UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark One)
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þ
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Quarterly Report Pursuant to Section 13 or 15 (d) of the
Securities Exchange Act of 1934
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For the quarterly period ended September 30, 2007.
OR
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o
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Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
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For the transition period from to .
Commission file number 001-32629
AVALON PHARMACEUTICALS, INC.
(Exact Name of Registrant as Specified in Its Charter)
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Delaware
(State or Other Jurisdiction of
Incorporation or Organization)
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52-2209310
(I.R.S. Employer Identification No.)
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20358 Seneca Meadows Parkway
Germantown, Maryland
(Address of Principal Executive Offices)
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20876
(Zip Code)
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Registrants Telephone Number, Including Area Code:
(301) 556-9900
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes
þ
No
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Indicate by check mark whether the registrant is a large accelerated filer, an accelerated
filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated
filer in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
o
Accelerated filer
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Non-accelerated filer
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Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of
the Exchange Act). Yes
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No
þ
As of October 31, 2007, 17,026,462 shares of Avalon Pharmaceuticals, Inc. common stock, par
value $.01 per share, were outstanding.
AVALON PHARMACEUTICALS, INC.
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Page
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PART I. FINANCIAL INFORMATION
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4
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Item 1. Financial Statements
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4
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Balance Sheets as of September 30, 2007 (unaudited) and December 31, 2006
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4
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Statements of Operations for the three and nine months ended September 30, 2007 and 2006 (unaudited)
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5
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Statements of Cash Flows for the nine months ended September 30, 2007 and 2006 (unaudited)
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6
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Notes to Financial Statements (unaudited)
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7
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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
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11
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
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16
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Item 4T. Controls and Procedures
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16
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PART II. OTHER INFORMATION
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17
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Item 6. Exhibits
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17
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SIGNATURES
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18
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2
FORWARD-LOOKING STATEMENTS
From time to time in this interim quarterly report we may make statements that reflect our
current expectations regarding our future results of operations, economic performance, and
financial condition, as well as other matters that may affect our business. In general, we try to
identify these forward-looking statements by using words such as anticipate, believe, expect,
estimate, and similar expressions.
All of these items involve significant risks and uncertainties. These and any of the other
statements we make in this quarterly report that are forward-looking are made pursuant to the safe
harbor provisions of the Private Securities Litigation Reform Act of 1995. We caution you that our
actual results may differ significantly from the results we discuss in the forward-looking
statements.
We discuss some factors that could cause or contribute to such differences in the Risk
Factors section of our Annual Report on
Form 10-K
for the fiscal year ended December 31, 2006, and
in Part II, Item 1A of our interim quarterly report on
Form 10-Q
for the quarter ended March 31,
2007. In addition, any forward-looking statements we make in this document speak only as of the
date of this document, and we do not intend to update any such forward-looking statements to
reflect events or circumstances that occur after that date.
3
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
AVALON PHARMACEUTICALS, INC.
BALANCE SHEETS
(in thousands, except share and per share amounts)
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September 30,
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December 31,
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2007
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2006
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(Unaudited)
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ASSETS
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Current assets:
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Cash and cash equivalents
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$
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6,581
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$
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3,099
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Marketable securities
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19,807
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9,980
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Accounts receivable
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724
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Interest receivable
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129
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175
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Prepaid expenses
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408
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642
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Deposits
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102
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102
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Total current assets
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27,027
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14,722
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Restricted cash and marketable securities
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4,898
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5,520
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Property and equipment, net
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7,774
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8,923
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Long-term marketable securities
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2,127
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1,831
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Deposits
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105
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Deferred financing costs
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274
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290
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Total assets
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$
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42,100
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$
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31,391
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LIABILITIES AND STOCKHOLDERS EQUITY
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Current liabilities:
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Accounts payable
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$
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1,229
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$
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1,857
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Accrued expenses and other current liabilities
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1,202
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1,232
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Deferred revenue
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707
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1,034
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Current portion of long-term debt
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1,243
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1,518
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Total current liabilities
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4,381
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5,641
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Deferred rent
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452
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469
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Long-term deferred revenue, net of current portion
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200
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200
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Long-term debt, net of current portion
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6,000
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7,207
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Stockholders equity:
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Series C Junior Participating Preferred stock,
$0.01 par value; 300,000 shares authorized; no
shares issued and outstanding
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Common stock, $0.01 par value; 60,000,000 shares
authorized; 17,023,394 and 10,137,340 shares
issued and outstanding at September 30, 2007 and
December 31, 2006, respectively
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170
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101
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Additional capital
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150,103
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120,477
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Other comprehensive income
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57
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Accumulated deficit
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(119,263
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(102,704
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Total stockholders equity
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31,067
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17,874
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Total liabilities and stockholders equity
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$
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42,100
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$
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31,391
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See accompanying notes.
4
AVALON PHARMACEUTICALS, INC.
STATEMENTS OF OPERATIONS
(in thousands, except share and per share amounts)
(Unaudited)
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Three Months Ended
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Nine Months Ended
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September 30,
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September 30,
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2007
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2006
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2007
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2006
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Revenues
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$
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$
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1,115
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$
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809
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$
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2,071
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Costs and expenses:
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Research and development
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3,531
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3,422
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11,709
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9,909
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General and administrative
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2,197
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1,685
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6,468
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5,734
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Total costs and expenses
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5,728
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5,107
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18,177
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15,643
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Loss from operations
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(5,728
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(3,992
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(17,368
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(13,572
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Other income (expense):
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Interest income
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470
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325
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1,187
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995
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Interest expense
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(155
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(202
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(486
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(626
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Other
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8
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146
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107
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491
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Total other income, net
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323
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269
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808
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861
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Net loss
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$
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(5,405
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$
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(3,723
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$
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(16,559
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$
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(12,711
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Net loss per share basic and diluted
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$
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(0.32
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$
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(0.37
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$
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(1.13
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$
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(1.30
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Weighted average number of shares
basic and diluted
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17,015,319
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10,106,947
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14,716,327
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9,744,184
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See accompanying notes.
