UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark One)
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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 March 31, 2008.
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
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Commission file number 001-32629
AVALON PHARMACEUTICALS, INC.
(Exact Name of Registrant as Specified in Its Charter)
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Delaware
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52-2209310
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(State or Other Jurisdiction of
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(I.R.S. Employer Identification No.)
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Incorporation or Organization)
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20358 Seneca Meadows Parkway
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Germantown, Maryland
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20876
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(Address of Principal Executive Offices)
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(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
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No
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Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company. See the definitions of large accelerated filer,
accelerated filer and smaller reporting
company in Rule 12b-2 of the Exchange Act. (Check one):
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Large accelerated filer
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Accelerated filer
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Non-accelerated filer
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(Do not check if a smaller reporting company)
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Smaller reporting company
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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
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As of April 30, 2008, 17,033,441 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 March 31, 2008 (unaudited) and December 31, 2007
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4
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Statements of Operations for the three months ended March 31, 2008 and 2007 (unaudited)
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5
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Statements of Cash Flows for the three months ended March 31, 2008 and 2007 (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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12
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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, 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 amounts)
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March 31,
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December 31,
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2008
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2007
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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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5,641
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$
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6,276
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Short-term marketable securities
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12,822
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15,558
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Accounts receivable
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200
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Interest receivable
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76
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190
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Prepaid expenses
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1,016
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743
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Deposits
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102
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Total current assets
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19,555
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23,069
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Restricted cash and marketable securities
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4,898
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5,275
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Property and equipment, net
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6,996
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7,325
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Long-term marketable securities
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264
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1,416
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Deferred financing costs, net
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199
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220
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Total assets
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$
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31,912
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$
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37,305
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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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2,472
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$
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1,063
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Accrued expenses and other current liabilities
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492
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1,207
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Deferred revenue and customer advances
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1,154
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1,204
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Current portion of long-term debt
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1,200
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1,211
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Total current liabilities
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5,318
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4,685
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Deferred rent
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439
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446
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Long-term debt, net of current portion
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6,000
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6,000
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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, $0.01 par value; 60,000,000 shares authorized;
17,029,913 and 17,026,462 shares issued and outstanding at March
31, 2008 and December 31, 2007, respectively
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170
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170
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Additional capital
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150,551
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150,331
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Other comprehensive income
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60
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50
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Accumulated deficit
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(130,626
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(124,377
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Total stockholders equity
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20,155
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26,174
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Total liabilities and stockholders equity
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$
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31,912
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$
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37,305
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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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March 31,
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2008
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2007
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Revenues
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$
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50
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$
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731
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Costs and expenses:
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Research and development
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4,360
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4,111
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General and administrative
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2,133
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2,228
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Total costs and expenses
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6,493
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6,339
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Loss from operations
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(6,443
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(5,608
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Other income (expense):
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Interest income
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307
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339
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Interest expense
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(115
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(172
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Other
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2
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96
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Total other income (expense):
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194
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263
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Net loss
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$
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(6,249
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$
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(5,345
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Net loss per share basic and diluted
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$
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(0.37
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$
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(0.43
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Weighted average number of shares basic and diluted
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17,029,837
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12,410,483
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See accompanying notes.
5
AVALON PHARMACEUTICALS, INC.
STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
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Three Months Ended
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March 31,
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2008
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2007
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Operating activities
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Net loss
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$
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(6,249
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$
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(5,345
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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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474
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546
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Non-cash interest expense
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53
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52
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Amortization of premium on investments
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(108
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(84
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Stock based compensation
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219
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703
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Changes in operating assets and liabilities:
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Prepaid expenses
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(273
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118
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Accounts receivable and other assets
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416
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147
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Accounts payable
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1,409
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(1,095
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Accrued expenses and other current liabilities
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(715
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(491
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Deferred revenue and customer advances
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(50
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418
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Deferred rent
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(7
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(5
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Net cash used in operating activities
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(4,831
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(5,036
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Investing activities
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Proceeds from the sale and maturities of marketable securities
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9,227
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6,540
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Purchases of marketable securities
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(4,843
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(7,629
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Purchases of property and equipment
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(145
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(264
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Net cash provided by (used in) investing activities
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4,239
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(1,353
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Financing activities
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Principal payments on debt
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(11
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(125
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Proceeds from issuance of common stock
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9,522
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Deferred financing costs
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(32
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Net cash provided by (used in) financing activities
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(43
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9,397
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Net (decrease) increase in cash and cash equivalents
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(635
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)
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3,008
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Cash and cash equivalents at beginning of period
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6,276
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3,099
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Cash and cash equivalents at end of period
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$
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5,641
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$
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6,107
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See accompanying notes.
