Vanda Pharmaceuticals
Annual Report 2012

Plain-text annual report

Table of ContentsUNITED STATES SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549Form 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGEACT OF 1934For the fiscal year ended December 31, 2012 ¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934Commission File No. 001-34186VANDA PHARMACEUTICALS INC.(Exact name of registrant as specified in its charter) Delaware 03-0491827(State or other jurisdiction ofincorporation or organization) (I.R.S. EmployerIdentification No.)2200 Pennsylvania Avenue NW, Suite 300 EWashington D.C. 20037(202) 734-3400(Address and telephone number, including area code, of registrant’s principal executive offices)Securities registered pursuant to Section 12(b) of the Exchange Act: Title of Each Class Name of Each Exchange on Which RegisteredCommon Stock, par value $0.001 The Nasdaq Stock Market LLC(NASDAQ Global Market)Rights to Purchase Series A Junior Participating Preferred Stock The Nasdaq Stock Market LLC(NASDAQ Global Market)Securities registered pursuant to Section 12(g) of the Exchange 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 Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ¨ No Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 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  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, to thebest of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to thisForm 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. Seethe definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer ¨ Accelerated filer  Non-accelerated filer ¨ Smaller reporting company ¨ (Do not check if a smaller reporting company) Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes ¨ No As of June 29, 2012, the aggregate market value of the Common Stock held by non-affiliates of the registrant was approximately $106.2 million basedon the closing price of the registrant’s Common Stock, as reported by the NASDAQ Global Market, on such date. Shares of Common Stock held by eachexecutive officer, director and stockholders known by the registrant to own 10% or more of the outstanding stock based on public filings and otherinformation known to the registrant have been excluded since such persons may be deemed affiliates. This determination of affiliate status is not necessarily aconclusive determination for other purposes.The number of shares of the registrant’s Common Stock, par value $0.001 per share, outstanding as of February 20, 2013 was 28,342,659.The exhibit index as required by Item 601(a) of Regulation S-K is included in Item 15 of Part IV of this report.DOCUMENTS INCORPORATED BY REFERENCESpecified portions of the registrant’s proxy statement with respect to the registrant’s 2013 Annual Meeting of Stockholders, which is to be filed pursuant toRegulation 14A within 120 days after the end of the registrant’s fiscal year ended December 31, 2012, are incorporated by reference into Part III of this Form10-K.Table of ContentsVanda Pharmaceuticals Inc.Form 10-KTable of Contents Page Part I Cautionary Note Regarding Forward-Looking Statements 2 Item 1. Business 3 Item 1A. Risk Factors 19 Item 1B. Unresolved Staff Comments 40 Item 2. Properties 40 Item 3. Legal Proceedings 40 Item 4. Mine Safety Disclosures 40 Part II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 41 Item 6. Selected Consolidated Financial Data 42 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 44 Item 7A. Qualitative and Quantitative Disclosures about Market Risk 56 Item 8. Financial Statements and Supplementary Data 56 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 56 Item 9A. Controls and Procedures 57 Item 9B. Other Information 57 Part III Item 10. Directors, Executive Officers and Corporate Governance 57 Item 11. Executive Compensation 57 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 58 Item 13. Certain Relationships and Related Transactions, and Director Independence 58 Item 14. Principal Accountant Fees and Services 58 Part IV Item 15. Exhibits and Financial Statements Schedules 59 Signatures 60 Exhibits 88 1Table of ContentsPART ICAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTSVarious statements throughout this report are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995.Forward-looking statements may appear throughout this report. Words such as, but not limited to, “believe,” “expect,” “anticipate,” “estimate,” “intend,”“plan,” “project,” “target,” “goal,” “likely,” “will,” “would,” and “could,” or the negative of these terms and similar expressions or words, identify forward-looking statements. Forward-looking statements are based upon current expectations that involve risks, changes in circumstances, assumptions anduncertainties. Important factors that could cause actual results to differ materially from those reflected in our forward-looking statements include, amongothers: • the inability to reach agreement with the U.S. Food and Drug Administration regarding our regulatory approval strategy or proposed path to approvalfor tasimelteon for the treatment of Non-24-Hour Disorder (Non-24); • the failure to obtain regulatory approval for our products or product candidates, particularly tasimelteon for the treatment of Non-24, or to complywith ongoing regulatory requirements; • a loss of rights to develop and commercialize our products, product candidates or partnered products under our license and sublicense agreements. • our failure to develop or obtain sales, marketing and distribution resources and expertise or to otherwise manage our growth; • the extent and effectiveness of the development, sales and marketing and distribution support Fanapt receives; • our ability to successfully commercialize Fanapt outside of the U.S. and Canada; • delays in the completion of our or our partners’ clinical trials; • a failure of our products, product candidates or partnered products to be demonstrably safe and effective; • a lack of acceptance of our products, product candidates or partnered products in the marketplace, or a failure to become or remain profitable; • our expectations regarding trends with respect to our revenues, costs, expenses and liabilities; • our inability to obtain the capital necessary to fund our research and development or commercial activities; • our failure to identify or obtain rights to new products or product candidates; • limitations on our ability to utilize some or all of our prior net operating losses and research and development credits; • a loss of any of our key scientists or management personnel; and • losses incurred from product liability claims made against us.All written and verbal forward-looking statements attributable to us or any person acting on our behalf are expressly qualified in their entirety by thecautionary statements contained or referred to in this section. We caution investors not to rely too heavily on the forward-looking statements we make or that aremade on our behalf. We undertake no obligation, and specifically decline any obligation, to update or revise publicly any forward-looking statements, whetheras a result of new information, future events or otherwise.We encourage you to read management’s discussion and analysis of our financial condition and results of operations and our consolidated financialstatements contained in this annual report on Form 10-K. We also encourage you to read Item 1A of Part 1 of this annual report on Form 10-K, entitled “RiskFactors,” which contains a more complete discussion of the risks and uncertainties associated with our business. In addition to the risks described above andin Item 1A of this report, other unknown or unpredictable factors also could affect our results. Therefore, the information in this report should be read togetherwith other reports and documents that 2®®Table of Contentswe file with the Securities and Exchange Commission (SEC) from time to time, including on Form 10-Q and Form 8-K, which may supplement, modify,supersede or update those risk factors. There can be no assurance that the actual results or developments anticipated by us will be realized or, even ifsubstantially realized, that they will have the expected consequences to, or effects on, us. Therefore no assurance can be given that the outcomes stated in suchforward-looking statements and estimates will be achieved. ITEM 1.BUSINESSOverviewVanda Pharmaceuticals Inc. (we, Vanda or the Company) is a biopharmaceutical company focused on the development and commercialization ofproducts for the treatment of central nervous system disorders. We believe that each of our products and partnered products will address markets withsignificant unmet medical needs. Our product portfolio includes tasimelteon, a compound for the treatment of circadian rhythm sleep disorders (CRSD),which is currently in clinical development for Non-24, Fanapt, a compound for the treatment of schizophrenia, the oral formulation of which is currentlybeing marketed and sold in the U.S. by Novartis Pharma AG (Novartis), and VLY-686, a small molecule neurokinin-1 receptor (NK-1R) antagonist.Throughout this annual report on Form 10-K, we refer to Fanapt within the U.S. and Canada as our partnered product and we refer to Fanapt outsidethe U.S. and Canada, tasimelteon and VLY-686 as our products. All other compounds are referred to herein as our product candidates. In addition, we refer toour partnered products, products and product candidates collectively as our compounds. Moreover, we refer to drug products generally as drugs or products.Since we began our operations in March 2003, we have devoted substantially all of our resources to the in-licensing and clinical development of ourcompounds. Our ability to generate revenue and achieve profitability largely depends on our ability, alone or with others, to complete the development of ourproducts or product candidates, and to obtain the regulatory approvals for and manufacture, market and sell our products and product candidates, includingtasimelteon for the treatment of Non-24-Hour Disorder (Non-24) and Novartis’ ability to successfully commercialize Fanapt in the U.S. The results of ouroperations will vary significantly from year-to-year and quarter-to-quarter and depend on a number of factors, including risks related to our business, risksrelated to our industry, and other risks which are detailed in Item 1A of Part I of this annual report on Form 10-K, entitled “Risk Factors.”Our activities will necessitate significant uses of working capital throughout 2013 and beyond. We are currently concentrating our efforts on thedevelopment of tasimelteon for the treatment of Non-24 and the preparation of a New Drug Application (NDA) for tasimelteon for the treatment of Non-24 thatwe plan to file with the U.S. Food and Drug Administration (FDA) in mid-2013. Additionally, we and our partners continue to pursue market approval ofFanapt in a number of foreign jurisdictions, with Israel and Argentina having already approved Fanapt for the treatment of schizophrenia.Our founder and Chief Executive Officer, Mihael H. Polymeropoulos, M.D., started our operations early in 2003 after establishing and leading thePharmacogenetics Department at Novartis. In acquiring and developing our compounds, we have relied upon our deep expertise in the scientific disciplines ofpharmacogenetics and pharmacogenomics. These scientific disciplines examine both genetic variations among people that influence response to a particulardrug, and the multiple pathways through which drugs affect people.Our products target prescription markets with significant unmet medical needs. We believe that tasimelteon may represent an important new treatmentoption for patients with CRSDs based on its potential to be the first compound approved as a circadian regulator with a demonstrated ability to reset the masterbody clock and align it to a constant 24-hour day. We believe that Fanapt may address some of the shortcomings of other currently available drugs, based onits observed safety profile. 3®®®®®®®Table of ContentsOur strategyOur goal is to create a leading biopharmaceutical company focused on developing and commercializing products that address critical unmet medicalneeds relating to central nervous system disorders through the application of our drug development expertise and our pharmacogenetics and pharmacogenomicsexpertise. The key elements of our strategy to accomplish this goal are to: • Pursue the clinical development and regulatory approval of our products and product candidates. We believe that Vanda has built a team ofcapable drug developers that can take products through the development and regulatory processes towards our goal of regulatory approval in marketsacross the world. In markets where we do not have local expertise, we will leverage partners or consultants to assist towards us. • Establish our capability to commercialize products. We intend to establish a commercial capability to market our products in certain indicationsand geographies. Vanda has begun to hire experienced sales and marketing professionals to enable the commercialization of our products. • Enter into partnerships to supplement our capabilities and to extend our commercial reach. We intend to build commercial relationships toboth supplement our capabilities in markets where we lead commercialization and to make our products available in markets where we do not intendto lead commercialization. • Apply our pharmacogenetics and pharmacogenomics expertise to differentiate our products and product candidates. We believe that ourpharmacogenetics and pharmacogenomics expertise will yield new insights into our products and product candidates. These insights may enable usto target our products and product candidates to certain patient populations and to identify unexpected conditions for our products and productcandidates to treat. • Expand our product portfolio through the identification and acquisition of additional compounds. We intend to continue to draw upon ourclinical development expertise and pharmacogenetics and pharmacogenomics expertise to identify and pursue the acquisition of additional clinical-stage compounds.Products and partnered productsWe have the following products and partnered products on the market or in clinical development: Product or Partnered Product Target Indications Select MilestonesTasimelteon Circadian RhythmSleep Disorders Phase III trial (SET Study) for Non-24 completed in December2012;Phase III trial (RESET Study) for Non-24 completed in January2013;Two ongoing open label safety studies Major DepressiveDisorder (MDD) Phase IIb/III trial (MAGELLAN) completed in January 2013 Insomnia Phase III trial for transient insomnia completed in 2006;Phase III trial for chronic primary insomnia completed in 2008Fanapt (Oral) Schizophrenia FDA approval in May 2009;Commercial rights in the U.S. and Canada sublicensed toNovartis in October 2009;Launched in the U.S. by Novartis in January 2010Fanapt (Injectable) Schizophrenia Phase II trial initiated by Novartis in 2011;Novartis has ceased the further clinical development of thisformulation 4®®Table of ContentsTasimelteonTasimelteon is a circadian regulator in development for the treatment of Non-24. Tasimelteon is a melatonin agonist of the human MT1 and MT2receptors, with greater specificity for MT2. Tasimelteon’s ability to reset the master body clock in the suprachiasmatic nucleus (SCN), located in thehypothalamus, results in the entrainment of the body’s melatonin and cortisol rhythms to align to the 24-hour day-night cycle. In December 2012 and January2013, we announced positive results for two Phase III studies for tasimelteon in the treatment of Non-24. The SET Phase III study demonstrated thattasimelteon was able to entrain the master body clock as measured by melatonin and cortisol circadian rhythms. Tasimelteon was also shown to significantlyimprove clinical symptoms across a number of sleep and wake measures. These results provided robust evidence of direct and clinically meaningful benefitsto patients with Non-24. The RESET Phase III study demonstrated the maintenance effect of 20 milligrams (mg) of tasimelteon to entrain melatonin andcortisol circadian rhythms in individuals with Non-24. Patients treated with tasimelteon maintained their clinical benefits while patients receiving placeboshowed significant deterioration in measures of nighttime sleep, daytime naps and timing of sleep. The tasimelteon Non-24 program continues towards its goalof a projected mid-2013 NDA filing with the FDA. We will meet with the FDA in the first quarter of 2013 for a pre-NDA meeting on tasimelteon in thetreatment of patients with Non-24.In January 2010, the FDA granted orphan drug designation status for tasimelteon in Non-24 in blind individuals without light perception. The FDAgrants orphan drug designation to drugs that may provide significant therapeutic advantage over existing treatments and target conditions affecting 200,000 orfewer U.S. patients per year. Orphan drug designation provides potential financial and regulatory incentives, including study design assistance, tax credits,waiver of FDA user fees, and up to seven years of market exclusivity upon marketing approval. In February 2011, the European Medicines Agency (EMA)designated tasimelteon as an orphan medicinal product for the same indication.Tasimelteon has also been studied in Major Depressive Disorder (MDD) and insomnia.Therapeutic opportunitySleep disorders are segmented into three major categories: primary insomnia, secondary insomnia and CRSDs. Insomnia is a symptom complex thatcomprises difficulty falling asleep or staying asleep, or non-refreshing sleep, in combination with daytime dysfunction or distress. The symptom complex canbe an independent disorder (primary insomnia) or be a result of another condition such as depression or anxiety (secondary insomnia). CRSDs result from amisalignment of the sleep/wake cycle and an individual’s daily activities or lifestyle. The circadian rhythm is the rhythmic output of the human biologicalclock and is governed by the hormones melatonin and cortisol. Both the timing of behavioral events (activity, sleep, and social interactions) and theenvironmental light/dark cycle result in a sleep/wake cycle that follows the circadian rhythm. Examples of CRSDs include transient disorders such as jet lagand chronic disorders such as shift work sleep disorder and Non-24. Non-24 is a serious, rare circadian rhythm disorder that affects a majority of totallyblind individuals who lack light perception and cannot entrain (reset) their master body clock to the 24-hour day. Based on market research we haveconducted with LEK Consulting, we believe that CRSDs represent a significant portion of the market for sleep disorders.While there are no FDA-approved treatments for CRSDs, there are a number of drugs approved and prescribed for patients with sleep disorders. Themost commonly prescribed drugs are hypnotics, such as generic zolpidem, Ambien (zolpidem) by sanofi-aventis (including Ambien CR), Lunesta(eszopiclone) by Dainippon Sumitomo Pharma, Sonata (zaleplon) by Pfizer Inc. and Silenor (doxepin) by Somaxon Pharmaceuticals, Inc. Hypnotics workby acting upon a set of brain receptors known as GABA receptors, which are separate and distinct from the melatonin receptors to which tasimelteon binds.Several drugs in development also utilize a mechanism of action involving binding to GABA receptors. Members of the benzodiazapine class of sedatives arealso approved for insomnia, but their usage has declined due to an inferior safety profile compared to hypnotics. Anecdotal evidence also suggests that sedativeantidepressants, such as trazodone and doxepin, are prescribed off-label for insomnia. FDA approved drugs for the treatment of insomnia also includeRozerem (ramelteon) by Takeda Pharmaceuticals Company Limited, a compound with a mechanism of action 5®®®®®®Table of Contentssimilar to tasimelteon. The class of melatonin agonists includes Rozerem (ramelteon) by Takeda Pharmaceuticals Company Limited, Valdoxan (agemelatine)by Servier, Circadin (long-acting melatonin) by Neurim Pharmaceuticals and the food supplement melatonin.Limitations of current treatmentsWe believe that each of the drugs currently used to treat sleep disorders has inherent limitations that leave CRSD patients underserved. The keylimitations include the potential for abuse, significant side effects, and a failure to address the underlying causes of CRSDs: • We believe that none of the drugs used and approved for sleep disorders, other than Rozerem, work through the body’s natural sleep/wake cycle,which is governed by melatonin. We believe that, for patients whose sleep disruption is due to a misalignment of this sleep/wake cycle (as is the casein CRSD), a drug that naturally modulates the sleep/wake cycle would be an attractive new alternative because it would address the underlying causeof the sleeplessness, rather than merely addressing its symptoms. • Many of the products prescribed commonly for sleep disorders, including Ambien, Lunesta, and Sonata, are classified as Schedule IV controlledsubstances by the United States Drug Enforcement Administration (DEA) due to their potential for abuse, tolerance and withdrawal symptoms.Drugs that are classified as Schedule IV controlled substances are subject to restrictions on how such drugs are prescribed and dispensed. • Many drugs approved for and used in sleep disorders also induce a number of nuisance side effects beyond the more serious abuse and addictioneffects associated with most approved products. These side effects include next-day grogginess, memory loss, unpleasant taste, dry mouth andhormonal changes.Potential advantages of tasimelteonWe believe that tasimelteon may represent a breakthrough treatment option for patients with CRSDs based on the compound’s demonstrated ability toreset the master body clock and align it with the 24-hour day. We believe that tasimelteon is unlikely to be scheduled as a controlled substance by the DEAbecause Rozerem, which has a similar mechanism of action to tasimelteon, was shown not to have potential for abuse and was not classified as a ScheduleIV controlled substance by the DEA. Tasimelteon also appears to be safe and well-tolerated, with no significant side effects or effects on next-day performance.Overview of Phase III clinical trials for Non-24In December 2012, we reported positive top-line results in a randomized, double-blind, multi-center, placebo-controlled Phase III trial (SET study) thatenrolled 84 patients. Tasimelteon succeeded in the primary endpoint of entrainment of the melatonin (aMT6s) rhythm as compared to placebo. Additionally,tasimelteon demonstrated significant improvements across a number of sleep and wake parameters including measures of total sleep time, nap duration, andtiming of sleep. Tasimelteon also showed significant improvements over placebo in the Non-24 Clinical Response Scale (N24CRS) as well as in the ClinicalGlobal Impression of Change (CGI-C), an overall global functioning scale. These results provide robust evidence of a direct and clinically meaningful benefitto patients with Non-24. In the SET study, tasimelteon was demonstrated to be safe and well tolerated. The trial examined 20mg of tasimelteon dosed 30minutes before bedtime versus placebo. The SET study was an 84 patient randomized, double-masked, placebo-controlled study in patients with Non-24. Theprimary endpoints for this study were entrainment of the melatonin (aMT6s) rhythm to the 24-hour clock and Clinical Response as measured by entrainmentplus a score of greater than or equal to 3 on N24CRS.In January 2013, we announced positive results for the second Phase III study of tasimelteon for the treatment of Non-24. The RESET studydemonstrated the maintenance effect of 20mg of tasimelteon to entrain melatonin and cortisol circadian rhythms in individuals with Non-24. Patients treatedwith tasimelteon maintained their clinical benefits while patients receiving placebo showed significant deterioration in measures of nighttime sleep, daytimenaps, and timing of sleep. The RESET study was a 20 patient randomized withdrawal 6®®®®®®®®Table of Contentsstudy designed to demonstrate the maintenance effect of 20mg of tasimelteon in the treatment of blind individuals with Non-24. Patients were treated withtasimelteon for three months during an open-label run-in phase. Patients who responded to tasimelteon treatment during the run-in phase, as measured byentrainment of the melatonin rhythm (aMT6s) to the 24-hour day, were then randomized to receive either placebo or continue receiving tasimelteon 20mg for 2months. The primary endpoint of the study was the maintenance of effect as measured by entrainment of the melatonin (aMT6s) rhythm.Two open-label safety studies are ongoing for tasimelteon in Non-24. The 3202 and 3204 clinical trials are open-label, multicenter, studies in blindsubjects with Non-24 to assess the safety of tasimelteon. The tasimelteon Non-24 program continues towards its goal of a projected mid-2013 NDA filing withthe FDA. We will meet with the FDA in the first quarter of 2013 for a pre-NDA meeting on tasimelteon in the treatment of patients with Non-24.Overview of Phase III clinical trials for insomniaIn November 2006, we reported positive top-line results in a randomized, double-blind, multi-center, placebo-controlled Phase III trial that enrolled 412adults in a sleep laboratory setting using a phase-advance, first-night assessment model of induced transient insomnia. The trial examined tasimelteon dosed30 minutes before bedtime at 20mg, 50mg and 100mg versus placebo.Tasimelteon achieved significant results in multiple endpoints, demonstrating a benefit in both sleep onset, or time to fall asleep, and sleep maintenance,or ability to stay asleep. Based on these trial results, we believe that tasimelteon will compare favorably to efficacy achieved by currently approved insomniadrugs. The Phase III trial also demonstrated that tasimelteon was safe and well-tolerated, with no significant side effects versus placebo and no impairment ofnext-day performance or mood.In June 2008, we reported positive top-line results in a randomized, double-blind, placebo-controlled Phase III trial in chronic primary insomnia thatenrolled 324 patients. The trial examined tasimelteon at 20mg and 50mg versus placebo over a period of 35 days. The trial measured time to fall asleep andsleep maintenance, as well as next-day performance.Overview of Phase IIb/ III clinical trials for major depressive disorderIn January 2013, Vanda reported top-line results of the Phase IIb/III clinical study (MAGELLAN) in MDD, investigating the efficacy and safety oftasimelteon as a monotherapy in the treatment of patients with MDD. The clinical study did not meet the primary endpoint of change from baseline in theHamilton Depression Scale (HAMD-17) after 8 weeks of treatment as compared to placebo. Tasimelteon was shown to be safe and well-tolerated, consistentwith observations in prior studies. Based on these proof of concept clinical study results, Vanda decided to discontinue all activities in this indication.MAGELLAN was a proof of concept, two arm (tasimelteon 20mg and placebo), 8-week, double-masked, randomized, phase IIb/III clinical study in patientswith MDD. The study enrolled 507 patients in 43 sites in the U.S.Intellectual propertyTasimelteon and its formulations, genetic markers and uses are covered by a total of 11 patent and patent application families worldwide. The primarynew chemical entity patent covering tasimelteon expires normally in 2017 in the U.S. and in most European markets. We believe that, like Fanapt,tasimelteon will meet the various criteria of the Hatch-Waxman Act and will receive five additional years of patent protection in the U.S., which would extendits new chemical entity patent protection in the U.S. until 2022. In Europe, data exclusivity will protect tasimelteon for at least ten years from approval.Outside the U.S. and Europe, data exclusivity will protect tasimelteon from generic competition for varying number of years depending on the country.Additional patent applications directed to specific sleep disorders and to methods of administration, if issued, would provide exclusivity for such indicationsand methods of administration. Patent applications directed to the treatment of Non-24, if granted, would provide exclusivity for this indication until at least2033.Our rights to the new chemical entity patent covering tasimelteon and related intellectual property have been acquired through a license with Bristol-Myers Squibb Company (BMS). Please see “License agreements” below for a discussion of this license. 7®Table of ContentsFanaptFanapt is a compound for the treatment of schizophrenia. In May 2009, the FDA granted U.S. marketing approval of Fanapt for the acute treatment ofschizophrenia in adults. On October 2009, we entered into an amended and restated sublicense agreement with Novartis. We had originally entered into asublicense agreement with Novartis in June 2004 pursuant to which we obtained certain worldwide exclusive licenses from Novartis relating to Fanapt.Pursuant to the amended and restated sublicense agreement, Novartis has exclusive commercialization rights to all formulations of Fanapt in the U.S. andCanada. In January 2010, Novartis launched Fanapt in the U.S. Novartis is responsible for the further clinical development activities in the U.S. andCanada, including the development of a long-acting injectable (or depot) formulation of Fanapt. In October 2012, Novartis informed us that it had determinedto cease the development of the long-acting injectable (or depot) formulation of Fanapt.We continue to explore the regulatory path and commercial opportunity for Fanapt oral formulation outside of the U.S. and Canada. In December 2012,the European Medicines Agency’s (EMA) Committee for Medicinal Product for Human Use (CHMP) issued a negative opinion recommending againstapproval of Fanaptum™ (oral iloperidone tablets) for the treatment of schizophrenia in adult patients in the European Union. The CHMP was of the opinionthat the benefits of Fanaptum™ did not outweigh its risks and recommended against marketing authorization at this point in time. In January 2013, weformally appealed the EMA’s negative opinion and requested a re-examination of the decision by the CHMP. We have entered into agreements with the followingpartners for the commercialization of Fanapt in the countries set forth below: Country PartnerMexico Probiomed S.A. de C.V.Israel Megapharm Ltd.In August 2012, the Israeli Ministry of Health granted market approval for Fanapt for the treatment of schizophrenia. In November 2012, we werenotified, that Fanapt had been granted market approval in Argentina for the treatment of schizophrenia.Our rights to the new chemical entity patent covering Fanapt and related intellectual property have been acquired through a license with Novartis. Pleasesee “License agreements” below for a discussion of this license.Therapeutic opportunitySchizophrenia is a chronic, debilitating mental disorder characterized by hallucinations, delusions, racing thoughts and other psychotic symptoms(collectively referred to as “positive symptoms”), as well as moodiness, anhedonia (inability to feel pleasure), loss of interest, eating disturbances andwithdrawal (collectively referred to as “negative symptoms”), and additionally attention and memory deficits (collectively referred to as “cognitivesymptoms”). Schizophrenia develops in late adolescence or early adulthood in approximately 1% of the world’s population. Most schizophrenia patients todayare treated with drugs known as “atypical” antipsychotics, which were first approved in the U.S. in the late 1980s. These antipsychotics have been named“atypical” for their ability to treat a broader range of negative symptoms than the first-generation “typical” antipsychotics, which were introduced in the 1950sand are now generic. Atypical antipsychotics are generally regarded as having improved side effect profiles and efficacy relative to typical antipsychotics andcurrently comprise approximately 90% of schizophrenia prescriptions. Currently approved atypical antipsychotics include, in addition to Fanapt, Risperdal(risperidone), including the depot formulation Risperdal Consta, and Invega (paliperidone), including the depot formulation Invega Sustenna™, each byOrtho-McNeil-Janssen Pharmaceuticals, Inc., Zyprexa (olanzapine), including the depot formulation Zyprexa Relprevv™, by Eli Lilly and Company,Seroquel (quetiapine) by AstraZeneca PLC, Abilify (aripiprazole) by BMS/Otsuka Pharmaceutical Co., Ltd., Geodon (ziprasidone) by Pfizer Inc.,Saphris (asenapine) by Schering-Plough, Latuda (lurasidone) by Dainippon Sumitomo Pharma, and generic clozapine.The long-acting injectable (or depot) formulation of Fanapt is administered once every four weeks and we believe will be a compelling complement to theoral formulation for both physicians and patients. Novartis conducted a two-month Phase I/IIa safety trial of this formulation in schizophrenia patients, inwhich it 8®®®®®®®®®®®®®®®®®®®®®®®®®®®Table of Contentsdemonstrated the benefit of consistent release over a four-week time period with no greater side effects relative to oral dosing. In October 2012, Novartisinformed us that it had determined to cease the development of the depot formulation.Intellectual propertyFanapt and its metabolites, formulations, genetic markers and uses are covered by a total of 18 patent and patent application families worldwide. Theprimary new chemical entity patent covering Fanapt was set to expire normally in 2011 in the U.S. and expired in 2010 in major markets outside the U.S. Inthe U.S., the United States Drug Price Competition and Patent Term Restoration Act of 1984, more commonly known as the “Hatch-Waxman Act” providesfor an extension of new chemical entity patents for a period of up to five years following the expiration of the patent covering that compound to compensate fortime spent in development. Fanapt has qualified for the full five-year patent term extension and so the term of the new chemical entity patent in the U.S. hasbeen extended until November 2016. In addition, we expect that Fanapt will be eligible for six months of pediatric exclusivity potentially extending the term ofthe new chemical entity patent in the U.S. until May 2017. In Europe, statutes provide for ten years of data exclusivity (with the potential for an additionalyear if the drug is developed for a significant new indication). No generic versions of Fanapt would be permitted to be marketed or sold during this 10-year (or11-year) period in most European countries. Consequently, assuming that pediatric exclusivity is granted by the FDA and that we receive regulatory approvalin Europe, we expect that Novartis’ rights to commercialize Fanapt will be exclusive until May 2017 in the U.S. and our rights to commercialize Fanapt willbe exclusive for at least 10 years from approval in Europe. Outside the U.S. and Europe, data exclusivity will protect Fanapt from generic competition forvarying numbers of years depending upon the country. The patent for the microsphere long-acting injectable (or depot) formulation of Fanapt expires in 2024in the U.S. and 2022 in most of the major markets in Europe. The pending patent application for the aqueous microcrystals long acting injectable (or depot)formulation of Fanapt will expire in 2023 in the U.S. The patent for the aqueous microcrystals long acting injectable (or depot) formulation of Fanapt willexpire in 2023 in most of the major markets in Europe. Several other patent applications covering metabolites, uses, formulations and genetic markers relatingto Fanapt extend beyond 2020.We acquired worldwide, exclusive rights to the new chemical entity patent covering Fanapt and certain related intellectual property from Novartis undera sublicense agreement we entered into in 2004, which was amended and restated in 2009. Please see “License agreements” below for a more completedescription of the rights we acquired from and relinquished to Novartis with respect to Fanapt.VLY-686VLY-686 is an NK-1R antagonist that we licensed from Eli Lilly and Company (Lilly) in April 2012. NK-1R antagonists have been evaluated in anumber of indications including chemotherapy-induced nausea and vomiting (CINV), post-operative nausea and vomiting (PONV), alcohol dependence,anxiety, depression and pruritus. We are currently examining the clinical and commercial profile of VLY-686. This strategic evaluation will further informpotential indications for an early development clinical program.Intellectual propertyVLY-686 is covered by a total of three patent and patent application families worldwide. The new chemical patent covering VLY-686 expires in April2023, except in the U.S., where it expires in June 2024 absent any applicable patent term adjustments.License agreementsOur rights to develop and commercialize our products and product candidates are subject to the terms and conditions of licenses granted to us by otherpharmaceutical companies.TasimelteonIn February 2004, we entered into a license agreement with BMS under which we received an exclusive worldwide license under certain patents andpatent applications, and other licenses to intellectual property, to develop and commercialize tasimelteon. In partial consideration for the license, we paid BMSan initial license 9®®®®®®®®®®®®®®Table of Contentsfee of $0.5 million. We made a milestone payment to BMS of $1.0 million under this license agreement in 2006 relating to the initiation of our first Phase IIIclinical trial for tasimelteon. We would be obligated to make future milestone payments to BMS and Massachusetts General Hospital (MGH) of less than $40.0million in the aggregate (the majority of which are tied to sales milestones). In the event that a tasimelteon NDA is accepted for filing by the FDA, we will incurmilestone obligations of $3.8 million. Additionally, we would be obligated to make royalty payments based on the net sales of tasimelteon at a rate which, as apercentage of net sales, is in the low teens. We would also be obligated under this license agreement to pay BMS a percentage of any sublicense fees, upfrontpayments and milestone and other payments (excluding royalties) that we receive from a third party in connection with any sublicensing arrangement, at a ratewhich is in the mid-twenties. We have agreed with BMS in our license agreement for tasimelteon to use our commercially reasonable efforts to develop andcommercialize tasimelteon and to meet certain milestones in initiating and completing certain clinical work.The license agreement with BMS was amended in May 2012 to, among other things, extend the deadline by which we must enter into a development andcommercialization agreement with a third party for tasimelteon until the earliest of: (i) the date mutually agreed upon by BMS and us following the provisionby us to BMS of a full written report of the Phase III clinical studies on which we intend to rely for filing for marketing authorization for tasimelteon in its firstmajor market country (Phase III report); (ii) the date of the acceptance by a regulatory authority of the filing by us for marketing authorization for tasimelteonin a major market country following the provision by us to BMS of the Phase III report; or (iii) December 31, 2013.If we have not entered into a development and commercialization agreement with respect to certain major market countries by the foregoing deadline, thenBMS will have the option to exclusively develop and commercialize tasimelteon on its own in those countries not covered by such an agreement on pre-determined financial terms, including milestone and royalty payments. In