5
AVALON PHARMACEUTICALS, INC.
STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
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Nine Months Ended
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September 30,
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2007
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2006
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Operating activities
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Net loss
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$
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(16,559
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$
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(12,711
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Adjustments to reconcile net loss to net cash used in operating activities:
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Depreciation
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1,552
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1,852
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Non-cash interest expense
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163
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225
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Amortization of premium (discount) on investments
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(496
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26
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Stock based compensation
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1,281
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1,398
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Changes in operating assets and liabilities:
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Prepaid expenses
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235
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118
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Accounts receivable and other assets
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875
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113
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Accounts payable
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(628
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)
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298
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Accrued expenses and other current liabilities
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(30
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(2
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Deferred revenue
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(326
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)
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77
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Deferred rent
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(17
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1
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Net cash used in operating activities
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(13,950
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)
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(8,759
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)
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Investing activities
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Proceeds from the sale of marketable securities
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26,290
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15,448
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Purchases of marketable securities
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(35,239
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)
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(17,768
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Purchases of property and equipment
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(403
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(114
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)
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Net cash used in investing activities
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(9,352
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)
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(2,434
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)
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Financing activities
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Principal payments on debt
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(282
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)
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(845
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)
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Proceeds from issuance of common stock
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28,413
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7,326
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Payments on bond payable
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(1,200
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)
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(1,200
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)
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Deferred financing costs
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(147
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)
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(205
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)
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Net cash provided by financing activities
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26,784
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5,076
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Net increase (decrease) in cash and cash equivalents
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3,482
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(6,117
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)
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Cash and cash equivalents at beginning of period
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3,099
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9,732
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Cash and cash equivalents at end of period
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$
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6,581
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$
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3,615
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See accompanying notes.
6
AVALON PHARMACEUTICALS, INC.
NOTES TO FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)
1. Basis of Presentation
The financial statements included in this report have been prepared, without audit, pursuant
to the rules and regulations of the Securities and Exchange Commission. Certain information and
footnote disclosures, normally included in financial statements prepared in accordance with U.S.
generally accepted accounting principles, have been condensed or omitted pursuant to such rules and
regulations. These financial statements should be read in conjunction with the audited financial
statements and the related notes included in our Annual Report on Form 10-K for the fiscal year
ended December 31, 2006.
In the opinion of our management, any adjustments contained in the accompanying unaudited
financial statements as of and for the three and nine months ended September 30, 2007 and 2006 are
of a normal recurring nature and are necessary to present fairly our financial position, results of
operations and cash flows. Interim results are not necessarily indicative of results for the full
fiscal year.
2. Organization
Avalon Pharmaceuticals, Inc. (Avalon, or the Company), was incorporated on November 10,
1999, under the laws of the state of Delaware. Avalon is a biopharmaceutical company using
proprietary technology, AvalonRx
®
, to discover and develop novel therapeutics.
3. Recent Accounting Pronouncements
In February 2007, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards (SFAS) No. 159,
The Fair Value for Financial Assets and Financial
Liabilities.
This Statement permits entities to choose to measure financial assets and liabilities,
with certain exceptions, at fair value at specified election dates. A business entity shall report
unrealized gains and losses on items for which the fair value option has been elected in earnings
at each subsequent reporting date. This Statement is effective as of the beginning of an entitys
first fiscal year that begins after November 15, 2007. The Company has not determined the impact,
if any, SFAS No. 159 will have on its financial statements.
On September 15, 2006 the FASB issued SFAS No. 157,
Fair Value Measurements.
The Statement
provides guidance for using fair value to measure assets and liabilities. This Statement references
fair value as the price that would be received to sell an asset or paid to transfer a liability in
an orderly transaction between market participants in the market in which the reporting entity
would transact such sale or transfer. The Statement applies whenever other standards require (or
permit) assets or liabilities to be measured at fair value. The Statement does not expand the use
of fair value in any new circumstances. It is effective for financial statements issued for fiscal
years beginning after November 15, 2007, and interim periods within those fiscal years. The
adoption of SFAS No. 157 is not expected to have a material impact on the Companys financial
statements.
4. Summary of Significant Accounting Policies
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally
accepted in the United States requires management to make estimates and assumptions that affect the
amounts reported in the financial statements and accompanying notes. Actual results could differ
from those estimates.
Cash and Cash Equivalents
The Company considers all highly liquid investments with a maturity of three months or less
when purchased to be cash equivalents. Cash equivalents consist primarily of money market funds and
commercial paper. The Company maintains cash balances with financial institutions in excess of
insured limits. The Company does not anticipate any losses with such cash balances.
Marketable Securities
Marketable securities consist primarily of U.S Treasury and agency debt securities with
various maturities. Management classifies the Companys marketable securities as
available-for-sale. Such securities are stated at market value, with the unrealized gains and
losses included as accumulated other comprehensive income (loss). Realized gains and losses and
declines in value judged to be other-than-temporary on securities available for sale, if any, are
included in operations. A decline in the market value of any available-for-sale security below cost
that is deemed to be other-than-temporary results in a reduction in fair value. The impairment is
charged to earnings, and a new cost basis for the security is established. Dividend and interest
income are recognized when earned. The cost of securities sold is calculated using the specific
identification method.
