sciences companies have historically been particularly volatile. Some of the factors that may cause the market price of ourcommon stock to fluctuate include: • our ability to obtain regulatory approvals for Intermezzo or other product candidates, and delays or failures to obtain such approvals; • the termination of key commercial partner agreements, such as our Collaboration Agreement with Purdue; • failure of any product candidates, if approved, to achieve commercial success; • issues in manufacturing approved products, if any, or product candidates; • the results of current and any future clinical trials of our product candidates; • the entry into, or termination of, key agreements, including additional commercial partner agreements; • the initiation of, material developments in, or conclusion of litigation to enforce or defend our intellectual property rights or defend against theintellectual property rights of others; • announcements by commercial partners or competitors of new commercial products, clinical progress or the lack thereof, significant contracts,commercial relationships or capital commitments; • adverse publicity relating to the insomnia market, including with respect to other products and potential products in such market; • the introduction of technological innovations or new therapies that compete with our potential products; • the loss of key employees; • changes in estimates or recommendations by securities analysts, if any, who cover our common stock; • future sales of our common stock; • general and industry-specific economic conditions that may affect our research and development expenditures; • changes in the structure of health care payment systems; and • period-to-period fluctuations in financial results.Moreover, the stock markets in general have experienced substantial volatility that has often been unrelated to the operating performance of individualcompanies. These broad market fluctuations may also adversely affect the trading price of our common stock.In the past, following periods of volatility in the market price of a company’s securities, stockholders have often instituted class action securitieslitigation against those companies. Such litigation, if instituted, could result in substantial costs and diversion of management attention and resources, whichcould significantly harm our profitability and reputation.Anti-takeover provisions in our Collaboration Agreement with Purdue, in our charter documents and under Delaware law could make an acquisition of usmore difficult and may prevent attempts by stockholders to replace or remove management.Provisions in our Collaboration Agreement with Purdue, certificate of incorporation and bylaws may delay or prevent an acquisition or a change inmanagement. These provisions include an agreement with Purdue that prevents Purdue from acquiring above a certain percentage of our stock and engagingin certain other activities 48® Table of Contentsthat may lead to an acquisition of our company. Such provisions in our charter documents include a classified board of directors, a prohibition on actions bywritten consent of stockholders and the ability of the board of directors to issue preferred stock without stockholder approval. In addition, because we areincorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which prohibits stockholders owningin excess of 15% of our outstanding voting stock from merging or combining with us. Although we believe these provisions collectively will provide for anopportunity to receive higher bids by requiring potential acquirers to negotiate with our board of directors, they would apply even if the offer may beconsidered beneficial by some stockholders. In addition, these provisions may frustrate or prevent any attempts by stockholders to replace or remove thethen-current management by making it more difficult for stockholders to replace members of the board of directors, which is responsible for appointing themembers of management.We have never paid dividends on our capital stock, and do not anticipate that we will pay any cash dividends in the foreseeable future.We have not paid cash dividends on any of our classes of capital stock to date, and our current expectation is that we will retain our future earnings tofund the development and growth of our business. As a result, capital appreciation, if any, of our common stock will be the sole source of gain, if any, as aresult of holding shares of our common stock, for the foreseeable future.Future sales of shares by existing stockholders could cause our stock price to decline.The market price of our common stock could decline as a result of sales by our existing stockholders in the market, or the perception that these salescould occur. These sales might also make it more difficult for us to issue and sell equity securities at a time and price that we deem appropriate. The lock-upagreements delivered by our executive officers and directors and certain other stockholders in connection with the merger of Novacea and TPI expired in July2009. Subject to applicable securities law restrictions and other agreements between the company and certain of such stockholders, these shares are nowfreely tradable.The highly concentrated ownership of our common stock may prevent stockholders from influencing significant corporate decisions and may result inconflicts of interest that could cause our stock price to decline.Our executive officers, directors and their affiliates beneficially own or control approximately 55% of the outstanding shares of our common stock as ofDecember 31, 2009. Accordingly, these executive officers, directors and their affiliates, acting as a group, will have substantial influence over the outcome ofcorporate actions requiring stockholder approval, including the election of directors, any merger, consolidation or sale of all or substantially all of our assetsor any other significant corporate transactions. These stockholders may also delay or prevent a change of control of us, even if such a change of controlwould benefit the other stockholders. The significant concentration of stock ownership may adversely affect the trading price of our common stock due toinvestors’ perception that conflicts of interest may exist or arise. Item 1B.Unresolved Staff CommentsNone. Item 2.PropertiesOur operational headquarters is located in Point Richmond, California, where we lease approximately 26,900 square feet of space under two separateleases, the first of which for approximately 14,600 square feet of space expires in May 2013, and the second of which for approximately 12,300 square feet ofspace also expires in May 2013, with an option to renew for an additional five years. Of the 26,900 square feet of space in Point Richmond, California,approximately 3,000 square feet is product development laboratory space and the remainder is general office space. 49 Table of ContentsTranscept also leases approximately 25,288 square feet of general office space in South San Francisco, California, under a lease that expires in October2012. All of such space was subleased to a third party in May and June 2009.Transcept believes that its current facilities are suitable and adequate for its current needs. Item 3.Legal ProceedingsFrom time to time, we may be involved in litigation relating to claims arising out of our operations. Transcept is not currently involved in any materiallegal proceedings.SPI Pharmaceuticals, Inc., the sole supplier of Pharmaburst, a key excipient used in Intermezzo, is the defendant in a lawsuit brought by RoquetteFrères, or Roquette, in the Federal District Court of Delaware on August 31, 2006 that alleges that certain of SPI’s products infringe one or more claims of aRoquette patent and seeks monetary damages and injunctive relief. Transcept has not been named in, and is not a party to, the lawsuit. Although notspecifically identified in the original complaint, press releases have indicated that Pharmaburst products are among the accused products. SPI has informedus that Roquette’s patent rights are not infringed by Pharmaburst and that they intend to defend their rights vigorously. Because Pharmaburst is a keyexcipient in Intermezzo, the interruption of supply of Pharmaburst through an injunction could materially harm our ability to supply Intermezzo and ourbusiness. SPI has agreed to indemnify us against certain damages related to any such infringement suit under the terms of our agreement with SPI. Item 4.Reserved 50®®®®®®®® Table of ContentsPART II Item 5.Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesMarket InformationOur common stock is currently traded on the NASDAQ Global Market, under the symbol “TSPT.” Prior to February 2, 2009, our common stock wastraded under the symbol “NOVC.” On January 30, 2009, in connection with the merger of Novacea and TPI, we completed a reverse stock split pursuant towhich each five shares of our common stock was converted into one share of our common stock. The share-related information presented in this Form 10-Khas been adjusted to reflect the reverse stock split.The following table sets forth the range of high and low sales prices of our common stock for the quarterly periods indicated, as reported by theNASDAQ Global Market (adjusted for the 1-for-5 reverse stock split which occurred on January 30, 2009). Sales Price High LowYear ended December 31, 2008 First quarter $16.40 $11.00Second quarter $17.00 $11.05Third quarter $13.50 $7.20Fourth quarter $8.70 $4.46Year ended December 31, 2009 First quarter $7.50 $2.56Second quarter $6.36 $2.70Third quarter $14.35 $4.54Fourth quarter $15.40 $4.45On January 30, 2009, Novacea completed a business combination with TPI. Novacea securities listed on the NASDAQ Global Market, trading underthe ticker symbol “NOVC,” were suspended for trading as of the close of business on Friday, January 30, 2009 and trading of Transcept securities on theNASDAQ Global Market under the ticker symbol “TSPT” commenced on Monday, February 2, 2009.The closing price of Transcept common shares as reported by the NASDAQ Global Market on March 26, 2010 was $7.8491 per share. As of March 26,2010 there were approximately 84 holders of record of our common stock.Dividend PolicyNo dividends have been declared or paid on Transcept common stock. Transcept does not anticipate that it will pay any cash dividends on its commonstock in the foreseeable future.Issuer Purchases of Equity SecuritiesThere were no repurchases of our common stock during the fourth quarter of fiscal 2009.Securities Authorized For Issuance Under Equity Compensation PlansInformation relating to compensation plans under which equity securities are authorized for issuance is set forth under Item 12—“Security Ownershipof Certain Beneficial Owners and Management and Related Stockholder Matters” of this Annual Report on Form 10-K. 51 Table of ContentsPerformance GraphThe following graph compares: • the performance of an investment in our common stock over the period of May 10, 2006 through December 31, 2009, beginning with aninvestment at the closing market price on May 10, 2006, the end of the first day our common stock traded on the NASDAQ Global Marketfollowing our initial public offering, and thereafter, based on the closing price of our common stock on the NASDAQ Global Market; with • an investment in the NASDAQ Composite Index and an investment in the NASDAQ Biotech Index, in each case, beginning with an investmentat the closing price on May 10, 2006 and thereafter, based on the closing price of the index.The graph assumes $100 was invested on the starting date at the price indicated above and that all dividends were reinvested on the date of paymentwithout payment of any commissions. We have not declared or paid any dividends on our common stock. The performance of our common stock shown inthe graph below represents past performance and should not be considered an indication of future performance.Comparison of Cumulative Total ReturnFor the Period from May 10, 2006 (trading commencement) through December 31, 2009Among Transcept Pharmaceuticals, Inc., the NASDAQ Composite Index and the NASDAQ Biotechnology Index 52 Table of ContentsItem 6.Selected Financial DataThe following selected financial data has been derived from our audited financial statements. The information below is not necessarily indicative ofthe results of future operations and should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results ofOperations,” and Item 1A, “Risk Factors,” of this Form 10-K, and the financial statements and related notes thereto included in Item 8 of this Form 10-K, inorder to fully understand factors that may affect the comparability of the information presented below. All per share amounts reflect the conversion of TPIcommon stock to our common stock on January 30, 2009 at the rate of 0.14134 shares of common stock, after giving effect to the 1-for-5 reverse stock split,for each share of TPI common stock outstanding on January 30, 2009. For the year ended December 31, 2009 2008 2007 2006 2005 (in thousands, except per share data) Statements of operations data License fee revenue $5,208 $— $— $— $— Operating expenses: Research and development 9,005 10,381 15,885 10,161 3,269 General and administrative 16,050 7,924 5,300 3,923 1,703 Merger related transaction costs 2,224 1,967 — — — Total operating expenses 27,279 20,272 21,185 14,084 4,972 Loss from operations (22,071) (20,272) (21,185) (14,084) (4,972) Interest and other income, net 271 313 801 458 98 Interest expense related to bridge loan warrants — — — — (535) Net loss $(21,800) $(19,959) $(20,384) $(13,626) $(5,409) Deemed dividend—Series C preferred stockholders — — — — (458) Loss attributable to common stockholders $(21,800) $(19,959) $(20,384) $(13,626) $(5,867) Basic and diluted net loss per share attributable to common stockholders $(1.79) $(49.77) $(68.86) $(60.83) $(33.15) Weighted average common shares outstanding 12,166 401 296 224 177 As of December 31, 2009 2008 2007 2006 2005 (in thousands) Selected Balance Sheet Data Cash, cash equivalents, marketable securities and restricted cash $89,102 $11,883 $35,434 $16,520 $20,910 Total assets 95,218 13,781 37,769 18,234 21,515 Working capital 74,293 6,875 29,612 12,627 20,561 Convertible preferred stock — 71,037 71,037 31,202 31,202 Common stock and additional paid-in capital 157,943 1,504 751 176 87 Accumulated deficit (86,911) (65,111) (45,152) (24,768) (11,141) Total stockholders’ equity (net capital deficiency) 71,071 (63,581) (44,316) (24,589) (11,062) 53 Table of ContentsItem 7.Management’s Discussion and Analysis of Financial Condition and Results of OperationsThe following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains certain statements that are notstrictly historical and are “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995 and involve a highdegree of risk and uncertainty. Actual results may differ materially from those projected in the forward-looking statements due to other risks anduncertainties. All forward-looking statements included in this section are based on information available to us as of the date hereof, and we assume noobligation to update any such forward-looking statement, except as required by law.OverviewWe are a specialty pharmaceutical company focused on the development and commercialization of proprietary products that address importanttherapeutic needs in neuroscience. Our most advanced product candidate, Intermezzo (zolpidem tartrate sublingual tablet), is a sublingual low doseformulation of zolpidem that is being developed for use in the middle of the night at the time a patient awakens and has difficulty returning to sleep.We submitted a new drug application, or NDA, for Intermezzo to the U.S. Food and Drug Administration, or FDA, on September 30, 2008. OnOctober 28, 2009, we received a Complete Response Letter from the FDA regarding our NDA indicating that it was not approved.In the Complete Response Letter, the FDA stated that it believes we had submitted substantial evidence of effectiveness for the use of Intermezzo forits proposed indication. Our proposed label for Intermezzo indicates that Intermezzo should only be taken when patients have at least four hours remainingin bed before being active again. The FDA further recognized that the Intermezzo data we submitted did not indicate significant next day residual effects atfour hours after use. However, the FDA indicated that the intended use of Intermezzo in the middle of the night represents a unique insomnia indication anddosing strategy for which safety has not been previously established and that we did not adequately demonstrate that Intermezzo could reliably be usedsafely. The FDA requested additional data demonstrating that Intermezzo, when taken as directed in the middle of the night, would not present anunacceptable risk of residual effects, with particular reference to next day driving ability. The FDA also expressed two concerns regarding the possibility ofpatient dosing errors in the middle of the night that could lead to next day residual effects with particular reference to next day driving ability. Specifically,the FDA has asked us to address methods to avoid inadvertent dosing with less than four hours of bedtime remaining, and inadvertent re-dosing in a singlenight.On January 20, 2010, we met with the FDA to discuss the Complete Response Letter. Before the meeting, we proposed a plan to resubmit theIntermezzo NDA. Our plan included new Intermezzo bedside, single unit-dose packaging and patient instructions designed to reduce the possibility ofinadvertent patient dosing errors. The FDA indicated in the meeting that the revised packaging appeared to reduce the potential for inadvertently takingmore than one dose in a single night, but expressed continuing concern about the risk of dosing with less than four hours of time remaining in bed, withparticular regard to the possibility of impaired driving. To further characterize the safety of dosing Intermezzo in the middle of the night, we subsequentlyproposed to conduct a pre-approval highway driving study to assess the effect of Intermezzo on driving ability beginning at approximately three hours andfour hours post-dosing. The FDA and Transcept also discussed on January 20, 2010, whether a pre-approval patient use study might help to define patientability to properly follow instructions under actual conditions of use.On a March 24, 2010 teleconference, the FDA agreed that our plan to conduct a highway driving study is a reasonable way to measure potential nextday driving impairment from dosing Intermezzo with four hours or less remaining in bed.Based on communications with the FDA, we plan to conduct a pre-approval highway driving study to assess the effect of Intermezzo on next morningdriving ability beginning at approximately three hours and four hours 54®®®®®®®®®®®®®®® Table of Contentsafter dosing Intermezzo in the middle of the night. We have no current plans to conduct a patient use study because of the challenges and limitations of sucha study, and have submitted to the FDA our position in this regard. The FDA indicated that it would consider our position on patient use studies as part of theoverall resubmission of the Intermezzo NDA. We also plan to include data from on-going studies of patient comprehension of label instructions in ourplanned resubmission.We plan to resubmit the Intermezzo NDA in the late fourth quarter of 2010 after we generate and analyze additional data from our planned highwaydriving study. Because our planned resubmission will include additional clinical data, our resubmitted Intermezzo NDA will result in a six-month reviewperiod at the FDA under the Prescription Drug User Fee Act, or PDUFA.On July 31, 2009, we entered into the United States License and Collaboration Agreement, or the Collaboration Agreement, with PurduePharmaceutical Products, L.P., or Purdue, that provides for an exclusive license to Purdue to commercialize Intermezzo in the United States and pursuant towhich: • On August 4, 2009, Purdue paid us a $25.0 million non-refundable license fee; • We are obligated to seek FDA approval of Intermezzo and to continue development of Intermezzo at our expense until FDA approval; and • If Purdue elects not to terminate our collaboration after its review of an FDA approval of Intermezzo: • Purdue is obligated to pay us up to $30.0 million, which amount is reduced by $2.0 million for each 30 day period that our receipt of anNDA approval for Intermezzo is delayed beyond June 30, 2010; • We are obligated to transfer the Intermezzo NDA to Purdue and Purdue is obligated to assume the expense associated with maintainingthe NDA and further development of Intermezzo in the United States, including any expense associated with post-approval studies; • Purdue is obligated to commercialize Intermezzo in the United States at its expense; • Purdue is obligated to pay us tiered double-digit base royalties on net sales of Intermezzo in the United States ranging up to the mid-twenty-percent level; • Purdue is obligated to pay us $10.0 million if either of two formulation patents are listed in the FDA’s Approved Drug Products withTherapeutic Equivalence Evaluations, or Orange Book; and • Purdue is potentially obligated to pay us up to an additional $80.0 million upon meeting certain intellectual property milestones andupon the achievement of certain net sales targets for Intermezzo in the United States.We retained an option to co-promote Intermezzo to psychiatrists in the United States as early as the first anniversary of commercial launch ofIntermezzo and upon entry into the market under the co-promotion option, we would receive an additional double-digit royalty from Purdue on salesgenerated by psychiatrists in the United States.We also granted Purdue and an associated company the right to negotiate for the commercialization of Intermezzo in Mexico and Canada,respectively, and retained rights to commercialize Intermezzo in the rest of the world.We have an active effort underway to enter into one or more development and marketing alliances to develop and commercialize Intermezzo withestablished pharmaceutical companies in major markets outside the United States.We have incurred net losses since inception as we have devoted substantially all of our resources to research and development, including contractmanufacturing and clinical trials. As of December 31, 2009, we had cash, 55®®®®®®®®®®®®®®®®®®® Table of Contentscash equivalents, and marketable securities of $88.9 million, working capital of $74.3 million and an accumulated deficit of $86.9 million.Our ability to generate near term revenue is dependent upon the receipt of milestone and royalty payments under our Collaboration Agreement withPurdue, which are dependent upon the regulatory approval by the FDA of our lead product candidate, Intermezzo. To achieve profitable operations,Intermezzo must be successfully developed and commercialized and we may need to identify, develop and commercialize future product candidates. Even ifapproved, our products may not achieve market acceptance and will face competition from both generic and branded pharmaceutical products.Merger with NovaceaPrior to January 30, 2009 we were known as Novacea, Inc. On January 30, 2009, we completed a business combination, referred to as the merger, withTranscept Pharmaceuticals, Inc., or TPI. For accounting purposes, TPI was deemed to be the acquiring entity in the merger. In connection with the merger, wechanged our name to Transcept Pharmaceuticals, Inc. and effected a 1-for-5 reverse stock split of our common stock. All share and per share disclosures havebeen retroactively adjusted to reflect the exchange of shares in the merger, and the 1-for-5 reverse split of our common stock on January 30, 2009. Allreferences to “Transcept,” “we,” “us,” “our” or the “Company” mean Transcept Pharmaceuticals, Inc., the publicly-traded combined company resulting fromthe merger and, as successor to the business of TPI, includes activities taking place with respect to the business of TPI prior to the merger of TPI and Novacea,as applicable.The following analysis reflects the historical financial results of TPI prior to the merger and that of the combined company following the merger, anddoes not include the historical financial results of Novacea prior to the completion of the merger.Financial Operations OverviewRevenueWe recognize revenue from the $25.0 million non-refundable license fee received pursuant to our Collaboration Agreement with Purdue ratably overan estimated 24-month period starting August 1, 2009 and ending on July 31, 2011. This represents the estimated period for which we have significantparticipatory obligations under the Collaboration Agreement. The revenue recognized in connection with the license fee during 2009 was $5.2 million.Research and Development ExpensesResearch and development expenses have represented approximately 33%, 51% and 75% of total operating expenses for the years ended December 31,2009, 2008 and 2007, respectively. Research and development costs are expensed as incurred. Research and development expenses consist of expensesincurred in identifying, researching, developing and testing product candidates. These expenses primarily consist of the following: • Salaries, benefits, travel and related expense of personnel associated with research and development activities; • Fees paid to professional service providers for services related to the conduct and analysis of clinical trials; • Contract manufacturing costs for formulations used in clinical trials, as well as scale up activities in anticipation of a potential launch ofIntermezzo; • Laboratory supplies and materials; • Depreciation of equipment; and • Allocated costs of facilities and infrastructure. 