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, 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
þ
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 November 12, 2008, 20,428,475 shares of Avalon Pharmaceuticals, Inc. common stock,
par value $.01 per share, were outstanding.
AVALON PHARMACEUTICALS, INC.
i
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.
ii
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
AVALON PHARMACEUTICALS, INC.
BALANCE SHEETS
(in thousands, except share amounts)
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September 30,
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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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2,749
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$
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6,276
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Short-term marketable securities
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4,318
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15,558
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Accounts receivable
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8
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200
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Interest receivable
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57
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190
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Prepaid expenses
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397
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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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7,529
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23,069
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Restricted cash and marketable securities
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4,358
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5,275
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Property and equipment, net
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6,309
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7,325
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Long-term marketable securities
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1,416
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Deferred financing costs, net
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212
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220
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Total assets
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$
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18,408
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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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1,583
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$
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1,063
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Accrued expenses and other current liabilities
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945
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1,207
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Deferred revenue and customer advances
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884
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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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4,612
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4,685
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Deferred rent
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416
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446
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Long-term debt, net of current portion
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4,800
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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, $0.01 par value; 60,000,000
shares authorized; 17,037,928 and 17,026,462
shares issued and outstanding at
September 30, 2008 and December 31, 2007,
respectively
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170
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170
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Additional capital
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150,587
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150,331
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Other comprehensive income
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(14
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50
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Accumulated deficit
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(142,163
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(124,377
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Total stockholders equity
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8,580
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26,174
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Total liabilities and stockholders equity
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$
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18,408
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$
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37,305
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See accompanying notes.
1
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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2008
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2007
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2008
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2007
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Revenues
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$
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124
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$
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$
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311
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$
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809
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Costs and expenses:
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Research and development
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3,994
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3,531
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12,863
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11,708
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General and administrative
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2,153
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2,197
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5,567
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6,468
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Total costs and expenses
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6,147
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5,728
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18,430
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18,176
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Loss from operations
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(6,023
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(5,728
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(18,119
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(17,367
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Other income (expense):
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Interest income
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98
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470
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559
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1,187
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Interest expense
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(97
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(155
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(305
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(486
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Other
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63
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8
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79
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107
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Total other income (expense), net
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64
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323
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333
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808
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Net loss
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$
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(5,959
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$
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(5,405
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$
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(17,786
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$
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(16,559
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Net loss per share basic and diluted
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$
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(.35
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$
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(.32
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$
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(1.04
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$
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(1.13
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Weighted average number of shares
basic and diluted
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17,037,830
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17,015,319
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17,033,705
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14,716,327
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See accompanying notes.
2
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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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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(17,786
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$
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(16,559
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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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1,261
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1,552
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Non-cash interest expense
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159
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163
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Amortization of premium on investments
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(153
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(496
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Stock based compensation
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256
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1,281
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Changes in operating assets and liabilities:
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Prepaid expenses
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346
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235
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Accounts receivable and other assets
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427
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875
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Accounts payable
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520
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(628
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Accrued expenses and other current liabilities
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(262
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(30
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Deferred revenue and customer advances
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(319
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)
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(326
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Deferred rent
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(29
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(17
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Net cash used in operating activities
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(15,580
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(13,950
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Investing activities
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Proceeds from the sale and maturities of marketable securities
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22,906
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26,290
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Purchases of marketable securities
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(9,245
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)
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(35,239
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Purchases of property and equipment
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(245
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(403
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Net cash provided by (used in) investing activities
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13,416
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(9,352
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Financing activities
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Principal payments on debt
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(1,211
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)
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(1,482
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Proceeds from issuance of common stock
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28,413
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Deferred financing costs
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(152
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(147
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Net cash provided by (used in) financing activities
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(1,363
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)
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26,784
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Net (decrease) increase in cash and cash equivalents
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(3,527
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)
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3,482
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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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2,749
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$
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6,581
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See accompanying notes.
3
AVALON PHARMACEUTICALS, INC.