7
Revenue Recognition
Revenues are recognized when there is persuasive evidence that an arrangement exists, delivery
has occurred, the price is fixed and determinable, and collection is reasonably assured. Payments
received in advance of work performed are recorded as deferred revenue and recognized ratably over
the performance period. Milestone payments are recognized as revenue in an amount commensurate with
the level of effort expended when the milestone is achieved, the contract partner acknowledges
completion of the milestone, no further performance obligations exist as defined in the agreements,
collection is reasonably assured and substantive effort was necessary to achieve the milestone.
During the first nine months of 2007, the Company recognized revenue from work performed and
expenses incurred on its collaboration agreement with Novartis, and recognized no revenue from its
other collaboration agreements.
Research and Development Costs
The Company expenses its research and development costs as incurred.
Restricted Cash and Investments
In accordance with the terms of a financing arrangement with the Maryland Industrial
Development Financing Authority (MIDFA) and Manufacturers and Traders Trust Company (M&T Bank), in
order to finance the build out of the Companys corporate headquarters and research facility
located in Germantown, Maryland, the Company established an investment account which is pledged as
collateral for a letter of credit. The issuer of the letter of credit, M&T Bank, maintains the
investment account. M&T Banks security interest in the account cannot exceed the minimum required
cash collateral amount, which as of September 30, 2007 was defined as an adjusted market value of
$4.9 million. This collateral agreement defines adjusted market value as the product of the fair
market value of each permitted investment by a defined percentage ranging from 60% to 100%,
depending on the nature of the permitted investment. The minimum cash collateral amount
automatically decreases each April 1, as specified in the collateral agreement.
Comprehensive Income
SFAS No. 130,
Reporting Comprehensive Income,
requires the presentation of comprehensive
income or loss and its components as part of the financial statements. For the nine months ended
September 30, 2007 and 2006, the Companys net loss plus its unrealized gains (losses) on
available-for-sale securities reflects comprehensive income (loss).
Stock-Based Compensation
The Company accounts for share-based payments in accordance with the provisions of FASB
Statement No. 123(R), Share-Based Payment, using the modified-prospective-transition method.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes
option-pricing fair value model. The following weighted-average assumptions were used for options
granted during the three months ended September 30, 2007 and 2006, and a discussion of our
methodology for developing each of the assumptions used in the valuation model follows:
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Three Months Ended
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|
Three Months Ended
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|
|
September 30, 2007
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|
September 30, 2006
|
Dividend yield
|
|
|
0.00
|
%
|
|
|
0.00
|
%
|
Expected volatility
|
|
|
70.5
|
%
|
|
|
68.6
|
%
|
Risk-free interest rate
|
|
|
5.00
|
%
|
|
|
4.77
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%
|
Expected life of the option term (in years)
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|
|
6.0
|
|
|
|
6.0
|
|
Forfeiture rate
|
|
|
4.20
|
%
|
|
|
3.99
|
%
|
Dividend Yield
The Company has never declared or paid dividends and has no plans to do so in the
foreseeable future.
Expected Volatility
Volatility is a measure of the amount by which a financial variable such as a
share price has fluctuated (historical volatility) or is expected to fluctuate (expected
volatility) during a period. Due to the Companys limited trading history, there had been
inadequate data to calculate historical volatility of our stock. Prior to June 30, 2007, the
Company used an average volatility of similar companies in the pharmaceutical industry. Beginning
with the three months ended September 30, 2007 the Company uses an average of the volatility of its
own stock and the average volatility of similar companies in the pharmaceutical industry.
Risk-Free Interest Rate
This is the U.S. Treasury rate for the week of each option grant during
the quarter having a term that most closely resembles the term of the option.
Expected Life of the Option Term
This is the period of time that the options granted are expected
to remain unexercised. Options granted during the quarter have a maximum term of ten years. The
Company has adopted SAB 107s simplified method for estimating the expected term of stock options.
Forfeiture Rate
This is the estimated number of stock options granted that are expected to be
forfeited or cancelled on an annual basis before becoming fully vested. The Company estimates the
forfeiture rate based on past turnover data.
Stock Compensation Plans
The Company adopted the Avalon Pharmaceuticals, Inc. 1999 Stock Incentive Plan (the 1999
Plan) to provide for the granting of stock awards, such as stock options, restricted common stock,
and stock appreciation rights to employees, directors and other individuals as determined by the
Board of Directors. The Company terminated the 1999 Plan as to future awards effective upon the
closing of the Companys initial public offering in October 2005. As of September 30, 2007, the
Company had reserved 451,117 shares of common stock to accommodate the exercise of outstanding
options granted under the 1999 Plan.
8
Effective upon the closing of the Companys initial public offering in October 2005, the
Company adopted the Avalon Pharmaceuticals, Inc. 2005 Omnibus Long-Term Incentive Plan (the 2005
Plan) to provide for the granting of stock awards, such as stock options, restricted common stock,
stock units, dividend equivalent rights, stock appreciation rights and unrestricted common stock,
and other performance and annual incentive awards to employees, directors and other individuals as
determined by the Board of Directors. At the inception of the 2005 Plan, 989,738 shares were
reserved for issuance under the 2005 Plan. The number of shares available for issuance under the
2005 Plan was increased from 989,738 to 1,581,582 in June 2006 and to 2,381,582 in June 2007.
Additionally, shares that become available due to forfeiture of outstanding awards under the 1999
Plan are available for awards under the 2005 Plan. As of September 30, 2007, the Company had
reserved 2,375,543 shares of common stock to accommodate the exercise of outstanding option grants
under the 2005 Plan and for future grants under the 2005 Plan.