56®®® Table of ContentsGeneral and Administrative ExpensesGeneral and administrative expenses consist primarily of salaries and related expenses for personnel in executive, marketing, finance and accounting,information technology and human resource functions. Other costs include facility costs not otherwise included in research and development expenses andprofessional fees for legal and accounting services.Following the merger, we increased our general and administrative expenses for activities associated with operating as a publicly-traded company,including professional fees for consulting, legal and accounting as well as business licenses and fees. These increases include the hiring of additionalpersonnel. As we continued working toward commercialization of Intermezzo in the United States, we increased spending on our sales and marketinginfrastructure, including increased headcount and marketing expenses necessary to prepare for the commercialization of Intermezzo . Following our entryinto the Collaboration Agreement with Purdue, the majority of our sales and marketing activities have been transitioned to Purdue.Interest IncomeWe receive interest income from cash, cash equivalents, restricted cash and marketable securities held with certain financial institutions.Interest ExpenseWe incurred interest expense on the outstanding balance from our $10.0 million venture debt facility agreement, which was repaid in full during thefirst quarter of 2009. We also incur interest expense on a $0.3 million loan for tenant improvements, payable to the landlord of our corporate facility in PointRichmond, California.Other Income (Expense), NetOther income (expense), net relates to the change in fair value of preferred stock warrants, gains or losses on sales of marketable securities and othermiscellaneous items. In connection with the merger, the outstanding preferred stock warrants became outstanding common stock warrants and therefore areno longer treated as a liability requiring remeasurement to fair market value at each balance sheet date.Results of OperationsComparison of the Years Ended December 31, 2009 and 2008The following table summarizes results of operations with respect to the items set forth below for the years ended December 31, 2009 and 2008, inthousands, together with the percentage change in those items. Year ended December 31, 2009 2008 $Change %Change Revenue $5,208 $— $5,208 — Research and development expenses 9,005 10,381 (1,376) (13%) General and administrative expenses 16,050 7,924 8,126 103% Merger related costs 2,224 1,967 257 13% Interest income 282 742 (460) (62%) Interest expense (179) (766) 587 77% Other income (expense), net 168 337 (169) (50%) 57®® Table of ContentsRevenueRevenue for 2009 relates to recognition of a portion of the $25.0 million non-refundable license fee we received from Purdue in connection with ourentry into the Collaboration Agreement. We plan to recognize revenue over an estimated 24-month period starting in August 2009 through July 2011 as wehave continuing participatory obligations under the agreement for the commercialization of Intermezzo. Therefore, we have deferred the license fee and willrecognize $1.04 million per month from the date we received the payment in August 2009 through July 2011.Research and Development ExpensesResearch and development expenses decreased 13% to $9.00 million for the year ended December 31, 2009 from $10.38 million for the comparableperiod in 2008. The decrease of $1.38 million is primarily attributable to Intermezzo development costs as a result of the following: • a decrease in clinical trial costs of $0.83 million due primarily to the Phase 3 outpatient trial being largely completed by year end 2007, withtrial closeout activities occurring during the first half of 2008 and no clinical trials being conducted in 2009; and • a decrease of $0.66 million in registration and submission third party costs related to the filing of our NDA in September 2008; partially offset by • an increase in manufacturing costs of $0.24 million attributable to, in 2009, the manufacture of validation batches as well as tooling costs relatedto our proposed Intermezzo packaging design and, in 2008, formulation development and packaging development as well as the purchase ofraw materials, which was largely completed by September 2008 when we filed our NDA.The remaining $0.13 million reduction in research and development expenses is due to a reduction of staffing levels in our clinical developmentdepartment during the latter half of 2008 resulting in reduced salary and related benefits during 2009 as compared to 2008. The decrease was partially offsetby severance expenses incurred in connection with the restructuring announced in August 2009 and increased consulting expenses in 2009 related to thedevelopment of Intermezzo in the European market.General and Administrative ExpensesGeneral and administrative expenses increased 103% to $16.05 million for the year ended December 31, 2009 from $7.92 million for the comparableperiod in 2008. The approximate $8.13 million increase consists of the following: • Personnel costs and related expenses increased by $2.44 million due to an increase in headcount to operate as a publicly-traded company and toprepare for the potential commercialization of Intermezzo. Headcount increases were in the marketing, finance, executive and operationsfunctions. In addition, severance expenses related to the restructuring as noted above and higher non-cash stock-based compensation expensealso contributed to increased general and administrative expenses in 2009; • Professional fees, including consulting, legal and accounting fees, increased by $2.86 million primarily attributable to costs associated withoperating as a publicly-traded company, negotiating our Collaboration Agreement with Purdue and pursuing our patent applications; • Market research and other third party expenses increased by $0.83 million to support the development of the Intermezzo commercializationplan; and • Other general and administrative expenses increased by $2.0 million due to increased insurance for operating as a publicly-traded company,costs associated with additional office space and increased travel to prepare for potential Intermezzo commericalization. 58®®®®®®® Table of ContentsMerger related transaction costsMerger related transaction costs consisted primarily of $2.0 million in financial and advisory fees and $0.2 million in legal fees incurred in connectionwith the close of the merger transaction in January 2009. Merger related transaction costs in 2008 consist primarily of $1.97 million in professional feesincurred in connection with the merger.Interest IncomeInterest income decreased 62% to $282,000 for the year ended December 31, 2009 from $742,000 for the comparable period in 2008. The decrease ofapproximately $460,000 for the year ended December 31, 2009 is primarily attributable to changing the mix of investments toward lower risk, lower yieldinstruments due to the downturn in the U.S. and world economy during the second half of 2008. In addition, investments held during 2008 were, in theaggregate, purchased at a discount to face value whereas investments held during 2009 were primarily acquired at a premium. Amortization of bondpremiums is recorded as a reduction of interest income.Interest ExpenseInterest expense decreased 77% to $179,000 for the year ended December 31, 2009 from $766,000 for the comparable period in 2008. The $587,000decrease for the year ended December 31, 2009 was primarily attributable to lower average outstanding debt during the 2009 period as compared to the sameperiod in the prior year due to the repayment in full of our debt under a Loan and Security Agreement with Hercules Technology Growth Capital during thefirst quarter 2009.Other Income (Expense), NetOther income (expense), net decreased 50% to $168,000 for the year ended December 31, 2009 from $337,000 for the comparable period in 2008. In2008 through January 2009, the fair market value of the preferred stock warrants declined significantly, resulting in a reduction of the warrant liability andcorresponding increase in other income. Other expense in 2009 included $143,000 of Delaware Franchise tax as compared to $15,000 during 2008. Thisincrease in 2009 other expense was partially offset by $111,000 of realized gains on the sales of marketable securitiesComparison of the Years Ended December 31, 2008 and 2007The following table summarizes results of operations with respect to the items set forth below for the years ended December 31, 2008 and 2007, inthousands, together with the percentage change in those items. Year ended December 31, $ % 2008 2007 Change Change Research and development expenses $10,381 $15,885 $(5,504) (35%) General and administrative expenses 7,924 5,300 2,624 50% Merger related transaction costs 1,967 — 1,967 — Interest income 742 2,029 (1,287) (63%) Interest expense (766) (1,195) 429 36% Other income (expense), net 337 (33) 370 1121% Research and Development ExpensesResearch and development expenses decreased 35% to $10.38 million for the year ended December 31, 2008 from $15.88 million for the comparableperiod in 2007. The $5.50 million decrease is primarily attributable to Intermezzo development costs as a result of the following: • a decrease in clinical trial costs of $4.84 million due primarily to the Phase 3 outpatient trial being largely completed by year end 2007, withtrial closeout activities occurring during the first half of 2008; 59® Table of Contents • a decrease in manufacturing costs of $1.06 million as formulation development and production of clinical batches had been completed in 2007;partially offset by • an increase of $0.72 million in registration and submission third party costs related to the filing of our NDA in September 2008.The remaining $0.32 million reduction in research and development expenses is related to the change in expenditures for earlier stage programs.General and Administrative ExpensesGeneral and administrative expenses increased 50% to $7.92 million in 2008 from $5.30 million in 2007. The approximate $2.62 million increaseconsists of the following: • Personnel costs and related expenses increased by $1.2 million due to an increase in headcount in the executive, finance, accounting, marketingand operations functions to support the ramp-up of clinical development and NDA activities, as well as in preparation to operate as a publicly-traded company; • Market research and other third party marketing expenses increased by $0.91 million to support the development of the Intermezzocommercialization plan; and • Other general and administrative expenses increased by $0.51 million due to increased professional fees incurred in support and anticipation ofour merger with Novacea, Inc.Merger related transaction costsMerger related transaction costs in 2008 consist primarily of $1.97 million in professional fees incurred in connection with our merger with Novacea,Inc.Interest IncomeInterest income decreased 63% to $0.72 million in 2008 from $2.03 million for the comparable period in 2007. The decrease of approximately $1.31million is primarily attributable to lower average cash and investments balances due to cash used in operations during the 2008 period as compared to thesame period in 2007.Interest ExpenseInterest expense decreased 36% to $0.77 million in 2008 from $1.20 million in 2007. The $0.43 million decrease was primarily attributable to loweraverage outstanding debt during 2008 compared to 2007.Other Income (Expense), NetOther income (expense), net increased to a gain of $337,000 in 2008 from a loss of $33,000 in 2007. In 2008, the fair market value of the preferredstock warrants declined significantly as compared to 2007, resulting in a reduction of the warrant liability and corresponding increase in other income.Liquidity and Capital ResourcesAt December 31, 2009, we had cash, cash equivalents and marketable securities of $88.9 million.From our inception through the completion of the merger, we financed our operations primarily through private placements of preferred stock, debtfinancing, the Collaboration Agreement and interest income. Through December 31, 2008, we received net proceeds of $71.0 million from the sale ofpreferred stock. In January 2009, through the merger, we acquired an additional $80.9 million in cash, cash equivalents and marketable securities. OnAugust 4, 2009, we received a $25.0 million non-refundable license fee from Purdue in connection with our entry into the Collaboration Agreement. 60® Table of ContentsIn February 2006, we entered into a $10.0 million venture debt facility agreement with Hercules Technology Growth Capital, Inc., or Hercules, anddrew down $4.0 million in May 2006 and $6.0 million in December 2006, against which interest accrued at rates of 10.69% and 10.94%, respectively.Outstanding principal, accrued interest, and unpaid interest under the loan and security agreement became due and payable on certain change of controltransactions. In conjunction with the merger of Novacea and TPI and pursuant to an agreement with Hercules, on February 3, 2009 we repaid in full allamounts outstanding related to this loan.The following table summarizes our cash provided by (used in) operating, investing and financing activities (in thousands): Year Ended December 31, 2009 2008 2007 Net cash provided by (used in) operating activities $830 $(20,130) $(18,822) Net cash provided by (used in) investing activities 14,652 22,438 (19,492) Net cash (used in) provided by financing activities (2,883) (3,572) 37,045 Net Cash Provided by (Used in) Operating ActivitiesNet cash provided by operating activities was $0.8 million for the year ended December 31, 2009. Net cash used in operating activities was $20.1million and $18.8 million for the years ended December 31, 2008 and 2007, respectively. Net cash provided by operations during 2009 was primarily due tothe receipt of the $25.0 million non-refundable license fee we received from Purdue in connection with our entry into the Collaboration Agreement partiallyoffset by our net loss adjusted for noncash items such as depreciation, amortization, stock-based compensation charges and noncash interest expense, as wellas net changes in working capital. Net cash used in operating activities for 2008 and 2007 consisted primarily of our net loss adjusted for noncash items suchas depreciation, amortization, stock-based compensation charges and noncash interest expense, as well as net changes in working capital.Net Cash Provided by (Used in) Investing ActivitiesNet cash provided by investing activities was $14.7 million for the year ended December 31, 2009 and $22.4 million for the year ended December 31,2008. $80.9 million of net cash provided by investing activities during 2009 relates to the cash, cash equivalents and marketable securities that came fromour merger with Novacea, Inc. This was partially offset by $65.9 million used in investing activities during 2009 due to purchases of marketable securities,net of sales and maturities. $22.7 million provided by investing activities in 2008 was due to maturities of marketable securities, net of purchases. $18.6million used in investing activities during 2007 was due to purchases of marketable securities, net of maturities. Uses of cash in investing activities in allperiods also included net purchases of property and equipment.Net Cash (Used in) Provided by Financing ActivitiesNet cash used in financing activities for the years ended December 31, 2009 and 2008 was $2.9 million and $3.6 million, respectively. While bothperiods consisted primarily of debt repayment, the outstanding debt with Hercules Technology Growth Capital was fully repaid during the first quarter of2009. Net cash provided by financing activities for the year ended December 31, 2007 of $37.0 million consisted primarily of net proceeds of $39.8 millionfrom the Series D preferred stock issuance, partially offset by $3.0 million of debt repayment.Capital ResourcesBased on currently available information, we expect that our cash, cash equivalents, and marketable securities balances will be sufficient to satisfy ourliquidity requirements for at least the next twelve months. If, at any time, our prospects for the commercialization of Intermezzo diminish, we may decide toreduce operating 61® Table of Contentsexpenses by limiting research and development efforts with respect to other potential product candidates. Alternatively, we may decide to raise funds throughpublic or private financings, collaboration relationships or other arrangements. There can be no assurance that funding, if needed, will be available onattractive terms, or at all. Furthermore, any additional equity financing may be dilutive to stockholders, and debt financing, if available, may involverestrictive covenants. Similarly, financing obtained through future collaborations may require us to forego certain commercialization and other rights to ourdrug candidates. Our failure to raise capital as and when needed could have a negative impact on our financial condition and our ability to pursue ourbusiness strategy.Merger Related Uses of CashShortly after the January 30, 2009 close of the merger with Novacea, we repaid in full our outstanding credit obligations to Hercules TechnologyGrowth Capital in the approximate amount of $2.8 million including interest and prepayment penalty and also paid merger-related financial advisory fees ofapproximately $2.0 million.Upon completion of the merger on January 30, 2009, we became liable to pay approximately $2.2 million in payments due to Novacea employeesupon a change in control, all of which has been paid as of September 30, 2009. None of these payments required on-going services of the employeessubsequent to the change in control.Potential Impact of Global Market and Economic Conditions on Our LiquidityIn the United States and around the world, recent market and economic conditions have been unprecedented and challenging, with tighter creditconditions and slower growth through 2008. During 2008 and into 2009, continued concerns about the systemic impact of the availability and cost of credit,energy costs, geopolitical issues, the U.S. mortgage market, a declining real estate market in the U.S. and added concerns fueled by the federal governmentinterventions in the U.S. financial and credit markets have contributed to instability in both U.S. and international capital and credit markets and diminishedexpectations for the U.S. and global economy. These conditions, combined with volatile oil prices, declining business and consumer confidence andincreased unemployment have contributed to volatility of unprecedented levels and an economic slowdown.As a result of these market conditions, the cost and availability of capital and credit has been and may continue to be adversely affected by illiquidcredit markets and wider credit spreads. If volatile and adverse market conditions continue, they may limit our ability to timely borrow or access the capitaland credit markets to meet liquidity needs, resulting in an adverse effect on our financial condition and results of operations. In addition, the bio-pharmaceutical industry has fluctuated significantly in the past and has experienced significant downturns in connection with, or in anticipation of,deterioration in general economic conditions, and we cannot accurately predict the severity or duration of any downturn.Off-Balance Sheet ArrangementsSince inception, we have not engaged in any off-balance sheet financing activities, including the use of structured finance, special purpose entities orvariable interest entities.ContingenciesThere are no legal proceedings or other matters as of December 31, 2009 that are expected to have a material adverse effect on our financial position,results of operations or cash flows. 