NOTES TO FINANCIAL STATEMENTS
SEPTEMBER 30, 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 and nine months ended September 30, 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, Avalon Pharmaceuticals, Inc. (the Company or Avalon) has incurred,
and continues to incur, significant losses from operations. As described below in Note 3, the
Company recently entered into an Agreement and Plan of Merger and Reorganization, dated October 27,
2008 (the Merger Agreement), with Clinical Data, Inc., a Delaware corporation (Clinical Data),
and API Acquisition Sub II, LLC, a Delaware limited liability company and an indirect wholly-owned
subsidiary of Clinical Data (API). The Merger Agreement provides that, upon the terms and subject
to the conditions set forth in the Merger Agreement, API will be merged with and into Avalon, with
Avalon continuing as the surviving corporation and a subsidiary of Clinical Data (the Merger).
Management estimates that its existing capital resources will be sufficient to fund the Companys
current operations through the end of the first quarter of 2009, prior to which time the Merger
with Clinical Data is expected to close.
If the Merger does not close by the end of the first quarter of 2009, the Companys
ability to continue as a going concern would be dependent on managements ability to raise
additional capital sufficient to meet the Companys obligations on a timely basis, and to
ultimately attain profitability. In light of the proposed Merger, the Companys management does not
expect to seek to raise additional capital. Should the Merger not close or if the closing is
delayed beyond the end of the first quarter of 2009, there is no assurance that the Company would
be able to raise capital sufficient to enable the Company to continue its operations significantly
beyond the end of the first quarter of 2009.
In the event the Company were unable to successfully raise additional capital in such
circumstances, the Company will not have sufficient cash flows and liquidity to finance its
business operations as currently contemplated. Accordingly, in such circumstances the Company would
be compelled to reduce general and administrative expenses and delay research and development
projects and the purchase of scientific equipment and supplies until it were able to obtain
sufficient financing.
Failure to close the Merger or raise additional capital would 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. Subsequent Events
On October 27, 2008, the Company entered into the Merger Agreement with Clinical Data and API.
The Merger Agreement provides that API will be merged with and into the Company, with the
Company continuing as the surviving corporation and an indirect wholly-owned subsidiary of Clinical
Data. As a condition to Clinical Data and Avalon entering into the Merger Agreement, on October 27,
2008, the parties entered into a number of other arrangements including a private placement of
securities, a license agreement and a secured loan arrangement.
Merger Agreement
Pursuant to the terms of the Merger Agreement, Clinical Data will acquire all of the
outstanding shares of Avalons common stock for consideration consisting of Clinical Data common
stock and certain contingent rights to acquire additional shares of Clinical Data common stock.
Shares of Avalon common stock held by Clinical Data and its subsidiaries, will be cancelled without
consideration at the closing (the
Closing). Upon the closing of the Merger, each outstanding share of Avalon common stock shall be
converted into a right to receive 0.0470 shares of Clinical Data common stock and a contingent
value right (a CVR) to receive an additional fraction of a share of Clinical Data common stock
upon the achievement of defined milestones.
4
If the Merger Agreement is terminated under specified circumstances, Avalon may be required to
pay Clinical Data a termination fee of $300,000 and reimburse Clinical Data up to $100,000 for its
expenses associated with the Merger Agreement.
Rights Plan Amendment
On October 27, 2008, the Company amended its Rights Agreement dated April 26, 2007 to
render it inapplicable to the Merger, the transactions contemplated by the Merger Agreement, and
the private placement described below.
Private Placement
In connection with the execution of the Merger Agreement, Avalon entered into a Securities
Purchase Agreement with Clinical Data for the sale of Company common stock and common stock
purchase warrants in a private placement for a total purchase price of $237,338. Pursuant to the
Securities Purchase Agreement, Clinical Data purchased a total of 3,390,547 shares of the Companys
common stock at a purchase price of $0.07 per share. In addition, the Company issued a common stock
purchase warrant exercisable into 1,695,273 shares of common stock. The exercise price of the
warrant is $0.86 per share, subject to adjustment for dilutive events. The warrant is not
exercisable for six months after issuance and may not be exercised to the extent that the aggregate
number of shares of Avalons common stock held by Clinical Data following exercise of the warrant
(including shares of Avalon common stock otherwise held by Clinical Data) would exceed 19.9% of the
outstanding stock of the Company unless the issuance of any additional shares is first approved by
a vote of Avalons stockholders in accordance with the rules of the NASDAQ Stock Market.