6
AVALON PHARMACEUTICALS, INC.
NOTES TO FINANCIAL STATEMENTS
MARCH 31, 2008
(UNAUDITED)
1. Basis of Presentation
The financial statements included in this report have been prepared, without audit, pursuant
to the rules and regulations of the Securities and Exchange Commission. Certain information and
footnote disclosures, normally included in financial statements prepared in accordance with U.S.
generally accepted accounting principles, have been condensed or omitted pursuant to such rules and
regulations. These financial statements should be read in conjunction with the audited financial
statements and the related notes included in our Annual Report on Form 10-K for the fiscal year
ended December 31, 2007.
In the opinion of our management, any adjustments contained in the accompanying unaudited
financial statements as of and for the three months ended March 31, 2008 and 2007 are of a normal
recurring nature and are necessary to present fairly our financial position, results of operations
and cash flows. Interim results are not necessarily indicative of results for the full fiscal year.
2. Liquidity Risks and Managements Plans
The accompanying financial statements have been prepared on a going-concern basis, which
contemplates the realization of assets and satisfaction of liabilities in the normal course of
business. Since inception, the Company has incurred, and continues to incur, significant losses
from operations. In addition, the Company needs to raise additional capital to continue its
business operations and fund deficits in operating cash flow. The Company plans to raise
additional capital to finance the development of its business operations, although this capital
raise cannot be assured.
The Companys ability to continue as a going concern is dependent on its success at raising
additional capital sufficient to meet its obligations on a timely basis, and to ultimately attain
profitability. Management is active in discussions to raise the necessary funds for the Companys
growth and development activities. However, there is no assurance that the Company will raise
capital sufficient to enable the Company to continue its operations for the next 12 months.
In the event the Company is unable to successfully raise additional capital, it is unlikely
that the Company will have sufficient cash flows and liquidity to finance its business operations
as currently contemplated. Accordingly, in the event new financing is not obtained, the Company
will likely reduce general and administrative expenses and delay research development projects as
well as further acquisition of scientific equipment and supplies until it is able to obtain
sufficient financing to do so.
These factors could significantly limit the Companys ability to continue as a going concern.
The balance sheets do not include any adjustments relating to recoverability and classification of
recorded asset amounts or the amounts and classification of liabilities that might be necessary
should the Company be unable to continue in existence.
3. 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.
4. Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157,
Fair Value Measurements
(SFAS 157). SFAS
157 provides guidance for using fair value to measure assets and liabilities. It also responds to
investors requests for expanded information about the extent to which companies measure assets and
liabilities at fair value, the information used to measure fair value and the effect of fair value
measurements on earnings. SFAS 157 applies whenever other standards require (or permit) assets or
liabilities to be measured at fair value, and does not expand the use of fair value in any new
circumstances. SFAS 157 is effective for financial statements issued for fiscal years beginning
after November 15, 2007. The Company has adopted the provisions of SFAS 157 as of January 1, 2008,
for financial instruments. Although the adoption of SFAS 157 did not materially impact its
financial condition, results of operations or cash flow, the Company is now required to provide
additional disclosures as part of its financial statements. SFAS 157 establishes a three-tier fair
value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include:
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Level 1, defined as observable inputs such as quoted prices in active markets for
identical assets;
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Level 2, defined as observable inputs other than level 1 prices such as quoted prices
for similar assets; quoted prices in markets that are not active; or other inputs that are
observable or can be corroborated by observable market data for substantially the full term
of the assets or liabilities; and
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Level 3, defined as unobservable inputs in which little or no market data exists,
therefore requiring an entity to develop its own assumptions.
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The Companys cash equivalents, short-term, long-term and restricted marketable securities are
subject to fair value measurements. The inputs used in measuring the fair value of these
instruments are considered to be level 1 in accordance with the SFAS 157 hierarchy.