62 Table of ContentsContractual Obligations and CommitmentsOur contractual obligations and commitments as of December 31, 2009 include potential purchase commitments and future minimum lease paymentsunder operating leases, as shown in the following table:Total Contractual Obligations(in thousands) Contractual Obligations Payments due by period Total Less thanone year 1 to 3years 3 to 5years More than5 yearsOperating leases(1) $3,777 $1,209 $2,568 $— $— Purchase commitments(2) 350 350 — — — Loan payable(3) 195 57 138 — — Total contractual obligations $4,322 $1,616 $2,706 $— $— (1)Includes obligations under an operating lease for current corporate facilities of Transcept, as well as obligations under an operating lease for the formerNovacea corporate facilities. In February 2006, we signed an operating lease for our corporate offices that include approximately 11,600 square feet ofoffice and laboratory space in Point Richmond, California. The lease term is for seven years, commencing on June 1, 2006. In June 2007, we amendedthis operating lease to add approximately 3,000 square feet of additional office space. The lease term of this amendment coincides with the originallease agreement, with a separate commencement date of September 12, 2007. Both of these leases provide for periodic rent increases based uponpreviously negotiated or consumer price indexed adjustments.On February 20, 2009, we signed an operating lease for 12,257 square feet of general office space in Point Richmond, California. The lease termcommenced in March 2009 and terminates on May 31, 2013, with an option to renew for an additional five years. Under the terms of the lease, we havethe option of accelerating the termination date of the lease to May 31, 2011.In June 2007, Novacea entered into an operating lease for its corporate facilities, located in South San Francisco, California. The Novacea lease for thecorporate facilities is non-cancelable and has a five year term. The lease provides for periodic rent increases based upon previously negotiated orconsumer price indexed adjustments. On March 25, 2009, we entered into a sublease agreement dated as of March 24, 2009 for 18,368 square feet ofthe 25,288 square feet located at our South San Francisco facilities. The term of the sublease commenced on June 1, 2009 and ends on October 31,2012. On June 16, 2009, we entered into a sublease agreement dated for reference purposes as of June 11, 2009 for the remaining 6,920 square feet ofthe South San Francisco facility. The term of the sublease commenced on July 1, 2009 and ends on October 31, 2012. The above obligations do notinclude partially offsetting sublease income of approximately $1.4 million. (2)Pursuant to the terms of our agreement with Plantex USA Inc., under the purchase order dated August 8, 2008, we are obligated to purchase $350,000worth of zolpidem tartrate during 2010. (3)Loan payable represents a loan from the landlord of our corporate offices in Point Richmond, California for tenant improvements.Recently Adopted Accounting StandardsEffective January 1, 2009, we adopted Accounting Standards Codification, or ASC, Topic 820, Fair Value Measurements and Disclosures, or ASCTopic 820 (formerly Statement of Financial Accounting Standard, or SFAS, No. 157, Fair Value Measurements), for nonfinancial assets and liabilities. Theadoption of ASC Topic 820 for nonfinancial assets and liabilities did not have a material effect on our results of operations and financial condition. 63 Table of ContentsEffective January 1, 2009, we adopted ASC Topic 805, Business Combinations, or ASC Topic 805 (formerly SFAS No. 141R, Business Combinations).ASC Topic 805 amends previous guidance, and retains the purchase method of accounting for acquisitions, but requires a number of changes, includingchanges in the way assets and liabilities are recognized in purchase accounting. It also changes the recognition of assets acquired and liabilities assumedarising from contingencies, requires the capitalization of in-process research and development at fair value, and requires the expensing of acquisition-relatedcosts as incurred. It also provides disclosure requirements to enable users of the financial statements to evaluate the nature and financial effects of thebusiness combination. We have recorded our acquisition of Novacea in accordance with the provision of ASC Topic 805. See Note 2, “Merger Agreement”for further details.In June 2009, the Financial Accounting Standards Board, or FASB, issued ASC Topic 105, Generally Accepted Accounting Principles, whichestablishes the ASC as the sole source of authoritative generally accepted accounting principles. Pursuant to the provisions of ASC Topic 105, we haveupdated references to generally accepted accounting principles in our financial statements issued for the period ended December 31, 2009. The adoption ofASC Topic 105 did not impact our financial position or results of operations.In September 2009, the FASB Emerging Issues Task Force reached a consensus on ASC Update 2009-13, or Topic 605-25, Multiple-DeliverableRevenue Arrangements, or ASC Update 2009-13. ASC Update 2009-13 applies to multiple-deliverable revenue arrangements that are currently within thescope of ASC Topic 605-25. ASC Update 2009-13 provides principles and application guidance on whether multiple deliverables exist and how thearrangement should be separated and the consideration allocated. ASC Update 2009-13 requires an entity to allocate revenue in an arrangement usingestimated selling prices of deliverables, if a vendor does not have vendor-specific objective evidence or third-party evidence of selling price. The updateeliminates the use of the residual method and requires an entity to allocate revenue using the relative selling price method and also significantly expands thedisclosure requirements for multiple-deliverable revenue arrangements. ASC Update 2009-13 should be applied on a prospective basis for revenuearrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with earlier application permitted. As a result, ASCUpdate 2009-13 will be effective for us no later than the first quarter of fiscal 2011. The Company is currently evaluating the impact of adopting ASC Update2009-13 on its financial position and results of operations.Critical Accounting PoliciesThis discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have beenprepared in accordance with U.S. generally accepted accounting principles. The preparation of these consolidated financial statements requires managementto make estimates and judgments that affect the reported amounts of assets, liabilities and expenses and the disclosure of contingent assets and liabilities atthe date of the financial statements, as well as revenue and expenses during the reporting periods. We evaluate our estimates and judgments on an ongoingbasis. We base our estimates on historical experience and on various other factors that we believed were reasonable under the circumstances, the results ofwhich form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Therefore, actualresults could differ materially from those estimates under different assumptions or conditions.Significant accounting policies are described in Note 1 to the financial statements included in Part I, Item 1 of this annual report on Form 10-K. Someof these accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates on matters that areinherently uncertain. We believe that the following critical accounting policies reflect the more significant estimates and assumptions used in the preparationof our financial statements. 64 Table of ContentsRevenue RecognitionWe apply the revenue recognition criteria outlined in Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements, and ASCTopic 605, Revenue Recognition, 25 Multiple-Element Arrangements.Revenue arrangements with multiple components are divided into separate units of accounting if certain criteria are met, including whether thedelivered component has stand-alone value to the customer, and whether there is objective and reliable evidence of the fair value of the undelivered items.Consideration received is allocated among the separate units of accounting based on their respective fair values. Applicable revenue recognition criteria arethen applied to each of the units.Revenue is recognized when the four basic criteria of revenue recognition are met: • persuasive evidence of an arrangement exists; • transfer of technology has been completed or services have been rendered; • the fee is fixed or determinable; and • collectability is reasonably assured.For each source of revenue, we apply the above revenue recognition criteria in the following manner: • Up-front license payments are assessed to determine whether or not the licensee is able to obtain any stand-alone value from the license. Wherethis is not the case, we do not consider the license deliverable to be a separate unit of accounting, and the revenue is deferred with revenuerecognition for the license fee being assessed in conjunction with the other deliverables that constitute the combined unit of accounting. Whenthe period of deferral cannot be specifically identified from the agreement, management estimates the period based upon provisions containedwithin the agreement and other relevant facts. We periodically review the estimated involvement period, which could impact the deferral periodand, therefore, the timing and the amount of revenue recognized. It is possible that future adjustments will be made if actual conditions differfrom our current plan and involvement assumptions. • Payments received that are related to substantive, performance-based “at-risk” milestones are recognized as revenue upon achievement of themilestone or event specified in the underlying contracts, which represents the culmination of the earnings process. Amounts received in advance,if any, are recorded as deferred revenue until the milestone is reached. • Royalty revenue from sales of our licensed products, if and when approved for marketing by the appropriate regulatory agency, will berecognized as earned in accordance with the contract terms when royalties from licensees can be reasonably estimated and collectability isreasonably assured.Clinical TrialsWe accrue and expense costs for clinical trial activities performed by third parties, including clinical research organizations and clinical investigators,based upon estimates made of the work completed as of the reporting date, in accordance with agreements established with contract research organizationsand clinical trial sites and the agreed upon fee to be paid for the services. We determine these estimates through discussion with internal personnel andoutside service providers as to the progress or stage of completion of the trials or services. If the actual timing of performance of services or the level of effortvaries from these estimates, the accrual will be adjusted accordingly. Costs of setting up clinical trial sites for participation in the trials are expensed as theactivities are performed. Clinical trial site costs related to patient enrollment are accrued as patients are entered into the trial and reduced by any initialpayment made to the clinical trial site when the first patient is enrolled. We adjust the estimates as actual costs become known. Through December 31, 2009,differences between actual 65 Table of Contentsand estimated activity levels for any particular study have not been material. However, if management does not receive complete and accurate informationfrom vendors or underestimates activity levels associated with a study at a given point in time, we would have to record additional and potentially significantresearch and development expenses in future periods.Stock-Based CompensationWe recognize stock based compensation in accordance with ASC Topic 718, Compensation—Stock Compensation, or ASC Topic 718 (formerlyStatement of Financial Accounting Standards, or SFAS, No. 123(R), Share-Based Payment). ASC Topic 718 requires an entity to measure the cost ofemployee services received in exchange for an award of equity instruments based on the fair value of the award on the date of grant and to recognize the costover the period during which the employee is required to provide service in exchange for the award. Additionally, we are required to include an estimate ofthe number of awards that will be forfeited in calculating compensation costs, which are recognized over the requisite service period of the awards on astraight-line basis.Measurement and recognition of share-based compensation under ASC Topic 718 involve significant estimates and subjective inputs. The grant datefair value of stock option awards is determined using an option valuation model, such as the Black-Scholes model that we used, and the amount of expenserecognized during the period is affected by many complex and subjective assumptions. These assumptions include estimates of our future volatility,employee exercise behavior, the expected term of the stock options, and the number of options expected to ultimately vest. Until the merger with Novacea,our stock did not have a readily available market. Consequently, expected future volatility is derived from the historical volatilities of several unrelatedpublic companies within the specialty pharmaceutical industry. When making the selection of our industry peer companies to be used in the volatilitycalculation, consideration is given to the stage of development, size and financial leverage of potential comparable companies. The risk-free interest rate isbased on the U.S. Treasury yield in effect at the time of grant for zero coupon U.S. Treasury notes with maturities approximately equal to each grant’sexpected life. The assumed dividend yield was based on our expectations of not paying dividends in the foreseeable future. Given our limited history toaccurately estimate the expected lives for the various employee groups, we used the “simplified” method as provided by Staff Accounting Bulletin No. 107,Share Based Payment. The “simplified” method is calculated as the average of the time-to-vesting and the contractual life of the options. Share-basedcompensation recorded in our Statements of Operations is based on awards expected to ultimately vest and has been reduced for estimated forfeitures.Estimated forfeitures may differ from actual forfeiture rates which would affect the amount of expense recognized during the period. Share-basedcompensation is adjusted to reflect the value of options which ultimately vest as such amounts become known in future periods.If in the future, our management determines that another method is more reasonable, or if another method for calculating these input assumptions isprescribed by authoritative guidance, and, therefore, should be used to estimate volatility or expected life, the fair value calculated for our stock optionscould change significantly. Higher volatility and longer expected lives result in an increase to stock-based compensation expense determined at the date ofgrant. Stock-based compensation expense affects both our research and development expense and general and administrative expense.There is inherent uncertainty in these estimates and if we had made different assumptions than those described above, the amount of stock-basedcompensation expense, net loss and net loss per share amounts could have been significantly different.No related tax benefits of share-based compensation costs have been recognized since our inception. 66 Table of ContentsFair Value Measurements.On January 1, 2008, we adopted ASC Topic 820, Fair Value Measurements and Disclosures (formerly SFAS No. 157) as it applies to our financialassets and financial liabilities. ASC Topic 820 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair valuemeasurements. Fair value is defined as the estimated exit price received to sell an asset or paid to transfer a liability in an orderly transaction between marketparticipants at the measurement date rather than on an entry price which represents the purchase price of an asset or liability. ASC Topic 820 establishes a fairvalue hierarchy that prioritizes observable and unobservable inputs used to measure fair value into three broad levels, which are described below: • Level 1—Quoted prices (unadjusted) in active markets that are accessible at the measurement date for assets or liabilities. The fair valuehierarchy gives the highest priority to Level 1 inputs. • Level 2—Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quotedprices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially thefull term of the assets or liabilities. • Level 3—Unobservable inputs (i.e. inputs that reflect the reporting entity’s own assumptions about the assumptions that market participantswould use in estimating the fair value of an asset or liability) are used when little or no market data is available. The fair value hierarchy givesthe lowest priority to Level 3 inputs.A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair valuemeasurement. Where quoted prices are available in an active market, securities are classified as Level 1 of the valuation hierarchy. Level 1 securities includehighly liquid money market funds. If quoted market prices are not available for the specific security, then we estimate fair value by using pricing models,quoted prices of securities with similar characteristics or discounted cash flows. Level 2 instruments include commercial paper, U.S. corporate debt, and U.S.government sponsored enterprise issues. In certain cases where there is limited activity or less transparency around inputs to valuation, securities areclassified as Level 3 within the valuation hierarchy. Level 3 liabilities that are measured at fair value on a recurring basis consist of convertible preferredstock warrant liabilities. The fair values of the outstanding preferred stock warrants are measured using the Black-Scholes option-pricing model. Inputs usedto determine fair market value include estimated market value of the underlying convertible preferred stock at the valuation measurement date, the remainingcontractual term of the warrant, risk-free interest rates and expected dividends on and expected volatility of the price of the underlying convertible preferredstock.During the year ended December 31, 2009, there were no significant changes to the valuation models used for purposes of determining the fair value ofLevel 2 assets or Level 3 liabilities. Concurrent with our merger with Novacea, Inc., the warrants to purchase preferred stock were converted into warrants topurchase common stock with the same exercise prices and expiration dates, and the aggregate fair value of these warrants was reclassified from a liability toadditional paid-in capital, a component of stockholders’ equity (net capital deficiency).Warrants to Purchase Convertible Preferred StockEffective July 1, 2005, we adopted the provisions of ASC Topic 480, Distinguishing Liabilities from Equity, or ASC Topic 480 (formerly FASB StaffPosition No. 150-5, Issuer’s Accounting Under FASB Statement No. 150 for Freestanding Warrants and Other Similar Instruments with Characteristics ofBoth Liabilities and Equity, an interpretation of SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities andEquity). Under ASC Topic 480, freestanding warrants to purchase shares of convertible preferred stock were classified as liabilities on the balance sheets atfair value because the warrants may conditionally obligate us to transfer assets at some point in the future. The warrants were subject to remeasurement ateach balance sheet date, and any change in fair value was recognized as a component of other 67 Table of Contentsincome (expense), net in the statements of operations. We estimated the fair value of these warrants at the respective balance sheet dates using the Black-Scholes option-pricing model as described in the stock-based compensation section above, based on the estimated market value of the underlyingconvertible preferred stock at the valuation measurement date, the remaining contractual term of the warrant, risk-free interest rates and expected dividendson and expected volatility of the price of the underlying convertible preferred stock. The assumptions used in the Black-Scholes option-pricing model,especially the market value of the underlying convertible preferred stock and the expected volatility, are highly judgmental.We continued to record adjustments to the fair value of the warrants at each balance sheet date until the closing of the merger transaction onJanuary 30, 2009, when they became warrants to purchase shares of common stock, wherein the warrants were no longer subject to ASC Topic 480. As ofJanuary 30, 2009, the current aggregate fair value of these warrants of $400,000 was reclassified from a liability to additional paid-in capital, a component ofstockholders’ equity (net capital deficiency). We no longer record any related periodic fair value adjustments. Upon the closing of the merger transaction, thepreferred stock warrants were converted into common stock warrants with the same exercise prices and expiration dates. Item 7A.Quantitative and Qualitative Disclosures About Market RiskOur exposure to market risk is confined to cash, cash equivalents and marketable securities which have contractual maturities of eighteen months orless, bear interest rates at fixed rates and are denominated in, and pay interest in, U.S. dollars. The goals of our investment policy are preservation of capital,fulfillment of liquidity needs, and fiduciary control of cash and investments. We also seek to achieve income from investments consistent with ourinvestment policy. Investments are classified as available-for-sale. We do not use derivative financial instruments in our investment portfolio. To achieve ourgoals, we invest excess cash in securities with different maturities to match projected cash needs and limit concentration of credit risk by diversifyinginvestments among a variety of high credit-quality issuers, including U.S. government agencies, commercial paper, corporate bonds and money market funds.The portfolio includes marketable securities with active secondary or resale markets to ensure portfolio liquidity, and we regularly review our portfolioagainst our policy. Our policy was further amended during 2009 to limit investments to U.S. Treasury debt or Securities and Exchange Commission, or SEC,registered money market funds effective September 30, 2009. A decline in short-term interest rates over time would reduce our interest income from our short-term investments. A hypothetical 100 basis point increase in interest rates would result in an approximate $248,000 decrease in the fair value of ourmarketable securities at December 31, 2009. 