Avalon also entered into a Registration Rights Agreement with Clinical Data contemporaneously
with entering into the Securities Purchase Agreement. Pursuant to the Registration Rights
Agreement, Avalon agreed to register for resale the shares of common stock issued in the private
placement and the shares of common stock issuable upon exercise of the warrant. The Registration
Rights Agreement requires Avalon to file the registration statement by November 26, 2008 or
Clinical Data shall be entitled to a liquidated damages payment in the amount of 1.5% of the total
purchase price of the shares issued in the private placement for each month the registration
statement remains unfiled after the deadline. In the event the registration statement is not
declared effective by the SEC by the earlier of (i) 90 days after the termination of the Merger
Agreement (or 120 days after termination in the event the registration statement is subject to
review by the SEC) or (ii) within 5 days following notice from the SEC that the registration
statement is no longer subject to review (the Effectiveness Deadline), Clinical Data shall be
entitled to a liquidated damages payment in the amount of 1.5% of the total purchase price for each
month (pro rated for any lesser period) after the Effectiveness Deadline during which such
registration statement has not been declared effective by the SEC.
License Agreement
In connection with the execution of the Merger Agreement, the Company entered into a license
agreement with Clinical Data pursuant to which Avalon granted Clinical Data a royalty-free,
fully-paid, worldwide, perpetual, irrevocable, sublicensable and exclusive license to AvalonRx
®
,
Avalons proprietary drug-development platform, in exchange for a one time payment of $1,000,000.
The license is subject to certain exceptions pursuant to which Avalon retained the right to utilize
AvalonRx
®
to fulfill its obligations under its existing collaboration agreements and to continue
development of AVN 944 and certain of its existing development programs.
Secured Loan
In connection with the execution of the Merger Agreement, Avalon entered into a Note Purchase
Agreement (the Note Purchase Agreement) with Clinical Data pursuant to which Clinical Data made a
loan to Avalon evidenced by a term note (the Term Note) in the principal amount of $3,000,000
(the Secured Loan). The term note bears interest at a fixed rate of seven percent per annum and
matures on March 31, 2009 unless accelerated pursuant to its terms. The Company has the right to
prepay the term note, together with any accrued interest, at any time without penalty. The maturity
of the term note accelerates if there is a default under the terms of the Note Purchase Agreement
or related documents, including any default, breach or termination of the license agreement or of
the Merger Agreement (other than a termination
of the Merger Agreement as a result of a failure to obtain the approval by Avalons stockholders of
the Merger). The Term Note is secured by collateral consisting of certain intellectual property
rights of Avalon.
Loan Default
On October 29, 2008, Avalon received notice from Manufacturers and Traders Trust Company (M&T
Bank) regarding the occurrence of an event of default related to its letter of credit with M&T
Bank upon the Companys entry into the Merger Agreement and the Secured Loan. As a result of the
default, M&T Bank declared all outstanding amounts under the letter of credit to be immediately due
and payable. On October 30, 2008 the Company made a payment of $6,062,489 to M&T Bank which
constituted all amounts due under the letter of credit. This payment was inclusive of $6,000,000
in principal, $34,508 of accrued interest, and $27,981 for related fees and expenses. As a result
of this payment, Avalon has no continuing obligations under the letter of credit or its financing
arrangement with the Maryland Industrial Development Financing Authority (MIDFA).
5
4. Restructuring
On August 13, 2008 the Company restructured its operations to focus on the pre-clinical and
clinical development of its Beta-catenin inhibitor program and on its existing collaborations, such
as with Merck. The Company curtailed its other development programs and is evaluating the clinical
data from its AVN944 development program to assess strategies for further development of AVN944. In
connection with the restructuring of its operations, the Company reduced its workforce by
approximately one third, or 19 employees. The Company recorded restructuring charges related to
these actions of $928,000 in the third quarter of 2008. Details of the restructuring charge and
amounts paid and accrued are set forth in the table below.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months
|
|
|
|
|
Ended 9/30/08
|
|
As of 9/30/08
|
|
|
Restructuring
|
|
Amount
|
|
Restructuring
|
|
|
Charges
|
|
Paid
|
|
Accrual
|
Severance
|
|
$
|
830
|
|
|
|
($562
|
)
|
|
$
|
268
|
|
Benefits
|
|
|
55
|
|
|
|
(11
|
)
|
|
|
45
|
|
Taxes & Other
|
|
|
43
|
|
|
|
(21
|
)
|
|
|
22
|
|
|
|
|
|
|
$
|
928
|
|
|
|
($594
|
)
|
|
$
|
334
|
|
|
|
|
5. Organization
Avalon 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.