7
In February 2007, the FASB issued SFAS No. 159,
The Fair Value Option for Financial Assets and
Financial Liabilities Including an amendment of FASB Statement No. 115
(SFAS 159). SFAS 159
expands the use of fair value accounting but does not affect existing standards that require assets
or liabilities to be carried at fair value. Under SFAS 159, a company may elect to use fair value
to measure accounts and loans receivable, available-for-sale and held-to-maturity securities,
equity method investments, accounts payable, guarantees and issued debt. Other eligible items
include firm commitments for financial instruments that otherwise would not be recognized at
inception and non-cash warranty obligations where a warrantor is permitted to pay a third party to
provide the warranty goods or services. If the use of fair value is elected, any upfront costs and
fees related to the item must be recognized in earnings and cannot be deferred, such as debt
issuance costs. The fair value election is irrevocable and generally made on an
instrument-by-instrument basis, even if a company has similar instruments that it elects not to
measure based on fair value. At the adoption date, unrealized gains and losses on existing items
for which fair value has been elected are reported as a cumulative adjustment to beginning retained
earnings. Subsequent to the adoption of SFAS 159, changes in fair value are recognized in earnings.
SFAS 159 is effective for financial statements issued for fiscal years beginning after November 15,
2007. The adoption of SFAS No. 159 did not have a material impact on our financial position or
results of operations.
In June 2007, the FASB ratified EITF 07-03,
Accounting for Nonrefundable Advance Payments for
Goods or Services Received for Use in Future Research and Development Activities
(EITF 07-03).
EITF 07-03 requires that nonrefundable advance payments for goods or services that will be used or
rendered for future research and development activities be deferred and capitalized and recognized
as an expense as the goods are delivered or the related services are performed. EITF 07-03 is
effective, on a prospective basis, for financial statements issued for fiscal years beginning after
December 15, 2007. The adoption of EITF 07-03 did not have a material impact on our financial
statements.
5. 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.
Reclassification
Certain reclassifications of prior period amounts have been made to conform with the current
year presentation.
Cash and Cash Equivalents
The Company considers all highly liquid investments with a maturity of three months or less
when purchased to be cash equivalents. Cash equivalents consist primarily of money market funds and
commercial paper. The Company maintains cash balances with financial institutions in excess of
insured limits. The Company does not anticipate any losses with such cash balances.
Marketable Securities
Marketable securities consist primarily of U.S Treasury, agency and corporate debt securities
with various maturities. Management classifies the 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.
Revenue Recognition
Revenue is recognized when there is persuasive evidence that an agreement exists, delivery has
occurred, the price is fixed and determinable, and collection is reasonably assured. Payments
received in advance of work performed are recorded as deferred revenue and recognized ratably over
the performance period. Milestone payments are recognized as revenue when milestones, as defined in
the contract, are achieved. During the first three months of 2008, the Company recognized revenue
from work performed on its collaboration agreement with Novartis, and recognized no revenue from
its other collaboration agreements.
Research and Development Costs
Expenditures, other than advance payments for research and development, subject to the
provisions of EITF 07-03, are expensed as incurred.
8
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 March 31, 2008 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 three months ended
March 31, 2008 and 2007, 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 and recognized as compensation expense over the vesting period of
the award using the accelerated attribution method. The following weighted-average assumptions were
used for options granted during the three months ended March 31, 2008 and 2007, and a discussion of
our methodology for developing each of the assumptions used in the valuation model follows:
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Three Months
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Three Months
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Ended
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Ended
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|
March 31, 2008
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March 31, 2007
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Dividend yield
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0.00
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%
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|
|
0.00
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%
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Expected volatility
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68.2
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%
|
|
|
69.8
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%
|
Risk-free interest rate
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|
|
3.59
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%
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|
|
4.80
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%
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Expected life of the option term (in years)
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|
6.8
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6.4
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Forfeiture rate
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|
|
4.20
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%
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|
|
4.20
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%
|
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. Since June
30, 2007, the Company uses an average of the volatility of its own stock and the average volatility
of similar companies in the pharmaceutical industry.
Risk-Free Interest Rate
This is the U.S. Treasury rate for the week of each option grant during
the quarter having a term that most closely resembles the expected life of the option term.
Expected Life of the Option Term
This is the period of time that the options granted are expected
to remain unexercised. The expected term is based upon managements consideration of the historical
life of options, the vesting period of the option granted and the contractual period of the option
granted.