Generally, stock options are granted with an exercise price that equals the fair market value
of the Companys common stock on the grant date. Options typically have a life of ten years and
vest over periods ranging from one to five years. Options generally expire 90 days after an
employee terminates employment with the Company.
Shares of common stock issued to non-employee directors as part of their annual director
compensation for the three and nine month periods ended September 30, 2007 were 6,832 and 20,137,
respectively. The fair market value of these shares, on the date of grant, was approximately
$29,000 and $85,200, respectively.
The total intrinsic value of stock options exercised during the three and nine month periods
ended September 30, 2007 was approximately $29,600 and $59,105, respectively. The weighted-average
grant-date fair value of equity awards granted during the three and nine month periods ended
September 30, 2007 was $2.85 and $2.98, respectively. The total fair value of stock options which
vested during the three and nine month periods ended September 30, 2007 was approximately $360,300
and $951,700, respectively. There were 1,438,242 fully vested stock options outstanding at
September 30, 2007. These stock options had a weighted average remaining life of 7.17 years.
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|
Weighted-
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|
|
|
|
Weighted-
|
|
Average
|
|
|
|
|
|
|
|
|
Average
|
|
Remaining
|
|
|
|
|
|
|
|
|
Exercise
|
|
Contractual
|
|
Aggregate
|
|
|
Shares
|
|
Price
|
|
Term
|
|
Intrinsic Value
|
Outstanding at June 30, 2007
|
|
|
1,976,912
|
|
|
$
|
4.12
|
|
|
|
|
|
|
|
|
|
Granted
|
|
|
146,503
|
|
|
|
4.27
|
|
|
|
|
|
|
|
|
|
Exercised
|
|
|
(13,750
|
)
|
|
|
3.20
|
|
|
|
|
|
|
|
|
|
Forfeited or expired
|
|
|
(29,412
|
)
|
|
|
5.42
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Outstanding at September 30, 2007
|
|
|
2,080,253
|
|
|
$
|
4.12
|
|
|
|
7.74
|
|
|
$
|
3,442
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Vested and expected to vest at September 30, 2007
|
|
|
1,438,242
|
|
|
$
|
4.24
|
|
|
|
7.17
|
|
|
$
|
2,224
|
|
Exercisable at September 30, 2007
|
|
|
1,438,242
|
|
|
$
|
4.24
|
|
|
|
7.17
|
|
|
$
|
2,224
|
|
Cash received from the exercise of stock options under all share-based payment arrangements
for the three months ended September 30, 2007 was $44,000. Due to the valuation allowance on all
deferred tax assets, the Company recorded no tax benefit for stock compensation expense recognized
during the three months ended September, 2007. As of September 30, 2007, there was approximately
$947,700 of total unrecognized compensation costs related to non-vested employee stock options.
That cost is expected to be recognized over a weighted average period of 2.45 years.
Basic and Diluted Net Loss Attributable to Common Stockholders Per Common Share
Basic net loss attributable to common stockholders per common share excludes dilution for
potential common stock issuances and is computed by dividing net loss by the weighted-average
number of common shares outstanding for the period. Diluted net loss per common share reflects the
potential dilution that could occur if securities or other contracts to issue common stock were
exercised or converted into common stock. Stock options and warrants were not considered in the
computation of diluted net loss per common share for the periods presented, as their effect is
antidilutive.
5. Stockholders Equity
Preferred Stock
In April 2007, the Company entered into a Rights Agreement (the Rights Agreement) between
the Company and American Stock Transfer & Trust Company, as Rights Agent. In connection with the
adoption of the Rights Agreement, the Board of Directors of the Company declared a dividend
distribution of one right (Right) for each outstanding share of common stock, par value $0.01 per
share of the Company, payable to stockholders of record on May 10, 2007. Each Right, when
exercisable, entitles the registered holder to purchase from the Company one one-thousandth of one
share of Series C Junior Participating Preferred Stock at a price of $60.00 per one one-thousandth
share, subject to adjustment. The description and terms of the Rights are set forth in the Rights
Agreement.
Initially, the Rights will be attached to all certificates representing shares of common stock
then outstanding, and no separate certificates evidencing the Rights will be distributed. The
Rights will separate from the common stock and a distribution of Rights Certificates will occur
upon the earlier to occur of (i) 10 days following a public announcement that a person or group of
affiliated or associated persons has acquired beneficial ownership of 20% or more of the
outstanding shares of common stock or (ii) 10 business days following the commencement of, or the
first public announcement of the intention to commence, a tender offer or exchange offer the
consummation of which would result in the beneficial ownership by a person of 20% or more of the
outstanding shares of common stock. (the earlier of such dates being called the Distribution
Date).
9
Until the Distribution Date, (i) the Rights will be evidenced by the common stock certificates, and
will be transferred with and only with the common stock certificates, (ii) new common stock
certificates issued after May 10, 2007 upon transfer or new issuance of the common stock will
contain a notation incorporating the Rights Agreement by reference, and (iii) the surrender for
transfer of any certificates for common stock outstanding will also constitute the transfer of the
Rights associated with the common stock represented by such certificate.
The Rights are not exercisable until the Distribution Date and will expire at the close of
business on May 10, 2017, unless such date is extended, the Rights Agreement is terminated, or the
Rights are earlier redeemed or exchanged by the Company as described below. The Rights will not be
exercisable by a holder in any jurisdiction where the requisite qualification to the issuance to
such holder, or the exercise by such holder, of the Rights has not been obtained or is not
obtainable.
As soon as practicable following the Distribution Date, separate certificates evidencing the
Rights will be mailed to holders of record of the common stock as of the close of business on the
Distribution Date and, thereafter, the separate Rights Certificates alone will evidence the Rights.