6. 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:
|
|
|
Level 1, defined as observable inputs such as quoted prices in active markets for identical assets;
|
|
|
|
|
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
|
|
|
|
|
Level 3, defined as unobservable inputs in which little or no market data exists, therefore
requiring an entity to develop its own assumptions.
|
6
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 2 in accordance with the SFAS 157 hierarchy.
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.
7. 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, 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 nine 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.
7
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.
Restricted Cash and Investments
In accordance with the terms of a financing arrangement with MIDFA and 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, 2008 was defined as an adjusted market value of
$4.3 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. On October 30,
2008 the Company paid off the related debt and the restrictions on this collateral were removed.
See Note 3 above.
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, 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
.
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
September 30, 2008 and 2007, and a discussion of our methodology for developing each of the
assumptions used in the valuation model follows:
|
|
|
|
|
|
|
|
|
|
|
Three Months
|
|
Three Months
|
|
|
Ended
|
|
Ended
|
|
|
September 30,
|
|
September 30,
|
|
|
2008
|
|
2007
|
Dividend yield
|
|
|
0.00
|
%
|
|
|
0.00
|
%
|
Expected volatility
|
|
|
65.5
|
%
|
|
|
70.5
|
%
|
Risk-free interest rate
|
|
|
3.45
|
%
|
|
|
5.00
|
%
|
Expected life of the option term (in years)
|
|
|
7.0
|
|
|
|
6.0
|
|
Forfeiture rate
|
|
|
4.2
|
%
|
|
|
4.2
|
%
|
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.
8
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, 2008, the
Company had reserved 447,456 shares of common stock to accommodate the exercise of outstanding
options granted under the 1999 Plan.
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 September 30, 2008, the Company had reserved 2,879,204 shares of common stock to accommodate
the exercise of outstanding option grants under the 1999 Plan and 2005 Plan and for future grants
under the 1999 Plan and 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 and nine month periods ended September 30, 2008 were 4,487 and 11,466
shares, respectively. The fair market value of these shares, on the date of grant, was
approximately $5,833 and $26,041, respectively.
The weighted-average grant-date fair value of equity awards granted during the three and
nine month periods ended September 30, 2008 was $.37 and $.69, respectively. The total fair value
of stock options which vested during the three and nine month periods ended September 30, 2008 was
approximately $151,000 and $757,000, respectively. There were 1,698,076 fully vested stock options
outstanding at September 30, 2008. These stock options had a weighted average remaining life of
6.49 years.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-
|
|
|
|
|
|
|
|
|
Weighted-
|
|
Average
|
|
Aggregate
|
|
|
|
|
|
|
Average
|
|
Remaining
|
|
Intrinsic
|
|
|
|
|
|
|
Exercise
|
|
Contractual
|
|
Value
|
|
|
Shares
|
|
Price
|
|
Term
|
|
(in thousands)
|
Outstanding at June 30, 2008
|
|
|
2,120,483
|
|
|
$
|
4.02
|
|
|
|
|
|
|
|
|
|
Granted
|
|
|
401,900
|
|
|
|
.80
|
|
|
|
|
|
|
|
|
|
Exercised
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Forfeited or expired
|
|
|
58,212
|
|
|
|
3.07
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Outstanding at September 30, 2008
|
|
|
2,464,171
|
|
|
|
3.52
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Vested and expected to vest at September 30, 2008
|
|
|
2,360,676
|
|
|
$
|
4.16
|
|
|
|
6.49
|
|
|
$
|
|
|
Exercisable at September 30, 2008
|
|
|
1,698,076
|
|
|
$
|
4.16
|
|
|
|
6.49
|
|
|
$
|
|
|
No stock options were exercised during the nine months ended September 30, 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 September 30, 2008. As of
September 30, 2008, unamortized stock-based compensation expenses of approximately $521,000 remains
to be recognized over a weighted average period of 2.3 years.