Forfeiture Rate
This is the estimated number of stock options granted that are expected to be
forfeited or cancelled on an annual basis before becoming fully vested. The Company estimates the
forfeiture rate based on past turnover data.
Stock Compensation Plans
The Company adopted the Avalon Pharmaceuticals, Inc. 1999 Stock Incentive Plan (the 1999
Plan) to provide for the granting of stock awards, such as stock options, restricted common stock,
and stock appreciation rights to employees, directors and other individuals as determined by the
Board of Directors. The Company terminated the 1999 Plan as to future awards effective upon the
closing of the Companys initial public offering in October 2005. As of March 31, 2008, the Company
had reserved 451,117 shares of common stock to accommodate the exercise of outstanding options
granted under the 1999 Plan.
9
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 shares to 1,581,582 shares in June 2006 and from 1,581,582
shares to 2,381,582 shares in June 2007. Additionally, shares that become available due to
forfeiture of outstanding awards under the 1999 Plan are available for awards under the 2005 Plan.
As of March 31, 2008, the Company had reserved 2,182,121 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 six months to five years. Options generally expire 90 days after an
employee terminates employment with the Company.
Shares of common stock issued to non-employee directors as part of their annual director
compensation for the three month periods ended March 31, 2008 and 2007 were 3,451 and 6,552 shares,
respectively. The fair market value of these shares, on the date of grant, was approximately
$11,500 and $31,900, respectively.
The weighted-average grant-date fair value of equity awards granted during the three month
period ended March 31, 2008 was $1.57. The total fair value of stock options which vested during
the three month period ended March 31, 2008 was approximately $271,000. There were 1,585,213 fully
vested stock options outstanding at March 31, 2008. These stock options had a weighted average
remaining life of 6.85 years.
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Weighted-
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|
Weighted-
|
|
Average
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Average
|
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Remaining
|
|
Aggregate
|
|
|
|
|
|
|
Exercise
|
|
Contractual
|
|
Intrinsic Value
|
|
|
Shares
|
|
Price
|
|
Term
|
|
(in thousands)
|
Outstanding at December 31, 2007
|
|
|
2,082,670
|
|
|
$
|
4.12
|
|
|
|
|
|
|
|
|
|
Granted
|
|
|
140,200
|
|
|
|
2.35
|
|
|
|
|
|
|
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|
Exercised
|
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|
|
|
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|
|
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Forfeited or expired
|
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|
(40,749
|
)
|
|
|
2.64
|
|
|
|
|
|
|
|
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|
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|
|
|
|
|
|
|
|
|
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|
Outstanding at March 31, 2008
|
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|
2,182,121
|
|
|
$
|
4.04
|
|
|
|
7.39
|
|
|
$
|
102
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Vested and expected to vest at March 31, 2008
|
|
|
1,518,634
|
|
|
$
|
4.19
|
|
|
|
6.85
|
|
|
$
|
81
|
|
Exercisable at March 31, 2008
|
|
|
1,585,213
|
|
|
$
|
4.19
|
|
|
|
6.85
|
|
|
$
|
81
|
|
No stock options were exercised during the three months ended March 31, 2008. Due to the
valuation allowance on all deferred tax assets, the Company recorded no tax benefit for stock
compensation expense recognized during the three months ended March 31, 2008. As of March 31, 2008,
unamortized stock-based compensation expenses of approximately $689,000 remains to be recognized
over a weighted average period of 2.5 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.
6. Debt
In February 2008, the Company entered into an amendment to the letter of credit with M&T Bank
and the Maryland Industrial Development Financing Authority to extend the expiry of the letter of
credit agreement to April 8, 2013. In addition, the amendment removes the Companys financial
covenant obligations under the letter of credit regarding the maintenance of (i) a minimum ratio of
current assets to current liabilities and (ii) a minimum tangible net worth.
10
7. Stockholders Equity
Preferred Stock
In April 2007, the Company entered into a Rights Agreement (the Rights Agreement) between
the Company and American Stock Transfer & Trust Company, as Rights Agent. In connection with the
adoption of the Rights Agreement, the Board of Directors of the Company declared a dividend
distribution of one right (Right) for each outstanding share of common stock, par value $0.01 per
share of the Company, payable to stockholders of record on May 10, 2007. Each Right, when
exercisable, entitles the registered holder to purchase from the Company one one-thousandth of one
share of Series C Junior Participating Preferred Stock at a price of $60.00 per one one-thousandth
share, subject to adjustment. The description and terms of the Rights are set forth in the Rights
Agreement.