Except as otherwise determined by the Board of Directors of the Company, only shares of common
stock issued prior to the Distribution Date will be issued with Rights.
In the event that a person becomes the beneficial owner of 20% or more of the then outstanding
shares of common stock, except pursuant to an offer for all outstanding shares of common stock
which the Directors determine to be fair to and otherwise in the best interests of the Company and
its stockholders, each holder of a Right will have the right to exercise the Right by purchasing,
for an amount equal to the Purchase Price, common stock (or, in certain circumstances, cash,
property or other securities of the Company) having a value equal to two times such amount.
Notwithstanding any of the foregoing, following the occurrence of the events set forth in this
paragraph, all Rights that are beneficially owned by any acquiring person will be null and void.
Common Stock
In January 2007, the Company raised $10.0 million through a private placement of 3,000,000
shares of its common stock to seventeen accredited institutional investors. The proceeds from this
financing are being used to fund the Companys lead oncology drug, AVN944, and the continued
development of additional pipeline programs using the Companys proprietary technology
AvalonRx
®
. Offering expenses of $499,000 were netted against gross proceeds and recorded
to additional capital.
In May 2007, the Company raised $20.0 million in gross proceeds through a private placement of
3,838,772 shares of its common stock to twenty accredited institutional investors. The investors
also received warrants to purchase up to 959,693 shares of common stock at an exercise price of
$6.00 per share. The warrants will expire in five years. The proceeds from this financing are being
used to fund the Companys lead oncology drug, AVN944, and the continued development of additional
pipeline programs using the Companys proprietary technology AvalonRx
®
. Offering
expenses of $1.3M were netted against gross proceeds and recorded to additional capital.
6. Related Party Transactions
The Company paid one member of the board of directors consulting fees totaling $79,200 for the
nine months ended September 30,2007 and two members of the board of directors consulting fees
totaling $92,100 for the nine months ended September 30, 2006.
7. Income Taxes
For the nine month periods ended September 30, 2007, and 2006, there is no current provision
for income taxes and the deferred tax benefit has been entirely offset by valuation allowances. The
difference between the amounts of income tax benefit that would result from applying domestic
federal statutory income tax rates to the net loss and the net deferred tax assets is related to
certain nondeductible expenses, state income taxes, and the change in the valuation allowance.
10
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our results of operations, financial condition and
liquidity and capital resources should be read in conjunction with our unaudited consolidated
financial statements and related notes contained in this Quarterly Report on
Form 10-Q
, as well as
the audited financial statements and related notes for the fiscal year ended December 31,2006 and
Managements Discussion and Analysis of Financial Condition and Results of Operations, contained
in our Annual Report on
Form 10-K
, for the fiscal year ended December 31, 2006.
Overview
We are a biopharmaceutical company focused on the discovery, development and commercialization
of first-in-class cancer therapeutics. Our lead product candidate, AVN944, an IMPDH inhibitor, is
in Phase II clinical development. We have preclinical programs to develop inhibitors of the
Beta-catenin and Aurora/Centrosome pathways, discovery programs for inhibitors of the Survivin and
Myc pathways, and partnerships with Merck, MedImmune, ChemDiv, Medarex and Novartis. We use
AvalonRx
®
, our proprietary platform which is based on large-scale biomarker identification and
monitoring, to discover and develop therapeutics for pathways that have historically been
characterized as undruggable.
Since our inception, our operations have consisted primarily of developing
AvalonRx
®
, utilizing our technology to seek to discover and develop novel cancer
therapeutics, and the in-license and development of AVN944. During that period, we have generated
limited revenue from collaborative partners, and have had no revenue from product sales. Our
operations have been funded principally through the offering of equity securities and debt
financings.
We have never been profitable and, as of September 30, 2007, we had an accumulated deficit of
$119.3 million. We had net losses of $16.6 million for the nine months ended September 30, 2007 and
net losses of $17.1 million for the year ended December 31, 2006. We expect to incur significant
and increasing operating losses for the foreseeable future as we advance our drug candidates from
discovery through preclinical testing and clinical trials and seek regulatory approval and eventual
commercialization. In addition to these increasing research and development expenses, we expect
general and administrative costs to increase as we add personnel. We will need to generate
significant revenues to achieve profitability, and we may never do so.
Financial Operations Overview
Revenue
We have not generated any revenue from sales of commercial products and do not expect to
generate any product revenue for the foreseeable future. To date, our revenue has consisted of
collaboration revenue.
Collaboration Revenue.
Since inception, we have generated revenue solely in connection with
our collaboration and pilot study agreements. Our collaborations with MedImmune and Novartis
include upfront payments, research funding, and payments for the achievement of certain discovery
and development related milestones. During the first nine months of 2007, we recognized revenue
under our collaboration with Novartis and recognized no revenue from our other collaborations.
Research and Development Expense
Research and development expense consists of expenses incurred in connection with developing
and advancing our drug discovery technology and identifying and developing our drug candidates and
supporting our collaborative relationships. These expenses consist primarily of salaries and
related expenses, the purchase of laboratory supplies, access to data sources, facility costs,
costs for preclinical development and expenses related to our in-license and clinical trials of
AVN944. We charge all research and development expenses to operations as incurred.
We expect our research and development costs to be substantial and to increase as we advance
AVN944 through clinical trials and move other drug candidates into preclinical testing and clinical
trials. Based on the results of our preclinical studies, we expect to selectively advance some drug
candidates into clinical trials. We anticipate that we will select drug candidates and research
projects for further development on an ongoing basis in response to their preclinical and clinical
success and commercial potential. In January 2006, we initiated U.S. Phase I clinical trials of
AVN944 in hematological cancers. In July 2007, we announced the initiation of a Phase II clinical
trial in pancreatic cancer patients.