9
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.
8. Debt
In February 2008, the Company entered into an amendment to the letter of credit with M&T
Bank supporting the Companys financing with MIDFA to extend the expiry of the letter of credit
agreement to April 8, 2013. In addition, the amendment removed 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. On October 30, 2008 the
Company paid off all amounts owed under the letter of credit and retired the letter of credit. As a
result of this payment, Avalon has no continuing obligations under the letter of credit or its
financing arrangement with MIDFA. See Note 3 above.
9. 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.
10
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.
In connection with the Companys proposed merger with Clinical Data, the Company and American
Stock Transfer & Trust Company entered into Amendment No. 1 to the Rights Agreement for the purpose
of amending the Rights Agreement to render it inapplicable to the Merger, the transactions
contemplated by the Merger Agreement, and the private placement described in Note 3.
10. Related Party Transactions
The Company paid one member of the board of directors consulting fees totaling $41,000
for the nine months ended September 30, 2008.
11. Income Taxes
For the nine month periods ended September 30, 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. 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, 2008, we had an accumulated
deficit of $142.0 million. We had net losses of $17.8 million for the nine months ended
September 30, 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.
As of September 30, 2008, we had cash, cash equivalents and marketable securities of
approximately $11.4 million. Of this amount, $4.4 million was held in a restricted account to
serve as collateral for our long-term debt.
We currently estimate that our existing capital resources will be sufficient to fund our
current operations through the end of the first quarter of 2009, by which time our pending merger
with a subsidiary of Clinical Data is expected to close. If our proposed merger does not close by
the end of the first quarter of 2009, we would need to raise additional funds to continue
operations and to repay our secured loan from Clinical Data. See Recent Developments below. In
light of the proposed merger, we do not expect to seek to raise additional capital. Should the
merger not close or if the closing is delayed beyond the end of the first quarter of 2009, there is
no assurance that we would be able to raise capital sufficient to enable us to continue our
operations significantly beyond the end of the first quarter of 2009. In the event we were unable
to successfully raise additional capital in such circumstances, we will not have sufficient cash
flows and liquidity to finance our business operations as currently contemplated. Accordingly, in
such circumstances we would be compelled to reduce general and administrative expenses and delay
research and development projects and the purchase of scientific equipment and supplies until we
were able to obtain sufficient financing.
Recent Developments
On October 27, 2008, we entered into a merger agreement with Clinical Data, Inc., or Clinical
Data, and API Acquisition Sub II, LLC, an indirect wholly-owned subsidiary of Clinical Data, or
API. The merger agreement provides that, upon the terms and subject to the conditions set forth in
the merger agreement, API will be merged with and into Avalon, with Avalon continuing as the
surviving corporation and a subsidiary of Clinical Data. In connection with entering into the
merger agreement with Clinical Data, we borrowed $3 million from Clinical Data under a secured loan
to fund our short term on-going operations, entered into a license agreement with Clinical Data
under which Clinical Data received an exclusive license (subject to certain exceptions) to
AvalonRx
®
in exchange for a one time license fee of $1 million, and engaged in a private placement
with Clinical Data of our common stock and warrants for a cash payment of $237,338 from Clinical
Data. As a result of entering into the merger agreement and receiving the $3 million secured loan
from Clinical Data, we were notified by Manufacturers and Traders Trust Company (M&T Bank) on
October 29, 2008, that we were in default under the terms of its letter of credit to the Maryland
Industrial Development Financing Authority (MIDFA). On October 30, 2008 we paid off all amounts
due M&T Bank under the letter of credit and as a result, we have no further obligations under the
letter of credit or our financing arrangement with MIDFA. See Note 3 to our unaudited financial
statements set forth above in this Form 10-Q for a more detailed description of the merger
agreement and the related transactions entered into by us with Clinical Data.