addition to the foregoing, pursuant to the May 2012 amendment, our deadline forfiling an NDA with the FDA for tasimelteon was extended until January 1, 2014.Either party may terminate the tasimelteon license agreement under certain circumstances, including a material breach of the agreement by the other. Inthe event that BMS has not exercised its option to reacquire the rights to tasimelteon and we terminate our license, or if BMS terminates our license due to ourbreach, all rights licensed and developed by us under this agreement will revert or otherwise be licensed back to BMS on an exclusive basis.FanaptWe acquired exclusive worldwide rights to patents and patent applications for Fanapt through a sublicense agreement with Novartis. A predecessorcompany of sanofi-aventis, Hoechst Marion Roussel, Inc. (HMRI), discovered Fanapt and completed early clinical work on the compound. In 1996,following a review of its product portfolio, HMRI licensed its rights to the Fanapt patents and patent applications to Titan Pharmaceuticals, Inc. (Titan) on anexclusive basis. In 1997, soon after it had acquired its rights, Titan sublicensed its rights to Fanapt on an exclusive basis to Novartis. In June 2004, weacquired exclusive worldwide rights to these patents and patent applications as well as certain Novartis patents and patent applications to develop andcommercialize Fanapt through a sublicense agreement with Novartis.In October 2009, we entered into an amended and restated sublicense agreement with Novartis which amended and restated our June 2004 sublicenseagreement with Novartis relating to Fanapt. Pursuant to the amended and restated sublicense agreement, Novartis has exclusive commercialization rights to allformulations of Fanapt in the U.S. and Canada. Novartis began selling Fanapt in the U.S. during the first quarter of 2010. Novartis is responsible for thefurther clinical development activities in the U.S. and Canada, including the development of a long-acting injectable (or depot) formulation of Fanapt. InOctober 2012, Novartis informed us that it had determined to cease the development of the long-acting injectable (or depot) formulation of Fanapt. Pursuant tothe amended and restated sublicense agreement, we received an upfront payment of $200.0 million and are eligible for additional payments totaling up to$265.0 million upon the achievement of certain commercial and development milestones for Fanapt in the U.S. and Canada. Based on the current salesperformance of Fanapt in the U.S. and the decision by Novartis to cease development of the long-acting injectable (or depot) formulation of Fanapt, we expectthat some or all of these commercial and development 10®®®®®®®®®®®®®®Table of Contentsmilestones will not be achieved by Novartis. We also receive royalties, which, as a percentage of net sales, are in the low double-digits, on net sales of Fanaptin the U.S. and Canada. We retain exclusive rights to Fanapt outside the U.S. and Canada and we have exclusive rights to use any of Novartis’ data forFanapt for developing and commercializing Fanapt outside the U.S. and Canada. At Novartis’ option, we will enter into good faith discussions withNovartis relating to the co-commercialization of Fanapt outside of the U.S. and Canada or, alternatively, Novartis will receive a royalty on net sales ofFanapt outside of the U.S. and Canada.We may lose our rights to develop and commercialize Fanapt outside the U.S. and Canada if we fail to comply with certain requirements in theamended and restated sublicense agreement regarding our financial condition, or if we fail to comply with certain diligence obligations regarding ourdevelopment or commercialization activities or if we otherwise breach the amended and restated sublicense agreement and fail to cure such breach. Our rights todevelop and commercialize Fanapt outside the U.S. and Canada may be impaired if we do not cure breaches by Novartis of similar obligations contained inits sublicense agreement with Titan for Fanapt. In addition, if Novartis breaches the amended and restated sublicense agreement with respect to itscommercialization activities in the U.S. or Canada, we may terminate Novartis’ commercialization rights in the applicable country and we would no longerreceive royalty payments from Novartis in connection with such country in the event of such termination.VLY-686In April 2012, we entered into a license agreement with Lilly pursuant to which we acquired an exclusive worldwide license under certain patents andpatent applications, and other licenses to intellectual property, to develop and commercialize an NK-1R antagonist, VLY-686, for all human indications.Pursuant to the agreement, we paid Lilly an initial license fee of $1.0 million and we will be responsible for all development costs. Lilly is also eligible toreceive additional payments based upon achievement of specified development and commercialization milestones as well as tiered-royalties on net sales atpercentage rates up to the low double digits. These milestones include $4.0 million for pre-NDA approval milestones and up to $95.0 million for futureregulatory approval and sales milestones. We have agreed to use commercially reasonable efforts to develop and commercialize VLY-686.Either party may terminate the agreement under certain circumstances, including a material breach of the agreement by the other. In the event that weterminate the agreement, or if Lilly terminates the agreement due to our breach or for certain other reasons set forth in the agreement, all rights licensed anddeveloped by us under the agreement will revert or otherwise be licensed back to Lilly on an exclusive basis, subject to payment by Lilly to us of a royalty onnet sales of products that contain VLY-686.Government regulationGovernment authorities in the U.S., at the federal, state and local level, as well as foreign countries and local foreign governments, regulate the research,development, testing, manufacture, labeling, promotion, advertising, distribution, sampling, marketing, import and export of our products. Other thanFanapt in the U.S., Israel and Argentina, all of our compounds will require regulatory approval by government agencies prior to commercialization. Inparticular, human pharmaceutical products are subject to rigorous pre-clinical and clinical trials and other approval procedures of the FDA and similarregulatory authorities in foreign countries. The process of obtaining these approvals and the subsequent compliance with appropriate domestic and foreignlaws, rules and regulations require the expenditure of significant time and human and financial resources.United States government regulationFDA approval processIn the U.S., the FDA regulates drugs under the Federal Food, Drug and Cosmetic Act, as amended, and implements regulations. If we fail to complywith the applicable requirements at any time during the product development process, approval process, or after approval, we may become subject toadministrative or judicial sanctions. These sanctions could include the FDA’s refusal to approve pending applications, withdrawals of approvals, clinicalholds, warning letters, product recalls, product seizures, total or partial suspension of our operations, injunctions, fines, civil penalties or criminalprosecution. Any such sanction could have a material adverse effect on our business. 11®®®®®®®®®®Table of ContentsThe steps required before a drug may be marketed in the U.S. include: • pre-clinical laboratory tests, animal studies and formulation studies under Current Good Laboratory Practices (cGLP); • submission to the FDA of an investigational new drug application, or IND, which must become effective before human clinical trials may begin; • execution of adequate and well-controlled clinical trials to establish the safety and efficacy of the drug for each indication for which approval issought; • submission to the FDA of an NDA; • satisfactory completion of an FDA inspection of the manufacturing facility or facilities at which the drug is produced to assess compliance withCurrent Good Manufacturing Practices (cGMP); and • FDA review and approval of the NDA.Pre-clinical studies generally are conducted in laboratory animals to evaluate the potential safety and activity of a drug. Violation of the FDA’s cGLPregulations can, in some cases, lead to invalidation of the studies, requiring these studies to be replicated. In the U.S., drug developers submit the results ofpre-clinical trials, together with manufacturing information and analytical and stability data, to the FDA as part of the IND, which must become effectivebefore clinical trials can begin in the U.S. An IND becomes effective 30 days after receipt by the FDA unless before that time the FDA raises concerns orquestions about issues such as the proposed clinical trials outlined in the IND. In that case, the IND sponsor and the FDA must resolve any outstanding FDAconcerns or questions before clinical trials can proceed. If these concerns or questions are unresolved, the FDA may not allow the clinical trials to commence.Pilot studies generally are conducted in a limited patient population, approximately three to 25 subjects, to determine whether the drug warrants furtherclinical trials based on preliminary indications of efficacy. These pilot studies may be performed in the U.S. after an IND has become effective or outside ofthe U.S. prior to the filing of an IND in the U.S. in accordance with applicable government regulations and institutional procedures.Clinical trials involve the administration of the investigational new drug to human subjects under the supervision of qualified investigators. Clinicaltrials are conducted under protocols detailing, among other things, the objectives of the study, the parameters to be used in assessing the safety and theeffectiveness of the drug. Each protocol must be submitted to the FDA as part of the IND prior to beginning the trial.Typically, clinical evaluation involves a time-consuming and costly three-Phase sequential process, but the phases may overlap. Each trial must bereviewed, approved and conducted under the auspices of an independent Institutional Review Board, and each trial must include the patient’s informedconsent. • Phase I: refers typically to closely-monitored clinical trials and includes the initial introduction of an investigational new drug into human patients orhealthy volunteer subjects. Phase I trials are designed to determine the safety, metabolism and pharmacologic actions of a drug in humans, thepotential side effects associated with increasing drug doses and, if possible, to gain early evidence of the drug’s effectiveness. Phase I trials alsoinclude the study of structure-activity relationships and mechanism of action in humans, as well as studies in which investigational new drugs areused as research tools to explore biological phenomena or disease processes. During Phase I trials, sufficient information about a drug’spharmacokinetics and pharmacological effects should be obtained to permit the design of well-controlled, scientifically valid Phase II studies. Thetotal number of subjects and patients included in Phase I trials varies, but is generally in the range of 20 to 80 people. • Phase II: refers to controlled clinical trials conducted to evaluate appropriate dosage and the effectiveness of a drug for a particular indication orindications in patients with a disease or condition under study and to determine the common short-term side effects and risks associated with thedrug. These trials are typically well-controlled, closely monitored and conducted in a relatively small number of patients, usually involving no morethan several hundred subjects. 12Table of Contents • Phase III: refers to expanded controlled and uncontrolled clinical trials. These trials are performed after preliminary evidence suggesting effectivenessof a drug has been obtained. Phase III trials are intended to gather additional information about the effectiveness and safety that is needed to evaluatethe overall benefit-risk relationship of the drug and to provide an adequate basis for physician labeling. Phase III trials usually include severalhundred to several thousand subjects.Phase I, II and III testing may not be completed successfully within any specified time period, if at all. The FDA closely monitors the progress of each ofthe three phases of clinical trials that are conducted in the U.S. and may, at its discretion, reevaluate, alter, suspend or terminate the testing based upon thedata accumulated to that point and the FDA’s assessment of the risk/benefit ratio to the patient. A clinical program is designed after assessing the causes of thedisease, the mechanism of action of the active pharmaceutical ingredient of the drug and all clinical and pre-clinical data of previous trials performed.Typically, the trial design protocols and efficacy endpoints are established in consultation with the FDA. Upon request through a special protocol assessment,the FDA can also provide specific guidance on the acceptability of protocol design for clinical trials. The FDA, we or our partners may suspend or terminateclinical trials at any time for various reasons, including a finding that the subjects or patients are being exposed to an unacceptable health risk. The FDA canalso request additional clinical trials be conducted as a condition to drug approval. During all clinical trials, physicians monitor the patients to determineeffectiveness and to observe and report any reactions or other safety risks that may result from use of the drug.Assuming successful completion of the required clinical trials, drug developers submit the results of pre-clinical studies and clinical trials, together withother detailed information including information on the manufacture and composition of the drug, to the FDA, in the form of an NDA, requesting approval tomarket the drug for one or more indications. In most cases, the NDA must be accompanied by a substantial user fee. The FDA reviews an NDA to determine,among other things, whether a drug is safe and effective for its intended use.Before approving an NDA, the FDA will inspect the facility or facilities where the drug is manufactured. The FDA will not approve the applicationunless cGMP compliance is satisfactory. The FDA will issue an approval letter if it determines that the application, manufacturing process and manufacturingfacilities are acceptable. If the FDA determines that the NDA, manufacturing process or manufacturing facilities are not acceptable, it will issue completeresponse letter (CRL), in which it will outline the deficiencies in the submission and will often request additional testing or information. Notwithstanding thesubmission of any requested additional information, the FDA may ultimately decide that the NDA does not satisfy the regulatory criteria for approval andrefuse to approve the NDA.The testing and approval process requires substantial time, effort and financial resources, and each may take several years to complete. The FDA maynot grant approval on a timely basis, or at all. We or our partners may encounter difficulties or unanticipated costs in our efforts to secure necessarygovernmental approvals, which could delay or preclude us or our partners from marketing our products or partnered products or product candidates.Furthermore, the FDA may prevent a drug developer from marketing a drug under a label for its desired indications or place other conditions on distribution asa condition of any approvals, which may impair commercialization of the drug. After approval, some types of changes to the approved drug, such as addingnew indications, manufacturing changes and additional labeling claims, are subject to further FDA review and approval. Similar regulatory procedures mustalso be complied within countries outside the U.S.If the FDA approves the NDA, the drug becomes available for physicians to prescribe in the U.S. After approval of our products or partnered productsor product candidates, we have to comply with a number of post-approval requirements, including delivering periodic reports to the FDA, submittingdescriptions of any adverse reactions reported, and complying with drug sampling and distribution requirements. We and our partners also are required toprovide updated safety and efficacy information and to comply with requirements concerning advertising and promotional labeling. Also, our quality controland manufacturing procedures must continue to conform to cGMP after approval. Drug manufacturers and their subcontractors are required to register theirfacilities and are subject to periodic unannounced inspections by the FDA to assess compliance with cGMP which imposes certain procedural anddocumentation requirements relating to quality assurance and quality control. Accordingly, manufacturers must continue to expend time, money and effort inthe area of production 13Table of Contentsand quality control to maintain compliance with cGMP and other aspects of regulatory compliance. The FDA may require post market testing and surveillanceto monitor the drug’s safety or efficacy, including additional studies, known as Phase IV trials, to evaluate long-term effects.In addition to studies requested by the FDA after approval, we or our partners may have to conduct other trials and studies to explore use of theapproved product for treatment of new indications, which require FDA approval. The purpose of these trials and studies is to broaden the application and useof the product or partnered product and its acceptance in the medical community.We use, and will continue to use, third-party manufacturers to produce our products and product candidates in clinical and commercial quantities.Future FDA inspections may identify compliance issues at our facilities or at the facilities of our contract manufacturers that may disrupt production ordistribution, or require substantial resources to correct. In addition, discovery of problems with a product or the failure to comply with requirements mayresult in restrictions on a product, manufacturer or holder of an approved NDA, including withdrawal or recall of the product from the market or othervoluntary or FDA-initiated action that could delay further marketing. Newly discovered or developed safety or effectiveness data may require changes to aproduct’s approved labeling, including the addition of new warnings and contraindications.In September 2007, the Food and Drug Administration Amendments Act, or the FDAAA, was enacted into law, amending both the FDC Act and thePublic Health Service Act. The FDAAA made a number of substantive and incremental changes to the review and approval processes in ways that could makeit more difficult or costly to obtain approval for new pharmaceutical products, or to produce, market and distribute existing pharmaceutical products. Mostsignificantly, the law changed the FDA’s handling of postmarked drug product safety issues by giving the FDA authority to require post approval studies orclinical trials, to request that safety information be provided in labeling, or to require an NDA applicant to submit and execute a Risk Evaluation andMitigation Strategy, or REMS.The FDAAA made certain changes to the user fee provisions to permit the use of user fee revenue to fund the FDA’s drug product safety activities andthe review of Direct-to-Consumer advertisements. The Food and Drug Administration Safety and Innovation Act of 2012, which became effective in October2012, reauthorized the authority of the FDA to collect user fees to fund the FDA’s review activities.In addition, new government requirements may be established that could delay or prevent regulatory approval of our products and product candidatesunder development.The Hatch-Waxman ActIn seeking approval for a drug through an NDA, applicants are required to list with the FDA each patent with claims that cover the applicant’s drug.Upon approval of a drug, each of the patents listed in the application for the drug is then published in the FDA’s Approved Drug Products with TherapeuticEquivalence Evaluations, commonly known as the Orange Book. Drugs listed in the Orange Book can, in turn be cited by potential competitors in support ofapproval of an abbreviated new drug application, or ANDA. An ANDA provides for marketing of a drug that has the same active ingredients in the samestrengths and dosage form as the listed drug and has been shown through bioequivalence testing to be therapeutically equivalent to the listed drug. ANDAapplicants are not required to conduct or submit results of pre-clinical or clinical tests to prove the safety or effectiveness of their drug, other than therequirement for bioequivalence testing. Drugs approved in this way are commonly referred to as “generic equivalents” to the listed drug, and can often besubstituted by pharmacists under prescriptions written for the original listed drug.The ANDA applicant is required to certify to the FDA concerning any patents listed for the approved drug in the FDA’s Orange Book. Specifically, theapplicant must certify that: (i) the required patent information has not been filed; (ii) the listed patent has expired; (iii) the listed patent has not expired, but willexpire on a particular date and approval is sought after patent expiration; or (iv) the listed patent is invalid or will not be infringed by the new drug. Acertification that the new drug will not infringe the already approved drug’s listed patents or that such patents are invalid is called a Paragraph IV certification.If the applicant does not challenge the listed patents, the ANDA application will not be approved until all the listed patents claiming the referenced drug haveexpired. 14Table of ContentsIf the ANDA applicant has provided a Paragraph IV certification to the FDA, the applicant must also send notice of the Paragraph IV certification to theNDA and patent holders once the ANDA has been accepted for filing by the FDA. The NDA and patent holders may then initiate a patent infringement lawsuitin response to the notice of the Paragraph IV certification. The filing of a patent infringement lawsuit within 45 days of the receipt of a Paragraph IVcertification automatically prevents the FDA from approving the ANDA until the earlier of 30 months, expiration of the patent, settlement of the lawsuit or adecision in the infringement case that is favorable to the ANDA applicant.The ANDA application also will not be approved until any non-patent exclusivity, such as exclusivity for obtaining approval of a new chemical entity,listed in the Orange Book for the referenced drug has expired. Federal law provides a period of five years following approval of a drug containing no previouslyapproved active ingredients, during which ANDAs for generic versions of those drugs cannot be submitted unless the submission contains a Paragraph IVchallenge to a listed patent, in which case the submission may be made four years following the original drug approval. Federal law provides for a period ofthree years of exclusivity following approval of a listed drug that contains previously approved active ingredients but is approved in a new dosage form, routeof administration or combination, or for a new use, the approval of which was required to be supported by new clinical trials conducted by or for the sponsor,during which FDA cannot grant effective approval of an ANDA based on that listed drug.Foreign regulationWhether or not we or our partners obtain FDA approval for a product or product candidate, we must obtain approval by the comparable regulatoryauthorities of foreign countries before we can commence clinical trials or marketing of the product or product candidate in those countries. The approvalprocess varies from country to country, and the time may be longer or shorter than that required for FDA approval. The requirements governing the conduct ofclinical trials, product licensing, pricing and reimbursement also vary greatly from country to country. Although governed by the applicable country, clinicaltrials conducted outside of the U.S. typically are administered with the three-Phase sequential process that is discussed above under “United Statesgovernment regulation.” However, the foreign equivalent of an IND is not a prerequisite to performing pilot studies or Phase I clinical trials.Under European Union regulatory systems, we may submit MAAs either under a centralized or decentralized procedure. The centralized procedure,which is available for drugs produced by biotechnology or which are highly innovative, provides for the grant of a single marketing authorization that is validfor all European Union member states. This authorization is a marketing authorization approval. The decentralized procedure provides for mutual recognitionof national approval decisions. Under this procedure, the holder of a national marketing authorization may submit an application to the remaining memberstates. Within 90 days of receiving the applications and assessment report, each member state must decide whether to recognize approval. This procedure isreferred to as the mutual recognition procedure.In addition, regulatory approval of prices is required in most countries other than the U.S. We face the risk that the resulting prices would beinsufficient to generate an acceptable return to us or our partners.Third-party reimbursement and pricing controlsIn the U.S. and elsewhere, sales of pharmaceutical products depend in significant part on the availability of reimbursement to the consumer from third-party payors, such as government and private insurance plans. Third-party payors are increasingly challenging the prices charged for medical products andservices. It will be time consuming and expensive for us or our partners to go through the process of seeking reimbursement from Medicare and private payors.Our compounds may not be considered cost-effective, and coverage and reimbursement may not be available or sufficient to allow us or our partners to sell ourcompounds on a competitive and profitable basis. The passage of the Medicare Prescription Drug and Modernization Act of 2003 imposes additionalrequirements for the distribution and pricing of prescription drugs which may affect the marketing of our compounds.In many foreign markets, including the countries in the European Union and Japan, pricing of pharmaceutical products is subject to governmentalcontrol. In the U.S., there have been, and we expect that there 15Table of Contentswill continue to be, a number of federal and state proposals to implement similar governmental pricing control. While we cannot predict whether suchlegislative or regulatory proposals will be adopted, the adoption of such proposals could have a material adverse effect on our business, financial conditionand profitability.Marketing and salesGiven the range of potential indications for tasimelteon, we may pursue one or more partnerships for the development and commercialization oftasimelteon worldwide.In October 2009, we entered into an amended and restated sublicense agreement with Novartis pursuant to which Novartis has exclusivecommercialization rights to all formulations of Fanapt in the U.S. and Canada. Novartis began selling Fanapt in the U.S. during the first quarter of 2010.We continue to explore the regulatory path and commercial opportunity for Fanapt oral formulation outside of the U.S. and Canada. In December 2012,the CHMP issued a negative opinion recommending against approval of Fanaptum™ (oral iloperidone tablets) for the treatment of schizophrenia in adultpatients in the European Union. The CHMP was of the opinion that the benefits of Fanaptum™ did not outweigh its risks and recommended againstmarketing authorization at this point in time. In January 2013, we formally appealed the EMA’s negative opinion and requested a re-examination of the decisionby the CHMP. We have entered into agreements with the following partners for the commercialization of Fanapt in the countries set forth below: Country PartnerMexico Probiomed S.A. de C.V.Israel Megapharm Ltd.In August 2012, the Israeli Ministry of Health granted market approval for Fanapt for the treatment of schizophrenia. In November 2012, we werenotified that Fanapt had been granted market approval in Argentina for the treatment of schizophrenia.Patents and proprietary rights; Hatch-Waxman protectionWe and our partners will be able to protect our compounds from unauthorized use by third parties only to the extent that our compounds are covered byvalid and enforceable patents, either licensed in from third parties or generated internally, that give us or our partners sufficient proprietary rights.Accordingly, patents and other proprietary rights are essential elements of our business.Fanapt, tasimelteon and VLY-686 are covered by new chemical entity and other patents. These patents cover the active pharmaceutical ingredient andprovide patent protection for all formulations containing these active pharmaceutical ingredients. The new chemical entity patent for Fanapt is owned bysanofi-aventis, and other patents and patent applications relating to Fanapt are owned by Novartis. BMS owns the new chemical entity patent for tasimelteonand Lilly owns the new chemical entity patent for VLY-686. We originally obtained exclusive worldwide rights to develop and commercialize the compoundscovered by these patents through license and sublicense arrangements. However, pursuant to the amended and restated sublicense agreement with Novartis,Novartis obtained exclusive commercialization rights to all formulations of Fanapt in the U.S. and Canada. For more on these license and sublicensearrangements, please see “License agreements” above. In addition, we have generated intellectual property, and filed patent applications covering thisintellectual property, for Fanapt and tasimelteon.The new chemical entity patent covering Fanapt was set to expire normally in 2011 in the U.S. and expired in 2010 in major markets outside of theU.S. The new chemical entity patent covering tasimelteon expires in 2017 in the U.S. and most European markets. The new chemical entity patent coveringVLY-686 expires in April 2023, except in the U.S., where it expires in June 2024 absent any applicable patent term adjustments. Additionally, Fanapt hasqualified for the full five-year patent term extension and so the term of the new chemical entity patent in the U.S. has been extended until November 2016. Asimilar extension is expected to be available for tasimelteon and may also be available for VLY-686. Fanapt will also be eligible for 6 months of additionalprotection for completing studies in the pediatric population potentially extending the term of the new 16®®®®®®®®®®®®®®Table of Contentschemical entity parent in the U.S. until May 2017. These studies, for which Novartis is responsible, are required by the FDA approval letter. In Europe,statutes provide for ten years of data exclusivity, with the potential for an additional year if the company develops the drug for a significant new indication. Nogeneric versions of Fanapt would be permitted to be marketed or sold during this 10-year (or 11-year) period in most European countries. Consequently,assuming that pediatric exclusivity is granted by the FDA and that we receive regulatory approval in Europe, we expect that Novartis’ rights to commercializeFanapt will be exclusive until May 2017 in the U.S. and our rights in Europe would be exclusive for at least 10 years from approval in Europe. Dataexclusivity periods in other countries vary from country to country. The patent for the microsphere long-acting injectable (or depot) formulation of Fanaptexpires in 2024 in the U.S. and 2022 in most of the major markets in Europe. The pending patent application for the aqueous microcrystals long actinginjectable (or depot) formulation of Fanapt will expire in 2023 in the U.S. The patent for the aqueous microcrystals long acting injectable (or depot)formulation of Fanapt will expire in 2023 in most of the major markets in Europe. Several other patent applications covering metabolites, uses, formulationsand genetic markers relating to Fanapt extend beyond 2020.Aside from the new chemical entity patents and other in-licensed patents relating to Fanapt, tasimelteon and VLY-686, as of December 31, 2012 wehad 29 patent and patent application families, most of which have been filed in key markets including the U.S., relating to Fanapt and tasimelteon. Inaddition, we had five other patent applications relating to compounds not presently in clinical studies. The claims in these various patents and patentapplications are directed to compositions of matter, including claims covering other product candidates, pharmaceutical compositions and methods of use.For proprietary know-how that is not appropriate for patent protection, processes for which patents are difficult to enforce and any other elements of ourdiscovery process that involve proprietary know-how and technology that is not covered by patent applications, we generally rely on trade secret protection andconfidentiality agreements to protect our interests. We require all of our employees, consultants and advisors to enter into confidentiality agreements. Where it isnecessary to share our proprietary information or data with outside parties, our policy is to make available only that information and data required toaccomplish the desired purpose and only pursuant to a duty of confidentiality on the part of those parties.Research and DevelopmentWe have built a research and development organization that includes extensive expertise in the scientific disciplines of pharmacogenetics andpharmacogenomics. We operate cross-functionally and are led by an experienced research and development management team. We use rigorous projectmanagement techniques to assist us in making disciplined strategic research and development program decisions and to help limit the risk profile of ourproduct pipeline. We also access relevant market information and key opinion leaders in creating target product profiles and, when appropriate, as we advanceour programs towards commercialization. We engage third parties to conduct portions of our preclinical research. In addition, we utilize multiple clinical sitesto conduct our clinical trials; however we are not substantially dependent upon any one of these sites for our clinical trials nor do any of them conduct a majorportion of our clinical trials.We incurred $45.4 million, $29.0 million and $12.3 million in research and development expenses in the years ended December 31, 2012, 2011 and2010, respectively.ManufacturingWe currently depend on, and expect to continue to depend on, a small number of third-party manufacturers to produce sufficient quantities of ourproducts and product candidates for use in our clinical studies. We are not obligated to obtain our products and product candidates from any particular third-party manufacturer and we believe that we would be able to obtain our products and product candidates from a number of third-party manufacturers atcomparable cost.We intend to rely on third-party contract manufacturers to produce sufficient quantities for large-scale commercialization of our products and productcandidates once approved for commercial use. If we do enter into commercial manufacturing arrangements with third parties, these third-party manufacturerswill be subject to 17®®®®®®®®Table of Contentsextensive governmental regulation. Specifically, regulatory authorities in the markets which we intend to serve will require that drugs be manufactured,packaged and labeled in conformity with cGMP or equivalent foreign standards. We intend to engage only those contract manufacturers who have thecapability to manufacture drugs in compliance with cGMP and other applicable standards in bulk quantities for commercial use.CompetitionThe pharmaceutical industry and the central nervous system segment of that industry, in particular, is highly competitive and includes a number ofestablished large and mid-sized companies with greater financial, technical and personnel resources than we have and significantly greater commercialinfrastructures than we have. Our market segment also includes several smaller emerging companies whose activities are directly focused on our target marketsand areas of expertise. Our compounds, once approved for commercial use, will compete with numerous therapeutic treatments offered by these competitors.While we believe that our compounds will have certain favorable features, existing and new treatments may also possess advantages. Additionally, thedevelopment of other drug technologies and methods of disease prevention are occurring at a rapid pace. These developments may render our compounds ortechnologies obsolete or noncompetitive.We believe the primary competitors for tasimelteon and Fanapt are as follows: • For tasimelteon in the treatment of CRSDs, there are no approved direct competitors. Insomnia treatments include, Rozerem (ramelteon) by TakedaPharmaceuticals Company Limited, hypnotics such as Ambien (zolpidem) by sanofi-aventis (including Ambien CR), Lunesta (eszopiclone) byDainippon Sumitomo Pharma, Sonata (zaleplon) by Pfizer Inc., Silenor (doxepin) by Somaxon Pharmaceuticals, Inc., generic compounds such aszolpidem, trazodone and doxepin, and over-the-counter remedies such as Benadryl and Tylenol PM. The class of melatonin agonists includesRozerem (ramelteon) by Takeda Pharmaceuticals Company Limited, Valdoxan (agemelatine) by Servier, Circadin (long-acting melatonin) byNeurim Pharmaceuticals and the food supplement melatonin. • For Fanapt in the treatment of schizophrenia, the atypical antipsychotics Risperdal (risperidone), including the depot formulation RisperdalConsta, and Invega (paliperidone), including the depot formulation Invega Sustenna™, each by Ortho-McNeil-Janssen Pharmaceuticals, Inc.,Zyprexa (olanzapine), including the depot formulation Zyprexa Relprevv™, by Eli Lilly and Company, Seroquel (quetiapine) by AstraZenecaPLC, Abilify (aripiprazole) by BMS/Otsuka Pharmaceutical Co., Ltd., Geodon (ziprasidone) by Pfizer Inc., Saphris (asenapine) by Schering-Plough, Latuda (lurasidone) by Dainippon Sumitomo Pharma, and generic clozapine, as well as the typical antipsychotics haloperidol,chlorpromazine, thioridazine, and sulpiride (all of which are generic).Our ability to compete successfully will depend in part on our ability to utilize our pharmacogenetics and pharmacogenomics and drug developmentexpertise to identify, develop, secure rights to and obtain regulatory approvals for promising pharmaceutical compounds before others are able to developcompetitive products. Our ability to compete successfully will also depend on our ability to attract and retain skilled and experienced personnel. Additionally,our ability to compete may be affected because insurers and other third-party payors in some cases seek to encourage the use of cheaper, generic products,which could make our compounds less attractive.EmployeesAs of December 31, 2012, we had 40 full-time employees. Of these employees, 24 were primarily engaged in research and development activities. Noneof our employees are represented by a labor union. We have not experienced any work stoppages and consider our employee relations to be good.Corporate InformationWe were incorporated in Delaware in 2002. Our principal executive offices are located at 2200 Pennsylvania Avenue NW, Suite 300E, Washington D.C.20037, and our telephone number is (202) 734-3400. Our website address is www.vandapharma.com and the information contained in, or that can be accessedthrough, our website is not part of this annual report and should not be considered part of this annual report. 