General and Administrative
General and administrative expense consists primarily of salaries and related expenses for
personnel in administrative, finance, business development and human resource functions. Other
costs include legal costs of pursuing patent protection of our intellectual property and other fees
for legal services.
Critical Accounting Policies and Significant Judgments and Estimates
Income Taxes
In July 2006, the FASB issued FASB Interpretation Number 48,
Accounting for Uncertainty in
Income Taxes
(FIN48). FIN No. 48 clarifies the accounting for income taxes by prescribing the
minimum recognition threshold a tax position is required to meet before being recognized in the
financial statements. FIN 48 also provides guidance on derecognition, measurement, classification,
interest and penalties, accounting in interim periods, disclosure and transition. In addition, FIN
48 scopes out income taxes from SFAS No. 5,
Accounting for Contingencies
. FIN 48 is effective for
fiscal years beginning after December 15, 2006.
We adopted the provisions of FASB Interpretation No. 48
Accounting for Uncertainty in Income
Taxes An Interpretation of FASB Statement No. 109,
on January 1, 2007. FIN 48 clarifies the
accounting for uncertainty in income taxes recognized in the financial statements if that position
is more likely than not of being sustained by the taxing authority. The adoption of FIN 48 did not
have an impact on our financial position or results of operations.
11
We file income tax returns in the state of Maryland. With few exceptions, we are subject to
U.S. federal, state and local income tax examinations by tax authorities for years after 1998. See
our most recent Annual Report filed on Form 10-K for the year ended December 31, 2006 for a
complete discussion of our critical accounting policies.
Stock-Based Compensation
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123, revised
2004, or SFAS 123(R),
Share-Based Payment
. SFAS 123(R) supersedes Accounting Principles Board
(APB) Opinion No. 25,
Accounting for Stock Issued to Employees
, and requires companies to
recognize compensation expense, using a fair-value based method, for costs related to share-based
payments, including those made pursuant to stock option and employee stock purchase plans.
We adopted SFAS 123(R) on January 1, 2006 using the modified prospective transition method,
which requires that stock-based compensation cost is recognized for all awards granted, modified or
settled after the effective date as well as for all awards granted to employees prior to the
effective date that remain unvested as of the effective date. Prior to the adoption, we disclosed
such costs on a pro forma basis in the notes to our financial statements.
For the nine months ended September 30, 2007, we recorded approximately $1.3 million of
stock-based compensation expenses, of which $0.2 million was included in research and development
expense and $1.1 million was included in general and administrative expense. Since we continue to
operate in a net loss, the adoption of SFAS 123(R) had no impact for tax-related effects on cash
flow from operations and cash flow from financing activities for the nine months ended September
30, 2007. As of September 30, 2007, unamortized stock-based compensation expenses of approximately
$947,700 remains to be recognized over a weighted-average period of approximately 2.45 years. We
amortize stock-based compensation expenses on a straight-line ratable basis over the vesting
period.
We estimated the fair value of stock options granted during the three months ended September
30, 2007 using the Black-Scholes option pricing model. The assumptions used under this model are as
follows: (i) expected term of 6 years based on the simplified method for estimating the expected
term of stock options; (ii) expected volatility of 70.5% based a combined average of the historical
volatility of our common stock and an average historical volatility of similar companies in the
pharmaceutical industry; (iii) weighted average risk-free interest rate of 5.00% based on the U.S.
Treasury yield curve in effect at the time of grant for periods corresponding with the expected
term of the option; and (iv) expected dividend yield of zero percent. In addition, under SFAS
123(R), the fair value of stock options granted is recognized as expense over the service period,
net of estimated forfeitures. Based on historical data, we calculated a 4.20% annual forfeiture
rate, which we believe is a reasonable assumption. However, the estimation of forfeitures requires
judgment, and to the extent actual results or updated estimates differ from our current estimates,
such amounts will be recorded as a cumulative adjustment in the period estimates are revised.
The Black-Scholes option pricing model requires the input of highly subjective assumptions.
Because our employee stock options have characteristics significantly different from those of
traded options, and because changes in the subjective input assumptions can materially affect the
fair value estimate, in managements opinion, the existing models may not provide a reliable single
measure of the fair value of our employee stock. In addition, management will continue to assess
the assumptions and methodologies used to calculate estimated fair value of share-based
compensation. Circumstances may change and additional data may become available over time, which
result in changes to these assumptions and methodologies, and which could materially impact our
fair value determination.
Results of Operations
Three Months Ended September 30, 2007 and 2006
Revenue.
No revenue was recognized during the three months ended September 30, 2007.
Collaboration efforts during the quarter, related to our partnership agreements with Merck,
Novartis and ChemDiv, may result in milestone or royalty payments in future periods.
Research and Development.
Research and development expenses increased by $109,000, or 3%, to
$3.5 million for the three months ended September 30, 2007 from $3.4 million for the same period in
2006. The increase in research and development expenses was primarily attributable to increases in
clinical trial costs related to our AVN944 drug candidate and salary expenses related to new hires.
Research and development expenses consist of direct costs which include salaries and related
costs of research and development personnel, and the costs of consultants, materials and supplies
associated with research and development projects. Indirect research and development costs include
facilities, depreciation, patents and other indirect overhead costs.
During the remainder of 2007, and thereafter, research and development expenses may increase
substantially as we continue development of our internal programs and clinical studies for our
AVN944 drug program.
General and Administrative.