68 Table of ContentsItem 8.Financial Statements and Supplementary DataIndex to Financial Statements PageReport of Independent Registered Public Accounting Firm 70Consolidated Balance Sheets 71Consolidated Statements of Operations 72Consolidated Statement of Convertible Preferred Stock and Stockholders’ Equity (Net Capital Deficiency) 73Consolidated Statements of Cash Flows 74Notes to Consolidated Financial Statements 75 69 Table of ContentsREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMThe Board of Directors and Stockholders of Transcept Pharmaceuticals, Inc.We have audited the accompanying consolidated balance sheets of Transcept Pharmaceuticals, Inc. as of December 31, 2009 and 2008 and the relatedconsolidated statements of operations, convertible preferred stock and stockholders’ equity (net capital deficiency), and cash flows for each of the three yearsin the period ended December 31, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audits.We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We werenot engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control overfinancial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on theeffectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on atest basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of TransceptPharmaceuticals, Inc. at December 31, 2009 and 2008, and the consolidated results of its operations and its cash flows for each of the three years in the periodended December 31, 2009, in conformity with U.S. generally accepted accounting principles./s/ Ernst & Young LLPPalo Alto, CaliforniaMarch 30, 2010 70 Table of ContentsTranscept Pharmaceuticals, Inc.Consolidated Balance Sheets(in thousands, except for share and per share amounts) December 31, 2009 2008 Assets Current assets: Cash and cash equivalents $17,031 $4,432 Marketable securities 71,871 7,251 Prepaid and other current assets 1,276 382 Restricted cash 200 200 Total current assets 90,378 12,265 Property and equipment, net 1,052 1,450 Goodwill 2,962 — Other assets 826 66 Total assets $95,218 $13,781 Liabilities, convertible preferred stock and stockholders’ equity (net capital deficiency) Current liabilities: Accounts payable $728 $575 Accrued liabilities 2,383 1,468 Deferred revenue, short-term portion 12,500 — Lease liability, short-term portion 429 — Loan payable, short-term portion 45 3,347 Total current liabilities 16,085 5,390 Deferred revenue, long-term portion 7,292 — Warrant liability — 600 Deposit for stock purchase 41 88 Deferred rent 72 77 Lease liability, long-term portion 519 — Loan payable, long-term portion 125 170 Other liabilities 13 — Total liabilities 24,147 6,325 Commitments and contingencies Convertible preferred stock: $0.001 par value; 7,593,091 shares authorized;0 shares issued and outstanding at December 31, 2009; Series A—60,212, Series B—1,126,020, Series C—2,838,091 andSeries D—3,325,647 shares issued and outstanding at December 31, 2008 — 71,037 Stockholders’ equity (net capital deficiency): Preferred stock: 5,000,000 shares authorized; 0 shares issued and outstanding — — Common stock: $0.001 par value; 100,000,000 shares authorized; 13,384,247 and 454,676 shares issued andoutstanding at December 31, 2009 and 2008, respectively 13 — Additional paid-in capital 157,930 1,504 Accumulated deficit (86,911) (65,111) Accumulated other comprehensive income 39 26 Total stockholders’ equity (net capital deficiency) 71,071 (63,581) Total liabilities, convertible preferred stock and stockholders’ equity (net capital deficiency) $95,218 $13,781 See accompanying notes. 71 Table of ContentsTranscept Pharmaceuticals, Inc.Consolidated Statements of Operations(in thousands, except per share amounts) Year Ended December 31, 2009 2008 2007 Revenue: License fee revenue $5,208 $— $— Operating expenses: Research and development 9,005 10,381 15,885 General and administrative 16,050 7,924 5,300 Merger related transaction costs 2,224 1,967 — Total operating expenses 27,279 20,272 21,185 Loss from operations (22,071) (20,272) (21,185) Interest income 282 742 2,029 Interest expense (179) (766) (1,195) Other income (expense), net 168 337 (33) Net loss $(21,800) $(19,959) $(20,384) Basic and diluted net loss per share $(1.79) $(49.77) $(68.86) Weighted average shares outstanding 12,166 401 296 See accompanying notes. 72 Table of ContentsTranscept Pharmaceuticals, Inc.Consolidated Statement of Convertible Preferred Stock and Stockholders’ Equity (Net Capital Deficiency)(in thousands, except per share amounts) ConvertiblePreferred Stock Common Stock AdditionalPaid-InCapital AccumulatedDeficit AccumulatedOtherComprehensiveIncome (Loss) TotalStockholders’Equity (NetCapitalDeficiency) Shares Amount Shares Amount Balance at December 31, 2006 4,024 $31,202 245 $— $177 $(24,768) $2 $(24,589) Issuance of Series D convertible preferred stock to investors for cash at $12.03 pershare, net of issuance costs of $165 in February 2007 3,326 39,835 — — — — — — Exercise of options to purchase common stock — — 12 — 10 — — 10 Stock-based compensation related to: Employee stock option grants — — — — 470 — — 470 Nonemployee stock option grants — — — — 13 — — 13 Vested restricted stock — — 99 — 82 — — 82 Net loss — — — — — (20,384) — (20,384) Unrealized gain on marketable securities — — — — — — 83 83 Total comprehensive loss (20,301) Balance at December 31, 2007 7,350 71,037 356 — 752 (45,152) 85 (44,315) Exercise of options to purchase common stock — — 64 — 67 — — 67 Stock-based compensation related to: Employee stock option grants — — — — 613 — — 613 Nonemployee stock option grants — — — — 24 — — 24 Vested restricted stock — — 35 — 48 — — 48 Net loss — — — — — (19,959) — (19,959) Unrealized loss on marketable securities — — — — — — (59) (59) Total comprehensive loss (20,018) Balance at December 31, 2008 7,350 71,037 455 — 1,504 (65,111) 26 (63,581) Exercise of options to purchase common stock — — 293 1 384 — — 385 Employee stock purchase under Employee stock purchase plan — — 22 — 85 — — 85 Stock-based compensation related to: Employee stock option grants — — — — 1,057 — — 1,057 Nonemployee stock option grants — — — — 121 — — 121 Employee stock purchase plan — — — — 62 — — 62 Stock option modifications — — — — 127 — — 127 Vested restricted stock — — 33 — 47 — — 47 Conversion of preferred shares to common stock (7,350) (71,037) 7,350 7 71,030 — — 71,037 Reclassification of warrant liability — — — — 400 — — 400 Effect of the Merger (Note 2) — — 5,231 5 83,113 — — 83,118 Net loss — — — — — (21,800) — (21,800) Unrealized gain on marketable securities — — — — — — 13 13 Total comprehensive loss (21,787) Balance at December 31, 2009 — $— 13,384 $13 $157,930 $(86,911) $39 $71,071 See accompanying notes. 73 Table of ContentsTranscept Pharmaceuticals, Inc.Consolidated Statements of Cash Flows(in thousands) Year Ended December 31, 2009 2008 2007 Operating activities Net Loss $(21,800) $(19,959) $(20,384) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 550 505 379 Stock-based compensation 1,367 637 483 Amortization of loan costs 28 37 37 Amortization of discount (warrants) on debt 47 151 216 Amortization of lease liability (281) — — Remeasurement of preferred stock warrants (200) (368) 13 Loss on disposals of fixed assets 157 4 — (Gain) loss on sale of marketable securities (111) 16 — Amortization (accretion) of premium/discount on available for sale securities 1,395 (486) (1,250) Changes in operating assets and liabilities: Prepaid and other current assets 455 150 (70) Other assets (18) — (6) Accounts payable 154 (242) 27 Accrued liabilities (700) (578) 1,720 Deferred revenue 19,792 — — Deferred rent (5) 3 13 Net cash provided by (used) in operating activities 830 (20,130) (18,822) Investing activities Purchases of property and equipment, net (318) (259) (643) Purchases of marketable securities (128,324) (22,857) (73,203) Maturities and sales of marketable securities 95,307 45,554 54,554 Cash and cash equivalents received from the Merger 47,987 — — Transfer to restricted cash — — (200) Net cash provided by (used in) investing activities 14,652 22,438 (19,492) Financing Activities Payments on long-term debt (3,353) (3,640) (3,008) Proceeds from issuances of convertible preferred stock, net — — 39,835 Proceeds from issuance of common stock, net 470 68 218 Net cash (used in) provided by financing activities (2,883) (3,572) 37,045 Net increase (decrease) in cash and cash equivalents 12,599 (1,264) (1,269) Cash and cash equivalents at beginning of period 4,432 5,696 6,965 Cash and cash equivalents at end of period $17,031 $4,432 $5,696 Supplemental disclosure of cash flow information Cash paid during the year for interest $136 $611 $921 Supplemental disclosure of noncash investing and financing activities Purchase of leasehold improvements in exchange for loan payable $— $— $258 Acquisition of leasehold improvements paid by landlord $— $— $60 See accompanying notes. 74 Table of ContentsTranscept Pharmaceuticals, Inc.Notes to Consolidated Financial Statements1. Organization and Summary of Significant Accounting PoliciesTranscept Pharmaceuticals, Inc. (“Transcept” or the “Company”) is a specialty pharmaceutical company focused on the development andcommercialization of proprietary products that address important therapeutic needs in neuroscience. The most advanced Transcept product candidate isIntermezzo (zolpidem tartrate sublingual tablet), for which a New Drug Application (“NDA”) was submitted to the U.S. Food and Drug Administration(“FDA”) in September 2008 seeking approval as a prescription sleep aid for use in the middle of the night at the time a patient awakens and has difficultyreturning to sleep. In October 2009, Transcept received a Complete Response Letter from the FDA on the Intermezzo NDA and is working to respond toissues raised in the letter. On July 31, 2009, Transcept and Purdue Pharmaceutical Products, L.P. (“Purdue”) entered into the United States License andCollaboration Agreement (the “Collaboration Agreement”) in connection with the development and commercialization of Intermezzo in the United States.As a result of the revenue recognized pursuant to the Collaboration Agreement and the late development stage of Intermezzo, Transcept is no longerconsidered a Development Stage Company as of the third quarter 2009. Transcept operates in one business segment.Prior to January 30, 2009, the name of the Company was Novacea, Inc. (“Novacea”). On August 29, 2008, Novacea, Pivot Acquisition, Inc., a Delawarecorporation and a wholly-owned subsidiary of Novacea, and Transcept Pharmaceuticals, Inc., a private Delaware corporation (“TPI”), entered into anAgreement and Plan of Merger and Reorganization, which was amended on December 23, 2008 (collectively referred to as the “Merger Agreement”). OnJanuary 30, 2009, Novacea completed its business combination with TPI in accordance with the terms of the Merger Agreement, pursuant to which TPIbecame a wholly-owned subsidiary of Novacea (referred to as the “Merger”). Also on January 30, 2009, in connection with the Merger, Novacea effected a 1-for-5 reverse stock split of its common stock, and the name of Novacea was changed to “Transcept Pharmaceuticals, Inc.” The Merger, reverse stock split andthe name change of Novacea were approved by the stockholders of Novacea at a special meeting of Novacea stockholders held on January 27, 2009. Thesefinancial statements reflect the historical results of TPI prior to the Merger and that of the combined company following the Merger, and do not include thehistorical results of Novacea prior to the completion of the Merger. All share and per share disclosures have been retroactively adjusted to reflect theexchange of shares in the Merger, and the 1-for-5 reverse stock split of the common stock on January 30, 2009.Under the terms of the Merger Agreement, Novacea issued shares of common stock to the TPI stockholders at the rate of 0.14134 shares of commonstock, after giving effect to the 1-for-5 reverse stock split, for each share of TPI common stock outstanding on January 30, 2009. Additionally, each share ofcommon stock underlying TPI options and warrants as of January 30, 2009 was converted to 0.14134 shares of Transcept common stock. After consummationof the Merger, former TPI stockholders, option holders and warrant holders as of January 30, 2009 owned approximately 61% of Transcept common stock ona fully-diluted basis. The stockholders, option holders and warrant holders of Novacea prior to the Merger owned approximately 39% of the Transceptcommon stock on a fully-diluted basis following the Merger. Under generally accepted accounting principles in the United States, the Merger is treated as a“reverse merger” under the purchase method of accounting. For accounting purposes, TPI is considered to have acquired Novacea.As part of the consummation of the Merger, Novacea securities listed on the NASDAQ Global Market, trading under the ticker symbol “NOVC,” weresuspended for trading as of the close of business on January 30, 2009 and trading of Transcept securities on the NASDAQ Global Market under the tickersymbol “TSPT” commenced on February 2, 2009. 75®®®® Table of ContentsNeed to Raise Additional CapitalAs of December 31, 2009, the Company had cash, cash equivalents and marketable securities of $88.9 million, working capital of $74.3 million, and anaccumulated deficit of $86.9 million. Management expects to continue to incur additional losses in the foreseeable future as the Company continues itsresearch and development activities and prepares for the potential commercialization of Intermezzo. Management believes that cash, cash equivalents andmarketable securities balances on hand at December 31, 2009 will be sufficient to fund planned expenditures for at least the next twelve months.Management recognizes the potential need to raise additional funds in the future. There can be no assurance that the Company will be successful inconsummating any such financing transaction, or if the Company does consummate such a transaction, that the terms and conditions of such transaction willbe favorable. Any failure to obtain additional funding may have a material negative effect on the Company and will likely result in a substantial reduction inthe scope of the Company’s operations.Use of EstimatesThe preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates andassumptions that affect the amounts reported in the financial statements and accompanying notes. Management bases its estimates on historical experienceand on assumptions believed to be reasonable under the circumstances. Actual results could differ materially from those estimates. Management makesestimates when preparing the financial statements including those relating to revenue recognition, clinical trials, stock-based compensation, restructuringand warrant liability valuation.Significant Accounting PoliciesPrinciples of ConsolidationThe accompanying consolidated financial statements include the results of operations of Transcept Pharmaceuticals, Inc. and its wholly-ownedsubsidiary, Transcept Pharma, Inc. All significant intercompany accounts and transactions have been eliminated in the consolidation.Cash and Cash EquivalentsThe Company invests its excess cash in bank deposits, money market accounts, and other marketable securities. The Company considers all highlyliquid investments purchased with a maturity of three months or less from the date of purchase to be cash equivalents. Cash equivalents are carried at fairvalue. The Company invests in money market securities in a U.S. bank and is exposed to credit risk in the event of default by the financial institution to theextent of amounts recorded on the balance sheet.Restricted cash represents a Certificate of Deposit (“CD”) which functions as security for the Company credit cards with the domestic financialinstitution that issued the credit cards. The CD will remain as security concurrent with the continuation of the Company credit card program.Marketable SecuritiesAll marketable securities have been classified as “available-for-sale” and are carried at fair value as determined based upon quoted market prices.Management determines the appropriate classification of its investments in debt securities at the time of purchase and reevaluates such designation as of eachbalance sheet date. Management views its investment portfolio as available for use in current operations and, accordingly, has reflected all such investmentsas current assets although the stated maturity of individual investments may be one year or more beyond the balance sheet date. Unrealized gains and lossesare included in other comprehensive net income (loss) and reported as a separate component of stockholders’ equity (net capital deficiency). Realized gainsand losses and declines in value judged to be other-than-temporary, if any, on available-for-sale securities are included in other income (expense), net. Thecost of securities sold is based on the specific identification 76® Table of Contentsmethod. Interest on marketable securities is included in interest income. The net carrying value of debt securities classified as available-for-sale is adjustedfor amortization of premiums and accretion of discounts to maturity, over the estimated life of the security. Such amortization is computed under the effectiveinterest method and included in interest income.Property and EquipmentProperty and equipment is stated at cost and depreciated using the straight-line method over the estimated useful lives of the assets, ranging from twoto five years. Leasehold improvements are amortized over the shorter of their estimated useful lives or the related lease term.Long-Lived AssetsLong-lived assets include property and equipment. The carrying value of long-lived assets is reviewed for impairment whenever events or changes incircumstances indicate that the asset may not be recoverable. An impairment loss is recognized when the total of estimated future cash flows expected toresult from the use of the asset and its eventual disposition is less than its carrying amount or appraised value, as appropriate. Through December 31, 2009,there have been no such impairments.GoodwillGoodwill represents purchase consideration in excess of fair values assigned to the underlying net assets of acquired businesses. Goodwill is notamortized, but tested for impairment annually at September 30th, and at any time when events suggest impairment may have occurred. The Company’sgoodwill impairment test is performed by comparing the fair value of the reporting unit to the carrying value of the reporting unit. The Company has onereporting unit to which the goodwill is assigned and tested for impairment. In the event the carrying value of a reporting unit exceeds its fair value, animpairment loss would be recognized to the extent the carrying amount of the reporting unit’s goodwill exceeds its implied fair value. Goodwill as ofDecember 31, 2009 was approximately $3.0 million, and was recorded in connection with the Company’s merger with Novacea (see Note 2). ThroughDecember 31, 2009, there have been no impairments.Revenue RecognitionThe Company applies the revenue recognition criteria outlined in Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements,and Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 605 Revenue Recognition, Sub-topic 25 Multiple-Element Arrangements.Revenue arrangements with multiple components are divided into separate units of accounting if certain criteria are met, including whether thedelivered component has stand-alone value to the customer, and whether there is objective and reliable evidence of the fair value of the undelivered items.Consideration received is allocated among the separate units of accounting based on their respective fair values. Applicable revenue recognition criteria arethen applied to each of the units.Revenue is recognized when the four basic criteria of revenue recognition are met: (1) persuasive evidence of an arrangement exists; (2) transfer oftechnology has been completed or services have been rendered; (3) the fee is fixed or determinable; and (4) collectability is reasonably assured.For each source of revenue, the Company applies the above revenue recognition criteria in the following manner: • Up-front license payments are assessed to determine whether or not the licensee is able to obtain any stand-alone value from the license. Wherethis is not the case, the Company does not consider the license deliverable to be a separate unit of accounting, and the revenue is deferred withrevenue 77 Table of Contents recognition for the license fee being assessed in conjunction with the other deliverables that constitute the combined unit of accounting. Whenthe period of deferral cannot be specifically identified from the agreement, management estimates the period based upon provisions containedwithin the agreement and other relevant facts. The Company periodically reviews the estimated involvement period, which could impact thedeferral period and, therefore, the timing and the amount of revenue recognized. It is possible that future adjustments will be made if actualconditions differ from the Company’s current plan and involvement assumptions. • Payments received that are related to substantive, performance-based “at-risk” milestones are recognized as revenue upon achievement of themilestone or event specified in the underlying contracts, which represents the culmination of the earnings process. Amounts received in advance,if any, are recorded as deferred revenue until the milestone is reached. • Royalty revenue from sales of the Company’s licensed products, if and when approved for marketing by the appropriate regulatory agency, willbe recognized as earned in accordance with the contract terms when royalties from licensees can be reasonably estimated and collectability isreasonably assured.Research and Development CostsResearch and development costs are expensed as incurred. Research and development costs consist of salaries and benefits, travel and related expenses,lab supplies and facility costs, as well as fees paid to other entities that conduct certain research and development activities on behalf of the Company.Comprehensive Net LossThe Company reports comprehensive net loss in accordance with FASB ASC Topic 220 Comprehensive Income (“ASC Topic 220”). Among otherthings, ASC Topic 220 requires unrealized gains or losses on the Company’s available-for-sale marketable securities to be included in other comprehensiveloss and be reported as a separate component of stockholders’ equity (net capital deficiency).Income TaxesThe Company utilizes the liability method of accounting for income taxes as required by FASB ASC Topic 740 Income Taxes. Under this method,deferred tax assets and liabilities are determined based on differences between financial reporting and tax reporting bases of assets and liabilities and aremeasured using enacted tax rates and laws that are expected to be in effect when the differences are expected to reverse. Uncertain tax positions are evaluatedin accordance with this topic and if appropriate, the amount of unrecognized tax benefits are recorded within deferred tax assets. Valuation allowances areestablished when necessary to reduce deferred tax assets to the amounts expected to be realized. Currently, there is no provision for income taxes as theCompany has incurred operating losses to date.Clinical TrialsThe Company accrues and expenses costs for clinical trial activities performed by third parties, including clinical research organizations and clinicalinvestigators, based upon estimates made of the work completed as of the reporting date, in accordance with agreements established with contract researchorganizations and clinical trial sites and the agreed upon fee to be paid for the services. The Company determines these estimates through discussion withinternal personnel and outside service providers as to the progress or stage of completion of the trials or services. Costs of setting up clinical trial sites forparticipation in the trials are expensed immediately as research and development expenses. Clinical trial site costs related to patient enrollment are accrued aspatients are entered into the trial and reduced by any initial payment made to the clinical trial site when the first patient is enrolled. 