18®®®®®®®®®®®®®®®®®®®®®®®®®Table of ContentsAvailable InformationVanda Pharmaceuticals Inc. files annual, quarterly, and current reports, proxy statements, and other documents with the Securities and ExchangeCommission (SEC) under the Securities Exchange Act of 1934 (the Exchange Act). The public may read and copy any materials that we file with the SEC atthe SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. The public may obtain information on the operation of the Public ReferenceRoom by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains an internet website at www.sec.gov that contains reports, proxy and informationstatements, and other information regarding issuers, including us, that file electronically with the SEC.We also make available free of charge on our Internet website at www.vandapharma.com our annual reports on Form 10-K, quarterly reports on Form10-Q, current reports on Form 8-K, and, if applicable, amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Actas soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.Our code of ethics, other corporate policies and procedures, and the charters of our Audit Committee, Compensation Committee andNominating/Corporate Governance Committee are available through our Internet website at www.vandapharma.com. ITEM 1A.RISK FACTORSInvesting in our common stock involves a high degree of risk. You should consider carefully the risks and uncertainties described below, togetherwith all of the other information in this report, including the consolidated financial statements and the related notes appearing at the end of this annualreport on Form 10-K, with respect to any investment in shares of our common stock. If any of the following risks actually occurs, our business,financial condition, results of operations and future prospects would likely be materially and adversely affected. In that event, the market price of ourcommon stock could decline and you could lose all or part of your investment.Risks related to our business and industryIf the FDA does not accept for filing the NDA that we intend to submit for tasimelteon for the treatment of Non-24, regulatory authoritiesdetermine that our clinical trial results for tasimelteon for the treatment of Non-24 do not demonstrate adequate safety and efficacy, or the FDAdoes not approve an applicable PDUFA date, continued development of tasimelteon will be significantly delayed or terminated, our business willbe significantly harmed, and the market price of our stock could decline.We commenced our Phase III program for tasimelteon for the treatment of Non-24-Hour Disorder (Non-24) in the third quarter of 2010. In December2012, we reported positive top-line results in a randomized, double-blind, multi-center, placebo-controlled Phase III trial (SET study) that enrolled 84 patients.In January 2013, we announced positive results for the second Phase III study of tasimelteon for the treatment of Non-24. In addition, we have two ongoingopen-label safety studies for tasimelteon in treatment of Non-24. Based on the results of our completed trials, we intend to submit a New Drug Application(NDA) with the U.S. Food and Drug Administration (FDA) in mid-2013. We will meet with the FDA in the first quarter of 2013 for a pre-NDA meeting ontasimelteon in the treatment of patients with Non-24. Any adverse developments or results or perceived adverse developments or results with respect to our pre-NDA meeting with the FDA, our regulatory submission or the tasimelteon Phase III program will significantly harm our business and could cause the marketprice of our stock to decline. Examples of such adverse developments include, but are not limited to: • the FDA determining that additional clinical studies are required with respect to the Phase III program in Non-24; • safety, efficacy or other concerns arising from clinical or non-clinical studies in this program; or • the FDA determining that the Phase III program in Non-24 raises safety concerns or does not demonstrate adequate efficacy. 19Table of ContentsWe and our partners face heavy government regulation. FDA regulatory approval of our compounds is uncertain and we and our partners arealso continually at risk of the FDA requiring us or them to discontinue marketing any compounds that have obtained, or in the future mayobtain, regulatory approval.The research, testing, manufacturing and marketing of compounds such as those that we have developed or we or in regard to partnered products, ourpartners, are developing are subject to extensive regulation by federal, state and local government authorities, including the FDA. To obtain regulatory approvalof such compounds, we or our partners must demonstrate to the satisfaction of the applicable regulatory agency that, among other things, the compound issafe and effective for its intended use. In addition, we or our partners must show that the manufacturing facilities used to produce such compounds are incompliance with current Good Manufacturing Practices regulations or cGMP.The process of obtaining FDA and other required regulatory approvals and clearances can take many years and will require us and, in the case ofpartnered products, our partners to expend substantial time and capital. Despite the time and expense expended, regulatory approval is never guaranteed. Thenumber of pre-clinical and clinical trials that will be required for FDA approval varies depending on the compound, the disease or condition that thecompound is in development for, and the requirements applicable to that particular compound. The FDA can delay, limit or deny approval of a compound formany reasons, including that: • a compound may not be shown to be safe or effective; • the FDA may interpret data from pre-clinical and clinical trials in different ways than we or our partners do; • the FDA may not approve our or our partners’ manufacturing processes or facilities; • a compound may not be approved for all the indications we or our partners request; • the FDA may change its approval policies or adopt new regulations; • the FDA may not meet, or may extend, the Prescription Drug User Fee Act (PDUFA) date with respect to a particular NDA; and • the FDA may not agree with our or our partners’ regulatory approval strategies or components of the regulatory filings, such as clinical trial designs.For example, if certain of our or our partners’ methods for analyzing trial data are not accepted by the FDA, we or our partners may fail to obtainregulatory approval for our compounds.Moreover, the marketing, distribution and manufacture of approved products remain subject to extensive ongoing regulatory requirements. Failure tocomply with applicable regulatory requirements could result in, among other things: • warning letters; • fines; • civil penalties; • injunctions; • recall or seizure of products; • total or partial suspension of production; • refusal of the government to grant future approvals; • withdrawal of approvals; and • criminal prosecution.Any delay or failure to obtain regulatory approvals for our compounds will result in increased costs, could diminish competitive advantages that wemay attain and would adversely affect the marketing and sale of our compounds. Other than Fanapt in the U.S., Israel and Argentina, we have not receivedregulatory approval to market any of our compounds in any jurisdiction. 20®Table of ContentsEven following regulatory approval of our compounds, the FDA may impose limitations on the indicated uses for which such compounds may bemarketed, subsequently withdraw approval or take other actions against us, our partners or such compounds that are adverse to our business. The FDAgenerally approves drugs for particular indications. An approval for a more limited indication reduces the size of the potential market for the product. Productapprovals, once granted, may be withdrawn or modified if problems occur after initial marketing.We and our partners also are subject to numerous federal, state and local laws, regulations and recommendations relating to safe working conditions,laboratory and manufacturing practices, the environment and the use and disposal of hazardous substances used in connection with discovery, research anddevelopment work. In addition, we cannot predict the extent to which new governmental regulations might significantly impede the discovery, development,production and marketing of our compounds. We or our partners may be required to incur significant costs to comply with current or future laws orregulations, and we may be adversely affected by the cost of such compliance or the inability to comply with such laws or regulations.We intend to seek regulatory approvals for our compounds in foreign jurisdictions, but we may not obtain any such approvals.Pursuant to our amended and restated sublicense agreement with Novartis, we retained the right to develop and commercialize Fanapt outside the U.S.and Canada. We intend to market our compounds outside the U.S. and Canada with one or more commercial partners. In order to market our compounds inforeign jurisdictions, we or our partners may be required to obtain separate regulatory approvals and to comply with numerous and varying regulatoryrequirements. The approval procedure varies among countries and jurisdictions and can involve additional trials, and the time required to obtain approvalmay differ from that required to obtain FDA approval. Additionally, the foreign regulatory approval process may include all of the risks associated withobtaining FDA approval. For all of these reasons, we or our partners may not obtain foreign regulatory approvals on a timely basis, if at all. Approval by theFDA does not ensure approval by regulatory authorities in other countries or jurisdictions, and approval by one foreign regulatory authority does not ensureapproval by regulatory authorities in other foreign countries or jurisdictions or by the FDA. We or our partners may not be able to file for regulatory approvalsand may not receive necessary approvals to commercialize our compounds in any market. The failure to obtain these approvals could harm our businessmaterially.We continue to explore the regulatory path and commercial opportunity for Fanapt oral formulation outside of the U.S. and Canada. In December 2012,the European Medicines Agency’s (EMA) Committee for Medicinal Product for Human Use (CHMP) issued a negative opinion recommending againstapproval of Fanaptum (oral iloperidone tablets) for the treatment of schizophrenia in adult patients in the European Union. The CHMP was of the opinionthat the benefits of Fanaptum did not outweigh its risks and recommended against marketing authorization at this point in time. In January 2013, weformally appealed the EMA’s negative opinion and requested a re-examination of the decision by the CHMP. We may not be successful in obtaining a positivedecision from CHMP of our appeal.Even after we or our partners obtain regulatory approvals of a product, acceptance of such compound in the marketplace is uncertain andfailure to achieve market acceptance will prevent or delay our ability to generate revenues.Even after obtaining regulatory approvals for the sale of our compounds, the commercial success of these compounds will depend, among other things,on their acceptance by physicians, patients, third-party payors and other members of the medical community as a therapeutic and cost-effective alternative tocompeting products 21®®™™Table of Contentsand treatments. The degree of market acceptance of any compound will depend on a number of factors, including the demonstration of its safety and efficacy,its cost-effectiveness, its potential advantages over other therapies, the reimbursement policies of government and third-party payors with respect to suchcompound, our ability to attract and maintain corporate partners, including pharmaceutical companies, to assist in commercializing our compounds, receiptof regulatory clearance of marketing claims for the uses that we or our partners are developing and the effectiveness of our and our partners’ marketing anddistribution capabilities. If our approved compounds fail to gain market acceptance, we may be unable to earn sufficient revenue to continue our business. Ifour approved compounds do not become widely accepted by physicians, patients, third-party payors and other members of the medical community, it isunlikely that we will ever become profitable on a sustained basis or achieve significant revenues.If we fail to obtain the capital necessary to fund our research and development activities and commercialization efforts, we may be unable tocontinue operations or we may be forced to share our rights to commercialize our products and product candidates with third parties on termsthat may not be attractive to us.Our activities will necessitate significant uses of working capital throughout 2013 and beyond. As of December 31, 2012, our total cash and cashequivalents and marketable securities were $120.4 million. Our long term capital requirements are expected to depend on many factors, including, amongothers: • our ability to commercialize tasimelteon globally; • the amount of royalty and milestone payments received from our commercial partners; • our ability to commercialize Fanapt outside the U.S. and Canada; • costs of developing and maintaining sales, marketing and distribution channels and our ability to sell our products; • costs involved in establishing manufacturing capabilities for commercial quantities of our products; • the number of potential formulations, products and product candidates in development; • progress with pre-clinical studies and clinical trials; • time and costs involved in obtaining regulatory (including FDA) approval; • costs involved in preparing, filing, prosecuting, maintaining and enforcing patent, trademark and other intellectual property claims; • competing technological and market developments; • market acceptance of our products; • costs for recruiting and retaining employees and consultants; • costs for training physicians; and • legal, accounting, insurance and other professional and business related costs.We expect to continue to receive royalty payments and hope to receive commercial and development milestone payments relating to Fanapt in connectionwith our amended and restated sublicense agreement with Novartis. Based on the current sales performance of Fanapt in the U.S. and the decision byNovartis to cease development of the long-acting injectable (or depot) formulation of Fanapt, we expect that some or all of these commercial and developmentmilestones will not be achieved by Novartis. As a result, we may need to raise additional capital to fund our anticipated operating expenses and execute on ourbusiness plans. In our capital-raising efforts, we may seek to sell debt securities or additional equity securities or obtain a bank credit facility, or enter intopartnerships or other collaboration agreements. The sale of additional equity or debt securities, if convertible, could result in dilution to our stockholders andmay also result in a lower price for our common stock. The incurrence of indebtedness would result in increased fixed obligations and could also result incovenants that could restrict our operations. However, we may not be able to raise additional funds on acceptable 22®®®®Table of Contentsterms, or at all. If we are unable to secure sufficient capital to fund our planned activities, we may not be able to continue operations, or we may have to enterinto partnerships or other collaboration agreements that could require us to share commercial rights to our products to a greater extent or at earlier stages in thedrug development process than is currently intended. These partnerships or collaborations, if consummated prior to proof-of-efficacy or safety of a givenproduct, could impair our ability to realize value from that product. If additional financing is not available when required or is not available on acceptableterms, we may be unable to fund our operations and planned growth, develop or enhance our technologies or products, take advantage of businessopportunities or respond to competitive market pressures, any of which would materially harm our business, financial condition and results of operations.We face substantial competition which may result in others developing or commercializing products before or more successfully than we do.Our future success will depend on our or our partners’ ability to demonstrate and maintain a competitive advantage with respect to our compounds andour ability to identify and develop additional products or product candidates through the application of our pharmacogenetics and pharmacogenomicsexpertise. Large, fully integrated pharmaceutical companies, either alone or together with collaborative partners, have substantially greater financial resourcesand have significantly greater experience than we do in: • developing products and product candidates; • undertaking pre-clinical testing and clinical trials; • obtaining FDA and other regulatory approvals of products and product candidates; and • manufacturing, marketing and selling products.These companies may invest heavily and quickly to discover and develop novel products that could make our compounds obsolete. Accordingly, ourcompetitors may succeed in obtaining patent protection, receiving FDA or foreign regulatory approval or commercializing superior products or other competingproducts before we do. Technological developments or the FDA or foreign regulatory approval of new therapeutic indications for existing products may makeour compounds obsolete or may make them more difficult to market successfully, any of which could have a material adverse effect on our business, resultsof operations and financial condition.Fanapt (and our other compounds, if successfully developed and approved for commercial sale) will compete with a number of drugs and therapiescurrently manufactured and marketed by major pharmaceutical and other biotechnology companies. Our compounds may also compete with new productscurrently under development by others or with products which may cost less than our compounds. Physicians, patients, third party payors and the medicalcommunity may not accept or utilize any of our compounds that may be approved. If Fanapt and our other compounds (if and when approved) do notachieve significant market acceptance, our business, results of operations and financial condition would be materially adversely affected. We believe theprimary competitors for Fanapt and tasimelteon are as follows: • For tasimelteon in the treatment of CRSDs, there are no approved direct competitors. Insomnia treatments include, Rozerem (ramelteon) by TakedaPharmaceuticals Company Limited, hypnotics such as Ambien (zolpidem) by sanofi-aventis (including Ambien CR), Lunesta (eszopiclone) byDainippon Sumitomo Pharma, Sonata (zaleplon) by Pfizer Inc., Silenor (doxepin) by Somaxon Pharmaceuticals, Inc., generic compounds such aszolpidem, trazodone and doxepin, and over-the-counter remedies such as Benadryl and Tylenol PM. The class of melatonin agonists includesRozerem (ramelteon) by Takeda Pharmaceuticals Company Limited, Valdoxan (agemelatine) by Servier, Circadin (long-acting melatonin) byNeurim Pharmaceuticals and the food supplement melatonin. • For Fanapt in the treatment of schizophrenia, the atypical antipsychotics Risperdal (risperidone), including the depot formulation RisperdalConsta, and Invega (paliperidone), including the depot formulation Invega Sustenna™, each by Ortho-McNeil-Janssen Pharmaceuticals, Inc.,Zyprexa (olanzapine), including the depot formulation Zyprexa Relprevv™, by Eli Lilly and Company, Seroquel (quetiapine) by AstraZenecaPLC, Abilify (aripiprazole) by BMS/Otsuka Pharmaceutical Co., 23®®®®®®®®®®®®®®®®®®®®®®®®Table of Contents Ltd., Geodon (ziprasidone) by Pfizer Inc., Saphris (asenapine) by Schering-Plough, Latuda (lurasidone) by Dainippon Sumitomo Pharma, andgeneric clozapine, as well as the typical antipsychotics haloperidol, chlorpromazine, thioridazine, and sulpiride (all of which are generic).Additionally, our ability to compete may be affected because insurers and other third-party payors in some cases seek to encourage the use of cheaper,generic products, which could make our compounds less attractive.We have no experience selling, marketing or distributing products, other than providing assistance to Novartis relating to the U.S.commercialization of Fanapt, which may make commercializing our products and product candidates difficult.At present, we have no marketing experience, other than providing assistance to Novartis relating to the U.S. commercialization of Fanapt. Therefore,in order for us to commercialize Fanapt, outside the U.S. and Canada, or our other compounds, including tasimelteon, we must either acquire or internallydevelop sales, marketing and distribution capabilities, or enter into collaborations with partners to perform these services for us. We may, in some instances,rely significantly on sales, marketing and distribution arrangements with our collaborative partners and other third parties. For example, we rely completely onNovartis to market, sell and distribute Fanapt in the U.S. and Canada.For the commercialization of Fanapt outside the U.S. and Canada or our other compounds, we may not be able to establish, other than those currentlyestablished, sales and distribution partnerships on acceptable terms or at all. In regard to our current foreign partners and any additional distributionarrangements or other agreements we may enter into, our success will be materially dependent upon the performance of our partner. In the event that we attemptto acquire or develop our own in-house sales, marketing and distribution capabilities, factors that may inhibit our efforts to commercialize our products andproduct candidates without partners or licensees include: • our inability to recruit and retain adequate numbers of effective sales and marketing personnel; • the inability of sales personnel to obtain access to or persuade adequate numbers of physicians to prescribe our products; • the lack of complementary products to be offered by our sales personnel, which may put us at a competitive disadvantage against companies withbroader product lines; and • unforeseen costs associated with creating our own sales and marketing team or with entering into a partnering agreement with an independent salesand marketing organization.The cost of establishing and maintaining a sales, marketing and distribution organization may exceed its cost effectiveness. If we fail to develop salesand marketing capabilities, if sales efforts are not effective or if costs of developing sales and marketing capabilities exceed their cost effectiveness, ourbusiness, results of operations and financial condition could be materially adversely affected.Novartis began selling, marketing and distributing our first approved product, Fanapt, in the U.S. in the first quarter of 2010 and we willdepend heavily on the success of this product in the marketplace.Our ability to generate revenue for the next few years will depend substantially on the success of Fanapt and the sales of this product by Novartis in theU.S. and Canada. The ability of Fanapt to generate revenue at the levels we expect will depend on many factors, including the following: • the extent and effectiveness of the development, sales and marketing and distribution support Fanapt receives; • the amount of resources and efforts utilized by Novartis in relation to the commercialization of Fanapt; • the ability of patients to be able to afford Fanapt or obtain health care coverage that covers Fanapt; • acceptance of, and ongoing satisfaction, with Fanapt by the medical community, patients receiving therapy and third party payers; 24®®®®®®®®®®®®®®®®Table of Contents • a satisfactory efficacy and safety profile as demonstrated in a broad patient population; • the size of the market for Fanapt; • successfully expanding and sustaining manufacturing capacity to meet demand; • cost and availability of raw materials; • safety concerns in the marketplace for schizophrenia therapies; • regulatory developments relating to the manufacture or continued use of Fanapt; • decisions as to the timing of product launches, pricing and discounts; • the competitive landscape for approved and developing therapies that will compete with Fanapt; • Novartis’ ability to obtain regulatory approval in Canada for Fanapt and our or our partners’ ability to obtain regulatory approval for Fanapt incountries outside the U.S. and Canada; • our ability to successfully develop and commercialize Fanapt, including a long-acting injectable (or depot) formulation of Fanapt, outside of theU.S. and Canada; and • the unfavorable outcome or other negative effects of any potential litigation relating to Fanapt.We entered into an amended and restated sublicense agreement with Novartis to commercialize Fanapt in the U.S. and Canada. As such, we are notdirectly involved in the marketing or sales efforts for Fanapt in the U.S. and Canada. Our revenues for the forseeable future depend substantially on royaltiesand milestone payments we may receive from Novartis. Pursuant to the amended and restated sublicense agreement with Novartis, we received an upfrontpayment of $200.0 million and are eligible for additional payments totaling up to $265.0 million upon Novartis’ achievement of certain commercial anddevelopment milestones for Fanapt in the U.S. and Canada. Based on the current sales performance of Fanapt in the U.S. and the decision by Novartis tocease development of the long-acting injectable (or depot) formulation of Fanapt, we expect that some or all of these commercial and development milestoneswill not be achieved by Novartis. We also receive royalties, which, as a percentage of net sales, are in the low double-digits, on net sales of Fanapt in the U.S.and Canada. Such royalties may not be significant and will depend on numerous factors, many of which we cannot control. We cannot control the amountand timing of resources that Novartis may devote to Fanapt. If Novartis fails to successfully commercialize Fanapt in the U.S. or fails to develop andcommercialize Fanapt in Canada, if Novartis’ efforts are not effective, or if Novartis focuses its efforts on other schizophrenia therapies or schizophreniadrug candidates, our business will be negatively affected. If Novartis does not successfully commercialize Fanapt in the U.S. or Canada, we will receivelimited revenues from them. Although we have developed and continue to develop additional products and product candidates for commercial introduction, weexpect to be substantially dependent on sales from Fanapt for the foreseeable future. For reasons outside of our control, including those mentioned above, salesof Fanapt may not meet our or financial or industry analysts’ expectations. Any significant negative developments relating to Fanapt, such as safety orefficacy issues, the introduction or greater acceptance of competing products or adverse regulatory or legislative developments, will have a material adverseeffect on our financial condition and results of operations.If our compounds are determined to be unsafe or ineffective in humans, whether commercially or in clinical trials, our business will bematerially harmed.Despite the FDA’s approval of the NDA for Fanapt in May 2009 and the positive results of our completed trials for Fanapt and tasimelteon, we areuncertain whether either of these products will ultimately prove to be effective and safe in humans. Frequently, products that have shown promising results inclinical trials have suffered significant setbacks in later clinical trials or even after they are approved for commercial sale. Future uses of our compounds,whether in clinical trials or commercially, may reveal that the compound is ineffective, unacceptably toxic, has other undesirable side effects, is difficult tomanufacture on a large scale, is uneconomical, infringes on proprietary rights of another party or is otherwise not fit for further use. If our compounds aredetermined to be unsafe or ineffective in humans, our business will be materially harmed. 25®®®®®®®®®®®®®®®®®®®®®®®Table of ContentsClinical trials for our compounds are expensive and their outcomes are uncertain. Any failure or delay in completing clinical trials for ourcompounds could severely harm our business.Pre-clinical studies and clinical trials required to demonstrate the safety and efficacy of our compounds are time-consuming and expensive and togethertake several years to complete. Before obtaining regulatory approvals for the commercial sale of any of our compounds, we or our partners must demonstratethrough preclinical testing and clinical trials that such compound is safe and effective for use in humans. We have incurred, and we will continue to incur,substantial expense for, and devote a significant amount of time to, preclinical testing and clinical trials.Historically, the results from preclinical testing and early clinical trials often have not predicted results of later clinical trials. A number of new drugshave shown promising results in clinical trials, but subsequently failed to establish sufficient safety and efficacy data to obtain necessary regulatoryapprovals. Clinical trials conducted by us, by our partners or by third parties on our or our partners’ behalf may not demonstrate sufficient safety andefficacy to obtain the requisite regulatory approvals for our compounds. Regulatory authorities may not permit us or our partners to undertake any additionalclinical trials for our compounds, may force us to stop any ongoing clinical trials and it may be difficult to design efficacy studies for our compounds in newindications.Clinical development efforts performed by us or our partners may not be successfully completed. Completion of clinical trials may take several years ormore. The length of time can vary substantially with the type, complexity, novelty and intended use of the compounds and the size of the prospective patientpopulation. The commencement and rate of completion of clinical trials for our compounds may be delayed by many factors, including: • the inability to manufacture or obtain from third parties materials sufficient for use in pre-clinical studies and clinical trials; • delays in beginning a clinical trial; • delays in patient enrollment and variability in the number and types of patients available for clinical trials; • difficulty in maintaining contact with patients after treatment, resulting in incomplete data; • poor effectiveness of our compounds during clinical trials; • unforeseen safety issues or side effects; and • governmental or regulatory delays and changes in regulatory requirements and guidelines.If we or our partners fail to complete successfully one or more clinical trials for our compounds, we or they may not receive the regulatory approvalsneeded to market that compound. Therefore, any failure or delay in commencing or completing these clinical trials would harm our business materially.Our compounds may cause undesirable side effects or have other properties that could delay, prevent or result in the revocation of theirregulatory approval or limit their marketability.Undesirable side effects caused by our compounds could interrupt, delay or halt clinical trials and could result in the denial of regulatory approval bythe FDA or other regulatory authorities for any or all targeted indications, and in turn prevent us or our partners from commercializing or continuing thecommercialization of such compounds and generating revenues from their sale. We and our partners, as applicable, will continue to assess the side effectprofile of our compounds in ongoing clinical development programs. However, we cannot predict whether the commercial use of our approved compounds (orour compounds in development, if and when they are approved for commercial use) will produce undesirable or unintended side effects that have not beenevident in the use of, or in clinical trials conducted for, such compounds to date. Additionally, incidents of product misuse may occur. These events, amongothers, could result in product recalls, product liability actions or withdrawals or additional regulatory controls, all of which could have a material adverseeffect on our business, results of operations and financial condition. 26Table of ContentsIn addition, if after receiving marketing approval of a compound, we, our partners or others later identify undesirable side effects caused by suchcompound, we or our partners could face one or more of the following: • regulatory authorities may require the addition of labeling statements, such as a “black box” warning or a contraindication; • regulatory authorities may withdraw their approval of the compound; • we or our partners may be required to change the way the compound is administered, conduct additional clinical trials or change the labeling of thecompound; and • our, our partner’s or the compound’s reputation may suffer.Any of these events could prevent us or our partners from achieving or maintaining market acceptance of the affected compound or could substantiallyincrease the costs and expenses of commercializing the compound, which in turn could delay or prevent us from generating significant revenues from its sale.We have a history of operating losses, anticipate future losses and may never become profitable on a sustained basis.We have been engaged in identifying and developing compounds since March 2003, which has required, and will continue to require, significantresearch and development expenditures.As of December 31, 2012, we had an accumulated deficit of $291.1 million, and we cannot estimate with precision the extent of our future losses. Ourability to generate revenue and achieve profitability largely depends on Novartis’ and our ability to sell Fanapt. Novartis launched Fanapt in the U.S. in thefirst quarter of 2010 and sales to date have not met our expectations. Fanapt may continue to not be as commercially successful as we expected, Novartis maynot succeed in gaining additional market acceptance of Fanapt in the U.S. or developing and commercializing Fanapt in Canada, and we may not succeed incommercializing Fanapt outside of the U.S. and Canada. In addition, we may not succeed in commercializing any other compounds. Tasimelteon is presentlyin development for Non-24 and will require significant resources prior to market approval. We may not be profitable even if our compounds are successfullycommercialized. We may be unable to fully develop, obtain regulatory approval for, commercialize, manufacture, market, sell and derive revenue from ourcompounds in the timeframes we project, if at all, and our inability to do so would materially and adversely impact the market price of our common stock andour ability to raise capital and continue operations.There can be no assurance that we will achieve sustained profitability. Our ability to achieve sustained profitability in the future depends, in part, upon: • our and our partners’ ability to obtain and maintain regulatory approval for our compounds, both in the U.S. and in foreign countries; • Novartis’ ability to successfully market and sell Fanapt in the U.S. and Canada and achieve certain product development and sales milestones; • our and our partners’ ability to successfully commercialize Fanapt outside the U.S. and Canada; • our ability to enter into and maintain agreements to develop and commercialize our products and product candidates; • our and our partners’ ability to develop, have manufactured and market our products and product candidates; • our and our partners’ ability to obtain adequate reimbursement coverage for our compounds from insurance companies, government programs andother third party payors; and • our ability to obtain additional research and development funding from collaborative partners or funding for our products and product candidates. 27®®®®®®®®Table of ContentsIn addition, the amount we spend will impact our profitability. Our spending will depend, in part, upon: • the progress of our research and development programs for our products and product candidates, including clinical trials; • the time and expense that will be required to pursue FDA and/or foreign regulatory approvals for our compounds and whether such approvals areobtained on a timely basis, if at all; • the time and expense required to prosecute, enforce and/or challenge patent and other intellectual property rights; • the cost of operating and maintaining development and research facilities; • the cost of third party manufacturers; • the number of product candidates we pursue; • how competing technological and market developments affect our compounds; • the cost of possible acquisitions of technologies, compounds, product rights or companies; • the cost of obtaining licenses to use technology owned by others for proprietary products and otherwise; • the costs and effects of potential litigation; and • the costs associated with recruiting and compensating a highly skilled workforce in an environment where competition for such employees may beintense.We may not achieve all or any of these goals and, thus, we cannot provide assurances that we will ever be profitable on a sustained basis or achievesignificant revenues. Even if we do achieve some or all of these goals, we may not achieve significant or sustained commercial success.Our ability to use net operating loss carryforwards and tax credit carryforwards to offset future taxable income may be limited as a result oftransactions involving our common stock.In general, under Section 382 of the Internal Revenue Code of 1986, as amended (Code), a corporation that undergoes an “ownership change” is subjectto limitations on its ability to utilize its pre-change net operating losses, or NOLs, and certain other tax assets to offset future taxable income. In general, anownership change occurs if the aggregate stock ownership of certain stockholders increases by more than 50 percentage points over such stockholders’ lowestpercentage ownership during the testing period (generally three years). Transactions involving our common stock, even those outside our control, such aspurchases or sales by investors, within the testing period could result in an ownership change. A limitation on our ability to utilize some or all of our NOLscould have a material adverse effect on our results of operations and cash flows.If our contract research organizations do not successfully carry out their duties or if we lose our relationships with contract researchorganizations, our drug development efforts could be delayed.Our arrangements with contract research organizations are critical to our success in bringing our products and product candidates to the market andpromoting such marketed products profitably. We are dependent on contract research organizations, third-party vendors and investigators for pre-clinicaltesting and clinical trials related to our drug discovery and development efforts and we will likely continue to depend on them to assist in our future discoveryand development efforts. These parties are not our employees and we cannot control the amount or timing of resources that they devote to our programs. Assuch, they may not complete activities on schedule or may not conduct our clinical trials in accordance with regulatory requirements or our stated protocols.The parties with which we contract for execution of our clinical trials play a significant role in the conduct of the trials and the subsequent collection andanalysis of data. If they fail to devote sufficient time and resources to our drug development programs or if their performance is substandard, it will delay thedevelopment, approval and commercialization of our products and product candidates. Moreover, these parties may also have relationships with othercommercial entities, some of which may compete with us. If they assist our competitors, it could harm our competitive position. 