General and administrative expenses increased by $512,000 or 30%,
to $2.2 million for the three months ended September 30, 2007, compared to $1.7 million for the
three months ended September 30, 2006. This increase was primarily attributable to an increase in
consulting costs and compensation expense related to stock options.
Interest Income.
Interest income increased by $145,000 or 44%, to $470,000 for the three
months ended September 30, 2007, compared to $325,000 for the three months ended September 30,
2006. The increase in interest income is a result of higher average cash balances and higher
average interest rates.
Interest Expense.
Interest expense decreased by $47,000 or 23%, to $155,000 for the three
months ended September 30, 2007, compared to $202,000 for the three months ended September 30,
2006. The decrease in interest expense was primarily related to lower balances on our long term
debt. This decrease was offset, in part, by higher average interest rates on our development bond
financing.
12
Other Income.
Other income was $8,000 for the three months ended September 30, 2007, compared
to $146,000 for the three months ended September 30, 2006. The decrease in other income was
primarily related to the discontinuation of income from subletting part of our facility and the
provision of shared services to subtenants during the first half of 2007.
Nine Months Ended September 30, 2007 and 2006
Revenue.
Total revenues for the nine months ended September 30, 2007 were $809,000, a decrease
of $1.3 million from the same period in the prior year. All 2007 revenue was attributable to our
collaboration agreement with Novartis and no revenue was recognized under our other collaboration
agreements.
Research and Development.
Research and development expenses increased by $1.8 million, or 18%,
to $11.7 million for the nine months ended September 30, 2007 from $9.9 million for the same period
in 2006. The increase in research and development expenses was primarily attributable to increases
in clinical trial costs related to our AVN944 drug candidate, increases in laboratory supplies
expense, and an increase in salaries and benefits expense related to new hires.
General and Administrative.
General and administrative expenses increased by $734,000 or 12%,
to $6.5 million for the nine months ended September 30, 2007, compared to $5.7 million for the nine
months ended September 30, 2006. This increase is primarily attributable to an increase in
consulting costs and an increase in compensation expense related to stock options.
Interest Income.
Interest income increased by $192,000 or 19%, to $1,187 for the nine months
ended September 30, 2007, compared to $995,000 for the nine months ended September 30, 2006. The
increase in interest income is a result of interest earned on higher average cash balances and
higher average interest rates.
Interest Expense.
Interest expense decreased by $140,000 or 22%, to $486,000 for the nine
months ended September 30, 2007, compared to $626,000 for the nine months ended September 30, 2006.
The decrease in interest expense was primarily related to lower balances on our long term debt.
This decrease was offset, in part, by higher average interest rates on our development bond
financing.
Other Income.
Other income decreased by $384,000 or 78%, to $107,000 for the nine months ended
September 30, 2007, compared to $491,000 for the nine months ended September 30, 2006. The decrease
in other income was primarily related to the discontinuation of income from subletting part of our
facility and the provision of shared services to subtenants during the first half of 2007.
Liquidity and Capital Resources
Our primary cash requirements are to:
|
|
|
fund our research and development and clinical programs;
|
|
|
|
|
obtain regulatory approvals;
|
|
|
|
|
prosecute, defend and enforce any patent claims and other intellectual property rights;
|
|
|
|
|
fund general corporate overhead; and
|
|
|
|
|
support our debt service requirements and contractual obligations.
|
Our cash requirements could change materially as a result of the progress of our research and
development and clinical programs, licensing activities, business development activities,
acquisitions, divestitures or other corporate developments.
We have incurred operating losses since our inception and historically have financed our
operations principally through public stock offerings, debt financings, private placements of
equity securities, strategic collaborative agreements that include research and development funding
and development milestones, and investment income.
In evaluating alternative sources of financing we consider, among other things, the dilutive
impact, if any, on our stockholders, the ability to leverage stockholder returns through debt
financing, the particular terms and conditions of each alternative financing arrangement and our
ability to service our obligations under such financing arrangements.
As of September 30, 2007, we had cash, cash equivalents and marketable securities of
approximately $33.4 million. Of this amount, $4.9 million is currently held in a restricted account
to serve as collateral for our long-term debt. Our funds are currently invested in investment grade
and United States government securities.
13
Sources and Uses of Cash
Operating Activities.
Net cash used in operating activities for the nine months ended
September 30, 2007 was $14.0 million, compared to $8.8 million for the same period in fiscal 2006.
During the first nine months of fiscal year 2007, our net loss of $16.6 million was reduced by
non-cash charges of $2.6 million, primarily for stock compensation and depreciation and
amortization. During the first nine months of fiscal year 2006, our net loss of $12.7 million was
reduced by non-cash charges of $3.9 million, primarily associated with stock compensation,
depreciation and amortization, offset by changes in our net operating assets and liabilities.
Investing Activities.
Net cash used in investing activities for the nine months ended
September 30, 2007 was $9.4 million, compared to $2.4 million for the same period in 2006. Cash
used in investing activities represents the amount used to purchase property and equipment and
marketable securities, net of proceeds from the sale and maturity of marketable securities.
Financing Activities.
Net cash provided by financing activities for the nine months ended
September, 2007 was $26.8 million, compared to $5.1 million for the same period in 2006. During the
first nine months of 2007, $28.4 million was raised from issuance of common stock. This amount was
offset by $1.5 million in repayments on debt.
Credit Arrangements
In April 2003, we entered into a series of agreements with the Maryland Industrial Development
Financing Authority, or MIDFA, and Manufacturers and Traders Trust Company, or M&T Bank, in order
to finance improvements to our corporate office and research facility located in Germantown,
Maryland. MIDFA sold development bonds in the amount of $12.0 million. The proceeds of the bond
sale were put in trust to reimburse us for the costs we incurred for improvements to our facility.