Initially, the Rights will be attached to all certificates representing shares of common stock
then outstanding, and no separate certificates evidencing the Rights will be distributed. The
Rights will separate from the common stock and a distribution of Rights Certificates will occur
upon the earlier to occur of (i) 10 days following a public announcement that a person or group of
affiliated or associated persons has acquired beneficial ownership of 20% or more of the
outstanding shares of common stock or (ii) 10 business days following the commencement of, or the
first public announcement of the intention to commence, a tender offer or exchange offer the
consummation of which would result in the beneficial ownership by a person of 20% or more of the
outstanding shares of common stock. (the earlier of such dates being called the Distribution
Date).
Until the Distribution Date, (i) the Rights will be evidenced by the common stock
certificates, and will be transferred with and only with the common stock certificates, (ii) new
common stock certificates issued after May 10, 2007 upon transfer or new issuance of the common
stock will contain a notation incorporating the Rights Agreement by reference, and (iii) the
surrender for transfer of any certificates for common stock outstanding will also constitute the
transfer of the Rights associated with the common stock represented by such certificate.
The Rights are not exercisable until the Distribution Date and will expire at the close of
business on May 10, 2017, unless such date is extended, the Rights Agreement is terminated, or the
Rights are earlier redeemed or exchanged by the Company as described below. The Rights will not be
exercisable by a holder in any jurisdiction where the requisite qualification to the issuance to
such holder, or the exercise by such holder, of the Rights has not been obtained or is not
obtainable.
As soon as practicable following the Distribution Date, separate certificates evidencing the
Rights will be mailed to holders of record of the common stock as of the close of business on the
Distribution Date and, thereafter, the separate Rights Certificates alone will evidence the Rights.
Except as otherwise determined by the Board of Directors of the Company, only shares of common
stock issued prior to the Distribution Date will be issued with Rights.
In the event that a person becomes the beneficial owner of 20% or more of the then outstanding
shares of common stock, except pursuant to an offer for all outstanding shares of common stock
which the Directors determine to be fair to and otherwise in the best interests of the Company and
its stockholders, each holder of a Right will have the right to exercise the Right by purchasing,
for an amount equal to the Purchase Price, common stock (or, in certain circumstances, cash,
property or other securities of the Company) having a value equal to two times such amount.
Notwithstanding any of the foregoing, following the occurrence of the events set forth in this
paragraph, all Rights that are beneficially owned by any acquiring person will be null and void.
7. Related Party Transactions
The Company paid one member of the board of directors consulting fees totaling $14,000 for the
three months ended March 31, 2008. During the first quarter of 2008, the Company received income
of $2,000 from Neodiagnostix for the rental of equipment. Bradley Lorimier, a Director and
Chairman of the Companys Board of directors and Kenneth C. Carter, Ph.D., the Companys President,
Chief Executive Officer and Director, are directors and minority shareholders in Neodiagnostix, a
privately held company focused on providing oncology diagnostic testing on a fee-for-service basis.
8. Income Taxes
For the three month periods ended March 31, 2008, and 2007, there is no current provision for
income taxes and the deferred tax benefit has been entirely offset by valuation allowances. The
difference between the amounts of income tax benefit that would result from applying domestic
federal statutory income tax rates to the net loss and the net deferred tax assets is related to
certain nondeductible expenses, state income taxes, and the change in the valuation allowance.
11
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, 2007 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, 2007.
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, AstraZeneca, 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 March 31, 2008, we had an accumulated deficit of
$130.6 million. We had net losses of $6.2 million for the three months ended March 31, 2008 and net
losses of $21.7 million for the year ended December 31, 2007. We expect to incur significant
operating losses for the foreseeable future as we advance our drug candidates from discovery
through preclinical testing and clinical trials and seek regulatory approval and eventual
commercialization. We will need to generate significant revenues to achieve profitability, and we
may never do so.
Financial Operations Overview
Revenue
We have not generated any revenue from sales of commercial products and do not expect to
generate any product revenue for the foreseeable future. To date, our revenue has consisted of
collaboration revenue.