78 Table of ContentsAdvertisingThe Company expenses non-direct response advertising when the advertising expense takes place. Advertising expense was $125,000 during 2009.There was no comparable expense during 2008 or 2007.Stock-Based CompensationThe Company records stock-based compensation in accordance with ASC Topic 718 Compensation—Stock Compensation (“ASC Topic 718”)(formerly Statement of Financial Accounting Standards (“SFAS”) No. 123(R), Share-Based Payment). ASC Topic 718 requires an entity to measure the cost ofemployee services received in exchange for an award of equity instruments based on the fair value of the award on the date of grant and to recognize the costover the period during which the employee is required to provide service in exchange for the award. Additionally, the Company is required to include anestimate of the number of awards that will be forfeited in calculating compensation costs, which are recognized over the requisite service period of the awardson a straight-line basis.During the years ended December 31, 2009, 2008 and 2007, the Company recorded employee share-based compensation costs of $1,246,000,$613,000 and $470,000, respectively, in accordance with the provisions of ASC Topic 718. No related tax benefits of share-based compensation costs havebeen recognized since the Company’s inception.The Company accounts for equity instruments issued to nonemployees in accordance with the provisions of ASC Topic 505, subtopic 50, Equity-Based Payments to Non-Employees (formerly Emerging Issues Task Force No. 96-18, Accounting for Equity Instruments That are Issued to Other ThanEmployees for Acquiring, or in Conjunction with Selling Goods or Services), using a fair-value approach. The equity instruments, consisting of stock optionsand warrants granted to lenders and consultants, are valued using the Black-Scholes valuation model. The measurement of stock-based compensation issubject to periodic adjustments as the underlying equity instruments vest and is recognized as an expense over the term of the related financing or the periodover which services are received.Warrants to Purchase Convertible Preferred StockEffective July 1, 2005, the Company adopted the provisions of ASC Topic 480 Distinguishing Liabilities from Equity (“ASC Topic 480”) (formerlyFASB Staff Position No. 150-5, Issuer’s Accounting Under FASB Statement No. 150 for Freestanding Warrants and Other Similar Instruments withCharacteristics of Both Liabilities and Equity, an interpretation of SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics ofBoth Liabilities and Equity). Under ASC Topic 480, freestanding warrants to purchase shares of convertible preferred stock were classified as liabilities on thebalance sheets at fair value because the warrants may conditionally obligate the Company to transfer assets at some point in the future. The warrants weresubject to remeasurement at each balance sheet date, and any change in fair value was recognized as a component of other income (expense), net in thestatements of operations.The Company recorded $200,000, $368,000 and ($13,000) in other income (expense), net relating to changes in fair value of all preferred stockwarrants during years ended December 31, 2009, 2008 and 2007, respectively. The Company continued to record adjustments to the fair value of the warrantsuntil the closing of the merger transaction on January 30, 2009, when they became warrants to purchase shares of common stock, at which point the warrantswere no longer subject to ASC Topic 480. As of January 30, 2009, $400,000, the then-current aggregate fair value of these warrants, was reclassified from aliability to additional paid-in capital, a component of stockholders’ equity (net capital deficiency). 79 Table of ContentsConcentration of Credit RiskFinancial instruments that are potentially subject to concentration of credit risk consist primarily of cash, cash equivalents, and marketable securities.The Company’s investment policy restricts investments to high-quality investments and limits the amounts invested with any one issuer other than U.S.Treasury debt obligations, U.S. agency debt obligations, or Securities and Exchange Commission (“SEC”) registered money market funds. This policy wasfurther amended during 2009 to limit investments to U.S. Treasury debt or SEC registered money market funds effective September 30, 2009. The goals of theinvestment policy are as follows: preservation of capital, fulfillment of liquidity needs, and fiduciary control of cash and investments. The Company’sexposure to market risk is limited primarily to interest income sensitivity, which is affected by changes in the general level of United States interest rates,particularly because the majority of the Company’s investments are in short-term debt securities.Recently Adopted Accounting StandardsEffective January 1, 2009, the Company adopted ASC Topic 820 Fair Value Measurements and Disclosures (“ASC Topic 820”) (formerly SFASNo. 157, Fair Value Measurements) for nonfinancial assets and liabilities. The adoption of ASC Topic 820 for nonfinancial assets and liabilities did not havea material effect on the Company’s results of operations and financial condition.Effective January 1, 2009, the Company adopted ASC Topic 805 Business Combinations (“ASC Topic 805”) (formerly SFAS No. 141R, BusinessCombinations). ASC Topic 805 amends previous guidance, and retains the purchase method of accounting for acquisitions, but requires a number of changes,including changes in the way assets and liabilities are recognized in purchase accounting. It also changes the recognition of assets acquired and liabilitiesassumed arising from contingencies, requires the capitalization of in-process research and development at fair value, and requires the expensing ofacquisition-related costs as incurred. It also provides disclosure requirements to enable users of the financial statements to evaluate the nature and financialeffects of the business combination. The Company has recorded its acquisition of Novacea in accordance with the provision of ASC Topic 805. See Note 2,“Merger Agreement” for further details.In June 2009, the FASB issued FASB ASC Topic 105 Generally Accepted Accounting Principles, which establishes the FASB ASC as the sole sourceof authoritative generally accepted accounting principles. Pursuant to the provisions of FASB ASC Topic 105, the Company has updated references togenerally accepted accounting principles in its financial statements issued for the period ended December 31, 2009. The adoption of FASB ASC Topic 105did not impact the Company’s financial position or results of operations.In September 2009, the FASB Emerging Issues Task Force reached a consensus on ASC Update 2009-13 (“Topic 605-25”) Multiple-DeliverableRevenue Arrangements, or (“ASC Update 2009-13”). ASC Update 2009-13 applies to multiple-deliverable revenue arrangements that are currently within thescope of ASC Topic 605-25. ASC Update 2009-13 provides principles and application guidance on whether multiple deliverables exist and how thearrangement should be separated and the consideration allocated. ASC Update 2009-13 requires an entity to allocate revenue in an arrangement usingestimated selling prices of deliverables, if a vendor does not have vendor-specific objective evidence or third-party evidence of selling price. The updateeliminates the use of the residual method and requires an entity to allocate revenue using the relative selling price method and also significantly expands thedisclosure requirements for multiple-deliverable revenue arrangements. ASC Update 2009-13 should be applied on a prospective basis for revenuearrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with earlier application permitted. As a result, ASCUpdate 2009-13 will be effective for the Company no later than the first quarter of fiscal 2011. The Company is currently evaluating the impact of adoptingthis ASC Update 2009-13 on its financial position and results of operations. 80 Table of Contents2. Merger AgreementAs described in Note 1, the Company completed the Merger on January 30, 2009. Pursuant to the Merger, stockholders of TPI exchanged their shares ofTPI stock for a total of 7,882,622 shares of Transcept common stock and a total of 156,007 warrants to purchase Transcept common stock. Immediatelyfollowing the Merger, approximately 61% of the fully-diluted shares of Transcept common stock were owned by former stockholders of TPI. For accountingpurposes, TPI was deemed to be the acquiring company, and the Merger was accounted for as a reverse acquisition.The purchase consideration was approximately $83.1 million. The purchase consideration was determined based on the fair value of the net assetsexchanged.Transcept and Novacea completed the Merger principally to utilize the cash resources held by Novacea to continue the development of the late-stageproduct candidate held by TPI.Allocation of total purchase consideration:Under the purchase method of accounting, the total purchase consideration was allocated to the net tangible and identifiable intangible assets acquiredand liabilities assumed based on their fair values as of January 30, 2009. The excess of the purchase price over the fair value of assets acquired and liabilitiesassumed was allocated to goodwill. The allocation of the purchase price is as follows (in thousands): Allocation ofPurchase Price Cash, cash equivalents and marketable securities $80,861 Other assets 3,794 Goodwill 2,962 Existing assumed liabilities (1,466) Assumed lease liability (856) Assumed severance, retention and other merger related obligations (2,177) Total $83,118 Goodwill is derived from the value obtained from the additional resources of the combined company. None of the goodwill will be deductible for taxpurposes as the merger was structured as a stock purchase transaction.Assumed severance, retention and other merger related obligations:Upon completion of the Merger on January 30, 2009, the Company became liable to pay approximately $2.2 million in payments due to Novaceaemployees upon a change in control, all of which has been paid as of December 31, 2009. None of these payments required on-going services of theemployees subsequent to the change in control. 81 Table of ContentsPro forma information:The following unaudited pro forma information presents a summary of the Company’s consolidated results of operations as if the Merger had takenplace as of January 1, 2008 (in thousands, except per share information): Year Ended December 31, 2009 2008 Revenue(1) $5,208 $60,621Net income (loss) $(22,572) $14,863Pro forma net income (loss) per share: Basic $(1.71) $1.15Diluted $(1.71) $1.11Shares used in computing net income (loss) per share: Basic 13,162 12,928Diluted 13,162 13,383 (1)Revenue for 2009 related to the Collaboration Agreement between the Company and Purdue (see Note 11). Revenue for 2008 related to thecollaboration agreement between Schering Corporation (“Schering”) and Novacea (the “Schering Collaboration Agreement”). Upon termination of theSchering Collaboration Agreement on April 4, 2008, Novacea recognized as revenue during the second quarter of 2008 the previously deferredrevenue balance of $52.4 million related to the non-refundable upfront payments. The deferred revenue balance related to the non-refundable upfrontpayments from Schering was zero as of December 31, 2008.The unaudited pro forma results of operations are not necessarily indicative of what would have occurred had the Merger been completed at thebeginning of the respective periods or of the results that may occur in the future.3. Results of OperationsNet Loss Per ShareBasic net loss per share is computed by dividing net loss by the weighted average number of vested shares outstanding during the period. Diluted netloss per share is computed by giving effect to all potential dilutive common securities, including options and common stock subject to repurchase.The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share amounts): 2009 2008 2007 Numerator: Loss attributable to common stockholders $(21,800) $(19,959) $(20,384) Denominator: Weighted average common shares outstanding 12,205 475 345 Less: Weighted average common shares subject to repurchase (39) (74) (49) Denominator for basic and diluted net loss per share 12,166 401 296 Basic and diluted net loss per share $(1.79) $(49.77) $(68.86) 82 Table of ContentsThe following outstanding shares subject to options and warrants to purchase common stock, common stock subject to repurchase, convertiblepreferred stock and shares subject to warrants to purchase convertible preferred stock were antidilutive due to a net loss in the periods presented and,therefore, were excluded from dilutive securities computation as of the periods indicated below (in thousands): December 31, 2009 2008 2007Shares subject to options to purchase common stock 1,718 1,066 1,062Shares subject to warrants to purchase common stock 156 — 3Common stock subject to repurchase 22 56 91Convertible preferred stock (as-converted basis) — 7,350 7,350Shares subject to warrants to purchase convertible preferred stock — 156 156Total 1,896 8,628 8,6624. Cash, Cash Equivalents and Marketable SecuritiesThe following is a summary of the fair value of cash, cash equivalents and available-for-sale securities (in thousands): December 31, 2009 AmortizedCost UnrealizedGains UnrealizedLosses EstimatedFair ValueCash $803 $— $— $803Certificates of deposit 200 — — 200Money market funds 16,228 — — 16,228U.S. Treasury securities 71,832 39 — 71,871 $89,063 $39 $— $89,102 December 31, 2008 AmortizedCost UnrealizedGains UnrealizedLosses EstimatedFair ValueCash $401 $— $— $401Corporate notes 998 2 — 1,000Certificates of deposit 200 — — 200Government sponsored enterprise issues 5,727 24 5,751Money market funds 4,031 — — 4,031U.S. Treasury securities 500 — — 500 $11,857 $26 $— $11,883During 2009, proceeds from the sales of available-for-sale marketable securities totaled $47,282,000 with realized gains of $111,000. In 2008,proceeds from the sales of available-for-sale marketable securities totaled $3,805,000 with realized losses of $16,000. The amortized cost and estimated fairvalue of available-for-sale marketable securities at December 31, 2009 and 2008 were as follows (in thousands): 2009 2008 Cost Fair value Cost Fair valueCash equivalents $17,031 $17,031 $4,432 $4,432Marketable securities 71,832 71,871 7,225 7,251Restricted cash 200 200 200 200 $89,063 $89,102 $11,857 $11,883 83 Table of ContentsAll of the Company’s investments had contractual maturities of one year or less at December 31, 2009.5. Fair ValueOn January 1, 2008, the Company adopted ASC Topic 820 Fair Value Measurements and Disclosures (formerly SFAS No. 157) as it applies to itsfinancial assets and financial liabilities. ASC Topic 820 defines fair value, establishes a framework for measuring fair value and expands disclosures aboutfair value measurements. Fair value is defined as the estimated exit price received to sell an asset or paid to transfer a liability in an orderly transactionbetween market participants at the measurement date rather than on an entry price which represents the purchase price of an asset or liability. ASC Topic 820establishes a fair value hierarchy that prioritizes observable and unobservable inputs used to measure fair value into three broad levels, which are describedbelow: • Level 1—Quoted prices (unadjusted) in active markets that are accessible at the measurement date for assets or liabilities. The fair valuehierarchy gives the highest priority to Level 1 inputs. • Level 2—Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quotedprices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially thefull term of the assets or liabilities. • Level 3—Unobservable inputs (i.e. inputs that reflect the reporting entity’s own assumptions about the assumptions that market participantswould use in estimating the fair value of an asset or liability) are used when little or no market data is available. The fair value hierarchy givesthe lowest priority to Level 3 inputs.A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair valuemeasurement. Where quoted prices are available in an active market, securities are classified as Level 1 of the valuation hierarchy. Level 1 securities includehighly liquid money market funds. If quoted market prices are not available for the specific security, then the Company estimates fair value by using pricingmodels, quoted prices of securities with similar characteristics or discounted cash flows. Level 2 instruments include commercial paper, U.S. corporate debt,and U.S. government sponsored enterprise issues. Level 3 liabilities that are measured at fair value on a recurring basis consist of convertible preferred stockwarrant liabilities. The fair values of the outstanding preferred stock warrants are measured using the Black-Scholes option-pricing model. Inputs used todetermine fair market value include estimated market value of the underlying convertible preferred stock at the valuation measurement date, the remainingcontractual term of the warrant, risk-free interest rates and expected dividends on and expected volatility of the price of the underlying convertible preferredstock.In accordance with ASC Topic 820, the following table represents the Company’s fair value hierarchy for its financial assets (cash equivalents andmarketable securities) and liabilities (convertible preferred stock warrant liabilities) measured at fair value on a recurring basis as of December 31, 2009 (inthousands): December 31,2009 Fair Value Measurements atReporting Date Using Quoted Pricesin ActiveMarkets forIdentical Assets(Level 1) SignificantOtherObservableInputs(Level 2) SignificantUnobservableInputs(Level 3)Assets Certificates of deposit $200 $200 $— $— Money market funds 16,228 16,228 — — U.S. Treasury securities 71,871 — 71,871 — $88,299 $16,428 $71,871 $— Liabilities Convertible preferred stock warrant liabilities $— $— $— $— 84 Table of ContentsThe following table represents the Company’s fair value hierarchy for its financial assets (cash equivalents and marketable securities) and liabilities(convertible preferred stock warrant liabilities) measured at fair value on a recurring basis as of December 31, 2008 (in thousands): December 31,2008 Fair Value Measurements atReporting Date Using Quoted Pricesin ActiveMarkets forIdentical Assets(Level 1) SignificantOtherObservableInputs(Level 2) SignificantUnobservableInputs(Level 3)Assets Certificates of deposit $200 $200 $— $— Money market funds 4,031 4,031 — — U.S. corporate debt 1,000 — 1,000 — U.S. government sponsored enterprise issues 5,751 — 5,751 — U.S. Treasury securities 500 — 500 — $11,482 $4,231 $7,251 $— Liabilities Convertible preferred stock warrant liabilities $600 $— $— $600The following table sets forth the changes in the fair value of the Company’s Level 3 financial liabilities (convertible preferred stock warrantliabilities), which were measured at fair value on a recurring basis for the period ended December 31, 2009 (in thousands): Fair value as of December 31, 2008 $600 Change in fair value (200) Transfer to equity upon conversion of preferredstock to common stock on January 30, 2009 (400) Fair value as of December 31, 2009 $— The decrease in fair value of the convertible preferred stock warrant liabilities of $200,000 was recognized in other income (expense), net in thestatements of operations. Concurrent with the Merger as described in Note 1 above, the warrants to purchase preferred stock were converted into warrants topurchase common stock with the same exercise prices and expiration dates, and the aggregate fair value of these warrants was reclassified from a liability toadditional paid-in capital, a component of stockholders’ equity (net capital deficiency).During the years ended December 31, 2009 and 2008, there were no significant changes to the valuation models used for purposes of determining thefair value of Level 2 assets and Level 3 liabilities. No other assets and liabilities were carried at fair value as of December 31, 2009.6. Property and Equipment, NetProperty and equipment consisted of the following (in thousands): December 31, 2009 2008 Computer equipment and software $617 $585 Furniture and fixtures 559 557 Research equipment 779 778 Leasehold improvements 624 624 Construction in progress — 6 2,579 2,550 Less accumulated depreciation and amortization (1,527) (1,100) Property and equipment, net $1,052 $1,450 85 Table of ContentsThe Company recorded depreciation and amortization expense of $550,000, $505,000 and $379,000 for the years ended December 31, 2009, 2008 and2007, respectively.7. Loans and Security AgreementIn February 2006, the Company entered into a Loan and Security Agreement (the “Agreement”) with Hercules Technology Growth Capital(“Hercules”). Under the terms of the Agreement, the Company was initially entitled to draw up to $4.0 million. This amount was raised to $10.0 million uponreaching certain development milestones, which were achieved in October 2006. Interest under the loan was fixed at prime plus 2.69% at the date of theinitial draw. The Company drew down an advance of $4.0 million on May 31, 2006, and drew down the remaining available advance of $6.0 million onDecember 28, 2006, against which interest accrued at rates of 10.69% and 10.94%, respectively. The draw required interest only repayment for the periodfrom initial borrowing to December 31, 2006. Principal and interest repayment commenced in January 2007, to be continued for 33 months. Under the termsof the Agreement, the Loan was secured by a perfected first priority security interest in all of the Company’s tangible and intangible assets owned orsubsequently acquired, except for intellectual property. On February 3, 2009, the Company repaid the remaining outstanding principal and interest under thisloan, in the amount of $2,763,000, which included a 2% prepayment charge. The prepayment charge of $54,000 was included in interest expense during thefirst quarter of 2009.In connection with the Agreement, the Company was required to pay approximately $123,000 in facility and other fees. These fees were capitalized inother assets and were being amortized to interest expense over the term of the loan. In conjunction with the full repayment of the loan in February 2009, asnoted above, the remaining facility and other fees of $28,000 were amortized to interest expense during the first quarter of 2009. Amortization expense was$28,000, $37,000 and $37,000 for the years ended December 31, 2009, 2008 and 2007, respectively.In addition, in connection with the Agreement in May and December 2006, the Company issued warrants to purchase 61,452 shares of Series Cconvertible preferred stock at an exercise price of $8.136 per share. These warrants were valued using the Black-Scholes valuation model, and the resultingestimated fair value of the warrants at the date of issuance was $440,000, which was recorded as a debt discount to the credit facility in 2006. The discountwas amortized to interest expense over the repayment period. In conjunction with the full repayment of the loan in February 2009, as noted above, theremaining debt discount of $47,000 was charged to interest expense during the first quarter of 2009. Interest expense was $179,000, $707,000 and$1,152,000 for the years ended December 31, 2009, 2008 and 2007, respectively, of which $47,000, $151,000 and $216,000 related to amortization of thedebt discount.The Agreement did not have financial covenants. See Note 10 for discussion of the assumptions and methodology used to estimate the fair value of thewarrant.As discussed in Note 8, the Company leased additional office space in 2007. Under the terms of the agreement, the landlord agreed to financeapproximately $258,000 of the costs for tenant improvements made to the space. The loan is being repaid at an interest rate of 8.25% over the period fromSeptember 2007 through May 2013. 