On August 13, 2008 we restructured our operations to focus on the pre-clinical and clinical
development of our Beta-catenin inhibitor program and on our existing collaborations, such as with
Merck. We curtailed our other development programs and are evaluating the clinical data from our
AVN944 development program to assess strategies for further development of AVN944. In connection
with the restructuring of
our operations, we reduced our workforce by approximately one third, or 19 employees. We recorded
restructuring charges related to these actions of $928,000 in the third quarter of 2008.
12
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 nine months 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 our 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. We are
currently conducting Phase I clinical trials for AVN944 in patients with hematological cancer and
Phase IIa clinical trials for patients with pancreatic cancer. In August 2008, we announced that
we had reached a likely maximum tolerated dose of AVN944 in both the ongoing Phase I clinical trial
and in the Phase IIa trial. Management is currently assessing strategies for further development
of AVN944.
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
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 nine months ended September 30, 2008, we recorded
approximately $230,000 of stock-based compensation expenses, of which $87,000 was included in
research and development expense and $143,000 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
nine months ended September 30, 2008. As of September 30, 2008, unamortized stock-based
compensation expenses of approximately $521,000 remains to be recognized over a weighted-average
period of approximately 2.3 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
September 30, 2008 using the Black-Scholes option pricing model. The assumptions used under this
model are as follows: (i) expected term of 7 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 65.5% based on historical and peer volatility data;
(iii) weighted average risk-free interest rate of 3.45% 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.
13
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, 2008 and 2007
Revenue.
Total revenues for the three months ended September 30, 2008 were $124,000,
compared with no revenues in the same period of the prior year. The reported revenues were
attributable to our collaboration agreement with Novartis.
Research and Development.
Research and development expenses increased by $463,000, or
13%, to $4.0 million for the three months ended September 30, 2008 from $3.5 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 and our
pre-clinical drug candidate AVN316.
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 $44,000 or
2% when comparing the three months ended September 30, 2008 with the three months ended
September 30, 2007. Lower stock compensation expense as well as lower costs for personnel and
consultants were largely offset by a $928,000 restructuring charge. The restructuring charge
included severance and related costs for the 19 employees who left Avalon when we restructured our
operations in August of 2008.
Interest Income.
Interest income decreased by $372,000 or 79%, to $98,000 for the three
months ended September 30, 2008, compared to $470,000 for the three months ended September 30,
2007. The decrease in interest income is due to lower balances of cash and investments and lower
average interest rates.
Interest Expense.
Interest expense decreased by $58,000, or 37%, to $97,000 for the
three months ended September 30, 2008, compared to $155,000 for the three months ended
September 30, 2007. The decrease in interest expense was related to lower debt balances and lower
average interest rates on debt.
Other Income.
Other income was $63,000 for the three months ended September 30, 2008,
compared to $8,000 for the three months ended September 30, 2007. The increase in other income was
primarily related to income from subletting part of our facility and the provision of shared
services to subtenants.
Nine Months Ended September 30, 2008 and 2007
Revenue.
Total revenues for the nine months ended September 30, 2008 were $311,000, a
decrease of $498,000 from the same period in the prior year. All 2007 and 2008 revenues were
attributable to our collaboration agreement with Novartis.
Research and Development.
Research and development expenses increased by $1.2 million,
or 10%, to $12.9 million for the nine months ended September 30, 2008 from $11.7 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 and our
pre-clinical drug candidate AVN316.
General and Administrative.
General and administrative expenses decreased by $901,000 or
14%, to $5.6 million for the nine months ended September 30, 2008, compared to $6.5 million for the
nine months ended September 30, 2007. Lower costs for stock compensation, personnel and
consultants were partially offset by a restructuring charge of $928,000 recorded in the third
quarter of 2008.
Interest Income.
Interest income decreased by $628,000 or 53%, to $559,000 for the nine
months ended September 30, 2008, compared to $1.2 million for the nine months ended September 30,
2007. The decrease in interest income is primarily due to lower balances of cash and investments
and lower average interest rates.
Interest Expense.
Interest expense decreased by $181,000, or 37%, to $305,000 for the
nine months ended September 30, 2008, compared to $486,000 for the nine months ended September 30,
2007. The decrease in interest expense was primarily related to lower debt balances and lower
average interest rates on debt.
14
Other Income.