Collaboration Revenue.
Since inception, we have generated revenue solely in connection with
our collaboration and pilot study agreements. Our collaborations with Merck, AstraZeneca and
Novartis include upfront payments, research funding, and/or payments for the achievement of certain
discovery and development related milestones. During the first quarter of 2008, we recognized
revenue from work performed under our collaboration with Novartis and recognized no revenue from
our other collaborations.
Research and Development Expense
Research and development expense consists of expenses incurred in connection with developing
and advancing our drug discovery technology and identifying and developing our drug candidates and
supporting our collaborative relationships. These expenses consist primarily of salaries and
related expenses, the purchase of laboratory supplies, access to data sources, facility costs,
costs for preclinical development and expenses related to our in-license and clinical trials of
AVN944. Other than for advance payments for research and development costs, subject to the
provisions of EITF 07-03, we charge all research and development expenses to operations as
incurred.
We expect our research and development costs to be substantial as we advance 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 July 2007, we initiated U.S. Phase II clinical trials of AVN944 in
patients diagnosed with pancreatic cancer. We are currently conducting Phase I clinical trials for
AVN944 in patients with hematological cancer and Phase II clinical trials for patients with
pancreatic cancer.
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.
12
Critical Accounting Policies and Significant Judgments and Estimates
Stock-Based Compensation
We account for share-based payments in accordance with the provisions of FASB Statement No.
123(R),
Share-Based Payment
. For the three months ended March 31, 2008, we recorded approximately
$208,000 of stock-based compensation expenses, of which $31,000 was included in research and
development expense and $177,000 was included in general and administrative expense. Since we
continue to operate in a net loss, stock-based compensation expense had no impact for tax-related
effects on cash flow from operations and cash flow from financing activities for the three months
ended March 31, 2008. As of March 31, 2008, unamortized stock-based compensation expenses of
approximately $689,000 remains to be recognized over a weighted-average period of approximately 2.5
years. We amortize stock-based compensation expenses on an accelerated basis over the vesting
period.
We estimated the fair value of stock options granted during the three months ended March 31,
2008 using the Black-Scholes option pricing model. The assumptions used under this model are as
follows: (i) expected term of 6.8 years based upon managements consideration of the historical
life of options, the vesting period of the option granted and the contractual period of the option
granted; (ii) expected volatility of 68.2% based on historical and peer volatility data; (iii)
weighted average risk-free interest rate of 3.590% 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 March 31, 2008 and 2007
Revenue.
Total revenues decreased by $681,000 or 93%, to $50,000 for the three months ended
March 31, 2008, compared to $731,000 for the three months ended March 31, 2007. All 2007 and 2008
revenues were attributable to our collaboration agreement with Novartis.
Research and Development.
Research and development expenses increased by $248,000, or 6%, to
$4.4 million for the three months ended March 31, 2008 from $4.1 million for the same period in
2007. The increase in research and development expenses was primarily attributable to increases in
clinical trial and product costs related to our AVN944 drug candidate.
Research and development expenses consist of direct costs which include salaries and related
costs of research and development personnel, and the costs of consultants, materials and supplies
associated with research and development projects. Indirect research and development costs include
facilities, depreciation, patents and other indirect overhead costs.
General and Administrative.
General and administrative expenses decreased by $96,000 or 4%, to
$2.1 million for the three months ended March 31, 2008, compared to $2.2 million for the three
months ended March 31, 2007. The decrease is primarily attributable to a decrease in compensation
expense related to stock options.
Interest Income.
Interest income decreased by $32,000 or 9%, to $307,000 for the three months
ended March 31, 2008, compared to $339,000 for the three months ended March 31, 2007. The decrease
in interest income is primarily due to lower average interest rates.
Interest Expense.
Interest expense decreased by $57,000, or 33%, to $115,000 for the three
months ended March 31, 2008, compared to $172,000 for the three months ended March 31, 2007. The
decrease in interest expense was primarily related to lower debt balances and lower average
interest rates on debt.
Other Income.
Other income was $2,000 for the three months ended March 31, 2008, compared to
$96,000 for the three months ended March 31, 2007. The decrease in other income was primarily
related to the discontinuation, during the first half of 2007, of income from subletting part of
our facility and the provision of shared services to subtenants.