86 Table of ContentsAt December 31, 2009, future minimum principal payments related to long-term debt were as follows (in thousands): Year ending December 31, 2010 $57 2011 57 2012 57 2013 24 2014 — Thereafter — 195 Less: Interest (25) Minimum principal payments 170 Less: Current minimum principal payments (45) Long-term minimum principal payments $125 8. Commitments and ContingenciesLeasesIn February 2006, the Company signed an operating lease for its corporate offices that included approximately 11,600 square feet of office andlaboratory space in Point Richmond, California. The lease term is for seven years, commencing on June 1, 2006. In June 2007, the Company amended thisoperating lease to add approximately 3,000 square feet of additional office space. The lease term of this amendment coincides with the original leaseagreement, with a separate commencement date of September 12, 2007. As part of this amendment, the landlord agreed to contribute $60,000 toward the costsof tenant improvements for the additional space. This landlord contribution is being amortized on a straight-line basis over the term of the lease as areduction to rent expense.On February 20, 2009, the Company signed an operating lease for 12,257 square feet of general office space in Point Richmond, California. The leaseterm commenced in March 2009 and terminates on May 31, 2013, with an option to renew for an additional five years. Under the terms of the lease, theCompany has the option of accelerating the termination date of the lease to May 31, 2011. Total base rent payable by the Company from commencement ofthe lease through the end of the first term of the lease is approximately $0.8 million. In conjunction with the restructuring described in Note 12 below, theCompany vacated this property in August 2009 and has recorded a charge to rent expense of $309,000 related to the fair value of the remaining leasepayments reduced by estimated sublease income. This liability is being amortized using the effective interest method over the remaining life of the lease.In June 2007, Novacea entered into an operating lease for 25,288 square feet for corporate facilities located in South San Francisco, California. Thelease for the facilities is non-cancelable and has a five-year term with a total obligation of $3.6 million. The lease provides for periodic rent increases basedupon previously negotiated or consumer price indexed adjustments, or in the case of an extension, market adjusted rates. As of December 31, 2009, theCompany maintained a Certificate of Deposit acting as a security deposit of $770,000 required under conditions of the lease, which was recorded as anoncurrent asset on the Company’s balance sheet. On March 25, 2009, the Company entered into a sublease agreement dated as of March 24, 2009 for 18,368square feet of the 25,288 square feet located in South San Francisco. The term of the sublease commenced on June 1, 2009 and ends on October 31, 2012.Total base rent payable by the sublessee through the end of the term of the sublease is approximately $1.1 million. In connection with this sublease, onApril 6, 2009 the Company received an irrevocable standby letter of credit in the amount of $100,000, expiring May 31, 2010, as a security deposit. OnJune 16, 2009, the Company entered into a sublease agreement dated for reference purposes as of June 11, 2009 for the remaining 6,920 square feet of theSouth San Francisco facility. The term of the sublease commenced on July 1, 2009 and ends on October 31, 2012. Total base rent payable by the sublesseethrough the end of the term of the sublease is approximately $0.4 million. 87 Table of ContentsFuture minimum payments under these leases as of December 31, 2009 are as follows (in thousands): Year ending December 31, 2010 $1,2092011 1,2542012 1,0942013 2202014 — Thereafter — Total $3,777In addition, as noted above, The Company has subleased certain of these facilities under operating leases to third parties. The future minimum subleasepayments due from lessees under those arrangements are $433,000 in 2010, $493,000 in 2011 and $422,000 in 2012.Rent expense for the years ended December 31, 2009, 2008 and 2007 was $986,000, $278,000 and $232,000, respectively. Sublease income for theyear ended December 31, 2009 was $123,000. There was no sublease income for the years ended December 31, 2008 or 2007.Purchase CommitmentsPursuant to the terms of an agreement with Plantex USA Inc., the Company is obligated to purchase $350,000 worth of zolpidem tartrate during 2010.Indemnity AgreementsThe Company indemnifies its officers and directors for certain events or occurrences, subject to certain limits. The Company believes the fair value ofthese indemnification agreements is minimal. Accordingly, the Company has not recognized any liabilities relating to these agreements as of December 31,2009.Legal ProceedingsFrom time to time, we may be involved in litigation relating to claims arising out of our operations. Transcept is not currently involved in any materiallegal proceedings.SPI Pharmaceuticals, Inc., the sole supplier of Pharmaburst, a key excipient used in Intermezzo, is the defendant in a lawsuit brought by RoquetteFrères, or Roquette, in the Federal District Court of Delaware on August 31, 2006 that alleges that certain of SPI’s products infringe one or more claims of aRoquette patent and seeks monetary damages and injunctive relief. Transcept has not been named in, and is not a party to, the lawsuit. Although notspecifically identified in the original complaint, press releases have indicated that Pharmaburst products are among the accused products. SPI has informedus that Roquette’s patent rights are not infringed by Pharmaburst and that they intend to defend their rights vigorously. Because Pharmaburst is a keyexcipient in Intermezzo, the interruption of supply of Pharmaburst through an injunction could materially harm our ability to supply Intermezzo and ourbusiness. SPI has agreed to indemnify us against certain damages related to any such infringement suit under the terms of our agreement with SPI. 88®®®®®®®® Table of Contents9. Accrued LiabilitiesAccrued liabilities consist of the following (in thousands): December 31, 2009 2008Accrued payroll and related $407 $449Accrued vacation pay 157 133Accrued professional fees 478 290Accrued merger related costs — 221Accrued tooling charges 812 — Accrued franchise taxes—Delaware 117 — Other accrued liabilities 412 375 $2,383 $1,46810. Warrant liabilityIn conjunction with the sale of the 2005 subordinated convertible promissory notes, the Company issued warrants for the purchase of 94,554 shares ofSeries C convertible preferred stock at $8.136 per share in October 2005. These warrants have a contractual life of seven years. The fair value of these warrantswas determined to be $535,000 at the date of issuance using the Black-Scholes Merton option valuation model with the following assumptions: a risk-freeinterest rate of 4.40%; no dividend yield; expected volatility of 70%; and an expected life of seven years.In addition, the Company issued warrants to purchase 24,581 and 36,872 shares of Series C convertible preferred stock at an exercise price of $8.136per share in May and December 2006, respectively. The aggregate fair value of these warrants was determined to be $440,000 at the dates of issuance usingthe Black-Scholes Merton option valuation model with the following assumptions: risk-free interest rates from 4.7% – 5.1%; no dividend yield; expectedvolatilities from 61% – 62%; and remaining contractual lives of 9.3 – 9.9 years.Pursuant to ASC Topic 480, all preferred stock warrants were recorded as liabilities at the time of issuance and remeasured to current fair value at eachreporting date.In conjunction with the closing of the merger transaction on January 30, 2009, all outstanding warrants became warrants to purchase shares of commonstock, at which point the warrants were no longer subject to ASC Topic 480. As of January 30, 2009, $400,000, the then-current aggregate fair value of thesewarrants, was reclassified from a liability to additional paid-in capital, a component of stockholders’ equity (net capital deficiency).At January 30, 2009 and December 31, 2008 and 2007, the fair value of all outstanding Series C convertible preferred stock warrants was remeasuredbased on the then-current reassessed fair value of the Company’s convertible preferred stock and the assumptions in the following table: Period EndedJanuary 30,2009 Year Ended December 31, 2008 2007Risk free interest rate 1.32 - 2.27% 1.87 - 2.25% 3.70 - 3.85%Remaining contractual terms 3.8 - 7.2 years 3.8 - 7.3 years 4.8 - 8.3 yearsVolatility 79 - 92% 79 - 92% 61%The aggregate fair value of all outstanding Series C warrants was determined to be $600,000 and $968,000 as of December 31, 2008 and 2007,respectively. Net changes in fair value of $200,000, $368,000 and ($13,000) have been included in other income (expense), net for the years endedDecember 31, 2009, 2008 and 2007, respectively. 89 Table of Contents11. Collaboration AgreementOn July 31, 2009, the Company signed the United States License and Collaboration Agreement (“Collaboration Agreement”) with PurduePharmaceutical Products L.P. (“Purdue”) that provides an exclusive license to Purdue to commercialize Intermezzo in the United States and pursuant towhich: • On August 4, 2009, Purdue paid the Company a $25.0 million non-refundable license fee; • The Company is obligated to seek FDA approval of Intermezzo and to continue development of Intermezzo at its expense until FDA approval;and • If Purdue elects not to terminate the collaboration after its review of an FDA approval of Intermezzo: • Purdue is obligated to pay the Company up to $30.0 million, which amount is reduced by $2.0 million for each 30-day period that theCompany’s receipt of an NDA approval for Intermezzo is delayed beyond June 30, 2010; • The Company is obligated to transfer the Intermezzo NDA to Purdue and Purdue is obligated to assume the expense associated withmaintaining the NDA and further development of Intermezzo in the United States, including any expense associated with post-approvalstudies; • Purdue is obligated to commercialize Intermezzo in the United States at its expense; • Purdue is obligated to pay the Company tiered double-digit base royalties on net sales of Intermezzo in the United States ranging up tothe mid-twenty-percent level; • Purdue is obligated to pay the Company $10.0 million if either of two formulation patents are listed in the FDA’s Approved DrugProducts with Therapeutic Equivalence Evaluations, or Orange Book; and • Purdue is potentially obligated to pay the Company up to an additional $80.0 million upon meeting certain intellectual propertymilestones and upon the achievement of certain net sales targets for Intermezzo in the United States.The Company retained an option to co-promote Intermezzo to psychiatrists in the United States as early as the first anniversary of commercial launchof Intermezzo and upon entry into the market under the co-promotion option, the Company would receive an additional double-digit royalty from Purdue onsales generated by psychiatrists in the United States.The Company also granted Purdue and an associated company the right to negotiate for the commercialization of Intermezzo in Mexico and Canada,respectively, and retained rights to commercialize Intermezzo in the rest of the world.The Company’s co-promote option may be terminated by Purdue upon acquisition of the Company or in the event of entry of generic competition toIntermezzo. The royalty payments discussed above are subject to reduction in connection with, among other things, the entry of generic competition toIntermezzo.The Company is recognizing revenue from the $25.0 million non-refundable license fee ratably over an estimated 24-month period starting August 1,2009 and ending on July 31, 2011. This period represents the estimated period for which it has significant participatory obligations under the CollaborationAgreement. The revenue recognized in connection with the license fee in 2009 was $5.2 million.12. RestructuringOn August 17, 2009, the Company implemented a reduction of approximately 30% of the Company’s workforce. Affected employees were notified onAugust 17, 2009. The reduction plan carried out a realignment of the Company’s workforce and operations after a reassessment of the Company’sdevelopment activities and 90®®®®®®®®®®®®®®®® Table of Contentscorporate objectives in connection with the Company’s recent entry into the Collaboration Agreement described in Note 11 above. The Companysubstantially completed the reduction plan at December 31, 2009. Employees subject to the workforce reduction plan were eligible for one-time severancebenefits that included severance pay of approximately $511,000 in total and one year accelerated vesting on outstanding options upon signing a separationand release agreement with the Company. Further, the affected employees were given the choice to extend the exercise period of their options to one yearfollowing termination. Total expense related to the modification of these stock option awards is expected to be approximately $79,000.Additionally, the Company recorded a charge of approximately $309,000 related to the fair value of the remaining lease payments on 12,257 squarefeet of general office space in Point Richmond, California. This liability will be amortized over the remaining life of the lease, which expires on May 31,2013.The Company records restructuring activities in accordance with ASC topic 420 Exit or Disposal Cost Obligations (formerly SFAS 146, Accountingfor Costs Associated with Exit or Disposal Activities.). The following tables summarize the charges recorded during the year ended December 31, 2009related to the restructuring plan by type of activity (no such charges were recorded in the comparable prior year periods) (in thousands). Year ended December 31, 2009 Severancebenefits Stockoptionmodification Contractterminationcosts TotalResearch and development $205 $24 $— $229General and administrative 272 41 309 622 $477 $65 $309 $851Since the inception of its restructuring plan through December 31, 2009, the Company has incurred approximately $477,000 of the estimated$511,000 of severance benefits expected to be incurred (in thousands). Severancebenefits Restructuring liability as of January 1, 2009 $— Expense 477 Payments (361) Restructuring liability as of December 31, 2009 $116 The severance benefit liability is included in accrued liabilities while the contract termination costs are included in the lease liability in the balancesheet.13. Convertible Preferred StockIn connection with the Company’s merger with Novacea on January 30, 2009, all shares of convertible preferred stock were converted to commonstock.14. Stockholders’ EquityCapital StockThe authorized capital stock of the Company consists of 100,000,000 shares of common stock, par value $0.001 per share and 5,000,000 shares ofpreferred stock, par value $0.001 per share. There are no shares of preferred stock issued or outstanding and the Company has no present plans to issue anyshares of preferred stock. 91 Table of ContentsStock OptionsVarious employees, directors and consultants have been granted options to purchase common shares under equity incentive plans adopted in 2001,2002 and 2006 (the “2001 Plan”, the “2002 Plan” and the “2006 Plan”). The 2001 Plan provided for the granting of incentive and non-statutory stockoptions to employees, officers, directors, and non-employees of the Company. The 2002 Plan provided for the granting of incentive and non-statutory stockoptions to employees, officers, directors, and consultants of the Company. Incentive stock options under all of these plans may be granted with exerciseprices of not less than estimated fair value, and non-statutory stock options may be granted with an exercise price of not less than 85% of the estimated fairvalue of the common stock on the date of grant. Stock options granted to a stockholder owning more than 10% of voting stock of the Company must have anexercise price of not less than 110% of the estimated fair value of the common stock on the date of grant. The Company estimated the fair value of commonstock until the Company became publicly traded. Stock options are generally granted with terms of up to ten years and vest over a period of four years. AtDecember 31, 2009, there were no shares available for future grant under either the 2001 or the 2002 Plans.The 2006 Plan became effective upon the completion of the Company’s initial public offering in 2006, and will terminate on the earlier of (i) ten yearsafter its approval by the Company’s stockholders or (ii) when the Company’s compensation committee, with the approval of the Company’s board ofdirectors, terminates the 2006 Plan. The 2006 Plan provides for the granting of incentive stock options, non-statutory stock options, restricted stock,performance share awards, performance stock units, dividend equivalents, restricted stock units, stock payments, deferred stock, performance-based awardsand stock appreciation rights. The employee stock options generally vest over four years, are exercisable over a period not to exceed the contractual term often years from the date the stock options are issued and are granted at prices equal to the fair value of the Company’s common stock on the grant date. Stockoption and restricted stock unit exercises are settled with newly issued common stock from the 2006 Plan’s previously authorized and available pool ofshares. A total of 500,000 shares of common stock was originally authorized for issuance pursuant to the 2006 Plan, plus the number of shares of theCompany’s common stock available for issuance under the 2001 Plan that are not subject to outstanding options, as of the effective date of the 2006 Plan(including shares that are subject to stock options outstanding under the 2001 Plan that expire, are cancelled or otherwise terminate unexercised, or sharesthat otherwise would have reverted to the share reserve of the 2001 Plan following the effective date of the 2006 Plan). In addition, the number of shares ofcommon stock reserved for issuance under the 2006 Plan increases automatically on the first day of each fiscal year, beginning in 2007, by a number of sharesequal to the least of: (i) 4.5% of shares of the Company’s common stock outstanding on a fully diluted basis on such date; (ii) 400,000 shares; or (iii) asmaller number determined by the Company’s board of directors. This provision resulted in an additional 400,000, 258,344 and 264,187 of the Company’scommon stock becoming available for issuance on January 1, 2010, 2009 and 2008, respectively under the 2006 Plan.At December 31, 2009, stock options to purchase 1,096,265 shares of common stock were vested and exercisable and 337,481 shares remain availablefor future grant under the 2006 Plan. 92 Table of ContentsThe following table summarizes the Company’s stock option activity and related information through December 31, 2009: Options Outstanding Numberof SharesAvailablefor Grant Number ofShares Weighted-AverageExercise PricePer ShareBalance at December 31, 2006 152,572 609,992 $0.870Options authorized 607,762 — Options granted (650,060) 650,060 $1.797Options exercised — (176,164) $1.238Options forfeited 21,853 (21,853) $1.160Balance at December 31, 2007 132,127 1,062,035 $1.373Options authorized 28,267 — Options granted (173,477) 173,477 $5.526Options exercised — (63,441) $1.061Options forfeited 106,151 (106,151) $1.274Balance at December 31, 2008 93,068 1,065,920 $2.080Options authorized 258,344 — Options granted (553,016) 553,016 $4.009Options exercised — (292,760) $1.313Options forfeited 125,571 (125,571) $9.6132002 Plan shares expired (150,576) — Acquired in the merger 564,090 517,653 $19.627Balance at December 31, 2009 337,481 1,718,258 $7.494The total intrinsic value of options exercised during the years ended December 31, 2009 and 2008 was $2,420,000 and $281,000, respectively. Theamount of cash received from exercise of stock options during the years ended December 31, 2009 and 2008 was $385,000 and $67,000, respectively.Additional information related to the status of options at December 31, 2009 is as follows: Shares Weighted-AverageExercisePrice PerShare Weighted-AverageRemainingContractualLife (Years) AggregateIntrinsicValue(in thousands)Outstanding 1,718,258 $7.494 6.46 $4,917Vested and exercisable 1,096,265 $9.706 5.20 $2,872The intrinsic value of options is the estimated fair value of the stock less the per share exercise price of the option multiplied by the number of shares.As of December 31, 2009 and 2008, there were 22,078 and 55,855 restricted common shares outstanding subject to repurchase rights held by theCompany. In accordance with ASC Topic 718, Compensation—Stock Compensation, the Company has shown $41,000 and $88,000 received as a liability inthe balance sheet as of December 31, 2009 and 2008, respectively, and has not shown these shares as outstanding as of December 31, 2009 or 2008. Theseshares are subject to repurchase upon termination of the stockholders’ services to the Company and are subject to repurchase at the original issuance price.The Company’s right to repurchase these shares lapses at a rate of 2.08% per month. 93 Table of ContentsThe following tables summarize information about stock options outstanding as of December 31, 2009: Range ofExercise Prices NumberOutstanding NumberExercisable Weighted-AverageRemainingcontractual Life(Years)$ 0.7075–$ 0.8844 212,557 211,966 5.76$1.7688 367,492 237,431 7.09$2.1225–$4.0328 239,988 51,218 8.78$4.1400 304,748 73,952 9.03$ 4.5000–$14.0000 253,660 181,885 6.12$14.0500–$15.1500 176,000 176,000 1.22$26.2500–$30.8500 94,233 94,233 4.70$31.0500–$32.5000 69,580 69,580 2.82 1,718,258 1,096,265 6.46Stock Compensation PlansThe Company has recorded compensation expense for employee stock-based awards of approximately $1,057,000, $613,000 and $470,000 during2009, 2008 and 2007, respectively.The following table shows the weighted-average assumptions used to compute the share-based compensation costs for the stock options granted duringthe years ended December 31, 2009, 2008 and 2007 using the Black-Scholes option pricing model: Year Ended December 31, 2009 2008 2007Risk free interest rate 1.79 - 2.90% 2.80 -3.49% 4.57%Expected life of the options 5.27 - 6.08 years 6.08 years 6.02 - 6.08 yearsDividend yield None None NoneVolatility 82.82 - 90.25% 70.29 - 77.59% 61.17 - 61.38%The risk-free interest rate assumption was based on the United States Treasury’s rates for U.S. Treasury zero-coupon bonds with maturities similar tothose of the expected term of the award being valued. The assumed dividend yield was based on the Company’s expectation of not paying dividends in theforeseeable future. The weighted-average expected life of the options was calculated using the simplified method as prescribed by the Securities andExchange Commission (“SEC”) Staff Accounting Bulletin No. 107 and No. 110 (“SAB No. 107 and 110”). This decision was based on the lack of relevanthistorical data due to the Company’s limited historical experience. In addition, due to the Company’s limited historical data, the estimated volatility alsoreflects the application of SAB No. 107 and 110, incorporating the historical volatility of comparable companies whose share prices are publicly available.The weighted-average grant-date fair value of stock options granted to employees during the years ended December 31, 2009, 2008 and 2007 was$2.894, $4.140 and $1.797 per share, respectively. As of December 31, 2009, there is approximately $1,888,000 of total unrecognized compensation costrelated to the unvested share-based compensation arrangements granted under the Company’s equity incentive plan. The remaining unrecognizedcompensation cost will be recognized over a weighted-average period of 2.47 years.As discussed in Note 1, the Company accounts for stock options granted to persons other than employees or directors at fair value using the Black-Scholes Merton option-pricing model in accordance with ASC Topic 505, subtopic 50 Equity-Based Payments to Non-Employees (formerly EITF IssueNo. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services).Stock options granted to such persons and stock options that are modified and continue to vest when an 94 Table of Contentsemployee has a change in employment status are subject to periodic revaluation over their vesting terms. The Company recognizes the resulting stock-basedcompensation expense during the service period over which the nonemployee provides services to the Company. In connection with the issuance of optionsto purchase shares of common stock to nonemployees, the Company recorded total stock-based compensation within stockholders’ equity totalingapproximately $121,000, $24,000 and $13,000 for the years ended December 31, 2009, 2008 and 2007, respectively.During 2009, the Company granted 30,000 options to purchase shares of common stock to one nonemployee that vest over four years, with an exerciseprice of $2.96 per share. During 2008, the Company granted 3,516 options to purchase shares of common stock to four nonemployees that vest over fouryears, with an exercise price of $4.033 per share. During 2007, the Company granted 2,120 options to purchase shares of common stock to one nonemployeethat vest over four years, with an exercise price of $1.769 per share. The following table shows the weighted-average assumptions used to compute the share-based compensation costs for stock options granted to nonemployees during the years ended December 31, 2009, 2008 and 2007 using the Black-ScholesMerton option pricing model: Year Ended December 31, 2009 2008 2007Risk free interest rate 2.28 - 3.85% 1.89 - 3.98% 4.71 - 4.72%Expected life of the options 6.25 - 9.92 years 7.20 - 9.93 years 8.21 - 9.26 yearsDividend yield None None NoneVolatility 80.47 - 88.36% 73.97 - 85.11% 65.40 - 66.29%Modification of Employee Stock-Based AwardsDuring the year ended December 31, 2009, the Company modified stock options of twelve of its employees in conjunction with their termination,primarily associated with those employees affected by the reduction-in-force described in Note 12. The modifications included accelerated vesting on certainoptions and extension of the exercise period after termination on certain of the options. These modifications resulted in additional compensation expense of$127,000 recorded in the year ended December 31, 2009. The Company accounted for the modifications of stock option awards in accordance with ASCTopic 718.Employee Stock Purchase PlanOn June 3, 2009, at the annual meeting of stockholders, the stockholders of the Company approved the 2009 Employee Stock Purchase Plan (“ESPP”).The number of shares available for issuance over the term of the ESPP is limited to 500,000 shares. The ESPP is designed to allow eligible employees of theCompany to purchase shares of common stock through periodic payroll deductions. The price of common stock purchased under the ESPP is equal to 85% ofthe lower of the fair market value of the common stock on the commencement date of each offering period or the specified purchase date. The first offeringperiod began July 16, 2009 and ended on November 30, 2009 and resulted in the purchase of 22,060 of the Company’s common stock, leaving 477,940shares available for issuance.The weighted average assumptions used to value purchases under the ESPP plan during 2009 were as follows: risk free interest rate – 0.15% to 0.24%;expected life – 0.38 to 0.50 years; dividend yield – 0; and volatility – 75.48% to 122.57%. The risk-free interest rate assumption was based on the UnitedStates Treasury’s rates for U.S. Treasury zero-coupon bonds with maturities similar to those of the expected term of the award being valued. The assumeddividend yield was based on the Company’s expectation of not paying dividends in the foreseeable future. The weighted-average expected life is based onthe duration of time in the purchasing period. In addition, due to the Company’s limited historical data, the estimated volatility also reflects the applicationof SAB No. 107 and 110, incorporating the historical volatility of comparable companies whose share prices are publicly available. The weighted averagegrant date fair value per share was $2.235. The Company has recorded compensation expense for employee stock-based purchase plan awards ofapproximately $62,000 during 2009. 95 Table of ContentsReserved SharesAt December 31, 2009, the Company has reserved shares of common stock for future issuance as follows: Number ofSharesEmployee stock purchase plan 477,940Stock option plans: Subject to outstanding options 1,718,258Available for future grants 337,481Warrants 156,007Total 2,689,68615. Income taxesThere is no provision for income taxes because the Company has incurred operating losses since inception. Income tax expense (benefit) differed fromthe amounts computed by applying the U.S. federal income tax rate of 35% to pretax losses from operations as a result of the following (in thousands): For the year ended December 31, 2009 2008 2007 Computed tax benefit at federal statutory rate $(7,630) $(6,979) $(7,135) State tax benefit, net of effect on Federal income taxes (1,253) (1,145) (1,166) State tax credits, net of Federal benefit (154) (161) (148) Federal tax credits (298) (301) (217) Permanent differences: Nondeductible stock option expense 231 188 165 Merger related costs 1,467 — — State tax effect from permanent differences 272 — — Other (70) 26 31 Change in valuation allowance 6,188 8,318 8,346 IRS section 382 NOL limitation 1,196 — — Other, net 51 54 124 Total tax expense $— $— $— Deferred income taxes reflect the net tax effects of net operating loss and tax credit carryovers and temporary differences between the carrying amountsof assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred taxassets are as follows (in thousands): December 31, 2009 2008Deferred tax assets: Net operating loss carryforwards $27,220 $24,652Depreciation 46 19Research and development credits 1,467 1,347Capitalized research and development expense 3,764 — Other 800 1,091 33,297 27,109Valuation allowance 33,297 27,109Total deferred tax assets — — Deferred tax liabilities: Depreciation — — Net deferred tax assets $— $— 96 Table of ContentsRealization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, the netdeferred tax assets have been fully offset by a valuation allowance. The valuation allowance increased by $6,188,000 during 2009 and $8,318,000 during2008.As of December 31, 2009, the Company had federal net operating loss carryforwards of approximately $68,920,000, which expire in the years 2022 to2029 if not utilized. The Company had net operating loss carryforwards for state income tax purposes of $53,918,000 which expire in the years 2012 to 2029if not utilized.The Company has carryforwards from the federal Credit for Increasing Research Expenditures of approximately $797,000, which expire in years 2023through 2029. The Company also has state credit carryforwards of approximately $1,032,000 that carry forward indefinitely.As a result of certain realization requirements of ASC Topic 718, the table of deferred tax assets and liabilities shown above does not include certaindeferred tax assets at December 31, 2009 that arose directly from tax deductions related to equity compensation in excess of compensation recognized forfinancial reporting purposes. Equity will be increased by approximately $64,000 if and when such deferred tax assets are ultimately realized.Utilization of the net operating loss and tax credit carryforwards may be subject to a substantial annual limitation due to the ownership changelimitations provided by the Internal Revenue Code of 1986, as amended, and similar state provisions. The annual limitation may result in the expiration ofnet operating losses and credits before utilization.The Company adopted ASC Topic 740, subtopic 10-50-15, Unrecognized Tax Benefit Related Disclosures (formerly FASB Interpretation 48,Accounting for Uncertainty in Income Taxes) on January 1, 2007.The following table summarizes the activity related to our unrecognized tax benefits (in thousands): 2009 2008 Balance as of January 1, $1,312 $1,335 Decreases related to prior year tax positions (1,312) (38) Increases related to current year tax positions — 15 Balance as of December 31, $— $1,312 The beginning balance of unrecognized tax benefits from Novacea was related to Research and Development credits. As a result of the merger, thosecredits were limited. Therefore, the balance related to prior year tax positions was reduced to zero. There are no accrued interest or penalties associated withany unrecognized tax benefits.The Company files U.S. and state income tax returns with varying statutes of limitations. The tax years from inception in 2002 forward remain open toexamination due to the carryover of unused net operating losses and tax credits. 97 Table of Contents16. Supplemental Financial InformationQuarterly Results of Operations (Unaudited)The following table presents the unaudited statements of operations data for each of the eight quarters in the period ended December 31, 2009. Theinformation has been presented on the same basis as the audited financial statements and all necessary adjustments, consisting only of normal recurringadjustments, have been included in the amounts below to present fairly the unaudited quarterly results when read in conjunction with the audited financialstatements and related notes. The operating results for any quarter should not be relied upon as necessarily indicative of results for any future period.Unaudited Quarterly Results of Operations(in thousands, except per share amounts) Three months ended Total foryear 2009 March 31,2009 June 30,2009 September 30,2009 December 31,2009 Revenue: License fee revenue $— $— $2,083 $3,125 $5,208 Total revenue — — 2,083 3,125 5,208 Operating expenses: Research and development 2,222 2,250 2,136 2,397 9,005 General and administrative 4,214 5,019 3,839 2,978 16,050 Merger related transaction costs 2,224 — — — 2,224 Total operating expenses 8,660 7,269 5,975 5,375 27,279 Loss from operations (8,660) (7,269) (3,892) (2,250) (22,071) Interest income 88 97 55 42 282 Interest expense (166) (5) (4) (4) (179) Other income (expense), net 200 64 36 (132) 168 Net loss $(8,538) $(7,113) $(3,805) $(2,344) $(21,800) Basic and diluted net loss per share $(0.95) $(0.54) $(0.29) $(0.18) $(1.79) Weighted average common shares outstanding 9,003 13,070 13,175 13,357 12,166 Three months ended Total foryear 2008 March 31,2008 June 30,2008 September 30,2008 December 31,2008 Operating expenses: Research and development $3,611 $2,781 $2,453 $1,536 $10,381 General and administrative 1,512 1,712 2,141 2,559 7,924 Merger related transaction costs — — — 1,967 1,967 Total operating expenses 5,123 4,493 4,594 6,062 20,272 Loss from operations (5,123) (4,493) (4,594) (6,062) (20,272) Interest income 336 212 134 60 742 Interest expense (237) (205) (177) (147) (766) Other income (expense), net (48) (22) 377 30 337 Net loss $(5,072) $(4,508) $(4,260) $(6,119) $(19,959) Basic and diluted net loss per share $(14.09) $(12.09) $(10.07) $(13.66) $(49.77) Weighted average common shares outstanding 360 373 423 448 401 98 Table of ContentsItem 9.Changes in and Disagreements with Accountants on Accounting and Financial DisclosureNot applicable. Item 9A(T).Controls and Procedures (a)Evaluation of disclosure controls and proceduresOur management evaluated, with the participation and under the supervision of our Chief Executive Officer and our Chief Financial Officer, theeffectiveness of our disclosure controls and procedures as of the end of the period covered by this Annual Report on Form 10-K. Based on this evaluation, ourChief Executive Officer and our Chief Financial Officer have concluded, that our disclosure controls and procedures are effective to ensure that informationwe are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported withinthe time periods specified in Securities and Exchange Commission, or SEC, rules and forms, and that such information is accumulated and communicated tomanagement as appropriate to allow timely decisions regarding required disclosures. (b)Internal control over financial reportingOur management is responsible for establishing and maintaining adequate internal control over financial reporting. We maintain a system of internalcontrol that is designed to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements forexternal purposes in accordance with generally accepted accounting principles.Management assessed our internal control over financial reporting as of December 31, 2009, the end of our last fiscal year. Management based itsassessment on criteria established in “Internal Control—Integrated Framework” issued by the Committee of Sponsoring Organizations of the TreadwayCommission. Management’s assessment included evaluation of such elements as the design and operating effectiveness of key financial reporting controls,process documentation, accounting policies and our overall control environment.Based on our assessment, management has concluded that our internal control over financial reporting was effective as of December 31, 2009 toprovide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes inaccordance with generally accepted accounting principles.There have not been any changes in our internal controls over financial reporting (as such item is defined in Rules 13a-15(f) and 15d-15(f) under theExchange Act) during our fiscal quarter ended December 31, 2009 that have materially affected, or are reasonably likely to materially affect, our internalcontrols over financial reporting.This annual report does not include an attestation report of the company’s independent registered public accounting firm regarding internal controlover financial reporting. Management’s report was not subject to attestation by the company’s independent registered public accounting firm pursuant totemporary rules of the Securities and Exchange Commission that permit the company to provide only management’s report in this annual report.The information contained under this caption “Internal control over financial reporting” shall not be deemed to be filed with the SEC, nor shall suchinformation be incorporated by reference into any future filing under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, asamended, except to the extent that we specifically incorporate it by reference into such filing. (c)Limitations on the Effectiveness of ControlsA control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the controlsare met. Because of the inherent limitations in all control systems, no 99 Table of Contentsevaluation of controls can provide absolute assurance that all control issues, if any, within a company have been detected. Accordingly, our controls andprocedures are designed to provide reasonable, not absolute, assurance that the objectives of our control system are met. Item 9B.Other InformationNone. 100 Table of ContentsPART III Item 10.Directors, Executive Officers and Corporate GovernanceExcept as set forth below, the information required by this Item 10 is incorporated herein by reference to our Proxy Statement to be filed with theCommission within 120 days of the end of our fiscal year pursuant to General Instruction G(3) to Form 10-K.Section 16(a) Beneficial Ownership Reporting ComplianceThe information regarding our Section 16 beneficial ownership reporting compliance is incorporated by reference from our definitive Proxy Statementdescribed above, where it appears under the heading “Section 16(a) Beneficial Ownership Reporting Compliance.”Code of Business Conduct and EthicsOur board of directors has adopted a code of business conduct and ethics. The code of business conduct applies to all of our employees, officers anddirectors. The full texts of our codes of business conduct and ethics are posted on our website at http://www.transcept.com under the Investor Relationssection. We intend to disclose future amendments to our codes of business conduct and ethics, or certain waivers of such provisions, at the same location onour website identified above and also in public filings. The inclusion of our website address in this report does not include or incorporate by reference theinformation on our website into this report. Item 11.Executive CompensationThe information required by this Item 11 is incorporated by reference to our Proxy Statement to be filed with the Commission within 120 days of theend of our fiscal year pursuant to General Instruction G(3) to Form 10-K. Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Stockholder MattersExcept as set forth below, the information required by this Item 12 is incorporated by reference to our Proxy Statement to be filed with the Commissionwithin 120 days of the end of our fiscal year pursuant to General Instruction G(3) to Form 10-K.The following table provides certain information with respect to all of our equity compensation plans in effect as of December 31, 2009. Plan Category Number ofSecurities tobe IssuedUponExercise ofOutstandingOptions andWarrants WeightedAverageExercisePrice ofOutstandingOptions andWarrants Number ofSecuritiesRemainingAvailable forFutureIssuanceUnder EquityCompensationPlans(1) Equity compensation plans approved by stockholders 1,718,258(2) $7.49(3) 815,421(4) Equity compensation plans not approved by stockholders 156,007 $8.14 — Total 1,874,265 $7.54 815,421 (1)The number of authorized shares under the 2006 Equity Incentive Plan, or the 2006 Plan, automatically increases on January 1 of each year by anumber of shares equal to the lesser of (i) 400,000 shares, (ii) 4.5% of the outstanding shares on the last day of the immediately preceding fiscal year, or(iii) an amount determined by the Board of Directors. 101 Table of Contents(2)Includes 1,718,258 shares relating to outstanding options.(3)Represents the weighted average exercise price of outstanding options.(4)Includes 477,940 available under the 2009 Employee Stock Purchase Plan and 337,481 available under the 2006 Plan. Item 13.Certain Relationships and Related Transactions, and Director IndependenceThe information required by this Item 13 is incorporated by reference to our Proxy Statement to be filed with the Commission within 120 days of theend of our fiscal year pursuant to General Instruction G(3) to Form 10-K. Item 14.Principal Accountant Fees and ServicesThe information required by this Item 14 is incorporated by reference to our Proxy Statement to be filed with the Commission within 120 days of theend of our fiscal year pursuant to General Instruction G(3) to Form 10-K. 102 Table of ContentsPART IV Item 15.Exhibits and Financial Statement Schedules(a)(1) Financial StatementsSee Index to Financial Statements under Item 8 on page 69.(a)(2) Financial Statement SchedulesFinancial statement schedules are omitted because they are not applicable or are not required or the information required to be set forth therein isincluded in the Financial Statements or notes thereto.(a)(3) ExhibitsThe exhibits listed in the Exhibit Index below are filed or incorporated by reference as part of this report.Exhibit Index Exhibit No. Description of Exhibit 2.1(1) Agreement and Plan of Merger and Reorganization, dated as of August 29, 2008, by and among Novacea Inc. (“Novacea”), PivotAcquisition, Inc. and Transcept Pharmaceuticals, Inc., a privately held corporation that is now named Transcept Pharma, Inc. (“TPI”)and is a wholly-owned subsidiary of Transcept Pharmaceuticals, Inc., a publicly-traded corporation formerly known as Novacea. 2.2(1) Amendment to Agreement and Plan of Merger and Reorganization, dated as of December 23, 2008, by and among Novacea, PivotAcquisition, Inc. and TPI. 3.1(2) Amended and Restated Certificate of Incorporation of Transcept Pharmaceuticals, Inc. 3.2(2) Bylaws of Transcept Pharmaceuticals, Inc., as amended. 4.1(3) Specimen Common Stock certificate of Transcept Pharmaceuticals, Inc. 4.2(3) Form of Preferred Stock Purchase Warrant issued to certain TPI investors as of March 21, 2005. 4.3(3) Preferred Stock Purchase Warrant issued by TPI to Hercules Technology Growth Capital, Inc., dated as of April 13, 2006. 10.1(4) Novacea 2001 Stock Option Plan and forms of agreements relating thereto. 10.2(5) Novacea 2006 Equity Incentive Plan, as amended, and forms of agreements relating thereto. 10.3(3) TPI Amended and Restated 2002 Stock Option Plan and forms of agreements relating thereto. 10.4(12) Transcept Pharmaceuticals, Inc. 2009 Employee Stock Purchase Plan. 10.5(3) Loan and Security Agreement, by and between Transcept Pharmaceuticals, Inc. and Hercules Technology Growth Capital, Inc. dated asof April 13, 2006. 10.6(3) Secured Promissory Note issued to Hercules Technology Growth Capital, Inc., dated as of May 31, 2006. 10.7(6) Office Lease, by and between Kashiwa Fudosan America, Inc. and Novacea, dated as of May 15, 2007. 10.8(8) Sublease dated as of March 24, 2009 by and between Transcept Pharmaceuticals, Inc. and BiPar Sciences, Inc. 103 Table of ContentsExhibit No. Description of Exhibit 10.9(11) Sublease dated for reference purposes as of June 11, 2009 by and between Transcept Pharmaceuticals, Inc. and Bay Area BioscienceAssociation. 10.10(3) Lease, by and between TPI and Point Richmond R&D Associates, L.P., dated as of February 22, 2006. 10.11(3) First Amendment to Lease, by and between TPI and Point Richmond R&D Associates, L.P., dated as of June 27, 2007. 10.12(7) Second Amendment to Lease, by and between Transcept Pharmaceuticals, Inc. and Point Richmond R&D Associates, L.P., dated asof February 9, 2009. 10.13(7) Lease, by and between Transcept and Point Richmond R&D Associates II, LLC, dated as of February 9, 2009. 10.14(3)† Supply Agreement, by and between TPI and Plantex USA, Inc., dated as of March 31, 2006. 10.15(3)† Letter Agreement, by and between TPI and Plantex USA, Inc., dated as of August 6, 2008. 10.16(13)† First Amendment Plantex Supply Agreement dated as of July 31, 2009. 10.17(3)† Packaging and Supply Agreement, by and between TPI and Anderson Packaging, Inc., dated as of September 14, 2006. 10.18(3)† Amendment to Packaging and Supply Agreement, by and between TPI and Anderson Packaging, Inc., dated as of September 14,2006. 