28Table of ContentsOur contract research organizations could merge with or be acquired by other companies or experience financial or other setbacks unrelated to ourcollaboration that could, nevertheless, materially adversely affect our business, results of operations and financial condition.If we lose our relationship with any one or more of these parties, we could experience a significant delay in both identifying another comparable providerand then contracting for its services. We may be unable to retain an alternative provider on reasonable terms, if at all. Even if we locate an alternative provider,it is likely that this provider may need additional time to respond to our needs and may not provide the same type or level of service as the original provider. Inaddition, any provider that we retain will be subject to current Good Laboratory Practices or cGLP, and similar foreign standards and we do not have controlover compliance with these regulations by these providers. Consequently, if these practices and standards are not adhered to by these providers, thedevelopment and commercialization of our products or product candidates could be delayed.We rely on a limited number of third party manufacturers to formulate and manufacture our products and product candidates and ourbusiness will be seriously harmed if these manufacturers are not able to satisfy our demand and alternative sources are not available.Our expertise is primarily in the research and development and pre-clinical and clinical trial phases of product development. We do not have an in-housemanufacturing capability and depend completely on a small number of third-party manufacturers and active pharmaceutical ingredient formulators for themanufacture of our products and product candidates. Therefore, we are dependent on third parties for our formulation development and manufacturing of ourproducts and product candidates. This may expose us to the risk of not being able to directly oversee the production and quality of the manufacturing processand provide ample commercial supplies to successfully launch and maintain the marketing of our products and product candidates. Furthermore, these thirdparty contractors, whether foreign or domestic, may experience regulatory compliance difficulty, mechanical shut downs, employee strikes, or otherunforeseeable events that may delay or limit production. Our inability to adequately establish, supervise and conduct (either ourselves or through third parties)all aspects of the formulation and manufacturing processes would have a material adverse effect on our ability to develop and commercialize our products andproduct candidates.We do not have long-term agreements with any of these third parties, and if they are unable or unwilling to perform for any reason, we may not be able tolocate alternative acceptable manufacturers or formulators or enter into favorable agreements with them. Any inability to acquire sufficient quantities of ourproducts or product candidates in a timely manner from these third parties could adversely affect sales of our products, delay clinical trials and prevent usfrom developing our products and product candidates in a cost-effective manner or on a timely basis. In addition, manufacturers of our products and productcandidates are subject to cGMP and similar foreign standards and we do not have control over compliance with these regulations by our manufacturers. If oneof our contract manufacturers fails to maintain compliance, the production of our products or product candidates could be interrupted, resulting in delays andadditional costs. In addition, if the facilities of such manufacturers do not pass a pre-approval or post-approval plant inspection, the FDA will not grantapproval and may institute restrictions on the marketing or sale of our products or product candidates.Our manufacturing strategy presents the following additional risks: • because most of our third-party manufacturers and formulators are located outside of the U.S., there may be difficulties in importing our productsand product candidates or their components into the U.S. as a result of, among other things, FDA import inspections, incomplete or inaccurateimport documentation or defective packaging; and • because of the complex nature of our products and product candidates, our manufacturers may not be able to successfully manufacture our productsand product candidates in a cost-effective and/or timely manner. 29Table of ContentsMaterials necessary to manufacture our compounds may not be available on commercially reasonable terms, or at all, which may delay thedevelopment, regulatory approval and commercialization of our compounds.We and our partners rely on manufacturers to purchase from third-party suppliers the materials necessary to produce our compounds for clinical trialsand commercialization. Suppliers may not sell these materials to such manufacturers at the times we or our partners need them or on commercially reasonableterms. We do not have any control over the process or timing of the acquisition of these materials by these manufacturers. Moreover, we currently do not haveany agreements for the commercial production of these materials. If the manufacturers are unable to obtain these materials for our or our partners’ clinicaltrials, product testing, potential regulatory approval of our compounds and commercial scale manufacturing could be delayed, significantly affecting our andour partners’ ability to further develop and commercialize our compounds. If we, our manufacturers or, in the case of our partnered products, our partners areunable to purchase these materials for our products or partnered products, as applicable, there would be a shortage in supply or the commercial launch ofsuch products or partnered products would be delayed, which would materially and adversely affect our or our partners’ ability to generate revenues from thesale of such products or partnered products.If we cannot identify, or enter into licensing arrangements for, new products or product candidates, our ability to develop a diverse productportfolio will be limited.A component of our business strategy is acquiring rights to develop and commercialize compounds discovered or developed by other pharmaceuticaland biotechnology companies for which we may find effective uses and markets through our unique pharmacogenetics and pharmacogenomics expertise forthe treatment of central nervous system disorders. Competition for the acquisition of these compounds is intense. If we are not able to identify opportunities toacquire rights to commercialize additional products or product candidates, we may not be able to develop a diverse portfolio of products and productcandidates and our business may be harmed. Additionally, it may take substantial human and financial resources to secure commercial rights to promisingproducts or product candidates. Moreover, if other firms develop pharmacogenetics and pharmacogenomics capabilities, we may face increased competition inidentifying and acquiring additional products or product candidates.We may not be successful in the development of products for our own account.In addition to our business strategy of acquiring rights to develop and commercialize products and product candidates, we may develop products andproduct candidates for our own account by applying our technologies to off-patent drugs as well as developing our own proprietary molecules. Because we willbe funding the development of such programs, there is a risk that we may not be able to continue to fund all such programs to completion or to provide thesupport necessary to perform the clinical trials, obtain regulatory approvals or market any approved products. We expect the development of products for ourown account to consume substantial resources. If we are able to develop commercial products on our own, the risks associated with these programs may begreater than those associated with our programs with collaborative partners.If we lose key scientists or management personnel, or if we fail to recruit additional highly skilled personnel, it will impair our ability to identify,develop and commercialize products.We are highly dependent on principal members of our management team and scientific staff, including our Chief Executive Officer, Mihael H.Polymeropoulos, M.D. These executives each have significant pharmaceutical industry experience. The loss of any such executives, includingDr. Polymeropoulos, or any other principal member of our management team or scientific staff, would impair our ability to identify, develop and market newproducts. Our management and other employees may voluntarily terminate their employment with us at any time. The loss of the services of these or other keypersonnel, or the inability to attract and retain additional qualified personnel, could result in delays to development or approval, loss of sales and diversion ofmanagement resources. In addition, we depend on our ability to attract and retain other highly skilled personnel, including research scientists. Competition forqualified personnel is intense, and the process of hiring and integrating such qualified personnel is often lengthy. We may be unable to recruit such personnelon a timely basis, if at all, which would negatively impact our development and commercialization programs. 30Table of ContentsAdditionally, we do not currently maintain “key person” life insurance on the lives of our executives or any of our employees. This lack of insurancemeans that we may not have adequate compensation for the loss of the services of these individuals.Product liability lawsuits could divert our resources, result in substantial liabilities and reduce the commercial potential of our compounds.The risk that we may be sued on product liability claims is inherent in the development and sale of pharmaceutical products. For example, we face arisk of product liability exposure related to the testing of our products and product candidates in clinical trials and will face even greater risks uponcommercialization by us or our partners of our compounds. We believe that we may be at a greater risk of product liability claims relative to otherpharmaceutical companies because our compounds are intended to treat central nervous system disorders, and it is possible that we may be held liable for thebehavior and actions of patients who use our compounds. These lawsuits may divert our management from pursuing our business strategy and may be costlyto defend. In addition, if we are held liable in any of these lawsuits, we may incur substantial liabilities and we or our partners may be forced to limit or foregofurther commercialization of one or more of our compounds. Although we maintain product liability insurance, our aggregate coverage limit under thisinsurance is $10.0 million, and while we believe this amount of insurance is sufficient to cover our product liability exposure, these limits may not be highenough to fully cover potential liabilities. As our development activities and commercialization efforts progress and we and our partners sell our compounds,this coverage may be inadequate, we may be unable to obtain adequate coverage at an acceptable cost or we may be unable to get adequate coverage at all or ourinsurer may disclaim coverage as to a future claim. This could prevent the commercialization or limit the commercial potential of our compounds. Even if weare able to maintain insurance that we believe is adequate, our results of operations and financial condition may be materially adversely affected by a productliability claim. Uncertainties resulting from the initiation and continuation of products liability litigation or other proceedings could have a material adverseeffect on our ability to compete in the marketplace. Product liability litigation and other related proceedings may also require significant management time.Legislative or regulatory reform of the healthcare system in the U.S. and foreign jurisdictions may affect our or our partners’ ability to sell ourproducts or partnered products profitably.The continuing efforts of the U.S. and foreign governments, insurance companies, managed care organizations and other payors of health care servicesto contain or reduce health care costs may adversely affect our or our partners’ ability to set prices for our products or partnered products which we or ourpartners believe are fair, and our ability to generate revenues and achieve and maintain profitability.Specifically, in both the U.S. and some foreign jurisdictions there have been a number of legislative and regulatory proposals to change the healthcaresystem in ways that could affect our or our partners’ ability to sell our products or partnered products profitably. In the U.S., the Medicare Prescription DrugImprovement and Modernization Act of 2003 reformed the way Medicare covered and provided reimbursement for pharmaceutical products. This legislationcould decrease the coverage and price that we or our partners may receive for our products or partnered products. Other third-party payors are increasinglychallenging the prices charged for medical products and services. It will be time-consuming and expensive for us or our partners to go through the process ofseeking reimbursement from Medicare and private payors. Our products or partnered products may not be considered cost effective, and coverage andreimbursement may not be available or sufficient to allow the sale of such products on a competitive and profitable basis. Further federal and state proposalsand healthcare reforms are likely which could limit the prices that can be charged for the drugs we develop and may further limit our commercial opportunity.Our results of operations could be materially adversely affected by the Medicare prescription drug coverage legislation, by the possible effect of this legislationon amounts that private insurers will pay and by other healthcare reforms that may be enacted or adopted in the future.The Patient Protection and Affordable Care Act of 2010, as amended by the Health Care and Education Reconciliation Act of 2010, or PPACA, is asweeping measure intended to expand healthcare coverage within the U.S., primarily through the imposition of health insurance mandates on employers andindividuals and expansion of the Medicaid program, and the establishment of health care exchanges. Several provisions of the new law, 31Table of Contentswhich have varying effective dates, may affect us, and will likely increase certain of our costs. For example, an increase in the Medicaid rebate rate from15.1% to 23.1% was effective as of January 1, 2010, and the volume of rebated drugs was expanded to include beneficiaries in Medicaid managed careorganizations effective as of March 23, 2010. The PPACA also imposes an annual fee on pharmaceutical manufacturers which began in 2011, based on themanufacturer’s sale of branded pharmaceuticals and biologics (excluding orphan drugs); expands the 340B drug discount program (excluding orphan drugs)including the creation of new penalties for non-compliance; and includes a 50% discount on brand name drugs for Medicare Part D participants in thecoverage gap, or “doughnut hole”. The law also revised the definition of “average manufacturer price” for reporting purposes (effective October 1, 2010),which could increase the amount of Medicaid drug rebates to states. Substantial new provisions affecting compliance also have been added, which mayrequire us to modify our business practices with health care practitioners.The reforms imposed by the new law will significantly impact the pharmaceutical industry; however, the full effects of the PPACA cannot be knownuntil these provisions are implemented and the Centers for Medicare & Medicaid Services and other federal and state agencies issue applicable regulations orguidance. Moreover, in the coming years, additional changes could be made to governmental healthcare programs that could significantly impact the successof our products or product candidates. We will continue to evaluate the PPACA, as amended, the implementation of regulations or guidance related to variousprovisions of the PPACA by federal agencies, as well as trends and changes that may be encouraged by the legislation and that may potentially impact on ourbusiness over time. These developments could, however, have a material adverse effect on our business, financial condition and results of operations.In some foreign countries, including major markets in the European Union and Japan, the pricing of prescription pharmaceuticals is subject togovernmental control. In these countries, pricing negotiations with governmental authorities can take nine to twelve months or longer after the receipt ofregulatory marketing approval for a product. To obtain reimbursement or pricing approval in some countries, we may be required to conduct a clinical trialthat compares the cost-effectiveness of our product to other available therapies. Our business could be materially harmed if reimbursement of our products isunavailable or limited in scope or amount or if pricing is set at unsatisfactory levels.Our business is subject to extensive governmental regulation and oversight and changes in laws could adversely affect our revenues andprofitability.Our business is subject to extensive government regulation and oversight. As a result, we may become subject to governmental actions which couldmaterially and adversely affect our business, results of operations and financial condition, including: • new laws, regulations or judicial decisions, or new interpretations of existing laws, regulations or decisions, related to patent protection andenforcement, health care availability, method of delivery and payment for health care products and services or our business operations generally; • changes in the FDA and foreign regulatory approval processes that may delay or prevent the approval of new products and result in lost marketopportunity; • new laws, regulations and judicial decisions affecting pricing or marketing; and • changes in the tax laws relating to our operations.In addition, the Food and Drug Administration Amendments Act of 2007 or the FDAAA included new authorization for the FDA to require post-marketsafety monitoring, along with a clinical trials registry, and expanded authority for the FDA to impose civil monetary penalties on companies that fail to meetcertain commitments. The amendments, among other things, require some new drug applicants to submit risk evaluation and minimization strategies tomonitor and address potential safety issues for products upon approval, grant the FDA the authority to impose risk management measures for marketedproducts and to mandate labeling changes in certain circumstances, and establish new requirements for disclosing the results of clinical trials. Companies thatviolate the law are subject to substantial civil monetary penalties. Additional measures have also been enacted to address the perceived shortcomings in theFDA’s handling of drug safety issues, and to limit 32Table of Contentspharmaceutical company sales and promotional practices. While the FDAAA has had, and is expected to have, a substantial effect on the pharmaceuticalindustry, the full extent of that effect is not yet known. As the FDA issues further regulations, guidance and interpretations relating to this legislation, theimpact on the industry as well as our business will become clearer. The requirements and other changes that the FDAAA imposes may make it more difficult,and likely more costly, to obtain approval of new pharmaceutical products and to produce, market and distribute existing products. Our and our partners’ability to commercialize approved products successfully may be hindered, and our business may be harmed as a result.Failure to comply with government regulations regarding the sale and marketing of our products or partnered products could harm ourbusiness.Our and our partners’ activities, including the sale and marketing of our products or partnered products, are subject to extensive government regulationand oversight, including regulation under the federal Food, Drug and Cosmetic Act and other federal and state statutes. We are also subject to the provisions ofthe Federal Anti-Kickback Statute and several similar state laws, which prohibit payments intended to induce physicians or others either to purchase orarrange for or recommend the purchase of healthcare products or services. While the federal law applies only to products or services for which payment maybe made by a federal healthcare program, state laws may apply regardless of whether federal funds may be involved. These laws constrain the sales,marketing and other promotional activities of manufacturers of drugs and biologicals, such as us, by limiting the kinds of financial arrangements, includingsales programs, with hospitals, physicians, and other potential purchasers of drugs and biologicals. Other federal and state laws generally prohibitindividuals or entities from knowingly presenting, or causing to be presented, claims for payment from Medicare, Medicaid, or other third party payors thatare false or fraudulent, or are for items or services that were not provided as claimed. Anti-kickback and false claims laws prescribe civil and criminalpenalties for noncompliance that can be substantial, including the possibility of exclusion from federal healthcare programs (including Medicare andMedicaid).Pharmaceutical and biotechnology companies have been the target of lawsuits and investigations alleging violations of government regulation, includingclaims asserting antitrust violations, violations of the Federal False Claim Act, the Anti-Kickback Statute, the Prescription Drug Marketing Act and otherviolations in connection with off-label promotion of products and Medicare and/or Medicaid reimbursement or related to environmental matters and claimsunder state laws, including state anti-kickback and fraud laws.While we continually strive to comply with these complex requirements, interpretations of the applicability of these laws to marketing practices are everevolving. If any such actions are instituted against us or our partners and we or they are not successful in defending such actions or asserting our rights, thoseactions could have a significant and material adverse impact on our business, including the imposition of significant fines or other sanctions. Even anunsuccessful challenge could cause adverse publicity and be costly to respond to, and thus could have a material adverse effect on our business, results ofoperations and financial condition.Future transactions may harm our business or the market price of our stock.We regularly review potential transactions related to technologies, products or product rights and businesses complementary to our business. Thesetransactions could include: • mergers; • acquisitions; • strategic alliances; • licensing agreements; and • co-promotion and similar agreements.We may choose to enter into one or more of these transactions at any time, which may cause substantial fluctuations in the market price of our stock.Moreover, depending upon the nature of any transaction, we may experience a charge to earnings, which could also materially adversely affect our results ofoperations and could harm the market price of our stock. 33Table of ContentsWe may undertake strategic acquisitions in the future, and difficulties integrating such acquisitions could damage our ability to achieve orsustain profitability.Although we have no experience in acquiring businesses, we may acquire businesses or assets that complement or augment our existing business. If weacquire businesses with promising product candidates or technologies, we may not be able to realize the benefit of acquiring such businesses if we are unableto move one or more products or product candidates through preclinical and/or clinical development to regulatory approval and commercialization. Integratingany newly acquired businesses or technologies could be expensive and time-consuming, resulting in the diversion of resources from our current business. Wemay not be able to integrate any acquired business successfully. We cannot assure you that, following an acquisition, we will achieve revenues, specific netincome or loss levels that justify the acquisition or that the acquisition will result in increased earnings, or reduced losses, for the combined company in anyfuture period. Moreover, we may need to raise additional funds through public or private debt or equity financing to acquire any businesses, which wouldresult in dilution for stockholders or the incurrence of indebtedness and may not be available on terms which would otherwise be acceptable to us. We may notbe able to operate acquired businesses profitably or otherwise implement our growth strategy successfully.Our quarterly operating results may fluctuate significantly.Our operating results will continue to be subject to quarterly fluctuations. The revenues we generate, if any, and our operating results will be affected bynumerous factors, including: • our addition or termination of development programs; • variations in the level of expenses related to our products, product candidates or future development programs; • our execution of collaborative, licensing or other arrangements, and the timing of payments we may make or receive under these arrangements; • the timing and amount of royalties or milestone payments; • regulatory developments affecting our compounds or those of our competitors; • product sales; • cost of product sales; • marketing and other expenses; • manufacturing or supply issues; • any intellectual property infringement or other lawsuit in which we may become involved; and • the timing and recognition of stock-based compensation expense.If our quarterly operating results fall below the expectations of investors or securities analysts, the price of our common stock could declinesubstantially. Furthermore, any quarterly fluctuations in our operating results may, in turn, cause the price of our stock to fluctuate substantially. We believethat quarterly comparisons of our financial results are not necessarily meaningful and should not be relied upon as an indication of our future performance.Risks related to intellectual property and other legal mattersOur rights to develop and commercialize our product and product candidates are subject in part to the terms and conditions of licenses orsublicenses granted to us by other pharmaceutical companies. With respect to tasimelteon, these terms and conditions include an option infavor of the licensor to reacquire rights to commercialize and develop this product in certain circumstances.Tasimelteon is based in part on patents that we have licensed on an exclusive basis and other intellectual property licensed from Bristol-Myers SquibbCompany (BMS). BMS holds certain rights with respect to 34Table of Contentstasimelteon in the license agreement. If we have not agreed to one or more partnering arrangements to develop and commercialize tasimelteon in certainsignificant markets with one or more third parties by a certain date, BMS has the option to exclusively develop and commercialize tasimelteon on its own onpre-determined financial terms, including milestone and royalty payments. BMS may terminate our license if we fail to meet certain milestones or if weotherwise breach our royalty or other obligations in the agreement. In the event that we terminate our license, or if BMS terminates our license due to ourbreach, all of our rights to tasimelteon (including any intellectual property we develop with respect to tasimelteon) will revert back to BMS or otherwise belicensed back to BMS on an exclusive basis. Any termination or reversion of our rights to develop or commercialize tasimelteon, including any reacquisitionby BMS of our rights, may have a material adverse effect on our business.Fanapt (iloperidone) is based in part on patents and other intellectual property owned by sanofi-aventis and Novartis. Titan Pharmaceuticals, Inc.(Titan) holds an exclusive license from sanofi-aventis to the intellectual property owned by sanofi-aventis, and Titan has sublicensed its rights under suchlicense on an exclusive basis to Novartis. We acquired exclusive rights to this and other intellectual property through a further sublicense from Novartis. Thesublicense with Novartis was amended and restated in October of 2009 to provide Novartis with exclusive rights to commercialize Fanapt in the U.S. andCanada and further develop and commercialize a long-acting injectable or depot formulation of Fanapt in the U.S. and Canada. In October 2012, Novartisinformed us that it had determined to cease development of the long-acting (or depot) formulation of Fanapt. We retained exclusive rights to Fanapt outside theU.S. and Canada and we have exclusive rights to use any of Novartis’ data for Fanapt for developing and commercializing Fanapt outside the U.S. andCanada. At Novartis’ option, we will enter into good faith discussions with Novartis relating to the co-commercialization of Fanapt outside of the U.S. andCanada or, alternatively, Novartis will receive a royalty on net sales of Fanapt outside of the U.S. and Canada. Novartis has chosen not to co-commercializeFanapt in Europe and certain other countries and will instead receive a royalty on net sales in those countries. These include, but are not limited to, thecountries in the European Union, as well as Switzerland, Norway, Liechtenstein and Iceland. We may lose our rights to develop and commercialize Fanaptoutside the U.S. and Canada if we fail to comply with certain requirements in the amended and restated sublicense agreement regarding our financialcondition, or if we fail to comply with certain diligence obligations regarding our development or commercialization activities or if we otherwise breach theamended and restated sublicense agreement and fail to cure such breach. Our rights to develop and commercialize Fanapt outside the U.S. and Canada maybe impaired if we do not cure breaches by Novartis of similar obligations contained in its sublicense agreement with Titan. Our loss of rights in Fanapt toNovartis would have a material adverse effect on our business, financial condition and results of operations. In addition, if Novartis breaches the amendedand restated sublicense agreement with respect to its commercialization activities in the U.S. or Canada, we may terminate Novartis’ commercialization rightsin the applicable country. We would no longer receive royalty payments from Novartis in connection with such country in the event of such termination.VLY-686 is based in part on patents that we have licensed on an exclusive basis and other intellectual property licensed from Lilly. Lilly may terminateour license if we fail to use our commercially reasonable efforts to develop and commercialize VLY-686 or if we materially breach the agreement and fail tocure that breach. In the event that we terminate our license, or if Lilly terminates our license for the reasons stated above, all of our rights to VLY-686(including any intellectual property we develop with respect to VLY-686) will revert back to Lilly, subject to payment by Lilly to us of a royalty on net sales ofproducts that contain VLY-686.If our efforts to protect the proprietary nature of the intellectual property related to our compounds are not adequate, we may not be able tocompete effectively in our markets.In addition to the rights we have licensed from Novartis, BMS and Lilly relating to our compounds, we rely upon intellectual property we own relatingto these compounds, including patents, patent applications and trade secrets. As of December 31, 2012, excluding in-licensed patents and patent applications,we had 29 patent and patent application families, most of which have been filed in key markets including the U.S., and one pending Patent CooperationTreaty application, relating to Fanapt and tasimelteon. In addition, we had five other patent applications relating to compounds not presently in clinicalstudies. Our patent applications may be challenged or 35®®®®®®®®®®®®®®Table of Contentsfail to result in issued patents and our existing or future patents may be too narrow to prevent third parties from developing or designing around these patents.In addition, we generally rely on trade secret protection and confidentiality agreements to protect certain proprietary know-how that is not patentable, forprocesses for which patents are difficult to enforce and for any other elements of our drug development processes that involve proprietary know-how,information and technology that is not covered by patent applications. While we require all of our employees, consultants, advisors and any third parties whohave access to our proprietary know-how, information and technology to enter into confidentiality agreements, we cannot be certain that this know-how,information and technology will not be disclosed or that competitors will not otherwise gain access to our trade secrets or independently develop substantiallyequivalent information and techniques. Further, the laws of some foreign countries do not protect proprietary rights to the same extent as the laws of the U.S.As a result, we may encounter significant problems in protecting and defending our intellectual property both in the U.S. and abroad. If we are unable toprotect or defend the intellectual property related to our technologies, we will not be able to establish or maintain a competitive advantage in our market.If we do not obtain protection under the Hatch-Waxman Act and similar foreign legislation to extend our patents and to obtain marketexclusivity for our products and partnered products, our business will be harmed.The United States Drug Price Competition and Patent Term Restoration Act of 1984, more commonly known as the “Hatch-Waxman Act,” provides foran extension of patent term for drugs for a period of up to five years to compensate for time spent in development. Assuming we gain a five-year patent termrestoration for tasimelteon, and that we continue to have rights under our license agreement with respect to this product, we would have exclusive rights totasimelteon’s U.S. “new chemical entity” patent (the primary patent covering the compound as a new composition of matter) until 2022. In August 2011, theU.S. Patent and Trademark Office issued a certificate of extension under the Hatch-Waxman Act, extending by five years the term of sanofi-aventis’ newchemical entity patent relating to Fanapt to November 2016. Fanapt will also be eligible for 6 months of additional protection for successfully completingstudies in the pediatric population potentially extending the term of the new chemical entity parent in the U.S. until May 2017. The patent for the microspherelong-acting injectable (or depot) formulation of Fanapt expires in 2024 in the U.S. and 2022 in most of the major markets in Europe. The pending patentapplication for the aqueous microcrystals long acting injectable (or depot) formulation of Fanapt will expire in 2023 in the U.S. The patent for the aqueousmicrocrystals long acting injectable (or depot) formulation of Fanapt will expire in 2023 in most of the major markets in Europe. A directive in the EuropeanUnion provides that companies that receive regulatory approval for a new compound will have a 10-year period of market exclusivity for that compound (withthe possibility of a further one-year extension) in most countries in Europe, beginning on the date of such European regulatory approval, regardless of when theEuropean new chemical entity patent covering such compound expires. A generic version of the approved drug may not be marketed or sold in Europe duringsuch market exclusivity period. This directive is of material importance with respect to Fanapt, since the European new chemical entity patent for Fanapthas expired.However, there is no assurance that we will receive the extensions of our patents or other exclusive rights available under the Hatch-Waxman Act orsimilar foreign legislation. If we fail to receive such extensions and exclusive rights, our ability or our partners’ ability to prevent competitors frommanufacturing, marketing and selling generic versions of our products or partnered products will be materially impaired.Litigation or third-party claims of intellectual property infringement could require us to divert resources and may prevent or delay our drugdiscovery and development efforts.Our commercial success depends in part on our not infringing the patents and proprietary rights of third parties. Third parties may assert that we areemploying their proprietary technology without authorization. In addition, third parties may obtain patents in the future and claim that use of our technologiesinfringes upon these patents. Furthermore, parties making claims against us may obtain injunctive or other equitable relief, which could effectively block ourability to develop and commercialize one or more of our products. Defense of these claims, regardless of their merit, would divert substantial financial andemployee resources from our business. In 36®®®®®®®Table of Contentsthe event of a successful claim of infringement against us, we may have to pay substantial damages, obtain one or more licenses from third parties or payroyalties. In addition, even in the absence of litigation, we may need to obtain additional licenses from third parties to advance our research or allowcommercialization of our products. We may fail to obtain any of these licenses at a reasonable cost or on reasonable terms, if at all. In that event, we would beunable to develop and commercialize further one or more of our products.In addition, in the future we could be required to initiate litigation to enforce our proprietary rights against infringement by third parties. Prosecution ofthese claims to enforce our rights against others could divert substantial financial and employee resources from our business. If we fail to enforce ourproprietary rights against others, our business will be harmed.If we use hazardous and biological materials in a manner that causes injury or violates applicable law, we may be liable for damages.Our research, development and commercialization activities involve the controlled use of potentially hazardous substances, including toxic chemical andbiological materials. Although our goal is for our safety procedures for handling and disposing of such materials to comply with state and federal standards,there will always be the risk of contamination, injury or other damages resulting from these hazardous substances. If we were to become liable for an accident,or if we or our partners or manufacturers were to suffer an extended facility shutdown, we could incur significant costs, damages and penalties that couldmaterially harm our business, results of operations and financial condition.In addition, our operations produce hazardous waste products. While third parties are responsible for disposal of our hazardous waste, we could beliable under environmental laws for any required cleanup of sites at which our waste is disposed. Federal, state, foreign and local laws and regulations governthe use, manufacture, storage, handling and disposal of these hazardous materials. If we fail to comply with these laws and regulations at any time, or if theychange, we may be subject to criminal sanctions and substantial civil liabilities, which may adversely affect our business.Even if we continue to comply with all applicable laws and regulations regarding hazardous materials, we cannot eliminate the risk of accidentalcontamination or discharge and our resultant liability for any injuries or other damages caused by these accidents. Although we maintain pollution liabilityinsurance, our coverage limit under this insurance is $2.0 million, and while we believe this amount and type of insurance is sufficient to cover riskstypically associated with our handling of materials, the insurance may not cover all environmental liabilities, and these limits may not be high enough to coverpotential liabilities for these damages fully. The amount of uninsured liabilities may exceed our financial resources and materially harm our business.Risks related to our common stockOur stock price has been highly volatile and may be volatile in the future, and purchasers of our common stock could incur substantial losses.The realization of any of the risks described in these risk factors or other unforeseen risks could have a dramatic and adverse effect on the market priceof our common stock. Between December 31, 2011 and December 31, 2012, the high and low sale prices of our common stock as reported on the NASDAQGlobal Market varied between $2.92 and $5.47. Additionally, market prices for securities of biotechnology and pharmaceutical companies, including ours,have historically been very volatile. The market for these securities has from time to time experienced significant price and volume fluctuations for reasons thatwere unrelated to the operating performance of any one company.The following factors, in addition to the other risk factors described in this section, may also have a significant impact on the market price of ourcommon stock: • publicity regarding actual or potential testing or trial results relating to products under development by us or our competitors; • the outcome of regulatory review relating to products under development by us or our competitors; 37Table of Contents • regulatory developments in the U.S. and foreign countries; • developments concerning any collaboration or other strategic transaction we may undertake; • announcements of patent issuances or denials, technological innovations or new commercial products by us or our competitors; • termination or delay of development or commercialization program(s) by our partners; • safety issues with our products or those of our competitors; • our partners’ ability to successfully commercialize our partnered products; • our ability to successfully execute our commercialization strategies; • announcements of technological innovations or new therapeutic products or methods by us or others; • actual or anticipated variations in our quarterly operating results; • changes in estimates of our financial results or recommendations by securities analysts or failure to meet such financial expectations; • changes in government regulations or policies; • changes in patent legislation or patent decisions or adverse changes to patent law; • additions or departures of key personnel or members of our board of directors; • publicity regarding actual or potential transactions involving us; or • economic, political and other external factors beyond our control.As a result of these factors, holders of our common stock might be unable to sell their shares at or above the price they paid for such shares.If there are substantial sales of our common stock, our stock price could decline.A small number of institutional investors and private equity funds hold a significant number of shares of our common stock. Sales by thesestockholders of a substantial number of shares, or the expectation of such sales, could cause a significant reduction in the market price of our common stock.In addition to our outstanding common stock, as of December 31, 2012, there were a total of 6,243,008 shares of common stock that we have registeredand that we are obligated to issue upon the exercise of currently outstanding options and settlement of restricted stock unit awards granted under our SecondAmended and Restated Management Equity Plan and 2006 Equity Incentive Plan. Upon the exercise of these options or settlement of the shares underlyingthese restricted stock units, as the case may be, in accordance with their respective terms, these shares may be resold freely, subject to restrictions imposed onour affiliates under Rule 144. If significant sales of these shares occur in short periods of time, these sales could reduce the market price of our common stock.Any reduction in the trading price of our common stock could impede our ability to raise capital on attractive terms, if at all.If we fail to maintain the requirements for continued listing on the NASDAQ Global Market, our common stock could be delisted from trading,which would adversely affect the liquidity of our common stock and our ability to raise additional capital.Our common stock is currently listed for quotation on the NASDAQ Global Market. We are required to meet specified listing criteria in order tomaintain our listing on the NASDAQ Global Market. If we fail to satisfy the NASDAQ Global Market’s continued listing requirements, our common stockcould be delisted from the NASDAQ Global Market, in which case we may transfer to the NASDAQ Capital Market, which generally has lower financialrequirements for initial listing or, if we fail to meet its listing requirements, the over-the-counter bulletin board. Any potential delisting of our common stockfrom the NASDAQ Global Market would make it more difficult for our stockholders to sell our stock in the public market and would likely result indecreased liquidity and increased volatility for our common stock. 