13
Liquidity and Capital Resources
Our primary cash requirements are to:
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fund our research and development and clinical programs;
|
|
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|
|
obtain regulatory approvals;
|
|
|
|
|
prosecute, defend and enforce any patent claims and other intellectual property rights;
|
|
|
|
|
fund general corporate overhead; and
|
|
|
|
|
support our debt service requirements and contractual obligations.
|
Our cash requirements could change materially as a result of the progress of our research and
development and clinical programs, licensing activities, acquisitions, divestitures or other
corporate developments.
We have incurred operating losses since our inception and historically have financed our
operations principally through public stock offerings, debt financings, private placements of
equity securities, strategic collaborative agreements that include research and development funding
and development milestones, and investment income.
In evaluating alternative sources of financing we consider, among other things, the dilutive
impact, if any, on our stockholders, the ability to leverage stockholder returns through debt
financing, the particular terms and conditions of each alternative financing arrangement and our
ability to service our obligations under such financing arrangements.
As of March 31, 2008, we had cash, cash equivalents and marketable securities of approximately
$23.6 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 commercial
paper and United States government securities.
Sources and Uses of Cash
Operating Activities.
Net cash used in operating activities for the three months ended March
31, 2008 was $4.8 million, compared to $5.0 million for the same period in fiscal 2007. During the
first three months of fiscal year 2008, our net loss of $6.2 million was reduced by non-cash
charges of $638,000, primarily for stock compensation, depreciation and amortization, offset by
changes in our net operating assets and liabilities.
Investing Activities.
Net cash provided by investing activities for the three months ended
March 31, 2008 was $4.2 million, compared to net cash used in investing activities of $1.4 million
for the same period in 2007. Proceeds from the sale and maturity of marketable securities were the
primary source of cash from investing activities, providing $9.2 million in the first three months
of 2008 and $6.5 million in the comparable period of 2007.
Financing Activities.
Net cash used by financing activities for the three months ended March
31, 2008 was $43,000, compared to $9.4 million of net cash provided by financing activities for the
same period in 2007. Aggregate proceeds of $9.5 million from the issuance of common stock in a
private placement was the principal source of net cash provided by financing activities during the
first three months of 2007.
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 three months ended March 31, 2008 and 2007 was 3.5% and 5.30% 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 March 31, 2008, 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, 2013, or the date the bonds have been
paid in full. In consideration of the letter of credit, we have granted M&T Bank a security
interest in certain facility improvements, equipment and cash collateral held as restricted cash.
The Company made its annual payment of $1.2 million under this loan on April 1, 2008.
14
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;
|
|
|
|
|
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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|
|
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|
competing technological and market developments;
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|
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|
|
acquisition, licensing and protection of intellectual property rights; and
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|
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|
|
the cost of establishing manufacturing capabilities and conducting commercialization activities.
|
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.
15
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Not applicable pursuant to the rules of the Securities and Exchange Commission relating to the
disclosure requirements for a smaller reporting company.
Item 4T. Controls and Procedures
Disclosure Controls and Procedures:
Under the supervision and with the participation of our
management, including our Chief Executive Officer and our Chief Financial Officer, we have
evaluated the effectiveness of our disclosure controls and procedures, as of March 31, 2008 (the
Evaluation Date). Based on that evaluation, our Chief Executive Officer and Chief Financial
Officer have concluded that, as of the Evaluation Date, our disclosure controls and procedures were
effective.
Changes in Internal Control over Financial Reporting:
There have been no changes in our
internal control over financial reporting during the quarter ended on the Evaluation Date that has
materially affected, or is reasonably likely to materially affect, our internal control over
financial reporting.
16
Item 6. Exhibits
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Exhibit No.
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Description
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10.1
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Fourth Modification Agreement, dated February 14, 2008, by and between Manufacturers and Traders Trust Company,
the Maryland Industrial Development Financing Authority and Avalon Pharmaceuticals, Inc. (incorporated by
reference to Exhibit 10.1 to the Companys Current Report on Form 8-K filed on February 15, 2008).
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10.2
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Severance Agreement and Release, dated March 8, 2008 by and between Avalon Pharmaceuticals, Inc. and David M. Muth.
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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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17
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: May 8, 2008
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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: May 8, 2008
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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: May 8, 2008
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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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18