10.19(3)† Manufacturing Services Agreement, by and between TPI and Patheon Pharmaceuticals, Inc., dated as of October 6, 2006. 10.20(3)† Amendment #1 to Manufacturing Services Agreement, by and between TPI and Patheon Pharmaceuticals, Inc., dated as of January 1,2008. 10.21(13) Amendment #2 to Manufacturing Services Agreement, by and between TPI and Patheon Pharmaceuticals, Inc., dated July 29, 2009. 10.22(3)† Supply and Sublicense Agreement, by and between TPI and Mikart, Inc., dated as of January 22, 2008. 10.23(3)† Manufacturing and Supply Agreement, by and between TPI and Mikart, Inc., dated as of August 21, 2008. 10.24(3)† Packaging and Supply Agreement, by and between TPI and Sharp Corporation, dated as of June 16, 2008. 10.25(3)† Supply and License Agreement, by and between TPI and SPI Pharma, Inc., dated as of June 27, 2006. 10.26(3)† Amendment #1 to Supply and License Agreement, by and between TPI and SPI Pharma, Inc., dated as of March 14, 2008. 10.27(3)† Supply Agreement, by and among TPI and SPI Pharma, Inc., dated as of July 23, 2007. 10.28(13) Amendment #1 to Supply Agreement by and between Pivot Acquisition, Inc. and SPI Pharma, Inc. dated July 30, 2009. 10.29(13)† Amendment #2 to Supply Agreement by and between Pivot Acquisition, Inc. and SPI Pharma, Inc dated July 30, 2009. 10.30(3) Offer Letter dated April 15, 2008, by and between TPI and Terrence Moore, including Side Letter dated August 20, 2008 and SideLetter dated December 23, 2008. 104 Table of ContentsExhibit No. Description of Exhibit 10.31(10) Amended and Restated Director Compensation Policy. 10.32(7) Lease, by and between Transcept and Point Richmond R&D Associates II, LLC, dated as of February 20, 2009. 10.33(7) Offer Letter dated March 4, 2009, by and between Transcept Pharmaceuticals, Inc. and Joseph Kennedy. 10.34(7) Change of Control and Severance Benefits Agreement, by and between Transcept Pharmaceuticals, Inc. and Joseph Kennedy datedMarch 4, 2009. 10.35(9) Form of Indemnification Agreement for officers and non-institutional investor affiliated directors. 10.36(9) Form of Indemnification Agreement for institutional investor affiliated directors. 10.37(11) Change of Control and Severance Benefits Agreement by and between Transcept Pharmaceuticals, Inc. and Nipun Davar, Ph.D. datedApril 30, 2009. 10.38(11) Change of Control and Severance Benefits Agreement by and between Transcept Pharmaceuticals, Inc. and Dennie Dyer dated April30, 2009. 10.39(11) Change of Control and Severance Benefits Agreement by and between Transcept Pharmaceuticals, Inc. and Terrence Moore datedApril 30, 2009. 10.40(11) Change of Control and Severance Benefits Agreement by and between Transcept Pharmaceuticals, Inc. and Glenn A. Oclassen datedApril 30, 2009. 10.41(11) Change of Control and Severance Benefits Agreement by and between Transcept Pharmaceuticals, Inc. and Sharon Sakai, Ph.D.dated April 30, 2009. 10.42(11) Change of Control and Severance Benefits Agreement by and between Transcept Pharmaceuticals, Inc. and Nikhilesh Singh, Ph.D.dated April 30, 2009. 10.43(11) Change of Control and Severance Benefits Agreement by and between Transcept Pharmaceuticals, Inc. and Thomas P. Solowaydated April 30, 2009. 10.44(11) Change of Control and Severance Benefits Agreement by and between Transcept Pharmaceuticals, Inc. and Marilyn E. Wortzmandated April 30, 2009. 10.45(13)† United States License and Collaboration Agreement by and between Transcept Pharmaceuticals, Inc. and Purdue PharmaceuticalProducts L.P. dated July 31, 2009. 10.46(13)† Letter agreement by and between Transcept Pharmaceuticals, Inc. and Purdue Pharmaceutical Products L.P. dated July 31, 2009. 10.47(13)† Letter agreement by and between Transcept Pharmaceuticals, Inc. and LP Clover Limited dated July 31, 2009. 21.1 Subsidiaries of the Registrant. 23.1 Consent of Independent Registered Public Accounting Firm. 31.1 Certification of the Company’s Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of the Company’s Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of the Company’s Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-OxleyAct of 2002. 105 Table of Contents (1)Incorporated by reference from the Registration Statement on Form S-4, Securities and Exchange Commission file number 333-153844, as declaredeffective on December 29, 2008.(2)Incorporated by reference from the Current Report on Form 8-K filed with the Securities and Exchange Commission on February 5, 2009.(3)Incorporated by reference from the Current Report on Form 8-K filed with the Securities and Exchange Commission on February 5, 2009.(4)Incorporated by reference from the Registration Statement on Form S-1, Securities and Exchange Commission file number 333-131741, filed onFebruary 10, 2006.(5)Incorporated by reference from the Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 2, 2007.(6)Incorporated by reference from the Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 17, 2008.(7)Incorporated by reference from the Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 2009.(8)Incorporated by reference from the Current Report on Form 8-K filed with the Securities and Exchange Commission on March 31, 2009.(9)Incorporated by reference from the Current Report on Form 8-K filed with the Securities and Exchange Commission on April 9, 2009.(10)Incorporated by reference from the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on May 15, 2009.(11)Incorporated by reference from the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on August 14, 2009.(12)Incorporated by reference from the Current Report on Form 8-K filed with the Securities and Exchange Commission on June 9, 2009.(13)Incorporated by reference from the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on November 16, 2009.†Confidential treatment has been granted as to certain portions, which portions have been omitted and filed separately with the Securities and ExchangeCommission.(b) ExhibitsSee Exhibits listed under Item 15(a)(3) above.(c) Financial Statement SchedulesFinancial statement schedules are omitted because they are not applicable or are not required or the information required to be set forth therein isincluded in the Financial Statements or notes thereto. 106 Table of ContentsSIGNATURESPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed onits behalf by the undersigned, thereunto duly authorized, in the City of Point Richmond, State of California, on the 30th day of March, 2010. Transcept Pharmaceuticals, Inc.By: /s/ GLENN A. OCLASSEN Glenn A. OclassenPresident and Chief Executive OfficerPOWER OF ATTORNEYKNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints each of Glenn A. Oclassenand Thomas P. Soloway his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and allcapacities, to sign any and all amendments to this annual report on Form 10-K, and to file the same, with all exhibits thereto, and other documents inconnection therewith, with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent, full power and authority to do andperform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could doin person, hereby ratifying and confirming all that said attorney-in-fact and agent, or his substitutes or substitute, may lawfully do or cause to be done byvirtue hereof.IN WITNESS WHEREOF, each of the undersigned has executed this Power of Attorney as of the date indicated opposite his/her name.Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrantand in the capacities and on the dates indicated. Signature Title Date/s/ GLENN A. OCLASSEN Glenn A. Oclassen President, Chief Executive Officer, and Director(Principal Executive Officer) March 30, 2010/s/ THOMAS P. SOLOWAY Thomas P. Soloway Senior Vice President, Operations and ChiefFinancial Officer(Principal Financial Officer) March 30, 2010/s/ MARILYN E. WORTZMAN Marilyn E. Wortzman Vice President, Finance(Principal Accounting Officer) March 30, 2010/s/ CHRISTOPHER B. EHRLICH Christopher B. Ehrlich Director March 30, 2010/s/ THOMAS D. KILEY Thomas D. Kiley Director March 30, 2010/s/ KATHLEEN D. LAPORTE Kathleen D. LaPorte Director March 30, 2010 107 Table of ContentsSignature Title Date/s/ JAKE R. NUNN Jake R. Nunn Director March 30, 2010/s/ G. KIRK RAAB G. Kirk Raab Chairman of the Board of Directors March 30, 2010/s/ FREDERICK J. RUEGSEGGER Frederick J. Ruegsegger Director March 30, 2010/s/ CAMILLE D. SAMUELS Camille D. Samuels Director March 30, 2010/s/ DANIEL K. TURNER III Daniel K. Turner III Director March 30, 2010/s/ JOHN P. WALKER John P. Walker Director March 30, 2010 108 Table of ContentsExhibit Index Exhibit No. Description of Exhibit 2.1(1) Agreement and Plan of Merger and Reorganization, dated as of August 29, 2008, by and among Novacea, Inc. (“Novacea”), PivotAcquisition, Inc. and Transcept Pharmaceuticals, Inc., a privately held corporation that is now named Transcept Pharma, Inc.(“TPI”)and is a wholly-owned subsidiary of Transcept Pharmaceuticals, Inc., a publicly-traded corporation formerly known as Novacea. 2.2(1) Amendment to Agreement and Plan of Merger and Reorganization, dated as of December 23, 2008, by and among Novacea, PivotAcquisition, Inc. and TPI. 3.1(2) Amended and Restated Certificate of Incorporation of Transcept Pharmaceuticals, Inc. 3.2(2) Bylaws of Transcept Pharmaceuticals, Inc., as amended. 4.1(3) Specimen Common Stock certificate of Transcept Pharmaceuticals, Inc. 4.2(3) Form of Preferred Stock Purchase Warrant issued to certain TPI investors as of March 21, 2005. 4.3(3) Preferred Stock Purchase Warrant issued by TPI to Hercules Technology Growth Capital, Inc., dated as of April 13, 2006.10.1(4) Novacea 2001 Stock Option Plan and forms of agreements relating thereto.10.2(5) Novacea 2006 Equity Incentive Plan, as amended, and forms of agreements relating thereto.10.3(3) TPI Amended and Restated 2002 Stock Option Plan and forms of agreements relating thereto.10.4(12) Transcept Pharmaceuticals, Inc. 2009 Employee Stock Purchase Plan.10.5(3) Loan and Security Agreement, by and between Transcept Pharmaceuticals, Inc. and Hercules Technology Growth Capital, Inc. dated asof April 13, 2006.10.6(3) Secured Promissory Note issued to Hercules Technology Growth Capital, Inc., dated as of May 31, 2006.10.7(6) Office Lease, by and between Kashiwa Fudosan America, Inc. and Novacea, dated as of May 15, 2007.10.8(8) Sublease dated as of March 24, 2009 by and between Transcept Pharmaceuticals, Inc. and BiPar Sciences, Inc.10.9(11) Sublease dated for reference purposes as of June 11, 2009 by and between Transcept Pharmaceuticals, Inc. and Bay Area BioscienceAssociation.10.10(3) Lease, by and between TPI and Point Richmond R&D Associates, L.P., dated as of February 22, 2006.10.11(3) First Amendment to Lease, by and between TPI and Point Richmond R&D Associates, L.P., dated as of June 27, 2007.10.12(7) Second Amendment to Lease, by and between Transcept Pharmaceuticals, Inc. and Point Richmond R&D Associates, L.P., dated as ofFebruary 9, 2009.10.13(7) Lease, by and between Transcept and Point Richmond R&D Associates II, LLC, dated as of February 9, 2009.10.14(3)† Supply Agreement, by and between TPI and Plantex USA, Inc., dated as of March 31, 2006.10.15(3)† Letter Agreement, by and between TPI and Plantex USA, Inc., dated as of August 6, 2008. 1 Table of ContentsExhibit No. Description of Exhibit10.16(13)† First Amendment Plantex Supply Agreement dated as of July 31, 2009.10.17(3)† Packaging and Supply Agreement, by and between TPI and Anderson Packaging, Inc., dated as of September 14, 2006.10.18(3)† Amendment to Packaging and Supply Agreement, by and between TPI and Anderson Packaging, Inc., dated as of September 14,2006.10.19(3)† Manufacturing Services Agreement, by and between TPI and Patheon Pharmaceuticals, Inc., dated as of October 6, 2006.10.20(3)† Amendment #1 to Manufacturing Services Agreement, by and between TPI and Patheon Pharmaceuticals, Inc., dated as of January 1,2008.10.21(13) Amendment #2 to Manufacturing Services Agreement, by and between TPI and Patheon Pharmaceuticals, Inc., dated July 29, 2009.10.22(3)† Supply and Sublicense Agreement, by and between TPI and Mikart, Inc., dated as of January 22, 2008.10.23(3)† Manufacturing and Supply Agreement, by and between TPI and Mikart, Inc., dated as of August 21, 2008.10.24(3)† Packaging and Supply Agreement, by and between TPI and Sharp Corporation, dated as of June 16, 2008.10.25(3)† Supply and License Agreement, by and between TPI and SPI Pharma, Inc., dated as of June 27, 2006.10.26(3)† Amendment #1 to Supply and License Agreement, by and between TPI and SPI Pharma, Inc., dated as of March 14, 2008.10.27(3)† Supply Agreement, by and among TPI and SPI Pharma, Inc., dated as of July 23, 2007.10.28(13) Amendment #1 to Supply Agreement by and between Pivot Acquisition, Inc. and SPI Pharma, Inc. dated July 30, 2009.10.29(13)† Amendment #2 to Supply Agreement by and between Pivot Acquisition, Inc. and SPI Pharma, Inc dated July 30, 2009.10.30(3) Offer Letter dated April 15, 2008, by and between TPI and Terrence Moore, including Side Letter dated August 20, 2008 and SideLetter dated December 23, 2008.10.31(10) Amended and Restated Director Compensation Policy.10.32(7) Lease, by and between Transcept and Point Richmond R&D Associates II, LLC, dated as of February 20, 2009.10.33(7) Offer Letter dated March 4, 2009, by and between Transcept Pharmaceuticals, Inc. and Joseph Kennedy.10.34(7) Change of Control and Severance Benefits Agreement, by and between Transcept Pharmaceuticals, Inc. and Joseph Kennedy datedMarch 4, 2009.10.35(9) Form of Indemnification Agreement for officers and non-institutional investor affiliated directors.10.36(9) Form of Indemnification Agreement for institutional investor affiliated directors.10.37(11) Change of Control and Severance Benefits Agreement by and between Transcept Pharmaceuticals, Inc. and Nipun Davar, Ph.D. datedApril 30, 2009. 2 Table of ContentsExhibit No. Description of Exhibit10.38(11) Change of Control and Severance Benefits Agreement by and between Transcept Pharmaceuticals, Inc. and Dennie Dyer dated April30, 2009.10.39(11) Change of Control and Severance Benefits Agreement by and between Transcept Pharmaceuticals, Inc. and Terrence Moore datedApril 30, 2009.10.40(11) Change of Control and Severance Benefits Agreement by and between Transcept Pharmaceuticals, Inc. and Glenn A. Oclassen datedApril 30, 2009.10.41(11) Change of Control and Severance Benefits Agreement by and between Transcept Pharmaceuticals, Inc. and Sharon Sakai, Ph.D. datedApril 30, 2009.10.42(11) Change of Control and Severance Benefits Agreement by and between Transcept Pharmaceuticals, Inc. and Nikhilesh Singh, Ph.D.dated April 30, 2009.10.43(11) Change of Control and Severance Benefits Agreement by and between Transcept Pharmaceuticals, Inc. and Thomas P. Soloway datedApril 30, 2009.10.44(11) Change of Control and Severance Benefits Agreement by and between Transcept Pharmaceuticals, Inc. and Marilyn E. Wortzmandated April 30, 2009.10.45(13)† United States License and Collaboration Agreement by and between Transcept Pharmaceuticals, Inc. and Purdue PharmaceuticalProducts L.P. dated July 31, 2009.10.46(13)† Letter agreement by and between Transcept Pharmaceuticals, Inc. and Purdue Pharmaceutical Products L.P. dated July 31, 2009.10.47(13)† Letter agreement by and between Transcept Pharmaceuticals, Inc. and LP Clover Limited dated July 31, 2009.21.1 Subsidiaries of the Registrant.23.1 Consent of Independent Registered Public Accounting Firm.31.1 Certification of the Company’s Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2 Certification of the Company’s Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1 Certification of the Company’s Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-OxleyAct of 2002. (1)Incorporated by reference from the Registration Statement on Form S-4, Securities and Exchange Commission file number 333-153844, as declaredeffective on December 29, 2008.(2)Incorporated by reference from the Current Report on Form 8-K filed with the Securities and Exchange Commission on February 5, 2009.(3)Incorporated by reference from the Current Report on Form 8-K filed with the Securities and Exchange Commission on February 5, 2009.(4)Incorporated by reference from the Registration Statement on Form S-1, Securities and Exchange Commission file number 333-131741, filed onFebruary 10, 2006.(5)Incorporated by reference from the Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 2, 2007.(6)Incorporated by reference from the Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 17, 2008.(7)Incorporated by reference from the Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 2009.(8)Incorporated by reference from the Current Report on Form 8-K filed with the Securities and Exchange Commission on March 31, 2009. 3 Table of Contents(9)Incorporated by reference from the Current Report on Form 8-K filed with the Securities and Exchange Commission on April 9, 2009.(10)Incorporated by reference from the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on May 15, 2009.(11)Incorporated by reference from the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on August 14, 2009.(12)Incorporated by reference from the Current Report on Form 8-K filed with the Securities and Exchange Commission on June 9, 2009.(13)Incorporated by reference from the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on November 16, 2009.†Confidential treatment has been granted as to certain portions, which portions have been omitted and filed separately with the Securities and ExchangeCommission. 4 Exhibit 21.1Subsidiaries of the RegistrantTranscept Pharma, Inc, a Delaware Corporation Exhibit 23.1Consent of Independent Registered Public Accounting FirmWe consent to the incorporation by reference in the following Registration Statements: (1)Registration Statement (Form S-8 No. 333-135506) pertaining to the Novacea, Inc. 2006 Incentive Award Plan and the Amended 2001Stock Option Plan of Novacea, Inc.; (2)Registration Statement (Form S-8 No. 333-150869) pertaining to the Novacea, Inc. 2006 Incentive Award Plan; (3)Registration Statement (Form S-8 No. 333-157927) pertaining to the Transcept Pharmaceuticals, Inc. 2006 Incentive Award Plan; (4)Registration Statement (Form S-8 No. 333-157929) pertaining to the Transcept Pharmaceuticals, Inc. Amended and Restated 2002 StockOption Plan; (5)Registration Statement (Form S-8 No. 333-160222) pertaining to the Transcept Pharmaceuticals, Inc. 2009 Employee Stock PurchasePlan; (6)Registration Statement (Form S-8 No. 333-164468) pertaining to the Transcept Pharmaceuticals, Inc. 2006 Incentive Award Plan; and (7)Registration Statement (Form S-3 No. 333-145840) and related Prospectus of Novacea, Inc.;of our report dated March 30, 2010, with respect to the consolidated financial statements of Transcept Pharmaceuticals, Inc., included in this Annual Report(Form 10-K) of Transcept Pharmaceuticals, Inc. for the year ended December 31, 2009./s/ Ernst & Young LLPPalo Alto, CaliforniaMarch 30, 2010 Exhibit 31.1Certification of Chief Executive OfficerPursuant to Section 302 of the Sarbanes-Oxley Act of 2002I, Glenn A. Oclassen, certify that: 1.I have reviewed this annual report on Form 10-K of Transcept Pharmaceuticals, Inc.; 2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by thisreport; 3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4.The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f))for the registrant and have: a.Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, toensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within thoseentities, particularly during the period in which this report is being prepared; b.Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under oursupervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements forexternal purposes in accordance with generally accepted accounting principles; c.Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about theeffectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d.Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recentfiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materiallyaffect, the registrant’s internal control over financial reporting; and 5.The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to theregistrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions): a.All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonablylikely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and b.Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controlover financial reporting.Date: March 30, 2010 /s/ GLENN A. OCLASSEN Glenn A. OclassenPresident and Chief Executive Officer(Principal Executive Officer) Exhibit 31.2Certification of Chief Financial OfficerPursuant to Section 302 of the Sarbanes-Oxley Act of 2002I, Thomas P. Soloway, certify that: 1.I have reviewed this annual report on Form 10-K of Transcept Pharmaceuticals, Inc.; 2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by thisreport; 3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4.The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f))for the registrant and have: a.Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, toensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within thoseentities, particularly during the period in which this report is being prepared; b.Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under oursupervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements forexternal purposes in accordance with generally accepted accounting principles; c.Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about theeffectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d.Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recentfiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materiallyaffect, the registrant’s internal control over financial reporting; and 5.The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to theregistrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions): a.All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonablylikely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and b.Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controlover financial reporting.Date: March 30, 2010 /s/ THOMAS P. SOLOWAY Thomas P. SolowaySenior Vice President, Operations andChief Financial Officer(Principal Financial Officer) Exhibit 32.1Certification of Chief Executive Officer and Chief Financial OfficerPursuant to Section 906 of the Sarbanes-Oxley Act of 2002Pursuant to 18 U.S.C. § 1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002, the undersigned officer of Transcept Pharmaceuticals, Inc.(the “Company”) hereby certifies, to such officer’s knowledge, that:(i) the accompanying Annual Report on Form 10-K of the Company for the annual period ended December 31, 2009 (the “Report”) fullycomplies with the requirements of Section 13(a) or Section 15(d), as applicable, of the Securities Exchange Act of 1934, as amended; and(ii) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of theCompany.Date: March 30, 2010 /s/ GLENN A. OCLASSEN Glenn A. OclassenPresident and Chief Executive Officer(Principal Executive Officer)/s/ THOMAS P. SOLOWAY Thomas P. SolowaySenior Vice President, Operations andChief Financial Officer(Principal Financial Officer)

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