38Table of ContentsIf securities or industry analysts do not publish research or reports or publish unfavorable research about our business, our stock price andtrading volume could decline.The trading market for our common stock will depend in part on the research and reports that securities or industry analysts publish about us or ourbusiness. We currently have research coverage by securities and industry analysts. If one or more of the analysts who covers us downgrades our stock, ourstock price would likely decline. If one or more of these analysts ceases coverage of our Company or fails to regularly publish reports on us, interest in thepurchase of our stock could decrease, which could cause our stock price or trading volume to decline.Our business could be negatively affected as a result of the actions of activist stockholders.Proxy contests have been waged against many companies in the biopharmaceutical industry, including us, over the last few years. If faced with a proxycontest or other type of shareholder activism, we may not be able to respond successfully to the contest or dispute, which would be disruptive to our business.Even if we are successful, our business could be adversely affected by a proxy contest or shareholder dispute involving us or our partners because: • responding to proxy contests and other actions by activist stockholders can be costly and time-consuming, disrupting operations and diverting theattention of management and employees; • perceived uncertainties as to future direction may result in the loss of potential acquisitions, collaborations or in-licensing opportunities, and maymake it more difficult to attract and retain qualified personnel and business partners; and • if individuals are elected to a board of directors with a specific agenda, it may adversely affect our ability to effectively and timely implement ourstrategic plan and create additional value for our stockholders.These actions could cause our stock price to experience periods of volatility.Anti-takeover provisions in our charter and bylaws, and in Delaware law, and our rights plan could prevent or delay a change in control ofour company.We are a Delaware corporation and the anti-takeover provisions of Section 203 of the Delaware General Corporation Law may discourage, delay orprevent a change in control by prohibiting us from engaging in a business combination with an interested stockholder for a period of three years after theperson becomes an interested stockholder, even if a change of control would be beneficial to our existing stockholders. In addition, our amended and restatedcertificate of incorporation and bylaws may discourage, delay or prevent a change in our management or control over us that stockholders may considerfavorable. Our amended and restated certificate of incorporation and bylaws: • authorize the issuance of “blank check” preferred stock that could be issued by our board of directors to thwart a takeover attempt; • do not provide for cumulative voting in the election of directors, which would allow holders of less than a majority of the stock to elect somedirectors; • establish a classified board of directors, as a result of which the successors to the directors whose terms have expired will be elected to serve from thetime of election and qualification until the third annual meeting following their election; • require that directors only be removed from office for cause; • provide that vacancies on the board of directors, including newly-created directorships, may be filled only by a majority vote of directors then inoffice; • limit who may call special meetings of stockholders; • prohibit stockholder action by written consent, requiring all actions to be taken at a meeting of the stockholders; and 39Table of Contents • establish advance notice requirements for nominating candidates for election to the board of directors or for proposing matters that can be acted uponby stockholders at stockholder meetings.Moreover, in September 2008, our board of directors adopted a rights agreement, the provisions of which could result in significant dilution of theproportionate ownership of a potential acquirer and, accordingly, could discourage, delay or prevent a change in our management or control over us.Unstable market, credit and financial conditions may exacerbate certain risks affecting our business and have serious adverse consequenceson our business.The global economic downturn and market instability has made the business climate more volatile and more costly. Our general business strategy maybe adversely affected by unpredictable and unstable market conditions. If the equity and credit markets deteriorate further, or do not improve, it may makeany necessary debt or equity financing more difficult, more costly, and more dilutive. While we believe we have adequate capital resources to meet currentworking capital and capital expenditure requirements, a lingering economic downturn or significant increase in our expenses could require additional financingon less than attractive rates or on terms that are excessively dilutive to existing stockholders. Failure to secure any necessary financing in a timely manner andon favorable terms could have a material adverse effect on our stock price and could require us to delay or abandon clinical development plans.Sales of our products and partnered products will be dependent, in large part, on reimbursement from government health administration authorities,private health insurers, distribution partners and other organizations. As a result of the current credit and financial market conditions, these organizations maybe unable to satisfy their reimbursement obligations or may delay payment. In addition, federal and state health authorities may reduce Medicare and Medicaidreimbursements, and private insurers may increase their scrutiny of claims. A reduction in the availability or extent of reimbursement could negatively affectour or our partners’ product sales and revenue. Customers may also reduce spending during times of economic uncertainty.In addition, we rely on third parties for several important aspects of our business. For example, we depend upon Novartis for Fanapt royalty revenue,we use third party contract research organizations for many of our clinical trials, and we rely upon several single source providers of raw materials andcontract manufacturers for the manufacture of our products and product candidates. Due to the recent tightening of global credit and the continued deteriorationin the financial markets, there may be a disruption or delay in the performance of our third party contractors, suppliers or partners. If such third parties areunable to satisfy their commitments to us, our business would be adversely affected. ITEM 1B.UNRESOLVED STAFF COMMENTSNot applicable. ITEM 2.PROPERTIESIn the second quarter of 2012, we relocated our headquarters to 21,400 square feet of leased office space at 2200 Pennsylvania Avenue NW, Washington,D.C. 20037. Management believes that our current facility is suitable for and adequate to meet our anticipated needs. ITEM 3.LEGAL PROCEEDINGSThe Company is not a party to any material pending legal proceedings, and management is not aware of any contemplated proceedings by anygovernmental authority against the Company. ITEM 4.MINE SAFETY DISCLOSURESNot applicable. 40®Table of ContentsPART II ITEM 5.MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASESOF EQUITY SECURITIESOur common stock is quoted on The NASDAQ Global Market under the symbol “VNDA.” The following table sets forth, for the periods indicated,the range of high and low sale prices of our common stock as reported on The NASDAQ Global Market: Year Ended December 31, 2012 High Low First quarter $5.47 $4.40 Second quarter 4.82 3.93 Third quarter 4.64 3.90 Fourth quarter 4.42 2.92 Year Ended December 31, 2011 High Low First quarter $10.17 $6.61 Second quarter 8.45 6.75 Third quarter 7.80 4.89 Fourth quarter 6.06 4.33 As of February 15, 2013, there were 10 holders of record of our common stock.DividendsThe Company has not paid dividends to its stockholders (other than a dividend of preferred share purchase rights which was declared in September2008) since its inception and does not plan to pay dividends in the foreseeable future. The Company currently intends to retain earnings, if any, to finance thegrowth of the Company. 41Table of ContentsMarket Price of and Dividends on the Registrant’s Common Equity and Related Stockholder MattersThe following graph shows the cumulative five-year total return on our common stock relative to the cumulative total returns of the NASDAQComposite Index and the NASDAQ Biotechnology Index. An investment of $100 (with reinvestment of dividends) is assumed to have been made in ourcommon stock and in each of the indexes on December 31, 2007 and its relative performance is tracked through December 31, 2012. The comparisons in thetable are required by the SEC and are not intended to forecast or be indicative of possible future performance of the Company’s common stock. We have notpaid dividends to our stockholders since the inception (other than a dividend of preferred share purchase rights which was declared in September 2008) anddo not plan to pay dividends in the foreseeable future. The following graph and related information is being furnished solely to accompany this annual reporton Form 10-K pursuant to Item 201(e) of Regulation S-K and shall not be deemed “soliciting materials” or to be “filed” with the SEC (other than as provided inItem 201), nor shall such information be incorporated by reference into any of our filings under the Securities Act of 1933 or the Securities Exchange Act of1934, whether made before or after the date hereof, and irrespective of any general incorporation language in any such filing. ITEM 6.SELECTED CONSOLIDATED FINANCIAL DATAThe consolidated statements of operations data for the years ended December 31, 2012, 2011 and 2010 and the consolidated balance sheet data as ofDecember 31, 2012 and 2011 are each derived from our audited consolidated financial statements included in this annual report on Form 10-K. Theconsolidated statements of operations data for the years ended December 31, 2009 and 2008, and the consolidated balance sheet data as of December 31, 2010,2009 and 2008 are each derived from our audited consolidated financial statements not included herein. Our historical results for any prior period are notnecessarily indicative of results to be expected in any future period. 42Table of ContentsThe following data should be read together with our consolidated financial statements and accompanying notes and the section entitled “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” included in this annual report on Form 10-K. (in thousands, except for share and per shareamounts) Year Ended December 31, 2012 2011 2010 2009 2008 Statements of operations data Revenue $32,727 $31,720 $35,709 $4,548 $— Operating expenses: Cost of sales 129 — 2,891 1,915 — Research and development 45,446 28,996 12,338 13,874 23,936 General and administrative 13,882 11,486 10,147 23,724 28,909 Intangible asset amortization 1,495 1,495 1,495 983 — Total operating expenses 60,952 41,977 26,871 40,496 52,845 Income (loss) from operations (28,225) (10,707) 8,838 (35,948) (52,845) Other income 561 461 431 89 1,781 Income (loss) before tax provision (27,664) (10,246) 9,269 (35,859) (51,064) Tax provision (benefit) — (444) 2,077 — — Net income (loss) $(27,664) $(9,802) $7,192 $(35,859) $(51,064) Net income (loss) per share: Basic $(0.98) $(0.35) $0.26 $(1.33) $(1.92) Diluted $(0.98) $(0.35) $0.25 $(1.33) $(1.92) Shares used in calculations of net income (loss) pershare: Basic 28,228,409 28,106,831 27,916,388 27,015,271 26,650,126 Diluted 28,228,409 28,106,831 28,534,617 27,015,271 26,650,126 December 31, 2012 2011 2010 2009 2008 Balance sheet data Cash and cash equivalents $ 88,772 $ 87,923 $ 42,559 $ 205,295 $ 39,079 Marketable securities, current 31,631 60,961 155,478 — 7,379 Marketable securities, non-current — 19,012 — — — Working capital 93,705 121,882 169,546 181,417 44,335 Total assets 135,448 182,618 213,101 225,714 49,934 Total liabilities 125,543 149,144 175,370 202,683 3,914 Accumulated deficit (291,107) (263,443) (253,641) (260,833) (224,974) Total stockholders’ equity 9,905 33,474 37,731 23,031 46,020 43Table of ContentsITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSYou should read the following discussion and analysis of our financial condition and results of operations together with “Selected ConsolidatedFinancial Data” and our consolidated financial statements and related notes appearing in this annual report on Form 10-K. Some of the informationcontained in this discussion and analysis or set forth elsewhere in this annual report on Form 10-K include historical information and otherinformation with respect to our plans and strategy for our business and contain forward-looking statements that involve risks, uncertainties andassumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors,including but not limited to those set forth under the “Risk Factors” section of this report and elsewhere in this annual report on Form 10-K.OverviewWe are a biopharmaceutical company focused on the development and commercialization of products for the treatment of central nervous systemdisorders. We believe that each of our products and partnered products will address a large market with significant unmet medical needs by offeringadvantages over currently available therapies. Our product portfolio includes Fanapt (iloperidone), a compound for the treatment of schizophrenia, the oralformulation of which is currently being marketed and sold in the U.S. by Novartis Pharma AG (Novartis), tasimelteon, a compound for the treatment ofcircadian rhythm sleep disorders (CRSD), which is currently in clinical development for the treatment of Non-24, and VLY-686, a small moleculeneurokinin-1 receptor (NK-1R) antagonist.In December 2012 and January 2013, we announced positive results for two Phase III studies for tasimelteon in the treatment of Non-24-Hour Disorder(Non-24). The SET Phase III study demonstrated that tasimelteon was able to entrain the master body clock as measured by melatonin and cortisol circadianrhythms. Tasimelteon was also shown to significantly improve clinical symptoms across a number of sleep and wake measures. These results providedrobust evidence of direct and clinically meaningful benefits to patients with Non-24. The RESET Phase III study demonstrated the maintenance effect of 20milligrams (mg) of tasimelteon to entrain melatonin and cortisol circadian rhythms in individuals with Non-24. Patients treated with tasimelteon maintainedtheir clinical benefits while patients receiving placebo showed significant deterioration in measures of nighttime sleep, daytime naps and timing of sleep. Thetasimelteon Non-24 program continues towards its goal of a projected mid-2013 New Drug Application (NDA) filing with the U.S. Food and DrugAdministration (FDA). We will meet with the FDA in the first quarter of 2013 for a pre-NDA meeting on tasimelteon in the treatment of patients with Non-24.In January 2013, Vanda reported top-line results of the Phase IIb/III clinical study (MAGELLAN) in Major Depressive Disorder (MDD), investigating theefficacy and safety of tasimelteon as a monotherapy in the treatment of patients with MDD. The clinical study did not meet the primary endpoint of changefrom baseline in the Hamilton Depression Scale (HAMD-17) after 8 weeks of treatment as compared to placebo. As a result, all activities have beendiscontinued related to the MDD indication for tasimelteon. We incurred $40.9 million in research and development costs in 2012 directly attributable to ourdevelopment of tasimelteon.Pursuant to the amended and restated sublicense agreement with Novartis, we received an upfront payment of $200.0 million in 2009 and are eligible foradditional payments totaling up to $265.0 million upon Novartis’ achievement of certain commercial and development milestones for Fanapt in the U.S. andCanada. Based on the current sales performance of Fanapt in the U.S. and the decision by Novartis to cease development of the long-acting injectable (ordepot) formulation of Fanapt, we expect that some or all of these commercial and development milestones will not be achieved by Novartis. We also receiveroyalties, which, as a percentage of net sales, are in the low double-digits, on net sales of Fanapt in the U.S. and Canada. We retain exclusive rights toFanapt outside the U.S. and Canada and we have exclusive rights to use any of Novartis’ data for Fanapt for developing and commercializing Fanaptoutside the U.S. and Canada. We incurred $1.5 million in research and development costs in 2012 directly attributable to our development of Fanapt.Since we began our operations in 2003, we have devoted substantially all of our resources to the in-licensing and clinical development of our compounds.Our ability to generate additional revenues largely depends upon our ability, alone or with others, to complete the development of our products or productcandidates to obtain the 44®®®®®®®®®Table of Contentsregulatory approvals for and manufacture, market and sell our products and product candidates and on Novartis’ ability to successfully commercializeFanapt in the U.S. The results of our operations will vary significantly from year-to-year and quarter-to-quarter and depend on a number of factors,including risks related to our business, risks related to our industry, and other risks which are detailed in Item 1A of Part I of this annual report on Form 10-K, entitled “Risk Factors”.Revenues. Our revenues are derived primarily from our amended and restated sublicense agreement with Novartis and include an upfront payment,product sales and future milestone and royalty payments. Revenue is considered both realizable and earned when the following four conditions are met:(i) persuasive evidence of an arrangement exists, (ii) the arrangement fee is fixed or determinable, (iii) delivery or performance has occurred and(iv) collectability is reasonably assured. Revenue related to the $200.0 million upfront payment is being recognized ratably on a straight-line basis from the datethe amended and restated sublicense agreement became effective (November 2009) through the expected life of the U.S. patent for Fanapt which we expect tolast until May 2017. This includes the Hatch-Waxman extension that extends patent protection for drug compounds for a period of five years to compensate fortime spent in development and a six-month pediatric term extension. Fanapt has qualified for the full five-year patent term Hatch-Waxman extension and weexpect that Fanapt will be eligible for six months of pediatric exclusivity. We recognize revenue from Fanapt royalties and commercial and developmentmilestones from Novartis when realizable and product revenue upon delivery of our products to Novartis.Research and development expenses. Research and development expenses consist primarily of fees for services provided by third parties inconnection with the clinical trials, costs of contract manufacturing services, milestone payments, costs of materials used in clinical trials and research anddevelopment, costs for regulatory consultants and filings, depreciation of capital resources used to develop products, related facilities costs, and salaries, otheremployee-related costs and stock-based compensation for research and development personnel. We expense research and development costs as they are incurredfor compounds in the development stage, including manufacturing costs and milestone payments made under license agreements prior to FDA approval. Uponand subsequent to FDA approval, manufacturing and milestone payments are capitalized. Milestone payments are accrued when it is deemed probable that themilestone event will be achieved. Costs related to the acquisition of intellectual property are expensed as incurred if the underlying technology is developed inconnection with our research and development efforts and has no alternative future use. We believe that significant investment in product development is acompetitive necessity and plan to continue these investments in order to realize the potential of our products and product candidates and pharmacogenetics andpharmacogenomics expertise.We incurred research and development expenses in the aggregate of $45.4 million in 2012 including employee stock-based compensation expense of $1.4million. We expect to incur significant research and development expenses as we continue to develop our products and product candidates. We expect to incurlicensing costs in the future that could be substantial, as we continue our efforts to develop our products, product candidates and partnered products and toevaluate potential in-license product candidates or compounds. 45®®®®®Table of ContentsThe following table summarizes our product development initiatives for 2012, 2011 and 2010, respectively. Included in this table are the research anddevelopment expenses recognized in connection with the clinical development of Fanapt, tasimelteon and VLY-686. Year Ended December 31, (in thousands) 2012 2011 2010 Direct project costs(1) Tasimelteon $40,939 $24,810 $8,329 Fanapt 1,494 2,197 2,708 VLY-686 1,144 — — Total direct product costs 43,577 27,007 11,037 Indirect project costs(1) Facility 1,280 1,507 609 Depreciation 354 259 184 Other indirect overhead costs 235 223 508 Total indirect expenses 1,869 1,989 1,301 Total research and development expenses $45,446 $28,996 $12,338 (1)Many of our research and development costs are not attributable to any individual project because we share resources across several developmentprojects. We record direct costs, including personnel costs and related benefits and stock-based compensation, on a project-by-project basis. We recordindirect costs that support a number of our research and development activities in the aggregate.General and administrative expenses. General and administrative expenses consist primarily of salaries, other related costs for personnel, includingemployee stock-based compensation, related to executive, finance, accounting, information technology, marketing, and human resource functions. Other costsinclude facility costs not otherwise included in research and development expenses and fees for legal, accounting and other professional services. General andadministrative expenses also include third party expenses incurred to support business development, marketing and other business activities related toFanapt. We incurred general and administrative expenses of $13.9 million in 2012, including employee stock-based compensation expense of $2.7 million.Other income. Other income consists of interest income earned on our cash and cash equivalents, marketable securities and restricted cash and non-recurring income (expense) transactions that are outside of our normal business operations.Critical Accounting PoliciesThe preparation of our consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets andliabilities and the disclosure of contingent assets and liabilities at the date of our financial statements, as well as the reported revenues and expenses during thereported periods. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the resultsof which form the basis for making judgments about the carrying value of assets and liabilities that are not apparent from other sources. Actual results maydiffer from these estimates under different assumptions or conditions.A summary of our significant accounting policies appears in the notes to our audited consolidated financial statements for the year ended December 31,2012 included in this annual report on Form 10-K. However, we believe that the following accounting policies are important to understanding and evaluatingour reported financial results, and we have accordingly included them in this discussion.Accrued liabilities. As part of the process of preparing financial statements we are required to estimate accrued liabilities. The estimation of accruedliabilities involves identifying services that have been performed on 46®®®Table of Contentsour behalf, and then estimating the level of service performed and the associated cost incurred for such services as of each balance sheet date in the financialstatements. Accrued liabilities include professional service fees, such as lawyers and accountants, contract service fees, such as those under contracts withclinical monitors, data management organizations and investigators in conjunction with clinical trials, fees to contract manufacturers in conjunction with theproduction of clinical materials, and fees for marketing and other commercialization activities. Pursuant to our assessment of the services that have beenperformed on clinical trials and other contracts, we recognize these expenses as the services are provided. Our assessments include, but are not limited to: (i) anevaluation by the project manager of the work that has been completed during the period, (ii) measurement of progress prepared internally and/or provided bythe third-party service provider, (iii) analyses of data that justify the progress, and (iv) our judgment. In the event that we do not identify certain costs thathave begun to be incurred or we under- or over-estimate the level of services performed or the costs of such services, our reported expenses for such periodwould be too low or too high.Milestone payments are accrued when it is deemed probable that the milestone event will be achieved. Upon FDA acceptance of an NDA filing fortasimelteon, the Company would be obligated to make milestone payments of $0.5 million under regulatory consulting agreements and $3.8 million underlicensing agreements, respectively.Revenue Recognition. Our revenues are derived primarily from our amended and restated sublicense agreement with Novartis and include an upfrontpayment, product revenue and future milestone and royalty revenues. Revenue related to the upfront payment is being recognized ratably from the date theamended and restated sublicense agreement became effective (November 2009) through the expected life of the U.S. patent for Fanapt, which we expect to lastuntil May 2017. This includes the Hatch-Waxman extension that extends patent protection for drug compounds for a period of five years to compensate fortime spent in development and a six-month pediatric term extension. Fanapt has qualified for the full five-year patent term Hatch-Waxman extension and weexpect that Fanapt will be eligible for six months of pediatric exclusivity. We recognize revenue related to Fanapt royalties and commercial and developmentmilestones as they are realizable and earned, and product revenue upon delivery of our products to Novartis. Our revenues have also been derived from grantrevenue which is recognized when it is received.Employee stock-based compensation. We use the Black-Scholes-Merton option pricing model to determine the fair value of stock options. Thedetermination of the fair value of stock options on the date of grant using an option pricing model is affected by our stock price as well as assumptionsregarding a number of complex and subjective variables. These variables include the expected stock price volatility over the expected term of the awards, actualand projected employee stock option exercise behaviors, risk-free interest rate and expected dividends. Expected volatility rates are based on the historicalvolatility of our publicly traded common stock and other factors. The weighted average expected term of stock options granted is based on the simplifiedmethod as the options meet the “plain vanilla” criteria required by authoritative guidance. Significant changes in the market price of the Company’s commonstock in recent years has made historical data less reliable for the purpose of estimating future vesting, exercise, and employment behavior. The simplifiedmethod provided a more reasonable approach for estimating the weighted average expected term for options granted in 2012.The risk-free interest rates are based on the U.S. Treasury yield for a period consistent with the expected term of the option in effect at the time of thegrant. We have not paid dividends to our stockholders since our inception (other than a dividend of preferred share purchase rights which was declared inSeptember 2008) and do not plan to pay dividends in the foreseeable future. Employee stock-based compensation expense for a period is also affected by theexpected forfeiture rate for the respective option grants. If our estimates of the fair value of these equity instruments or expected forfeitures are too high or toolow, it would have the effect of overstating or understating expenses. 47®®®®Table of ContentsEmployee stock-based compensation expense related to stock-based awards for the years ended December 31, 2012, 2011 and 2010, was comprised ofthe following: Year Ended December 31, (in thousands) 2012 2011 2010 Research and development $1,356 $2,450 $2,536 General and administrative 2,718 3,036 2,271 Total employee stock-based compensation expense $4,074 $5,486 $4,807 The research and development portion of employee stock-based compensation expense for 2012 was impacted by the termination of our Chief MedicalOfficer in the third quarter of 2012 and the resulting reversal of employee stock-based compensation expense resulting from the cancellation of certain of hisoutstanding equity awards.Income taxes. On a periodic basis, we evaluate the realizability of our deferred tax assets and liabilities and will adjust such amounts in light ofchanging facts and circumstances, including but not limited to future projections of taxable income, the reversal of deferred tax liabilities, tax legislation,rulings by relevant tax authorities and tax planning strategies. Settlement of filing positions that may be challenged by tax authorities could impact our incometaxes in the year of resolution.In assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets willnot be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the period in which thosetemporary differences becomes deductible or the net operating losses (NOLs) and credit carryforwards can be utilized. When considering the reversal of thevaluation allowance, we consider the level of past and future taxable income, the reversal of deferred tax liabilities, the utilization of the carryforwards andother factors. Revisions to the estimated net realizable value of the deferred tax asset could cause our provision for income taxes to vary significantly fromperiod to period.Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of thedeferred tax assets will not be realized. The fact that we have historically generated NOLs serves as strong evidence that it is more likely than not that deferredtax assets will not be realized in the future. Therefore, we have a full valuation allowance against all deferred tax assets as of December 31, 2012.Recent Accounting PronouncementsThere are no new accounting pronouncements that have had or that we expect will have a material effect on our consolidated financial statements.Results of OperationsWe anticipate that our results of operations will fluctuate for the foreseeable future due to several factors, including any possible payments made orreceived pursuant to license or collaboration agreements, progress of our research and development efforts, the timing and outcome of clinical trials and relatedpossible regulatory approvals and our and our partners’ ability to successfully commercialize our products, product candidates and partnered products. Ourlimited operating history makes predictions of future operations difficult or impossible. Since our inception, we have incurred significant losses. As ofDecember 31, 2012, we had an accumulated deficit of $291.1 million.Year ended December 31, 2012 compared to year ended December 31, 2011Revenues. Revenues were $32.7 million for the year ended December 31, 2012 compared to revenues of $31.3 million for the year ended December 31,2011. Revenues for the year ended December 31, 2012 included $26.8 million recognized from Novartis related to straight-line recognition of upfront licensefees and $5.9 48Table of Contentsmillion in royalty revenue based on 2012 net sales of Fanapt. Revenues for the year ended December 31, 2011 included $26.8 million recognized fromNovartis related to straight-line recognition of upfront license fees and $4.5 million in royalty revenue based on 2011 net sales of Fanapt.Intangible asset amortization. Intangible asset amortization was $1.5 million for both the year ended December 31, 2012 and the year endedDecember 31, 2011. Intangible amortization relates to the capitalized intangible asset of $12.0 million resulting from the Fanapt milestone payment toNovartis in May 2009.Research and development expenses. Research and development expenses increased by $16.4 million, or 56.7%, to $45.4 million for the year endedDecember 31, 2012 compared to $29.0 million for the year ended December 31, 2011.The following table discloses the components of research and development expenses reflecting all of our project expenses for the years endedDecember 31, 2012 and 2011: Year EndedDecember 31, (in thousands) 2012 2011 Direct project costs: Clinical trials $28,296 $14,440 Contract research and development manufacturing, consulting, materials and other direct costs 9,047 5,987 Salaries, benefits and related costs 4,878 4,130 Employee stock-based compensation expense 1,356 2,450 Total direct costs 43,577 27,007 Indirect project costs 1,869 1,989 Total $45,446 $28,996 Direct costs increased by $16.6 million, or 61.4%, to $43.6 million for the year ended December 31, 2012 compared to $27.0 million for the yearended December 31, 2011 primarily as a result of increases in clinical trial costs, contract research and development, consulting, materials and other directcosts and salaries, benefits and related costs partially offset by lower stock-based compensation. Clinical trials costs increased by $13.9 million, or 96.0%,to $28.3 million for the year ended December 31, 2012 compared to $14.4 million for the year ended December 31, 2011 primarily due to costs related to thetasimelteon trials for the treatment of Non-24 in blind individuals without light perception and the tasimelteon trial for the treatment of MDD. Contract researchand development, consulting, materials and other direct costs increased by $3.1 million, or 51.1%, to $9.0 million for the year ended December 31, 2012compared to $6.0 million for the year ended December 31, 2011 primarily due to costs related to the tasimelteon Non-24 and MDD trials, costs related to thepreparation of a future tasimelteon New Drug Application (NDA) filing with the FDA and the $1.0 initial license fee associated with VLY-686. Salaries,benefits and related costs increased by $0.7 million, or 18.1%, to $4.9 million for the year ended December 31, 2012 compared to $4.1 million for the yearended December 31, 2011 due to new employees hired in 2011 and 2012 and the termination of our Chief Medical Officer in the third quarter of 2012 and theseverance costs associated with his termination. Employee stock-based compensation expense decreased by $1.1 million, or 44.7%, to $1.4 million for the yearended December 31, 2012 compared to $2.5 million for the year ended December 31, 2011 due to the termination of our Chief Medical Officer in the thirdquarter of 2012 and the reversal of employee stock-based compensation expense resulting from the cancellation of certain of his outstanding equity awards anda reduction in the amortization of employee stock-based compensation expense from the lower fair value of equity awards granted during 2011 and 2012compared to equity awards granted in prior periods.General and administrative expenses. General and administrative expenses increased by $2.4 million, or 20.9%, to $13.9 million for the year endedDecember 31, 2012 compared to $11.5 million for the year ended December 31, 2011. 