We are required to repay the trust $1.2 million annually for these borrowings. The borrowing bears
interest at a variable rate and matures on April 8, 2013. The weighted-average interest rate during
the nine months ended September, 2007 and 2006 was 5.42% and 5.10%, respectively.
In connection with the development bond financing, we entered into an agreement with M&T Bank
to issue the trustee an irrevocable letter of credit to provide payment of the principal and
interest of the bonds. The amount of the letter of credit changes annually, as principal payments
are made. As of September 30, 2007, that amount is $7,318,356, consisting of $7.2 million of
principal and $118,356 in interest, computed at 50 days at an assumed maximum rate of interest of
12% per annum. The letter of credit expires the earlier of April 8, 2008, or the date the bonds
have been paid in full. In consideration of the letter of credit, we have granted M&T Bank a
security interest in certain facility improvements, equipment and cash collateral held as
restricted cash.
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Operating Capital and Capital Expenditure Requirements
Our future funding requirements will depend on many factors, including but not limited to:
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the size and complexity of our research and development programs;
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the scope and results of our preclinical testing and clinical trials;
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continued scientific progress in our research and development programs;
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the time and expense involved in seeking regulatory approvals;
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competing technological and market developments;
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acquisition, licensing and protection of intellectual property rights; and
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the cost of establishing manufacturing capabilities and conducting commercialization activities.
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Until we can generate a sufficient amount of product revenue to finance our cash requirements,
which we may never do, we expect to finance future cash needs primarily through public or private
equity offerings, debt financings or strategic collaborations. If we are successful in raising
additional funds through the issuance of equity securities, investors likely will experience
dilution, or the equity securities may have rights, preferences or privileges senior to those of
the holders of our common stock. If we raise funds through the issuance of debt securities, those
securities would have rights, preferences and privileges senior to those of our common stock. We do
not know whether additional funding will be available on acceptable terms, or at all. If we are not
able to secure additional funding when needed, we may have to delay, reduce the scope of, or
eliminate one or more of our clinical trials or research and development programs. In addition, we
may have to partner one or more of our drug candidate programs at an earlier stage of development,
which would lower the economic value of those programs to our Company.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to market risk from changes in interest rates. At September 30, 2007, we had
$7.2 million of obligations which were subject to variable rates of interest under our development
bond financing with MIDFA. If market interest rates increased 1% from the rate at September 30,
2007, our annual interest expense would increase approximately $72,000, assuming that obligations
subject to variable interest rates remained constant.
In addition, the value of our portfolio of cash equivalents and investments is subject to
market risk from changes in interest rates.
The primary objective of our investment activities is to preserve our capital for the purpose
of funding operations while at the same time maximizing the income we receive from our investments
without significantly increasing risk. To achieve these objectives, our investment policy allows us
to maintain a portfolio of cash equivalents and investments in a variety of securities, including
commercial paper, money market funds and corporate debt securities. As of September 30, 2007, we
had cash and cash equivalents, short-term and long-term investments and restricted cash of $33.4
million as follows:
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Cash and cash equivalents
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$ 6.6 million
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Short-term investments
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$19.8 million
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Long-term investments
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$ 2.1 million
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Restricted cash
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$ 4.9 million
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We maintain an investment portfolio of investment grade government agency notes and corporate
bonds. The securities in our investment portfolio are not leveraged, are classified as
available-for-sale and are, due to their predominantly short-term nature, subject to minimal
interest rate risk. We currently do not hedge interest rate exposure on our investment portfolio.
As of September 30, 2007, securities totaling $19.8 million mature in the next 12 months and $2.1
million mature after September 30, 2008. While we do not believe that an increase in market rates
of interest would have any significant negative impact on the realizable value of our investment
portfolio, changes in interest rates affect the investment income we earn on our investments and,
therefore, impact our cash flow and results of operations.
We have operated in the United States and all revenues to date have been received in U.S.
dollars. Accordingly, we have not had any material exposure to foreign currency rate fluctuations.
Item 4T. Controls and Procedures
Disclosure Controls and Procedures:
Under the supervision and with the participation of our
management, including our Chief Executive Officer and our Chief Financial Officer, we have
evaluated the effectiveness of our disclosure controls and procedures, as of September 30, 2007
(the Evaluation Date). Based on that evaluation, our Chief Executive Officer and Chief Financial
Officer have concluded that, as of the Evaluation Date, our disclosure controls and procedures were
effective.
Changes in Internal Control over Financial Reporting:
There have been no changes in our
internal control over financial reporting during the quarter ended on the Evaluation Date that has
materially affected, or is reasonably likely to materially affect, our internal control over
financial reporting.
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PART II. OTHER INFORMATION
Item 6. Exhibits
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Exhibit No.
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Description
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31.1
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Certification of Chief Executive Officer pursuant to Rule
13a-14(a) under the Securities Exchange Act of 1934 as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
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31.2
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Certification of Chief Financial Officer pursuant to Rule
13a-14(a) under the Securities Exchange Act of 1934 as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
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32.1
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Certification of Chief Executive Officer and Chief Financial
Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly
caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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AVALON PHARMACEUTICALS, INC.
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Date: November 14, 2007
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By:
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/s/ Kenneth C. Carter
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Kenneth C. Carter, Ph.D.
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President, Chief Executive Officer and
Director
(Principal Executive Officer)
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Date: November 14, 2007
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By:
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/s/ C. Eric Winzer
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C. Eric Winzer
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Executive Vice President and Chief
Financial Officer
(Principal Financial Officer)
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Date: November 14, 2007
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By:
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/s/ Glen Farmer
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Glen Farmer
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Controller
(Principal Accounting Officer)
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