Other income was $79,000 for the nine months ended September 30, 2008,
compared to $107,000 for the nine months ended September 30, 2007. The decrease in other income was
primarily related to lower income from subletting part of our facility and the provision of shared
services to subtenants in the 2008 period.
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;
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prosecute, defend and enforce any patent claims and other intellectual property rights;
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fund general corporate overhead; and
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support our debt service requirements and contractual obligations.
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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 September 30, 2008, we had cash, cash equivalents and marketable securities of
approximately $11.4 million. Of this amount, $4.4 million was held in a restricted account to
serve as collateral for our long-term debt. In connection with entering into the merger agreement
with Clinical Data, on October 27, 2008, we borrowed $3 million from Clinical Data under a secured
loan to fund our short term on-going operations, entered into a license agreement with Clinical
Data under which Clinical Data received an exclusive license (subject to certain exceptions) to
AvalonRx
®
in exchange for a one time license fee of $1 million, and engaged in a private placement
with Clinical Data of our common stock and warrants for a cash payment of $237,338 from Clinical
Data. As a result of entering into the merger agreement and receiving the $3 million secured loan
from Clinical Data, we were required under the terms of our letter of credit from M&T Bank to pay
off all amounts due under the letter of credit. On October 30, 2008 we paid off all amounts due
M&T Bank under the letter of credit and as a result, we have no further obligations under the
letter of credit or our financing arrangement with MIDFA.
As a result of our borrowing $3 million from Clinical Data and the receipt of other payments
from Clinical Data in connection with the private placement and exclusive license grant of
AvalonRx
®
to Clinical Data described above, we currently estimate that our existing capital
resources will be sufficient to fund our current operations through the end of the first quarter of
2009, by which time our pending merger with a subsidiary of Clinical Data is expected to close.
If our proposed merger does not close by the end of the first quarter of 2009, we would need to
raise additional funds to continue operations and to repay our secured loan from Clinical Data. In
light of the proposed merger, we do not expect to seek to raise additional capital. Should the
merger not close or if the closing is delayed beyond the end of the first quarter of 2009, there is
no assurance that we would be able to raise capital sufficient to enable us to continue our
operations significantly beyond the end of the first quarter of 2009. In the event we were unable
to successfully raise additional capital in such circumstances, we will not have sufficient cash
flows and liquidity to finance our business operations as currently contemplated. Accordingly, in
such circumstances we would be compelled to reduce general and administrative expenses and delay
research and development projects and the purchase of scientific equipment and supplies until we
were able to obtain sufficient financing.
Sources and Uses of Cash
Operating Activities.
Net cash used in operating activities for the nine months ended
September 30, 2008 was $15.6 million, compared to $14.0 million for the same period in fiscal 2007.
During the first nine months of fiscal year 2008, our net loss of $17.8 million was reduced by
non-cash charges of $1.5 million, primarily for stock compensation, depreciation and amortization,
while changes in our net operating assets and liabilities provided and additional $0.6 million in
cash.
15
Investing Activities.
Net cash provided by investing activities for the nine months
ended September 30, 2008 was $13.4 million, compared to net cash used in investing activities of
$9.4 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 $22.9 million in
the first nine months of 2008 and $26.3 million in the comparable period of 2007. Cash used in
investing activities principally represents the amount used to purchase marketable securities, net
of proceeds from the sale and maturity of marketable securities.
Financing Activities.
Net cash used by financing activities for the nine months ended
September 30, 2008 was $1.4 million, compared to $26.8 million of net cash provided by financing
activities for the same period in 2007. Aggregate proceeds of $28.4 million from the issuance of
common stock in two private placements was the principal source of net cash provided by financing
activities during the first nine months of 2007.
Credit Arrangements
In April 2003, we entered into a series of agreements with MIDFA and 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, on the first day of April, 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 30, 2008 and 2007 was 3.02% and 5.42%
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, 2008, that amount is $6,098,630, consisting of $6.0 million of
principal and $98,630 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.
On October 30, 2008 we paid off all amounts due M&T Bank under the letter of credit and as a
result, we have no further obligations under the letter of credit or our financing arrangement with
MIDFA. See Recent Developments above.
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 September 30, 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
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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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: November 13, 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: November 13, 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 and Principal Accounting Officer)
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