49®®®Table of ContentsThe following table discloses the components of our general and administrative expenses for the years ended December 31, 2012 and 2011: Year EndedDecember 31, (in thousands) 2012 2011 Salaries, benefits and related costs $3,247 $2,065 Employee stock-based compensation expense 2,718 3,036 Marketing, legal, accounting and other professional services 4,777 3,575 Other expenses 3,140 2,810 Total $13,882 $11,486 Salaries, benefits and related costs increased by $1.2 million, or 57.2%, to $3.2 million for the year ended December 31, 2012 compared to $2.1million for the year ended December 31, 2011 primarily due to the hiring of an executive in the fourth quarter of 2011 and other new hires in 2011 and 2012.Marketing, legal, accounting and other professional expenses increased by $1.2 million, or 33.6%, to $4.8 million for the year ended December 31, 2012compared to $3.6 million for the year ended December 31, 2011 primarily due to increased legal costs associated with developing Fanapt outside the U.S. andCanada and increased market development expenses associated with tasimelteon. Other expenses included lease exit costs and related accelerated depreciation in2012 and a lease termination penalty in 2011 relating to our former headquarters lease in Rockville, Maryland.Other income. Other income increased $0.1 million, or 21.7%, to $0.6 million for the year ended December 31, 2012 compared to $0.5 million forthe year ended December 31, 2011 primarily as a result of a legal settlement related to a lawsuit filed against one of our stockholders partially offset by lowerinterest income. While we did not participate in the lawsuit proceedings, we received a portion of the settlement.Tax provision (benefit). The tax benefit for the year ended December 31, 2012 was fully offset by a tax valuation allowance resulting from ourassessment that it is more likely than not that our deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon thegeneration of future taxable income during the period in which NOLs and credit carryforwards can be utilized. The benefit for income taxes of $0.4 million forthe year ended December 31, 2011 is the result of the approval for a change in accounting method from the Internal Revenue Service (IRS).Year ended December 31, 2011 compared to year ended December 31, 2010Revenues. Revenues were $31.3 million for the year ended December 31, 2011 compared to revenues of $35.7 million for the year ended December 31,2010. Revenues for the year ended December 31, 2011 included $26.8 million recognized from Novartis related to straight-line recognition of upfront licensefees and $4.5 million in royalty revenue based on 2011 sales of Fanapt. Revenues for the year ended December 31, 2010 included $26.8 million recognizedfrom Novartis related to straight-line recognition of upfront license fees, $3.1 million in royalty revenue based on 2010 sales of Fanapt, $5.3 million forFanapt product sales to Novartis and grant revenue of $0.5 million for qualified research and development investments under the Internal Revenue Service’sTherapeutic Discovery Project Credit Program. For the year ended December 31, 2011, there were no sales of products to Novartis and no grant revenue.Cost of sales. There were no sales of products for the year ended December 31, 2011 compared to cost of sales of $2.9 million for the year endedDecember 31, 2010.Intangible asset amortization. Intangible asset amortization was $1.5 million for both the year ended December 31, 2011 and the year endedDecember 31, 2010. The amortization is the result of the capitalized intangible asset related to the $12.0 million milestone payment to Novartis in May 2009.Research and development expenses. Research and development expenses increased by $16.7 million, or 135.0%, to $29.0 million for the yearended December 31, 2011 compared to $12.3 million for the year ended December 31, 2010. 50®®®®Table of ContentsThe following table discloses the components of research and development expenses reflecting all of our project expenses for the years endedDecember 31, 2011 and 2010: Year EndedDecember 31, (in thousands) 2011 2010 Direct project costs: Clinical trials $14,440 $2,542 Contract research and development manufacturing, consulting, materials and other direct costs 5,987 2,976 Salaries, benefits and related costs 4,130 2,983 Employee stock-based compensation expense 2,450 2,536 Total direct costs 27,007 11,037 Indirect project costs 1,989 1,301 Total $28,996 $12,338 Direct costs increased by $16.0, or 144.7%, to $27.0 million for the year ended December 31, 2011 compared to $11.0 million for the year endedDecember 31, 2010 primarily as a result of higher clinical trial expenses, manufacturing costs and salary and benefit expenses, partially offset by lower stock-based compensation expenses. Clinical trials expense increased by $11.9 million, or 468.1%, to $14.4 million for the year ended December 31, 2011compared to $2.5 million for the year ended December 31, 2010 primarily due to the costs associated with four Phase III clinical trials for tasimelteon in Non-24 in blind individuals without light perception, which were initiated in 2010 and 2011, and one Phase IIb/III clinical trial for tasimelteon in MDD, which wasinitiated in the third quarter of 2011. Contract research and development manufacturing, consulting, materials and other direct costs increased by $3.0million, or 101.2%, to $6.0 million for the year ended December 31, 2011 compared to $3.0 million for the year ended December 31, 2010 primarily as aresult of increased manufacturing costs for tasimelteon in 2011 and increased regulatory consulting expenses related to tasimelteon in 2011. Salary and benefitexpenses increased by $1.1 million, or 38.5%, to $4.1 million for the year ended December 31, 2011 compared to $3.0 million for the year endedDecember 31, 2010 primarily due to new employees hired in 2011 to support the tasimelteon trials in Non-24 and MDD. Indirect costs increased by $0.7million, or 52.9%, to $2.0 million for the year ended December 31, 2011 compared to $1.3 million for the year ended December 31, 2010 primarily as a resultof the lease termination penalty recognized in the fourth quarter of 2011.General and administrative expenses. General and administrative expenses increased by $1.3 million, or 13.2%, to $11.5 million for the year endedDecember 31, 2011 from $10.1 million for the year ended December 31, 2010.The following table discloses the components of our general and administrative expenses for the years ended December 31, 2011 and 2010: Year EndedDecember 31, (in thousands) 2011 2010 Salaries, benefits and related costs $2,065 $1,745 Employee stock-based compensation expense 3,036 2,271 Marketing, legal, accounting and other professional services 3,575 3,611 Other expenses 2,810 2,520 Total $11,486 $10,147 Salaries, benefits and related costs increased by $0.3 million, or 18.3%, to $2.1 million for the year ended December 31, 2011 compared to $1.7 millionfor the year ended December 31, 2010 as a result of executive 51Table of Contentshirings made in the fourth quarter of 2010 and 2011. Employee stock-based compensation expense increased by $0.8 million, or 33.7%, to $3.0 million for theyear ended December 31, 2011 compared $2.3 million for the year ended December 31, 2010 as a result of executive hirings made in the fourth quarter of 2010and 2011. Other expenses increased by $0.3, or 11.6%, to $2.8 million for the year ended December 31, 2011 compared to $2.5 million for the year endedDecember 31, 2010 primarily due to the lease termination penalty recognized in the fourth quarter of 2011.Other income. Other income increased $0.1 million, or 7.0%, to $0.5 million for the year ended December 31, 2011 from $0.4 million for the yearended December 31, 2010 due to a higher rate of return on investments.Tax provision (benefit). The benefit for income taxes of $0.4 million for the year ended December 31, 2011 is a result of the approval for a change inaccounting method from the IRS. Our effective tax rate of (4.3%) for the year ended December 31, 2011 was favorably impacted by the approval for a changein accounting method from the IRS. In addition, our tax rate was favorably impacted by the research and development and orphan drug credits.Intangible AssetThe following is a summary of our intangible asset as of December 31, 2012: EstimatedUsefulLife(Years) December 31, 2012 (in thousands) GrossCarryingAmount AccumulatedAmortization NetCarryingAmount Fanapt 8 $12,000 $5,468 $6,532 In May 2009, we announced that the FDA had approved the NDA for Fanapt. As a result of the FDA’s approval of the NDA, we met a milestone underour original sublicense agreement with Novartis which required us to make a payment of $12.0 million to Novartis. The $12.0 million was capitalized and isbeing amortized over the remaining life of the U.S. patent for Fanapt, which we expect to last until May 2017. This includes the Hatch-Waxman extensionthat provides patent protection for drug compounds for a period of five years to compensate for time spent in development and a six-month pediatric termextension. Fanapt has qualified for the full five-year patent term Hatch-Waxman extension and we expect that Fanapt will be eligible for six months ofpediatric exclusivity. This term is our best estimate of the life of the patent; if, however, the pediatric extension is not granted, the intangible asset will beamortized over a shorter period.We capitalized and began amortizing the asset immediately following the FDA approval of the NDA for Fanapt. The intangible asset is being amortizedover its estimated useful economic life using the straight-line method. Amortization expense was $1.5 million for the years ended December 31, 2012, 2011and 2010, respectively.The following table summarizes our intangible asset amortization schedule as of December 31, 2012: (in thousands) Total 2013 2014 2015 2016 After 2016 Intangible asset $6,532 $1,495 $1,495 $1,495 $1,495 $552 52®®®®®®Table of ContentsDeferred RevenueThe following is a summary of changes in total deferred revenue for the years ended December 31, 2012, 2011 and 2010: (in thousands) Balance atBeginning ofYear Reductionsfrom LicensingRevenueRecognized Balance at Endof Year Year ended: December 31, 2012 $143,853 $26,789 $117,064 December 31, 2011 170,642 26,789 143,853 December 31, 2010 197,431 26,789 170,642 We entered into an amended and restated sublicense agreement with Novartis in October 2009, pursuant to which Novartis has the right tocommercialize and develop Fanapt in the U.S. and Canada. Under the amended and restated sublicense agreement, we received an upfront payment of $200.0million in December 2009. We established a Joint Steering Committee (JSC) with Novartis following the effective date of the amended and restated sublicenseagreement. We concluded that the JSC constitutes a deliverable under the amended and restated sublicense agreement and that revenue related to the upfrontpayment will be recognized ratably over the term of the JSC; however, the delivery or performance has no term as the exact length of the JSC is undefined. As aresult, we deemed the performance period of the JSC to be the life of the U.S. patent for Fanapt, which we expect to last until May 2017. This includes theHatch-Waxman extension that provides patent protection for drug compounds for a period of five years to compensate for time spent in development and a six-month pediatric term extension. Fanapt has qualified for the full five-year patent term Hatch-Waxman extension and we expect that Fanapt will be eligible forsix months of pediatric exclusivity. This term is our best estimate of the life of the patent. Revenue related to the upfront payment will be recognized ratablyfrom the date the amended and restated sublicense agreement became effective (November 2009) through the expected life of the U.S. patent for Fanapt (May2017). For each of the years ended December 31, 2012, 2011 and 2010, we recognized revenue of $26.8 million for the license agreement.Liquidity and Capital ResourcesAs of December 31, 2012, our total cash and cash equivalents and marketable securities were $120.4 million compared to $167.9 million atDecember 31, 2011. Our cash and cash equivalents are deposits in operating accounts and highly liquid investments with an original maturity of 90 days orless at date of purchase and consist of time deposits, investments in money market funds with commercial banks and financial institutions, and commercialpaper of high-quality corporate issuers. Our marketable securities consist of investments in government sponsored enterprises and commercial paper. 53®®®®®Table of ContentsAs of December 31, 2012 and 2011, our liquidity resources are summarized as follows: As of December 31, (in thousands) 2012 2011 Cash and cash equivalents Cash and cash equivalents $88,772 $87,923 Marketable securities, current U.S. Treasury and government agencies 14,442 23,755 Corporate debt 17,189 37,206 Marketable securities, current 31,631 60,961 Marketable securities, non-current U.S. Treasury and government agencies — 19,012 Marketable securities, non-current — 19,012 Total $120,403 $167,896 As of December 31, 2012, we maintained all of our cash and cash equivalents in two financial institutions. Deposits held with these institutions mayexceed the amount of insurance provided on such deposits, but we do not anticipate any losses with respect to such deposits.We expect to continue to incur substantial expenses relating to our research and development efforts, as we focus on clinical trials and manufacturingrequired for the development of our products. The duration and cost of clinical trials are a function of numerous factors such as the number of patients to beenrolled in the trial, the amount of time it takes to enroll them, the length of time they must be treated and observed, and the number of clinical sites andcountries for the trial. In addition, orphan clinical trials create an additional challenge due to the limited number of available patients afflicted with the disease.We must receive regulatory approval to launch any of our products commercially. In order to receive such approval, the appropriate regulatory agencymust conclude that our clinical data establish safety and efficacy and that our products and the manufacturing facilities meet all applicable regulatoryrequirements. We cannot be certain that we will establish sufficient safety and efficacy data to receive regulatory approval for any of our compounds or thatour compounds and the manufacturing facilities will meet all applicable regulatory requirements.Because of the uncertainties discussed above, the costs to advance our research and development projects are difficult to estimate and may varysignificantly. We expect that our existing funds will be sufficient to fund our currently planned operations. Our future capital requirements and the adequacyof our available funds will depend on many factors, primarily including the scope and costs of our clinical development programs, the scope and costs of ourmanufacturing and process development activities, the magnitude of our discovery and preclinical development programs and the level of our pre-commerciallaunch activities. There can be no assurance that any additional financing required in the future will be available on acceptable terms, if at all.Cash flowThe following table summarizes our cash flows for the years ended December 31, 2012, 2011 and 2010. Year Ended December 31, (in thousands) 2012 2011 2010 Net cash provided by (used in): Operating activities $(44,917) $(28,410) $(10,898) Investing activities 45,754 73,749 (155,622) Financing activities 12 25 3,784 Net change in cash and cash equivalents $849 $45,364 $(162,736) 54Table of ContentsYear ended December 31, 2012 compared to year ended December 31, 2011Net cash used in operations was $44.9 million for the year ended December 31, 2012 compared to $28.4 million for the year ended December 31, 2011.The increase in net cash used in operations for the year ended December 31, 2012 as compared to the year ended December 31, 2011 was primarily due to thecosts associated with four Phase III clinical trials for tasimelteon in Non-24 in blind individuals without light perception, which were initiated in 2010 and2011, and one Phase IIb/III clinical trial for tasimelteon in MDD, which was initiated in the third quarter of 2011. Adjustments to reconcile net loss to net cashused in operating activities for the year ended December 31, 2012 included non-cash charges for depreciation and amortization of $2.7 million, employee andnon-employee stock-based compensation expense of $4.1 million, landlord contributions for tenant improvements of $1.8 million, a net increase of $0.9million in prepaid expenses and other assets, accounts receivable, inventory, accounts payable, accrued liabilities and other liabilities and a decrease indeferred revenue of $26.8 million. Net cash provided by investing activities for the year ended December 31, 2012 was $45.8 million and consisted of netmaturities, sales and purchases of marketable securities of $47.8 million and purchases of property and equipment of $2.0 million.Year ended December 31, 2011 compared to year ended December 31, 2010Net cash used in operations was $28.4 million for the year ended December 31, 2011 and $10.9 million for the year ended December 31, 2010. Theincrease in net cash used in operations for the year ended December 31, 2011 as compared to the year ended December 31, 2010 was primarily due to the costsassociated with four Phase III clinical trials for tasimelteon in Non-24 in blind individuals without light perception, which were initiated in 2010 and 2011,and one Phase IIb/III clinical trial for tasimelteon in MDD, which was initiated in the third quarter of 2011. Adjustments to reconcile net loss to net cash usedin operating activities for the year ended December 31, 2011 included non-cash charges for depreciation and amortization of $2.9 million, stock-basedcompensation of $5.5 million, decreases in deferred tax benefits of $1.8 million, decreases in accrued income taxes of $2.3 million, increases in prepaidexpenses and other assets, accounts receivable, accounts payable, accrued liabilities and other liabilities of $0.3 million and a decrease in deferred revenue of$26.8 million. Net cash provided by investing activities for the year ended December 31, 2011 was $73.7 million and consisted of net maturities, sales andpurchases of marketable securities of $74.6 million, purchases of property and equipment of $0.3 million and change in restricted cash of $0.6 million. Netcash provided from financing activities for the year ended December 31, 2011 was $0.03 million consisting of proceeds from the exercise of stock options.Off-balance sheet arrangementsWe have no off-balance sheet arrangements, as defined in Item 303(a)(4) of the Securities and Exchange Commission’s Regulation S-K.Contractual obligations and commitmentsThe following is a summary of our non-cancellable long-term contractual cash obligations as of December 31, 2012: Cash payments due by period (in thousands)(1)(2)(3) Total 2013 2014 2015 2016 2017 After 2017 Operating leases $12,003 $1,312 $1,052 $1,079 $1,106 $1,133 $6,321 (1)This table does not include various agreements that we have entered into for services with third party vendors, including agreements to conduct clinicaltrials, to manufacture product candidates, and for consulting and other contracted services due to the cancelable nature of the services. We accrued thecosts of these agreements based on estimates of work completed to date. (2)This table does not include milestone payments that could be due under our agreement with a regulatory consultant we have engaged to assist in ourefforts to prepare, file and obtain FDA approval of an NDA for tasimelteon. As part of the engagement and subject to certain conditions, we could beobligated to make 55Table of Contents milestone payments upon the achievement of certain milestones, including $0.5 million in the event that the tasimelteon NDA is accepted for filing bythe FDA and $2.0 million in the event that the tasimelteon NDA is approved by the FDA. (3)This table does not include milestone payments that could be due under our license agreements. Under our license agreement with Bristol-Myers Squibb(BMS) for the exclusive rights to develop and commercialize tasimelteon, we would be obligated to make future milestone payments to BMS andMassachusetts General Hospital (MGH) of less than $40.0 million in the aggregate (the majority of which are tied to sales milestones). In the event that atasimelteon NDA is accepted for filing by the FDA, we will incur milestone obligations of $3.8 million. Under our license agreement with Eli Lilly andCompany for the exclusive rights to develop and commercialize VLY-686, we could be obligated to make future milestone payments of up to $4.0million for pre-NDA approval milestones and up to $95.0 million for future regulatory approval and sales milestones.Operating leasesOur commitments related to operating leases represent the minimum annual payments for the operating lease for our headquarters located in Washington,D.C., which expires in 2023 and the lease exit liability for our former headquarters located in Rockville, Maryland, up to the lease termination date of June 30,2013.In July 2011, we entered into an office lease with Square 54 Office Owner LLC (the Landlord) for our current headquarters, consisting of 21,400 squarefeet at 2200 Pennsylvania Avenue, N.W. in Washington, D.C. (the Lease). Under the Lease, rent payments are abated for the first 12 months. The Landlordprovided us with a cash contribution of $1.9 million for tenant improvements during the year ended December 31, 2012. Subject to the prior rights of othertenants in the building, we have the right to renew the Lease for five years following the expiration of its original term. We also have the right to sublease orassign all or a portion of the premises, subject to standard conditions. The Lease may be terminated early by us or the Landlord upon certain conditions. ITEM 7A.QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISKInterest ratesOur exposure to market risk is currently confined to our cash and cash equivalents, marketable securities and restricted cash. We currently do not hedgeinterest rate exposure. We have not used derivative financial instruments for speculation or trading purposes. Because of the short-term maturities of our cashand cash equivalents and marketable securities, we do not believe that an increase in market rates would have any significant impact on the realized value ofour investments.Marketable securitiesWe deposit our cash with financial institutions that we consider to be of high credit quality and purchase marketable securities which are generallyinvestment grade, liquid, short-term fixed income securities and money-market instruments denominated in U.S. dollars. Our marketable securities consist ofcertificates of deposit, commercial paper, corporate notes and U.S. government agency notes.Effects of inflationInflation has not had a material impact on our results of operations. ITEM 8.FINANCIAL STATEMENTS AND SUPPLEMENTARY DATAThe consolidated financial statements and related financial statement schedules required to be filed are listed in the Index to Consolidated FinancialStatements and are incorporated herein. ITEM 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURENone. 56Table of ContentsITEM 9A.CONTROLS AND PROCEDURESConclusion Regarding the Effectiveness of Disclosure Controls and ProceduresUnder the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we evaluatedthe effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities andExchange Act of 1934 (Exchange Act)) as of December 31, 2012. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officerconcluded that our disclosure controls and procedures are effective as of December 31, 2012, the end of the period covered by this annual report, to ensure thatthe information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicatedto our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.Management’s Report on Internal Control Over Financial ReportingOur management is responsible for establishing and maintaining an adequate system of internal control over financial reporting, as defined in theExchange Act Rule 13a-15(f). Management conducted an assessment of our internal control over financial reporting based on the framework established by theCommittee of Sponsoring Organizations of the Treadway Commission in Internal Control — Integrated Framework. Based on the assessment,management concluded that, as of December 31, 2012, our internal control over financial reporting was effective.The effectiveness of our internal control over financial reporting as of December 31, 2012 has been audited by PricewaterhouseCoopers LLP, anindependent registered public accounting firm, as stated in their report included in this annual report on Form 10-K.Changes in Internal Control over Financial ReportingThere has been no change in our internal controls over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) during thefourth quarter of 2012 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. ITEM 9B.OTHER INFORMATIONNone.PART III ITEM 10.DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCEInformation required under this item will be contained in our Proxy Statement for the Annual Meeting of Stockholders to be filed with the SEC within120 days after the end of the fiscal year ended December 31, 2012, under the captions “Election of Directors,” “Executive Officers,” “Corporate Governance”,and “Section 16(a) Beneficial Ownership Reporting Compliance” and is incorporated herein by reference pursuant to General Instruction G (3) to Form 10-K. ITEM 11.EXECUTIVE COMPENSATIONInformation required under this item will be contained in our Proxy Statement for the Annual Meeting of Stockholders to be filed with the SEC within120 days after the end of the fiscal year ended December 31, 2012, under the captions “Corporate Governance” and “Executive Compensation,” and isincorporated herein by reference pursuant to General Instruction G(3) to Form 10-K, except that information required by Item 407(e)(5) of Regulation S-K willbe deemed furnished in this Form 10-K and will not be deemed incorporated by reference into any filing under the Securities Act of 1933 or the SecuritiesExchange Act of 1934, except to the extent that we specifically incorporate it by reference into such filing. 57Table of ContentsITEM 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERSIn addition to the information set forth under the caption “Securities Authorized for Issuance Under Equity Compensation Plans” below, the informationrequired under this item will be contained in our Proxy Statement for the Annual Meeting of Stockholders to be filed with the SEC within 120 days after theend of the fiscal year ended December 31, 2012, under the caption “Security Ownership by Certain Beneficial Owners and Management” and is incorporatedherein by reference pursuant to General Instruction G(3) to Form 10-K.Securities Authorized for Issuance Under Equity Compensation PlansThe following table provides certain information regarding our equity compensation plans in effect as of December 31, 2012:Equity Compensation Plan Information Plan Category Number of Securities to beIssued Upon Exercise ofOutstanding Options,Warrants and Rights Weighted-AverageExercise Price ofOutstanding Options,Warrants and Rights Number of SecuritiesRemaining Available forIssuance Under EquityCompensation Plans(Excluding SecuritiesReflected in Column (a)) (a) (b) (c) Equity compensation plans approved by securityholders 6,243,008 $9.74 1,161,688 Equity compensation plans not approved by securityholders — — — Total 6,243,008 $9.74 1,161,688 (a)Includes 5,537,632 shares issuable upon exercise of outstanding options and 705,376 shares issuable upon settlement of RSUs under the 2006 EquityIncentive Plan and Second Amended and Restated Management Equity Plan. (b)Does not take into account RSUs which have no exercise price. (c)On January 1 of each year, the number of shares reserved under the 2006 Equity Incentive Plan is automatically increased by 4% of the total number ofshares of common stock that are outstanding at that time, or, if less, by 1,500,000 shares (or such lesser number as may be approved by theCompany’s Board of Directors). ITEM 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCEInformation required under this item will be contained in our Proxy Statement for the Annual Meeting of Stockholders to be filed with the SEC within120 days after the end of the fiscal year ended December 31, 2012, under the caption “Corporate Governance” and is incorporated herein by reference pursuantto General Instruction G(3) to Form 10-K. ITEM 14.PRINCIPAL ACCOUNTANT FEES AND SERVICESInformation required under this item will be contained in our Proxy Statement for the Annual Meeting of Stockholders to be filed with the SEC within120 days after the end of the fiscal year ended December 31, 2012, under the caption “Ratification of Selection of Independent Registered Public AccountingFirm” and is incorporated herein by reference pursuant to General Instruction G (3) to Form 10-K. 58Table of ContentsPART IV ITEM 15.EXHIBITS AND FINANCIAL STATEMENTS SCHEDULESThe consolidated financial statements filed as part of this annual report on Form 10-K are listed in the Index to Consolidated Financial Statements.Certain schedules are omitted because they are not applicable, or not required, or because the required information is included in the consolidated financialstatements or notes thereto.The Exhibits are listed in the Exhibit Index. 59Table of ContentsSignaturesPursuant to the requirements of Section 13 and 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this annual report on Form10-K to be signed on its behalf by the undersigned, thereunto duly authorized. Vanda Pharmaceuticals Inc.February 26, 2013 By: /s/ Mihael H. Polymeropoulos, M.D. Mihael H. Polymeropoulos, M.D. President and Chief Executive OfficerPursuant to the requirements of the Securities Act of 1934, this annual report on Form 10-K has been signed below by the following persons on behalf ofthe registrant and in the capacities and on the dates indicated. Name Title Date/s/ Mihael H. Polymeropoulos, M.D. Mihael H. Polymeropoulos, M.D. President and Chief Executive Officer and Director(principal executive officer) February 26, 2013/s/ James P. Kelly James P. Kelly Senior Vice President, Chief Financial Officer,Secretary and Treasurer (principal financial officerand principal accounting officer) February 26, 2013/s/ Howard Pien Howard Pien Chairman of the Board and Director February 26, 2013/s/ Michael Cola Michael Cola Director February 26, 2013/s/ Richard W. Dugan Richard W. Dugan Director February 26, 2013/s/ Steven K. Galson, M.D. Steven K. Galson, M.D. Director February 26, 2013/s/ Vincent J. Milano Vincent J. Milano Director February 26, 2013/s/ H. Thomas Watkins H. Thomas Watkins Director February 26, 2013 60Table of ContentsVanda Pharmaceuticals Inc.Index to Consolidated Financial Statements Page Report of Independent Registered Public Accounting Firm 62 Consolidated Balance Sheets at December 31, 2012 and 2011 63 Consolidated Statements of Operations for the years ended December 31, 2012, 2011 and 2010 64 Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2012, 2011 and 2010 65 Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2012, 2011 and 2010 66 Consolidated Statements of Cash Flows for the years ended December 31, 2012, 2011 and 2010 67 Notes to the Consolidated Financial Statements 68 61Table of ContentsReport of Independent Registered Public Accounting FirmTo the Board of Directors and Stockholders of Vanda Pharmaceuticals Inc.In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of comprehensive income (loss), ofchanges in stockholders’ equity, and of cash flows present fairly, in all material respects, the financial position of Vanda Pharmaceuticals Inc. andSubsidiary (collectively, the Company) at December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years inthe period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, theCompany maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established inInternal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’smanagement is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of theeffectiveness of internal control over financial reporting, included in Management’s Report on Internal Control Over Financial Reporting appearing underItem 9A. Our responsibility is to express opinions on these financial statements and on the Company’s internal control over financial reporting based on ourintegrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatementand whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements includedexamining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reportingincluded obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluatingthe design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as weconsidered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reportingand the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal controlover financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are beingmade only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluationof effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliancewith the policies or procedures may deteriorate./s/ PricewaterhouseCoopers LLPBaltimore, MarylandFebruary 25, 2013 62Table of ContentsVanda Pharmaceuticals Inc.Consolidated Balance Sheets December 31, (in thousands, except for share and per share amounts) 2012 2011 Assets Current assets Cash and cash equivalents $88,772 $87,923 Marketable securities, current 31,631 60,961 Accounts receivable 1,168 1,618 Inventory 57 — Prepaid expenses and other current assets 3,910 2,999 Restricted cash, current 430 — Total current assets 125,968 153,501 Marketable securities, non-current — 19,012 Property and equipment, net 2,348 964 Other assets, non-current — 84 Intangible asset, net 6,532 8,027 Restricted cash, non-current 600 1,030 Total assets $135,448 $182,618 Liabilities and Stockholders’ Equity Current liabilities Accounts payable $287 $996 Accrued liabilities 5,187 3,381 Deferred rent, current — 453 Deferred revenues, current 26,789 26,789 Total current liabilities 32,263 31,619 Deferred rent, non-current 3,005 461 Deferred revenues, non-current 90,275 117,064 Total liabilities 125,543 149,144 Commitments and contingencies (Note 10) Stockholders’ equity Preferred stock, $0.001 par value; 20,000,000 shares authorized, and no shares issued or outstanding — — Common stock, $0.001 par value; 150,000,000 shares authorized; 28,241,743 and 28,117,026 shares issued andoutstanding at December 31, 2012 and 2011, respectively 28 28 Additional paid-in capital 300,974 296,868 Accumulated other comprehensive income 10 21 Accumulated deficit (291,107) (263,443) Total stockholders’ equity 9,905 33,474 Total liabilities and stockholders’ equity $135,448 $182,618 The accompanying notes are an integral part of these consolidated financial statements. 63Table of ContentsVanda Pharmaceuticals Inc.Consolidated Statements of Operations Year Ended December 31, (in thousands, except for share and per share amounts) 2012 2011 2010 Revenue: Licensing agreement $26,789 $26,789 $26,789 Royalty revenue 5,938 4,481 3,141 Product sales — — 5,290 Grant revenue — — 489 Total revenue 32,727 31,270 35,709 Operating expenses: Cost of sales 129 — 2,891 Research and development 45,446 28,996 12,338 General and administrative 13,882 11,486 10,147 Intangible asset amortization 1,495 1,495 1,495 Total operating expenses 60,952 41,977 26,871 Income (loss) from operations (28,225) (10,707) 8,838 Other income 561 461 431 Income (loss) before tax provision (27,664) (10,246) 9,269 Tax provision (benefit) — (444) 2,077 Net income (loss) $(27,664) $(9,802) $7,192 Net income (loss) per share: Basic $(0.98) $(0.35) $0.26 Diluted $(0.98) $(0.35) $0.25 Shares used in calculations of net income (loss) per share: Basic 28,228,409 28,106,831 27,916,388 Diluted 28,228,409 28,106,831 28,534,617 The accompanying notes are an integral part of these consolidated financial statements. 64Table of ContentsVanda Pharmaceuticals Inc.Consolidated Statements of Comprehensive Income (Loss) Year Ended December 31, (in thousands) 2012 2011 2010 Net income (loss) $(27,664) $(9,802) $7,192 Other comprehensive income (loss): Change in net unrealized gain (loss) on marketable securities (11) 19 2 Tax provision on other comprehensive income (loss) — — — Other comprehensive income (loss), net of tax (11) 19 2 Comprehensive income (loss) $(27,675) $(9,783) $7,194 The accompanying notes are an integral part of these consolidated financial statements. 65Table of ContentsVanda Pharmaceuticals Inc.Statements of Changes in Stockholders’ Equity Common Stock AdditionalPaid-InCapital AccumulatedOtherComprehensiveIncome (Loss) AccumulatedDeficit Total (in thousands, except for share amounts) Shares Par Value Balances at December 31, 2009 27,568,595 $28 $283,836 $— $(260,833) $23,031 Issuance of common stock from the exercise of stock optionsand settlement of restricted stock units 472,784 — 892 — — 892 Employee and non-employee stock-based compensation — — 4,982 — — 4,982 Excess tax benefits from exercise of stock options — — 1,632 — — 1,632 Net income — — — — 7,192 7,192 Other comprehensive income, net of tax — — — 2 — 2 Balances at December 31, 2010 28,041,379 28 291,342 2 (253,641) 37,731 Issuance of common stock from the exercise of stock optionsand settlement of restricted stock units 75,647 — 25 — — 25 Employee and non-employee stock-based compensation — — 5,501 — — 5,501 Net loss — — — — (9,802) (9,802) Other comprehensive income, net of tax — — — 19 — 19 Balances at December 31, 2011 28,117,026 28 296,868 21 (263,443) 33,474 Issuance of common stock from the exercise of stock optionsand settlement of restricted stock units 124,717 — 12 — — 12 Employee and non-employee stock-based compensation — — 4,094 — — 4,094 Net loss — — — — (27,664) (27,664) Other comprehensive loss, net of tax — — — (11) — (11) Balances at December 31, 2012 28,241,743 $28 $300,974 $10 $(291,107) $9,905 The accompanying notes are an integral part of these consolidated financial statements. 66Table of ContentsVanda Pharmaceuticals Inc.Consolidated Statements of Cash Flows Year Ended December 31, (in thousands) 2012 2011 2010 Cash flows from operating activities Net income (loss) $(27,664) $(9,802) $7,192 Adjustments to reconcile net income (loss) to net cash used in operating activities Depreciation and amortization of property and equipment 633 469 336 Employee and non-employee stock-based compensation 4,094 5,501 4,982 Loss on disposal of assets — — (23) Amortization of discounts and premiums on marketable securities 560 900 212 Amortization of intangible asset 1,495 1,495 1,495 Deferred tax expense (benefit) — 1,821 (1,821) Excess tax benefits from exercise of stock options — — (2,892) Landlord contributions for tenant improvements 1,826 — — Changes in assets and liabilities: Prepaid expenses and other assets (827) (1,240) 250 Accounts receivable 450 (1,107) 2,653 Inventory (57) — 2,399 Accounts payable (709) 348 (1,776) Accrued liabilities 1,806 1,836 (997) Accrued income taxes — (2,266) 3,898 Other liabilities 265 424 (17) Deferred revenue (26,789) (26,789) (26,789) Net cash used in operating activities (44,917) (28,410) (10,898) Cash flows from investing activities Purchases of property and equipment (2,017) (275) — Proceeds from sale of property and equipment — — 66 Purchases of marketable securities (60,866) (160,213) (202,438) Proceeds from sale of marketable securities 2,497 8,667 — Maturities of marketable securities 106,140 226,170 46,750 Changes in restricted cash — (600) — Net cash provided by (used in) investing activities 45,754 73,749 (155,622) Cash flows from financing activities Excess tax benefits from stock-based compensation — — 2,892 Proceeds from exercise of stock options 12 25 892 Net cash provided by financing activities 12 25 3,784 Net change in cash and cash equivalents 849 45,364 (162,736) Cash and cash equivalents Beginning of period 87,923 42,559 205,295 End of period $88,772 $87,923 $42,559 Non-cash investing activities Purchases of property and equipment in accrued liabilities $— $221 $— The accompanying notes are an integral part of these consolidated financial statements. 67Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements1. Business Organization and PresentationBusiness organizationVanda Pharmaceuticals Inc. (Vanda or the Company) is a biopharmaceutical company focused on the development and commercialization of productsfor the treatment of central nervous system disorders. Vanda commenced its operations in 2003. Vanda’s product portfolio includes tasimelteon, a compoundfor the treatment of circadian rhythm sleep disorders (CRSD), which is currently in clinical development for Non-24, Fanapt, a compound for the treatmentof schizophrenia, the oral formulation of which is currently being marketed and sold in the U.S. by Novartis Pharma AG (Novartis), and VLY-686, a smallmolecule neurokinin-1 receptor (NK-1R) antagonist.Vanda refers to tasimelteon, Fanapt outside the U.S. and Canada and VLY-686 as its products and Fanapt within the U.S. and Canada as itspartnered product. All other compounds are referred to as Vanda’s product candidates. In addition, Vanda refers to its products, partnered products andproduct candidates collectively as its compounds. Moreover, Vanda refers to drug products generally as drugs or products.Basis of presentationThe accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the UnitedStates of America. All intercompany accounts and transactions have been eliminated in consolidation.2. Summary of Significant Accounting PoliciesUse of estimatesThe preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requiresmanagement to make estimates that affect the reported amounts of assets and liabilities at the date of the financial statements, disclosure of contingent assetsand liabilities, and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.Cash and cash equivalentsFor purposes of the consolidated balance sheets and consolidated statements of cash flows, cash equivalents represent highly-liquid investments with amaturity date of three months or less at the date of purchase.Marketable securitiesThe Company classifies all of its marketable securities as available-for-sale securities. The Company’s investment policy requires the selection of high-quality issuers, with bond ratings of AAA to A1+/P1. Available-for-sale securities are carried at fair market value, with unrealized gains and losses reported asa component of stockholders’ equity in accumulated other comprehensive income/loss. Interest and dividend income is recorded when earned and included ininterest income. Premiums and discounts on marketable securities are amortized and accreted, respectively, to maturity and included in interest income. TheCompany uses the specific identification method in computing realized gains and losses on the sale of investments, which would be included in theconsolidated statements of operations when generated. Marketable securities with a maturity of more than one year as of the balance sheet date and which theCompany does not intend to sell within the next twelve months are classified as non-current. All other marketable securities are classified as current.InventoryThe Company values its inventory at acquisition cost following the first-in first-out method. The Company analyzes its inventory levels quarterly andwrites down inventory that has become obsolete, has a cost basis in 68®®®Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) excess of its expected net realizable value or inventory quantities in excess of expected requirements. Expired inventory is disposed of and the related costs arewritten off to cost of sales.Intangible assetCosts incurred for products or product candidates not yet approved by the U.S. Food and Drug Administration (FDA) and for which no alternativefuture use exists are recorded as expense. In the event a product or product candidate has been approved by the FDA or an alternative future use exists for aproduct or product candidate, patent and license costs are capitalized and amortized over the expected patent life of the related product or product candidate.Milestone payments to the Company’s partners are recognized when it is deemed probable that the milestone event will occur.As a result of the FDA’s approval of the New Drug Application (NDA) for Fanapt in May 2009, the Company met a milestone under its originalsublicense agreement with Novartis which required the Company to make a payment of $12.0 million to Novartis. The $12.0 million is being amortized on astraight line basis over the remaining life of the U.S. patent for Fanapt, which the Company expects to last until May 2017. This includes the Hatch-Waxmanextension that extends patent protection for drug compounds for a period of five years to compensate for time spent in development and a six-month pediatricterm extension. Fanapt has qualified for the full five-year patent term Hatch-Waxman extension and the Company expects that Fanapt will be eligible for sixmonths of pediatric exclusivity. This term is the Company’s best estimate of the life of the patent; if, however, the pediatric extension is not granted, theintangible asset will be amortized over a shorter period. The carrying value of the intangible asset is periodically reviewed to determine if the facts andcircumstances suggest that a potential impairment may have occurred. The Company has had no impairment of its intangible asset.Property and equipmentProperty and equipment are stated at cost less accumulated depreciation and amortization. The costs of leasehold improvements funded by orreimbursed by the lessor are capitalized and amortized as leasehold improvements along with a corresponding deferred rent liability. Depreciation of propertyand equipment is provided on a straight-line basis over the estimated useful lives of the assets. Amortization of leasehold improvements is provided on astraight-line basis over the shorter of their estimated useful life or the lease term. The costs of additions and improvements are capitalized, and repairs andmaintenance costs are charged to operations in the period incurred. Upon retirement or disposition of property and equipment, the cost and accumulateddepreciation and amortization are removed from the accounts and any resulting gain or loss is reflected in the statement of operations for that period.Revenue recognitionThe Company’s revenues are derived primarily from the amended and restated sublicense agreement with Novartis and include an upfront payment,product sales and future milestone and royalty payments. Revenue is considered both realizable and earned when the following four conditions are met:(i) persuasive evidence of an arrangement exists, (ii) the arrangement fee is fixed or determinable, (iii) delivery or performance has occurred, and(iv) collectability is reasonably assured. Pursuant to the amended and restated sublicense agreement, Novartis has the right to commercialize and developFanapt in the U.S. and Canada. Under the agreement, the Company received an upfront payment of $200.0 million in December of 2009. The Company andNovartis established a Joint Steering Committee (JSC) following the effective date of the amended and restated sublicense agreement. The Company concludedthat the JSC constitutes a deliverable under the amended and restated sublicense agreement and that revenue related to the upfront payment will be recognizedratably over the term of the JSC; however, the delivery or performance has no term as the exact length of the JSC is undefined. As a result, the Companydeems the performance period of the JSC to be the life of the U.S. patent of Fanapt, which 69®®®®®®Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) the Company expects to last until May 2017. This includes the Hatch-Waxman extension that provides patent protection for drug compounds for a period offive years to compensate for time spent in development and a six-month pediatric term extension. Fanapt has qualified for the full five-year patent term Hatch-Waxman extension and the Company expects that Fanapt will be eligible for six months of pediatric exclusivity. This term is the Company’s best estimate ofthe life of the patent. Revenue related to the upfront payment will be recognized ratably from the date the amended and restated sublicense agreement becameeffective (November 2009) through the expected life of the U.S. patent for Fanapt (May 2017). The Company recognizes revenue from Fanapt royalties andcommercial and development milestones from Novartis when realizable and earned.Concentrations of credit riskFinancial instruments which potentially subject the Company to significant concentrations of credit risk consist primarily of cash, cash equivalentsand marketable securities. The Company places its cash, cash equivalents and marketable securities with highly-rated financial institutions. At December 31,2012, the Company maintained all of its cash, cash equivalents and marketable securities in two financial institutions. Deposits held with these institutionsmay exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand, and the Company believes there isminimal risk of losses on such balances.Accrued liabilitiesThe Company’s management is required to estimate accrued liabilities as part of the process of preparing financial statements. The estimation of accruedliabilities involves identifying services that have been performed on the Company’s behalf, and then estimating the level of service performed and theassociated cost incurred for such services as of each balance sheet date in the financial statements. Accrued liabilities include professional service fees, such aslawyers and accountants, contract service fees, such as those under contracts with clinical monitors, data management organizations and investigators inconjunction with clinical trials, fees to contract manufacturers in conjunction with the production of clinical materials, and fees for marketing and othercommercialization activities. Pursuant to management’s assessment of the services that have been performed on clinical trials and other contracts, theCompany recognizes these expenses as the services are provided. Such management assessments include, but are not limited to: (i) an evaluation by the projectmanager of the work that has been completed during the period, (ii) measurement of progress prepared internally and/or provided by the third-party serviceprovider, (iii) analyses of data that justify the progress, and (iv) management’s judgment. In the event that the Company does not identify certain costs thathave begun to be incurred or the Company under- or over-estimates the level of services performed or the costs of such services, the Company’s reportedexpenses for such period would be too low or too high.Research and development expensesResearch and development expenses consist primarily of fees for services provided by third parties in connection with the clinical trials, costs ofcontract manufacturing services, milestone payments, costs of materials used in clinical trials and research and development, costs for regulatory consultantsand filings, depreciation of capital resources used to develop products, related facilities costs, and salaries, other employee-related costs and stock-basedcompensation for research and development personnel. The Company expenses research and development costs as they are incurred for compounds in thedevelopment stage, including manufacturing costs and milestone payments made under license agreements prior to FDA approval. Upon and subsequent toFDA approval, manufacturing and milestone payments are capitalized. Milestone payments are accrued when it is deemed probable that the milestone eventwill be achieved. Costs related to the acquisition of intellectual property are expensed as incurred if the underlying technology is developed in connection withthe Company’s research and development efforts and has no alternative future use. 70®®®®Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) General and administrative expensesGeneral and administrative expenses consist primarily of salaries, other employee-related costs and stock-based compensation for personnel servingexecutive, business development, marketing, finance, accounting, information technology, marketing and human resource functions, facility costs nototherwise included in research and development expenses, insurance costs and professional fees for legal, accounting and other professional services. Generaland administrative expenses also include third-party expenses incurred to support business development, marketing and other business activities related totasimelteon and Fanapt.Employee stock-based compensationCompensation costs for all stock-based awards to employees and directors are measured based on the grant date fair value of those awards andrecognized over the period during which the employee or director is required to perform service in exchange for the award. The Company generally recognizesthe expense over the award’s vesting period.The fair value of stock options granted is amortized using the accelerated attribution method. The fair value of restricted stock units (RSUs) awarded isamortized using the straight line method. As stock-based compensation expense recognized in the consolidated statements of operations is based on awardsultimately expected to vest, it has been reduced for estimated forfeitures. Forfeitures are required to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates.Total employee stock-based compensation expense recognized for the years ended December 31, 2012, 2011 and 2010, was comprised of the following: Year Ended December 31, (in thousands) 2012 2011 2010 Research and development $1,356 $2,450 $2,536 General and administrative 2,718 3,036 2,271 Total employee stock-based compensation expense $4,074 $5,486 $4,807 The research and development portion of employee stock-based compensation expense for the year December 31, 2012 was impacted by the terminationof the Company’s Chief Medical Officer in the third quarter of 2012 and the reversal of employee stock-based compensation expense resulting from thecancellation of certain of his outstanding equity awards.The fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton option pricing model that uses the assumptionsnoted in the following table. Expected volatility rates are based on the historical volatility of the Company’s publicly traded common stock and other factors.The weighted average expected term of stock options granted is based on the simplified method as the options meet the “plain vanilla” criteria required byauthoritative guidance. Significant changes in the market price of the Company’s common stock in recent years has made historical data less reliable for thepurpose of estimating future vesting, exercise, and employment behavior. The simplified method provided a more reasonable approach for estimating theweighted average expected term for options granted in 2012. The risk-free interest rates are based on the U.S. Treasury yield for a period consistent with theexpected term of the option in effect at the time of the grant. The Company has not paid dividends to its stockholders since its inception (other than a dividendof preferred share purchase rights, which was declared in September 2008) and does not plan to pay dividends in the foreseeable future. 71®Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) Assumptions used in the Black-Scholes-Merton option pricing model for employee and director stock options granted during the years endedDecember 31, 2012, 2011 and 2010 were as follows: Year EndedDecember 31, 2012 2011 2010 Expected dividend yield 0% 0% 0% Weighted average expected volatility 68% 71% 68% Weighted average expected term (years) 6.03 6.03 6.03 Weighted average risk-free rate 0.94% 1.45% 2.32% Weighted average fair value $2.08 $3.50 $5.32 Income taxesThe Company accounts for income taxes in accordance with the authoritative guidance on accounting for income taxes, which requires companies toaccount for deferred income taxes using the asset and liability method. Under the asset and liability method, current income tax expense or benefit is theamount of income taxes expected to be payable or refundable for the current year. A deferred income tax asset or liability is recognized for future taxconsequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and taxcredits and loss carryforwards. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not thatsome portion or all of the deferred tax assets will not be realized. The fact that the Company has historically generated net operating losses (NOLs) serves asstrong evidence that it is more likely than not that deferred tax assets will not be realized in the future. Therefore, the Company has a full valuation allowanceagainst all deferred tax assets as of December 31, 2012 and 2011, respectively. Tax rate changes are reflected in income during the period such changes areenacted. Changes in ownership may limit the amount of NOL carryforwards that can be utilized in the future to offset taxable income.Segment informationThe Company’s management has determined that the Company operates in one business segment which is the development and commercialization ofpharmaceutical products.Recent accounting pronouncementsThere are no new accounting pronouncements that have had or that the Company expects will have a material effect on our consolidated financialstatements.Certain risks and uncertaintiesThe Company’s products and product candidates under development require approval from the FDA or other international regulatory agencies prior tocommercial sales. There can be no assurance the products will receive the necessary clearance. If the Company is denied clearance or clearance is delayed, itmay have a material adverse impact on the Company.The Company’s products are concentrated in rapidly-changing, highly-competitive markets, which are characterized by rapid technological advances,changes in customer requirements and evolving regulatory requirements and industry standards. Any failure by the Company to anticipate or to respondadequately to technological developments in its industry, changes in customer requirements or changes in regulatory requirements or industry standards or anysignificant delays in the development or introduction of products or services could have a material adverse effect on the Company’s business, operating resultsand future cash flows. 72Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) The Company depends on single source suppliers for critical raw materials for manufacturing, as well as other components required for theadministration of its products and product candidates. The loss of these suppliers could delay the clinical trials or prevent or delay commercialization of theproducts and product candidates.3. Earnings per ShareBasic earnings per share (EPS) is calculated by dividing the net income (loss) by the weighted average number of shares of common stock outstanding.Diluted EPS is computed by dividing the net income (loss) by the weighted average number of shares of common stock outstanding, plus potentialoutstanding common stock for the period. Potential outstanding common stock includes stock options and shares underlying RSUs, but only to the extent thattheir inclusion is dilutive.The following table presents the calculation of basic and diluted net income (loss) per share of common stock for the years ended December 31, 2012,2011, and 2010: Year Ended December 31, (in thousands, except for share and per share amounts) 2012 2011 2010 Numerator: Net income (loss) $(27,664) $(9,802) $7,192 Denominator: Weighted average shares of common stock outstanding, basic 28,228,409 28,106,831 27,916,388 Stock options and restricted stock units related to the issuance ofcommon stock — — 618,229 Weighted average shares of common stock outstanding, diluted 28,228,409 28,106,831 28,534,617 Net income (loss) per share: Basic $(0.98) $(0.35) $0.26 Diluted $(0.98) $(0.35) $0.25 Anti-dilutive securities not included in diluted net income (loss) pershare calculations: Options to purchase common stock and restricted stock units 5,219,183 4,559,432 3,017,096 The Company incurred a net loss for the years ended December 31, 2012 and 2011 causing inclusion of any potentially dilutive securities to have ananti-dilutive effect, resulting in dilutive loss per share and basic loss per share attributable to common stockholders being equivalent. 73Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) 4. Marketable SecuritiesThe following is a summary of the Company’s available-for-sale marketable securities as of December 31, 2012: (in thousands) AmortizedCost GrossUnrealizedGains GrossUnrealizedLosses Fair MarketValue Current: U.S. Treasury and government agencies $14,439 $3 $— $14,442 Corporate debt 17,182 7 — 17,189 $31,621 $10 $— $31,631 The following is a summary of the Company’s available-for-sale marketable securities as of December 31, 2011: (in thousands) AmortizedCost GrossUnrealizedGains GrossUnrealizedLosses Fair MarketValue Current: U.S. Treasury and government agencies $23,747 $10 $(2) $23,755 Corporate debt 37,205 8 (7) 37,206 $60,952 $18 $(9) $60,961 Non-current: U.S. Treasury and government agencies $19,000 $12 $— $19,012 5. Prepaid Expenses and Other Current AssetsThe following is a summary of the Company’s prepaid expenses and other current assets as of December 31, 2012 and 2011: December 31, (in thousands) 2012 2011 Prepaid insurance $155 $165 Other prepaid expenses and vendor advances 3,479 2,474 Accrued interest income 276 244 Other — 116 Total prepaid expenses and other current assets $3,910 $2,999 74Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) 6. Property and EquipmentThe following is a summary of the Company’s property and equipment-at cost, as of December 31, 2012 and 2011: (in thousands) EstimatedUseful Life(Years) December 31,2012 December 31,2011 Laboratory equipment 5 $— $1,273 Computer equipment 3 768 1,105 Furniture and fixtures 7 572 700 Leasehold improvements 11 1,826 960 3,166 4,038 Less — accumulated depreciation and amortization (818) (3,074) $2,348 $964 Depreciation and amortization expense for the years ended December 31, 2012, 2011 and 2010 was $0.6 million, $0.5 million and $0.3 million,respectively.7. Intangible AssetThe following is a summary of the Company’s intangible asset as of December 31, 2012: December 31, 2012 (in thousands) EstimatedUseful Life(Years) GrossCarryingAmount AccumulatedAmortization NetCarryingAmount Fanapt 8 $12,000 $5,468 $6,532 The following is a summary of the Company’s intangible asset as of December 31, 2011: December 31, 2011 (in thousands) EstimatedUseful Life(Years) GrossCarryingAmount AccumulatedAmortization NetCarryingAmount Fanapt 8 $12,000 $3,973 $8,027 In May 2009, the Company announced that the FDA had approved the NDA for Fanapt. As a result of the FDA’s approval of the NDA for Fanapt,the Company met a milestone under its original sublicense agreement with Novartis which required the Company to make a license payment of $12.0 millionto Novartis. The $12.0 million is being amortized on a straight line basis over the remaining life of the U.S. patent for Fanapt, which the Company expects tolast until May 2017. This includes the Hatch-Waxman extension that provides patent protection for drug compounds for a period of five years to compensatefor time spent in development and a six-month pediatric term extension. Fanapt has qualified for the full five-year patent term Hatch-Waxman extension andthe Company expects that Fanapt will be eligible for six months of pediatric exclusivity. This term is the Company’s best estimate of the life of the patent; if,however, the pediatric extension is not granted, the intangible asset will be amortized over a shorter period.The intangible asset is being amortized over its estimated useful economic life using the straight line method. Amortization expense was $1.5 million foreach of the years ended December 31, 2012, 2011 and 2010. The Company capitalized and began amortizing the asset immediately following the FDAapproval of the NDA for Fanapt. 75®®®®®®®®Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) The following is a summary of the future intangible asset amortization schedule as of December 31, 2012: (in thousands) Total 2013 2014 2015 2016 2017 Intangible asset $6,532 $1,495 $1,495 $1,495 $1,495 $552 8. Accrued LiabilitiesThe following is a summary of the Company’s accrued liabilities as of December 31, 2012 and 2011: December 31, (in thousands) 2012 2011 Accrued research and development expenses $3,900 $1,967 Accrued consulting and other professional fees 386 317 Employee benefits 127 100 Accrued lease exit liability (refer to footnote 10) 453 740 Other accrued liabilities 321 257 Total accrued liabilities $5,187 $3,381 9. Deferred RevenueThe following is a summary of changes in total deferred revenue for the years ended December 31, 2012, 2011 and 2010: (in thousands) Balance atBeginning ofYear Reductionsfrom LicensingRevenueRecognized Balance at Endof Year Year ended: December 31, 2012 $143,853 $26,789 $117,064 December 31, 2011 170,642 26,789 143,853 December 31, 2010 197,431 26,789 170,642 Vanda entered into an amended and restated sublicense agreement with Novartis in October 2009, pursuant to which Novartis has the right tocommercialize and develop Fanapt in the U.S. and Canada. Under the amended and restated sublicense agreement, Vanda received an upfront payment of$200.0 million in December 2009. The Company and Novartis established a Joint Steering Committee (JSC) following the effective date of the amended andrestated sublicense agreement. The Company concluded that the JSC constitutes a deliverable under the amended and restated sublicense agreement and thatrevenue related to the upfront payment will be recognized ratably over the term of the JSC; however, the delivery or performance has no term as the exact lengthof the JSC is undefined. As a result, the Company deems the performance period of the JSC to be the life of the U.S. patent of Fanapt, which the Companyexpects to last until May 2017. This includes the Hatch-Waxman extension that provides patent protection for drug compounds for a period of five years tocompensate for time spent in development and a six-month pediatric term extension. Fanapt has qualified for the full five-year patent term Hatch-Waxmanextension and the Company expects that Fanapt will be eligible for six months of pediatric exclusivity. This term is the Company’s best estimate of the life ofthe patent. Revenue related to the upfront payment will be recognized ratably from the date the amended and restated sublicense agreement became effective(November 2009) through the expected life of the U.S. patent for Fanapt (May 2017). For each of the years ended December 31, 2012, 2011 and 2010, theCompany recognized revenue of $26.8 million for the license agreement. 76®®®®®Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) 10. Commitments and ContingenciesOperating leasesThe following is a summary of the minimum annual future payments under operating leases as of December 31, 2012: Cash payments due by period (in thousands) Total 2013 2014 2015 2016 2017 After 2017 Operating leases $12,003 $1,312 $1,052 $1,079 $1,106 $1,133 $6,321 The minimum annual future payments for operating leases consists of the lease for office space for the Company’s headquarters located in Washington,D.C., which expires in 2023 and the lease exit liability for the Company’s former headquarters located in Rockville, Maryland, up to the lease termination dateof June 30, 2013.In July 2011, the Company entered into an office lease with Square 54 Office Owner LLC (the Landlord) for Vanda’s current headquarters, consistingof 21,400 square feet at 2200 Pennsylvania Avenue, N.W. in Washington, D.C. (the Lease). Under the Lease, rent payments are abated for the first 12 months.The Landlord provided the Company with a cash contribution of $1.9 million for tenant improvements during the year ended December 31, 2012 that isreflected in the consolidated financial statements as an increase to capitalized leasehold improvements and an increase to deferred rent. Subject to the priorrights of other tenants in the building, the Company has the right to renew the Lease for five years following the expiration of its original term. The Companyhas the right to sublease or assign all or a portion of the premises, subject to standard conditions. The Lease may be terminated early by the Company or theLandlord upon certain conditions.As a result of the Company’s relocation from its former headquarters office space in Rockville, Maryland, to Washington, D.C., the Companyprovided notice in the fourth quarter of 2011 to the landlord that it was terminating the Rockville lease effective June 30, 2013. As a result, the Companyrecognized an expense of $0.7 million in the year ended December 31, 2011 related to a lease termination penalty. Of this amount, $0.6 million was includedas research and development expense and $0.1 million was included as general and administrative expense in the consolidated statement of operations for theyear ended December 31, 2011. In the first quarter of 2012, the Company ceased using the Rockville, Maryland, location and, as a result, recognizedadditional rent expense of $0.8 million. This $0.8 million consisted of a lease exit liability of $1.3 million for the remaining lease payments, net of reversal ofthe deferred rent liability of $0.5 million related to the Rockville lease. Of the $0.8 million, $0.6 million is included as research and development expense and$0.2 million is included as general and administrative expense in the consolidated statement of operations for the year ended December 31, 2012.The following is a summary of the Company’s lease exit activity: (in thousands) Balance atBeginning of Period Costs Incurred andCharged to Expense Costs Paid orOtherwise Settled Balance at End ofPeriod Year ended December 31, 2012 $740 $1,220 $1,507 $453 Year ended December 31, 2011 $— $740 $— $740 Rent expense under operating leases, including lease exit costs, was $2.0 million, $2.1 million and $1.0 million for the years ended December 31, 2012,2011 and 2010, respectively.Consulting feesThe Company has engaged a regulatory consultant to assist the Company’s efforts to prepare, file and obtain FDA approval of an NDA for tasimelteon.As part of the engagement and subject to certain conditions, the 77Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) Company would be obligated to make milestone payments upon the achievement of certain milestones, including $0.5 million in the event that the tasimelteonNDA is accepted for filing by the FDA and $2.0 million in the event that the tasimelteon NDA is approved by the FDA. In addition to consulting fees andmilestone payments, the Company is obligated to reimburse the consultant for ordinary and necessary business expenses incurred in connection with theengagement. The Company may terminate the engagement at any time upon prior notice; however, subject to certain conditions, the Company will remainobligated to make some or all of the milestone payments if the milestones are achieved following such termination.Guarantees and indemnificationsThe Company has entered into a number of standard intellectual property indemnification agreements in the ordinary course of its business. Pursuant tothese agreements, the Company indemnifies, holds harmless, and agrees to reimburse the indemnified party for losses suffered or incurred by the indemnifiedparty, generally the Company’s business partners or customers, in connection with any U.S. patent or any copyright or other intellectual propertyinfringement claim by any third party with respect to the Company’s products. The term of these indemnification agreements is generally perpetual from thedate of execution of the agreement. The maximum potential amount of future payments the Company could be required to make under these indemnificationagreements is unlimited. The Company also indemnifies its officers and directors for certain events or occurrences, subject to certain conditions. Sinceinception, the Company has not incurred costs to defend lawsuits or settle claims related to these indemnification agreements. The Company believes that thefair value of the indemnification agreements is minimal, and accordingly the Company has not recognized any liabilities relating to these agreements as ofDecember 31, 2012 and 2011, respectively.License agreementsThe Company’s rights to develop and commercialize its products are subject to the terms and conditions of licenses granted to the Company by otherpharmaceutical companies.Tasimelteon. In February 2004, the Company entered into a license agreement with Bristol-Myers Squibb (BMS) under which the Company receivedan exclusive worldwide license under certain patents and patent applications, and other licenses to intellectual property, to develop and commercializetasimelteon. In partial consideration for the license, the Company paid BMS an initial license fee of $0.5 million. The Company would be obligated to makefuture milestone payments to BMS and Massachusetts General Hospital (MGH) of less than $40.0 million in the aggregate (the majority of which are tied tosales milestones). In the event that a tasimelteon NDA is accepted for filing by the FDA, the Company will incur milestone obligations of $3.8 million.Additionally, the Company would be obligated to make royalty payments based on net sales of tasimelteon which, as a percentage of net sales, are in the lowteens. The Company made a milestone payment to BMS of $1.0 million under this license agreement in 2006 relating to the initiation of its first Phase IIIclinical trial for tasimelteon. The Company is also obligated under this agreement to pay BMS a percentage of any sublicense fees, upfront payments andmilestone and other payments (excluding royalties) that the Company receives from a third party in connection with any sublicensing arrangement, at a ratewhich is in the mid-twenties. The Company has agreed with BMS in the license agreement for tasimelteon to use commercially reasonable efforts to developand commercialize tasimelteon and to meet certain milestones in initiating and completing certain clinical work. The license agreement with BMS was amendedin May 2012 to, among other things, extend the deadline by which the Company must enter into a development and commercialization agreement with a thirdparty for tasimelteon until the earliest of: (i) the date mutually agreed upon by the Company and BMS following the provision by the Company to BMS of afull written report of the Phase III clinical studies on which the Company intends to rely for filing for marketing authorization for tasimelteon in its first majormarket country (Phase III report); (ii) the date of the acceptance by a regulatory authority of the filing by the Company for marketing authorization fortasimelteon in a major market country following the provision by the Company to BMS of the Phase III report; or (iii) December 31, 2013. 78Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) If the Company has not entered into such a development and commercialization agreement with respect to certain major market countries by the foregoingdeadline, then BMS will have the option to exclusively develop and commercialize tasimelteon on its own in those countries not covered by such an agreementon pre-determined financial terms, including milestone and royalty payments. In addition to the foregoing, pursuant to the May 2012 amendment, Vanda’sdeadline for filing an NDA for tasimelteon was extended until January 1, 2014.Either party may terminate the tasimelteon license agreement under certain circumstances, including a material breach of the agreement by the other. Inthe event that BMS has not exercised its option to reacquire the rights to tasimelteon and the Company terminates the license, or if BMS terminates the licensedue to the Company’s breach, all rights licensed and developed by the Company under this agreement will revert or otherwise be licensed back to BMS on anexclusive basis.Fanapt. The Company acquired exclusive worldwide rights to patents and patent applications for Fanapt (iloperidone) in 2004 through a sublicenseagreement with Novartis. A predecessor company of sanofi-aventis, Hoechst Marion Roussel, Inc. (HMRI), discovered Fanapt and completed early clinicalwork on the compound. In 1996, following a review of its product portfolio, HMRI licensed its rights to the Fanapt patents and patent applications to TitanPharmaceuticals, Inc. (Titan) on an exclusive basis. In 1997, soon after it had acquired its rights, Titan sublicensed its rights to Fanapt on an exclusivebasis to Novartis. In June 2004, the Company acquired exclusive worldwide rights to these patents and patent applications, as well as certain Novartis patentsand patent applications to develop and commercialize Fanapt, through a sublicense agreement with Novartis. In partial consideration for this sublicense, theCompany paid Novartis an initial license fee of $0.5 million and was obligated to make future milestone payments to Novartis of less than $100.0 million inthe aggregate (the majority of which were tied to sales milestones), as well as royalty payments to Novartis at a rate which, as a percentage of net sales, was inthe mid-twenties. In November 2007, the Company met a milestone under this sublicense agreement relating to the acceptance of its filing of the NDA forFanapt for the treatment of schizophrenia and made a milestone payment of $5.0 million to Novartis. As a result of the FDA’s approval of the NDA forFanapt in May 2009, the Company met an additional milestone under this sublicense agreement, which required the Company to make a payment of $12.0million to Novartis.In October 2009, Vanda entered into an amended and restated sublicense agreement with Novartis, which amended and restated the June 2004 sublicenseagreement. Pursuant to the amended and restated sublicense agreement, Novartis has exclusive commercialization rights to all formulations of Fanapt in theU.S. and Canada. Novartis began selling Fanapt in the U.S. during the first quarter of 2010. Novartis is responsible for the further clinical developmentactivities in the U.S. and Canada, including the development of a long-acting injectable (or depot) formulation of Fanapt. In October 2012, Novartis informedVanda that it had determined to cease the development of the long-acting injectable (or depot) formulation of Fanapt. Pursuant to the amended and restatedsublicense agreement, Vanda received an upfront payment of $200.0 million and is eligible for additional payments totaling up to $265.0 million uponNovartis’ achievement of certain commercial and development milestones for Fanapt in the U.S. and Canada. Based on the current sales performance ofFanapt in the U.S. and the decision by Novartis to cease development of the long-acting injectable (or depot) formulation of Fanapt, Vanda expects that someor all of these commercial and development milestones will not be achieved by Novartis. Vanda also receives royalties, which, as a percentage of net sales, arein the low double-digits, on net sales of Fanapt in the U.S. and Canada. Vanda retains exclusive rights to Fanapt outside the U.S. and Canada and Vandahas exclusive rights to use any of Novartis’ data for Fanapt for developing and commercializing Fanapt outside the U.S. and Canada. At Novartis’ option,Vanda will enter into good faith discussions with Novartis relating to the co-commercialization of Fanapt outside of the U.S. and Canada or, alternatively,Novartis will receive a royalty on net sales of Fanapt outside of the U.S. and Canada. Novartis has chosen not to co-commercialize Fanapt with Vanda inEurope and certain other countries and will instead receive a royalty on net sales in those countries. These include, but are not limited to, the countries in theEuropean Union as well as Switzerland, Norway, Liechtenstein and Iceland. In December 2012, the EMA’s CHMP issued a negative opinion recommendingagainst approval of Fanaptum™ (oral iloperidone tablets) for the treatment of schizophrenia in adult patients in the European Union. The CHMP was of 79®®®®®®®®®®®®®®®®®®®®®®Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) the opinion that the benefits of Fanaptum™ did not outweigh its risks and recommended against marketing authorization at this point in time. Vanda hasinitiated an appeal of this opinion and requested a re-examination of the decision by the CHMP. Vanda has entered into agreements with the following partnersfor the commercialization of Fanapt in the countries set forth below: Country PartnerMexico Probiomed S.A. de C.V.Israel Megapharm Ltd.In August 2012, the Israeli Ministry of Health granted market approval for Fanapt for the treatment of schizophrenia. In November 2012, Vanda wasnotified that Fanapt had been granted market approval in Argentina for the treatment of schizophrenia.VLY-686. In April 2012, the Company entered into a license agreement with Eli Lilly and Company (Lilly) pursuant to which the Company acquiredan exclusive worldwide license under certain patents and patent applications, and other licenses to intellectual property, to develop and commercialize an NK-1R antagonist, VLY-686, for all human indications. The patent describing VLY-686 as a new chemical entity expires in April 2023, except in the U.S., whereit expires in June 2024 absent any applicable patent term adjustments.Pursuant to the agreement, the Company paid Lilly an initial license fee of $1.0 million and will be responsible for all development costs. The initiallicense fee was recognized as an expense in the second quarter of 2012 and is presented as research and development expense in the consolidated statement ofoperations for the year ended December 31, 2012. Lilly is also eligible to receive additional payments based upon achievement of specified development andcommercialization milestones as well as tiered-royalties on net sales at percentage rates up to the low double digits. These milestones include $4.0 million forpre-NDA approval milestones and up to $95.0 million for future regulatory approval and sales milestones. Vanda has agreed to use its commerciallyreasonable efforts to develop and commercialize VLY-686.Either party may terminate the agreement under certain circumstances, including a material breach of the agreement by the other. In the event that Vandaterminates the agreement, or if Lilly terminates due to Vanda’s breach or for certain other reasons set forth in the agreement, all rights licensed and developedby Vanda under the agreement will revert or otherwise be licensed back to Lilly on an exclusive basis, subject to payment by Lilly to us of a royalty on netsales of products that contain VLY-686.Future milestone payments. No amounts were recorded as liabilities nor were any contractual obligations relating to the license agreements included inthe consolidated financial statements as of December 31, 2012, since the amounts, timing and likelihood of these future payments are unknown and willdepend on the successful outcome of future clinical trials, regulatory filings, favorable FDA regulatory approvals, growth in product sales and other factors.Research and development and marketing agreementsIn the course of its business, the Company regularly enters into agreements with clinical organizations to provide services relating to clinical developmentand clinical manufacturing activities under fee service arrangements. The Company’s current agreements for clinical services may be terminated on no morethan 60 days notice without incurring additional charges, other than charges for work completed but not paid for through the effective date of termination andother costs incurred by the Company’s contractors in closing out work in progress as of the effective date of termination.11. Income TaxesAs of December 31, 2012 and 2011, the Company has provided a valuation allowance for the full amount of its net deferred tax asset since realization ofany future benefit from deductible temporary differences and NOLs could not be sufficiently assured. 80®®®Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) The following is a summary of the Company’s current and deferred income tax provision (benefit) for years ended December 31, 2012, 2011 and 2010: Year Ended December 31, (in thousands) 2012 2011 2010 Current income tax expense (benefit): Federal $— $(1,114) $2,413 State — (1,151) 1,485 Deferred income tax expense (benefit): Federal — 1,821 (1,821) State — — — Total income tax expense (benefit) $— $(444) $2,077 The following is a reconciliation between the Company’s statutory tax rate and effective tax rate for the years ended December 31, 2012, 2011 and 2010: Year Ended December 31, 2012 2011 2010 Federal tax at statutory rate (34.0)% (34.0)% 35.0% State taxes (3.3)% (5.3)% 11.0% Change in valuation allowance 70.3% 101.1% (25.0)% Research and development credit 0.8% (4.6)% (2.7)% Orphan drug credit (30.3)% (60.4)% (21.1)% Stock options 1.4% (0.2)% 22.7% Section 162(m) limitation —% —% 2.5% Tax rate change (7.0)% —% —% Meals, entertainment and other non-deductible items 2.1% (0.9)% —% Effective tax rate —% (4.3)% 22.4% During the year ended December 31, 2011, the Company received approval for a change in accounting method from the Internal Revenue Service (the“IRS”). The Company originally treated certain expenses as start-up expenditures under Section 195 of the Internal Revenue Code of 1986, as amended (the“IRC”) and requested a change in this accounting method to re-characterize the expenditures as trade or business expenses under IRC Section 162. As a resultthe Company was able to deduct $53.8 million, which resulted in the Company not needing to utilize NOL carryforwards and research and developmentcredits in the year ended December 31, 2010. In the year ended December 31, 2011, the Company reflected a benefit in the statement of operations in theamount of $0.4 million. The benefit recognized in the year ended December 31, 2011 was from the reduction in income tax expense for the year endedDecember 31, 2010, due to the change in accounting method. As a result the Company has reestablished NOL carryforwards and credits in its deferred taxassets that are fully offset by a tax valuation allowance. 81Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) The following is a summary of the components of the Company’s deferred tax assets, net, and the related valuation allowance as of December 31, 2012and 2011: December 31, (in thousands) 2012 2011 Deferred tax assets: Net operating loss carryforwards $38,840 $25,065 Stock-based compensation 17,348 15,898 Deferred revenue 47,509 56,743 Accrued and deferred expenses 522 395 Research and development and orphan drug credit carryforwards 31,302 18,803 Depreciation and amortization, net 28 93 Total deferred tax assets 135,549 116,997 Deferred tax liabilities: Licensing agreements (2,273) (3,166) Unrealized gain on available for sale securities (4) (8) Total deferred tax liabilities (2,277) (3,174) Deferred tax assets 133,272 113,823 Valuation allowance (133,272) (113,823) Net deferred tax assets $— $— The fact that the Company has historically generated NOLs serves as strong evidence that it is more likely than not that deferred tax assets will not berealized in the future. Therefore, the Company had a full valuation allowance against all deferred tax assets as of December 31, 2012 and 2011. The netincrease in the tax valuation allowance was $19.4 million and $10.3 million for the years ended December 31, 2012 and 2011, respectively. The net decreasein the tax valuation allowance was $2.3 million for the year ended December 31, 2010.As of December 31, 2012, the Company had federal NOL carryforwards of $97.7 million, state NOL carryforwards of $97.7 million, research anddevelopment credits of $6.2 million and orphan drug carryforward credits of $25.1 million. These NOL carryforwards and credits will begin to expire in2028 and 2024, respectively.Because the Company has generated NOLs from inception through December, 31, 2012, all income tax returns filed by the Company are open toexamination by tax jurisdictions. As of December 31, 2012, the Company’s income tax returns have not been under examination by any federal or state taxjurisdictions.The Company’s tax attributes, including NOLs and credits, are subject to any ownership changes as defined under IRC Section 382. A change inownership could affect the Company’s ability to use its NOLs and credit carryforwards. An ownership change did occur as of December 31, 2008. However,the Company had sufficient Built-In-Gain to offset the IRC Section 382 limitation as well as any remaining NOL carryforwards generated as of the ownershipchange. As of December 31, 2012, the Company does not believe that an additional ownership change has occurred. Any future ownership changes may causethe Company’s existing tax attributes to have additional limitations.As of December 31, 2012 and 2011, the Company had no uncertain tax positions. 82Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) 12. Fair Value MeasurementsAuthoritative guidance establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include: • Level 1 — defined as observable inputs such as quoted prices in active markets • Level 2 — defined as inputs other than quoted prices in active markets that are either directly or indirectly observable • Level 3 — defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptionsMarketable securities classified in Level 1 and Level 2 at December 31, 2012 and 2011 are available-for-sale marketable securities. The valuation ofLevel 1 instruments is determined using a market approach, and is based upon unadjusted quoted prices for identical assets in active markets. The valuationof investments classified in Level 2 also is determined using a market approach based upon quoted prices for similar assets in active markets, or other inputsthat are observable for substantially the full term of the financial instrument. Level 2 securities include certificates of deposit, commercial paper, corporatenotes and U.S. government agency notes that use as their basis readily observable market parameters.As of December 31, 2012, the Company held certain assets that are required to be measured at fair value on a recurring basis, as follows: Fair Value Measurements at Reporting Date Using (in thousands) December 31,2012 Quoted Prices inActive marketsfor IdenticalAssets(Level 1) Significant OtherObservableInputs(Level 2) SignificantUnobservableInputs(Level 3) Description: Available-for-sale securities $31,631 $14,442 $17,189 $— As of December 31, 2011, the Company held certain assets that are required to be measured at fair value on a recurring basis, as follows: Fair Value Measurements at Reporting Date Using (in thousands) December 31,2011 Quoted Prices inActive markets forIdentical Assets(Level 1) Significant OtherObservableInputs(Level 2) SignificantUnobservableInputs(Level 3) Description: Available-for-sale securities $79,973 $42,767 $37,206 $— The Company also has financial assets and liabilities, not required to be measured at fair value on a recurring basis, which primarily consist of cashand cash equivalents, accounts receivable, restricted cash, accounts payable and accrued liabilities, the carrying value of which materially approximate theirfair values. 83Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) 13. Restricted CashThe following is a summary of the Company’s restricted cash used to collateralize various letters of credit as of December 31, 2012 and 2011: December 31, (in thousands) 2012 2011 Current: Rockville, Maryland office lease $430 $— Non-current: Rockville, Maryland office lease $— $430 Washington, D.C. office lease 500 500 Maryland Board of Pharmacy license 100 100 Total non-current $600 $1,030 14. Equity Incentive PlansAs of December 31, 2012, the Company had two equity incentive plans, the Second Amended and Restated Management Equity Plan (the 2004 Plan)and the 2006 Equity Incentive Plan (the 2006 Plan) that were adopted in December 2004 and April 2006, respectively. An aggregate of 672,145 shares weresubject to outstanding options granted under the 2004 Plan as of December 31, 2012, and no additional options will be granted under this plan. As ofDecember 31, 2012, there were 7,866,260 shares of the Company’s common stock reserved for issuance under the 2006 Plan, of which 5,570,863 shareswere subject to outstanding options and RSUs granted to employees and non-employees and 1,161,688 shares remained available for future grant. OnJanuary 1 of each year, the number of shares reserved under the 2006 Plan is automatically increased by 4% of the total number of shares of common stockthat are outstanding at that time, or, if less, by 1,500,000 shares (or such lesser number as may be approved by the Company’s board of directors). As ofJanuary 1, 2013, the number of shares of common stock that may be issued under the 2006 Plan was automatically increased by 1,129,670 shares,representing 4% of the total number of shares of common stock outstanding on January 1, 2013, increasing the number of shares of common stock availablefor issuance under the Plan to 8,995,930 shares.The Company has granted two types of options, option awards with service conditions (service option awards) and options with service andperformance conditions (performance option awards). Service option awards are subject to terms and conditions established by the compensation committee ofthe board of directors. Service option awards have 10-year contractual terms and all service option awards granted prior to December 31, 2006, service optionawards granted to new employees, and certain service option awards granted to existing employees vest and become exercisable on the first anniversary of thegrant date with respect to the 25% of the shares subject to service option awards. The remaining 75% of the shares subject to the service option awards vestand become exercisable monthly in equal installments thereafter over three years. Certain service option awards granted to existing employees afterDecember 31, 2006 vest and become exercisable monthly in equal installments over four years. The initial service option awards granted to directors upon theirelection vest and become exercisable in equal monthly installments over a period of four years, while the subsequent annual service option awards granted todirectors vest and become exercisable in equal monthly installments over a period of one year. Certain service option awards to executives and directors providefor accelerated vesting if there is a change in control of the Company. Certain service option awards to employees and executives provide for accelerated vestingif the respective employee’s or executive’s service is terminated by the Company for any reason other than cause or permanent disability. During the year endedDecember 31, 2012, the Company granted 151,250 performance option awards. The performance option awards are subject to the same terms and conditionsas option awards with the exception of their vesting requirements. The performance option awards granted in 2012 vest upon the acceptance by the FDA of theCompany’s NDA for tasimelteon in the treatment of 84Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) Non-24 (the Vesting Event), provided that the employee remains continuously employed through the Vesting Event. As of December 31, 2012, $2.6 million ofunrecognized compensation costs related to unvested service option awards are expected to be recognized over a weighted average period of 1.7 years. As ofDecember 31, 2012, $0.3 million of unrecognized compensation costs related to unvested performance option awards are expected to be recognized over theremaining service period beginning in the period the Company determines the performance goal is probable of achievement. Since the Company’s managementhas not yet determined the goal is probable of achievement as of December 31, 2012, no compensation expense has been recognized for the performance optionawards for the year ended December 31, 2012. None of the option awards or performance option awards are classified as a liability as of December 31, 2012.The following is a summary of option activity for the 2004 Plan for the years ended December 31, 2012, 2011, and 2010: (in thousands, except for share and per share amounts) Number ofShares Weighted AverageExercise Price atGrant Date Weighted AverageRemaining Term(Years) AggregateIntrinsic Value Outstanding at December 31, 2009 732,894 $1.97 5.79 $6,798 Expired (4) 4.73 Exercised (52,136) 4.58 137 Outstanding at December 31, 2010 680,754 1.77 4.77 5,232 Exercised (3,609) 0.33 22 Outstanding at December 31, 2011 677,145 1.78 3.78 2,016 Exercised (5,000) 0.33 14 Outstanding at December 31, 2012 672,145 1.79 2.78 1,512 Exercisable at December 31, 2012 672,145 1.79 2.78 1,512 85Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) The following is a summary of option activity for the 2006 Plan for the years ended December 31, 2012, 2011, and 2010: (in thousands, except for share and per share amounts) Number ofShares Weighted AverageExercise Price atGrant Date Weighted AverageRemaining Term(Years) AggregateIntrinsic Value Outstanding at December 31, 2009 3,484,845 $15.91 8.45 $5,347 Granted 787,125 8.54 Forfeited (343,575) 24.99 Expired (471,957) 13.03 Exercised (131,648) 4.96 364 Outstanding at December 31, 2010 3,324,790 14.07 8.01 3,426 Granted 982,000 5.55 Forfeited (26,764) 9.24 Expired (15,369) 13.51 Exercised (9,976) 2.38 37 Outstanding at December 31, 2011 4,254,681 12.16 7.65 396 Granted 846,000 3.42 Forfeited (149,091) 7.50 Expired (76,103) 10.68 Exercised (10,000) 1.02 22 Outstanding at December 31, 2012 4,865,487 10.83 7.15 634 Exercisable at December 31, 2012 3,057,940 14.00 6.09 257 Proceeds from the exercise of stock options amounted to $0.01 million, $0.03 million and $0.9 million for the years ended December 31, 2012, 2011and 2010, respectively.An RSU is a stock award that entitles the holder to receive shares of the Company’s common stock as the award vests. The fair value of each RSU isbased on the closing price of the Company’s stock on the date of grant. The Company has granted two types of RSUs, RSUs with service conditions (serviceRSUs) and RSUs with service and performance conditions (performance RSUs). These awards vest in four equal annual installments provided that theemployee remains employed with the Company. During 2012, the Company granted 48,750 performance RSUs. The performance RSUs are subject to thesame terms and conditions as service RSUs with the exception of their vesting requirements. The performance RSUs granted in 2012 vest upon the VestingEvent, provided that the employee remains continuously employed through the Vesting Event. As of December 31, 2012, $2.9 million of unrecognizedcompensation costs related to unvested service RSUs are expected to be recognized over a weighted average period of 1.3 years. As of December 31, 2012, $0.2million of total unrecognized compensation costs related to unvested performance RSUs are expected to be recognized over the remaining service periodbeginning in the period the Company determines the performance goal is probable of achievement. Since the Company’s management has not yet determinedthe goal is probable of achievement as of December 31, 2012, no compensation expense has been recognized for the performance awards for the year endedDecember 31, 2012. None of the service RSUs or performance RSUs are classified as a liability as of December 31, 2012. 86Table of ContentsVanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) The following is a summary of RSU activity for the 2006 Plan for the years ended December 31, 2012, 2011, and 2010: (in thousands, except for share and per share amounts) Number ofShares Weighted AveragePrice/Share Aggregate GrantDate Fair Value Unvested at December 31, 2009 12,500 $0.80 $10 Granted 479,625 10.27 Vested (2,500) 0.80 2 Vested and unissued (59,562) 10.31 606 Forfeited (70,500) 11.67 Unvested at December 31, 2010 359,563 9.75 3,507 Granted 283,000 5.39 Vested (2,500) 0.80 2 Vested and unissued (109,717) 9.74 1,068 Forfeited (8,000) 9.57 Unvested at December 31, 2011 522,346 7.43 3,883 Granted 245,000 3.28 Forfeited (61,970) 7.64 Unvested at December 31, 2012 705,376 5.91 4,208 15. Employee Benefit PlanThe Company has a defined contribution plan under the Internal Revenue Code Section 401(k). This plan covers substantially all employees who meetminimum age and service requirements and allows participants to defer a portion of their annual compensation on a pre-tax basis. Currently, the Companymatches 50 percent up to the first six percent of employee contributions. All matching contributions have been paid by the Company. The Company matchvests over a 4 year period. The total Company match was $0.1 million for each of the years ended December 31, 2012, 2011 and 2010.16. Quarterly Financial Data (unaudited) (in thousands, except for per share amounts) FirstQuarter SecondQuarter ThirdQuarter FourthQuarter 2012 Revenue $8,141 $8,378 $8,288 $7,920 Loss from operations (8,317) (8,085) (5,395) (6,428) Net loss (7,962) (8,007) (5,326) (6,369) Net loss per share: Basic $(0.28) $(0.28) $(0.19) $(0.23) Diluted $(0.28) $(0.28) $(0.19) $(0.23) 2011 Revenue $7,501 $7,430 $7,969 $8,370 Income (loss) from operations 7 (1,513) (3,293) (5,908) Net income (loss) 136 (1,341) (3,074) (5,523) Net income (loss) per share: Basic $— $(0.05) $(0.11) $(0.20) Diluted $— $(0.05) $(0.11) $(0.20) 87Table of ContentsVANDA PHARMACEUTICALS INC.EXHIBITS ExhibitNumber Description 3.8 Form of Amended and Restated Certificate of Incorporation of the registrant (filed as Exhibit 3.8 to Amendment No. 2 to the registrant’sRegistration Statement on Form S-1 (File No. 333-130759), as filed on March 17, 2006, and incorporated herein by reference). 3.10 Form of Certificate of Designation of Series A Junior Participating Preferred Stock (filed as Exhibit 3.10 to the registrant’s current report onForm 8-K (File No. 001-34186) as filed on September 25, 2008 and incorporated herein by reference). 3.11 Second Amended and Restated Bylaws of the registrant, as amended and restated on December 16, 2008 (filed as Exhibit 3.11 to theregistrant’s current report on Form 8-K (File No. 001-34186) as filed on December 17, 2008 and incorporated herein by reference). 4.1 2004 Securityholder Agreement (as amended) (filed as Exhibit 4.1 to the registrant’s Registration Statement on Form S-1 (File No. 333-130759), as originally filed on December 29, 2005, and incorporated herein by reference). 4.4 Specimen certificate representing the common stock of the registrant (filed as Exhibit 4.4 to Amendment No. 2 to the registrant’s RegistrationStatement on Form S-1 (File No. 333-130759), as filed on March 17, 2006, and incorporated herein by reference). 4.5 Rights Agreement, dated as of September 25, 2008, between the registrant and American Stock Transfer & Trust Company, LLC, asRights Agent (filed as Exhibit 4.5 to the registrant’s current report on Form 8-K (File No. 001-34186) as filed on September 25, 2008 andincorporated herein by reference). 4.6 Amendment to Rights Agreement, dated as of December 22, 2009, between the registrant and American Stock Transfer & Trust Company,LLC, as Rights Agent (filed as Exhibit 4.6 to the registrant’s current report on Form 8-K (File No. 001-34186) as filed on December 22,2009 and incorporated herein by reference).10.1 Registrant’s Second Amended and Restated Management Equity Plan (filed as Exhibit 10.1 to the registrant’s Registration Statement onForm S-1 (File No. 333-130759), as originally filed on December 29, 2005, and incorporated herein by reference).10.2# Sublicense Agreement between the registrant and Novartis Pharma AG dated June 4, 2004 (as amended) (relating to Fanapt) (filed asExhibit 10.2 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1 (File No. 333-130759), as filed on February 16,2006, and incorporated herein by reference).10.3# Amended and Restated License, Development and Commercialization Agreement by and between Bristol-Myers Squibb Company and theregistrant dated July 24, 2005 (relating to tasimelteon) (filed as Exhibit 10.3 to Amendment No. 1 to the registrant’s Registration Statementon Form S-1 (File No. 333-130759), as filed on February 16, 2006, and incorporated herein by reference).10.7 Lease Agreement between the registrant and Red Gate III LLC dated June 25, 2003 (lease of Rockville, MD office space) (filed as Exhibit10.7 to the registrant’s Registration Statement on Form S-1 (File No. 333-130759), as originally filed on December 29, 2005, andincorporated herein by reference).10.8 Amendment to Lease Agreement between the registrant and Red Gate III LLC dated September 27, 2003 (filed as Exhibit 10.8 to theregistrant’s Registration Statement on Form S-1 (File No. 333-130759), as originally filed on December 29, 2005, and incorporated hereinby reference).10.9 Lease Agreement between the registrant and MCC3 LLC (by Spaulding and Slye LLC) dated August 4, 2005 (filed as Exhibit 10.9 to theregistrant’s Registration Statement on Form S-1 (File No. 333-130759), as originally filed on December 29, 2005, and incorporated hereinby reference). 88®Table of ContentsExhibitNumber Description10.10 Summary Plan Description provided for the registrant’s 401(k) Profit Sharing Plan & Trust (filed as Exhibit 10.10 to the registrant’sRegistration Statement on Form S-1 (File No. 333-130759), as originally filed on December 29, 2005, and incorporated herein byreference).10.11 Form of Indemnification Agreement entered into by directors (filed as Exhibit 10.11 to the registrant’s Registration Statement on Form S-1(File No. 333-130759), as originally filed on December 29, 2005, and incorporated herein by reference).10.17 2006 Equity Incentive Plan (filed as Exhibit 10.17 to Amendment No. 2 to the registrant’s Registration Statement on Form S-1 (File No. 333-130759), as filed on March 17, 2006, and incorporated herein by reference).10.19 Amendment to Lease Agreement between the registrant and MCC3 LLC (by Spaulding and Slye LLC) dated November 15, 2006 (filed asExhibit 10.19 to the registrant’s annual report on Form 10-K (File No. 000-51863) for the year ending December 31, 2006 and incorporatedherein by reference).10.20 Form of Tax Indemnity Agreement (filed as Exhibit 10.20 to the registrant’s quarterly report on Form 10-Q (File No. 000-51863) for theperiod ending September 30, 2007 and incorporated herein by reference).10.22 Second Amendment to Lease Agreement between the registrant and MCC3 LLC (by Spaulding and Slye MCC3 LLC) dated September 14,2007 (filed as Exhibit 10.22 to the registrant’s annual report on Form 10-K (File No. 000-51863) for the year ending December 31, 2007and incorporated herein by reference).10.34 Amended and Restated Employment Agreement for Mihael H. Polymeropoulos dated December 16, 2008 (filed as Exhibit 10.34 to theregistrant’s quarterly report on Form 10-Q (File No. 001-34186) for the quarter ending June 30, 2009 and incorporated herein by reference).10.36 Employment Agreement for John Feeney dated May 22, 2009 (filed as Exhibit 10.36 to the registrant’s quarterly report on Form 10-Q (FileNo. 001-34186) for the quarter ending June 30, 2009 and incorporated herein by reference).10.37# Amended and Restated Sublicense Agreement between the registrant and Novartis Pharma AG dated October 12, 2009 (relating to Fanapt)(filed as Exhibit 10.37 to the registrant’s annual report on Form 10-K for the year ending December 31, 2009 and incorporated herein byreference).10.38 Employment Agreement for James Kelly dated December 13, 2010 (filed as Exhibit 10.38 to the registrant’s annual report on Form 10-K forthe year ending December 31, 2010 and incorporated herein by reference).10.39 Amendment dated December 16, 2010 to Amended and Restated Employment Agreement for Mihael H. Polymeropoulos dated December16, 2008 (filed as Exhibit 10.39 to the registrant’s annual report on Form 10-K for the year ending December 31, 2010 and incorporatedherein by reference).10.40 Amendment dated December 16, 2010 to Employment Agreement for John Feeney dated May 22, 2009 (filed as Exhibit 10.39 to theregistrant’s annual report on Form 10-K for the year ending December 31, 2010 and incorporated herein by reference).10.41 Amended and Restated Tax Indemnity Agreement dated December 16, 2010 by and between the Registrant and Mihael H. Polymeropoulos(filed as Exhibit 10.41 to the registrant’s annual report on Form 10-K for the year ending December 31, 2010 and incorporated herein byreference).10.42 Lease effective as of July 25, 2011 by and between Registrant and Square 54 Office Owner LLC filed as Exhibit 10.42 to the registrant’squarterly report on Form 10-Q for the quarter ending September 31, 2011 and incorporated herein by reference).10.43 Employment Agreement for Robert Repella dated October 24, 2011 (filed as Exhibit 10.43 to the registrant’s annual report on Form 10-K forthe year ended December 31, 2011 and incorporated herein by reference). 89®Table of ContentsExhibitNumber Description10.44 Form of Notice of Stock Option Grant and Stock Option Agreement under 2006 Equity Incentive Plan 2011 (filed as Exhibit 10.44 to theregistrant’s annual report on Form 10-K for the year ended December 31, 2011 and incorporated herein by reference).10.45 Form of Restricted Stock Unit Award Agreement under 2006 Equity Incentive Plan 2011 (filed as Exhibit 10.45 to the registrant’s annualreport on Form 10-K for the year ended December 31, 2011 and incorporated herein by reference).10.46 Amendment to Amended and Restated License, Development and Commercialization Agreement, dated as of April 15, 2010 (filed asExhibit 10.38 to the registrant’s current report on Form 8-K filed on April 19, 2010 and incorporated herein by reference).10.47 Amendment to Amended and Restated License, Development and Commercialization Agreement, dated as of May 24, 2012, by andbetween the Registrant and Bristol-Myers Squibb Company (filed as Exhibit 10.46 to the registrant’s current report on Form 8-K filed onMay 30, 2012 and incorporated herein by reference).10.48# License, Development and Commercialization Agreement, dated as of April 12, 2012, by and between Eli Lilly and Company and theRegistrant (filed as Exhibit 10.48 to the registrant’s quarterly report on Form 10-Q for the quarter ended June 30, 2012 and incorporatedherein by reference).10.49 Separation and Release Agreement for John Feeney, M.D., dated as of September 18, 2012 (filed as Exhibit 10.49 to the registrant’squarterly report on Form 10-Q for the quarter ended September 30, 2012 and incorporated herein by reference).23.1 Consent of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm.31.1 Certification of the Chief Executive Officer, as required by Section 302 of the Sarbanes-Oxley Act of 2002.31.2 Certification of the Chief Financial Officer as required by Section 302 of the Sarbanes-Oxley Act of 2002.32.1 Certification of the Chief Executive Officer and Chief Financial Officer as required by Section 906 of the Sarbanes-Oxley Act of 2002.101 The following financial information from this annual report on Form 10-K for the fiscal year ended December 31, 2012, formatted inXBRL (eXtensible Business Reporting Language) and furnished electronically herewith: (i) Consolidated Balance Sheets as of December31, 2012 and December 31, 2011; (ii) Consolidated Statements of Operations for the years ended December 31, 2012, 2011 and 2010; (iii)Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2012, 2011 and 2010; (iv) ConsolidatedStatements of Changes in Stockholders’ Equity for the years ended December 31, 2012, 2011 and 2010; (v) Consolidated Statements ofCash Flows for the years ended December 31, 2012, 2011 and 2010; and (vi) Notes to the Consolidated Financial Statements. #Confidential treatment has been granted with respect to certain provisions of this exhibit. 90Table of ContentsVANDA PHARMACEUTICALS INC.EXHIBIT INDEX ExhibitNumber Description23.1 Consent of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm31.1 Certification of the Chief Executive Officer, as required by Section 302 of the Sarbanes-Oxley Act of 200231.2 Certification of the Chief Financial Officer as required by Section 302 of the Sarbanes-Oxley Act of 200232.1 Certification of the Chief Executive Officer and Chief Financial Officer as required by Section 906 of the Sarbanes-Oxley Act of 2002101 The following financial information from this annual report on Form 10-K for the fiscal year ended December 31, 2012, formatted in XBRL(eXtensible Business Reporting Language) and furnished electronically herewith: (i) Consolidated Balance Sheets as of December 31, 2012and December 31, 2011; (ii) Consolidated Statements of Operations for the years ended December 31, 2012, 2011 and 2010; (iii)Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2012, 2011 and 2010; (iv) ConsolidatedStatements of Changes in Stockholders’ Equity for the years ended December 31, 2012, 2011 and 2010; (v) Consolidated Statements ofCash Flows for the years ended December 31, 2012, 2011 and 2010; and (vi) Notes to the Consolidated Financial Statements. 91Exhibit 23.1CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMWe hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (No. 333-133368, No. 333-138070, No. 333-141571, No. 333-148924, No. 333-156995, No. 333-164567, No. 333-171962 No. 333-179265 and No. 333-186509) and on Form S-3 (No. 333-171963) of VandaPharmaceuticals Inc. of our report dated February 25, 2013 relating to the financial statements and the effectiveness of internal control over financial reporting,which appears in this Form 10-K./s/ PricewaterhouseCoopers LLPBaltimore, MarylandFebruary 25, 2013EXHIBIT 31.1CERTIFICATION OF CHIEF EXECUTIVE OFFICERPURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002I, Mihael H. Polymeropoulos, certify that: 1.I have reviewed this annual report on Form 10-K of Vanda 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 this report; 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(s) 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 for externalpurposes 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(s) 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. February 26, 2013 /s/ Mihael H. Polymeropoulos, M.D. Mihael H. Polymeropoulos, M.D. President and Chief Executive Officer(Principal Executive Officer)EXHIBIT 31.2CERTIFICATION OF CHIEF FINANCIAL OFFICERPURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002I, James P. Kelly, certify that: 1.I have reviewed this annual report on Form 10-K of Vanda 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 this report; 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(s) 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 for externalpurposes 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(s) 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. February 26, 2013 /s/ James P. Kelly James P. Kelly Senior Vice President, Chief Financial Officer,Secretary and Treasurer(Principal Financial Officer and PrincipalAccounting Officer)EXHIBIT 32.1CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICERPursuant to Section 906 of the Sarbanes-Oxley Act of 2002(Subsections (a) and (b) of Section 1350, Chapter 63 of Title 18, United States Code)Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of section 1350, chapter 63 of title 18, United States Code), each of theundersigned officers of Vanda Pharmaceuticals Inc., (the “Company”), does hereby certify, to the best of such officer’s knowledge, that:The Annual Report on Form 10-K for the year ended December 31, 2012 (the Form 10-K) of the Company fully complies with the requirements ofSection 13(a) or 15(d) of the Securities Exchange Act of 1934, and the information contained in the Form 10-K fairly presents, in all material respects, theconsolidated financial condition and results of operations of the Company. February 26, 2013 /s/ Mihael H. Polymeropoulos, M.D. Mihael H. Polymeropoulos, M.D.President and Chief Executive Officer(Principal Executive Officer)February 26, 2013 /s/ James P. Kelly James P. KellySenior Vice President, Chief Financial Officer,Secretary and Treasurer(Principal Financial Officer and Principal Accounting Officer)A signed original of this written statement required by Section 906 has been provided to the Company and will be retained by the Company andfurnished to the Securities and Exchange Commission (SEC) or its staff upon request. This certification “accompanies” the Form 10-K to which itrelates, is not deemed filed with the SEC and is not to be incorporated by reference into any filing of the Company under the Securities Act of 1933, asamended, or the Securities Exchange Act of 1934, as amended (whether made before or after the date of the Form 10-K), irrespective of any generalincorporation language contained in such filing.

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