SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q
 
(Mark One)
 
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2008
 
OR
 
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to

Commission file number 1-14207

INSITE VISION INCORPORATED
(Exact name of registrant as specified in its charter)
 
Delaware
94-3015807
(State or other jurisdiction)
(IRS Employer
of incorporation or organization)
Identification No.)
   
965 Atlantic Avenue, Alameda, California
94501
(Address of principal executive offices)
(Zip Code)

(510) 865-8800
Registrant's telephone number, including area code
 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 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  x   No  ¨  

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨
Accelerated filer x
Non-accelerated filer ¨
Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12-b2 of the Exchange Act. Yes ¨     No x
 
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Class
 
Outstanding as of October 31, 2008
Common Stock, $0.01 par value per share
 
94,628,937 shares
 

QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2008

TABLE OF CONTENTS

   
Page
   
PART I. FINANCIAL INFORMATION
 
     
Item 1.
Financial Statements
 
     
 
Condensed Consolidated Balance Sheets at
 
 
September 30, 2008 (unaudited) and December 31, 2007
1
     
 
Unaudited Condensed Consolidated Statements of Operations
 
 
for the three and nine months ended September 30, 2008 and 2007
2
     
 
Unaudited Condensed Consolidated Statements of Cash Flows
 
 
for the nine months ended September 30, 2008 and 2007
3
     
 
Unaudited Notes to Condensed Consolidated Financial Statements
4
     
Item 2.
Management’s Discussion and Analysis of
 
 
Financial Condition and Results of Operations
10
     
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
14
     
Item 4.
Controls and Procedures
14
     
PART II. OTHER INFORMATION
 
     
Item 1.
Legal Proceedings
14
     
Item 1A.
Risk Factors
15
     
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
27
     
Item 3.
Defaults Upon Senior Securities
27
     
Item 4.
Submission of Matters to a Vote of Security Holders
27
     
Item 5.
Other Information
28
     
Item 6.
Exhibits
28
     
Signatures
29
 

PART I FINANCIAL INFORMATION
Item 1.   Financial Statements

InSite Vision Incorporated
Condensed Consolidated Balance Sheets

(in thousands, except share amounts)
 
September 30, 
2008
 
December 31, 
2007
 
   
(UNAUDITED)
 
 
(1)
 
ASSETS
             
Current assets:
             
Cash and cash equivalents
 
$
44,366
 
$
11,532
 
Restricted cash and short-term investments
   
1,382
   
75
 
Accounts receivable
   
944
   
719
 
Prepaid financing costs
   
-
   
538
 
Prepaid expenses and other current assets
   
556
   
810
 
Total current assets
   
47,248
   
13,674
 
Property and equipment, net
   
1,502
   
1,338
 
Debt issuance cost, net
   
4,446
   
-
 
Total assets
 
$
53,196
 
$
15,012
 
               
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
             
Current liabilities:
             
Accounts payable
   
282
   
2,196
 
Accrued liabilites
   
1,563
   
862
 
Accrued compensation and related expense
   
837
   
979
 
Accrued interest
   
1,200
   
-
 
Deferred revenues
   
390
   
10,145
 
Other current liabilities
   
117
   
48
 
Total current liabilities
   
4,389
   
14,230
 
Notes payable
   
60,000
   
-
 
Capital lease obligation, less current portion
   
25
   
36
 
Total liabilities
   
64,414
   
14,266
 
               
Commitments and contingencies
             
               
Stockholders’ equity (deficit):
             
               
Preferred stock, $0.01 par value, 5,000,000 shares authorized, none issued and outstanding at September 30, 2008 and December 31, 2007
   
-
   
-
 
Common stock, $0.01 par value, 240,000,000 shares authorized; 94,628,937 and 94,585,449 issued and outstanding at September 30, 2008 and December 31, 2007
   
946
   
946
 
Additional paid-in capital
   
148,105
   
147,327
 
Accumulated deficit
   
(160,269
)
 
(147,527
)
Total stockholders’ equity (deficit)
   
(11,218
)
 
746
 
Total liabilities and stockholders’ equity (deficit)
   
53,196
   
15,012
 

__________________________________________________________
(1) Derived from the Company’s audited consolidated financial statements as of December 31, 2007.
See accompanying notes to condensed consolidated financial statements.

1

InSite Vision Incorporated
Condensed Consolidated Statements of Operations
(Unaudited)

   
Three months ended September 30,
 
Nine months ended September 30,
 
(in thousands, except per share amounts)
 
2008
 
2007
 
2008
 
2007
 
                   
Revenues:
                         
Licensing
 
$
16
 
$
7,440
 
$
9,955
 
$ 
14,641
 
Royalties
 
 
944
   
436
   
 2,141
   
436
 
Other product and service revenues
   
-
   
395
   
100
   
740
 
Total revenues
   
960
   
8,271
   
12,196
   
15,817
 
                           
Cost of revenues
   
167
   
450
   
376
   
713
 
Gross profit
   
793
   
7,821
   
11,820
   
15,104
 
Operating expenses:
                         
Research and development (a)
   
3,694
   
2,707
   
12,722
   
6,628
 
General and administrative (a)
   
2,724
   
1,537
   
6,293
   
5,211
 
Total operating expenses
   
6,418
   
4,244
   
19,015
   
11,839
 
                           
Income (loss) from operations
   
(5,625
)
 
3,577
   
(7,195
)
 
3,265
 
                           
Interest (expense) and other income, net
   
(2,325
)
 
(2
)
 
(5,547
)
 
(106
)  
                           
Net income (loss)
 
$
(7,950
)
$
3,575
 
$
(12,742
)
$
3,159
 
                           
Net income (loss) per share:
                         
- basic
 
$
(0.08
)
$
0.04
 
$
(0.13
)
$
0.03
 
- diluted
 
$
(0.08
)
$
0.04
 
$
(0.13
)
$
0.03
 
                           
Weighted average shares used in per-share calculation:
                         
- Basic
   
94,629
   
94,551
   
94,600
   
94,002
 
- Diluted
   
94,629
   
102,018
   
94,600
   
102,871
 
                           
(a) Includes the following amounts related to stock based compensation:
                         
Research and development
 
$
68
 
$
89
 
$
210
 
$
198
 
General and administrative
   
174
   
189
   
548
   
511
 
 
__________________________________________________________
See accompanying notes to condensed consolidated financial statements.

2

InSite Vision Incorporated
Condensed Consolidated Statements of Cash Flows
(Unaudited)

   
Nine months ended September 30,
 
(in thousands)
 
2008
 
2007
 
               
OPERATING ACTIVITIES:
         
Net income (loss)
 
$
(12,742
)
$
3,159
 
Adjustment to reconcile net income (loss) to net cash (used in) provided by operating activities:
         
Depreciation
   
299
   
157
 
Amortization of debt issuance costs
   
255
   
22
 
Stock-based compensation
   
758
   
709
 
Changes in operating assets and liabilities:
         
Accounts receivable
   
(225
)
 
(436
)
Prepaid expenses and other current assets
   
792
   
738
 
Inventory
   
-
   
(219
)
Accounts payable
   
(1,914
)
 
452
 
Accrued interest
   
1,200
   
(702
)
Deferred revenue
   
(9,755
)
 
17,359
 
Accrued liabilities
   
701
   
256
 
Accrued compensation and related expense, and other current liabilities
   
(74
)
 
131
 
Net cash (used in) provided by operating activities
   
(20,705
)
 
21,626
 
INVESTING ACTIVITIES:
             
Purchase of property and equipment
   
(463
)
 
(849
)
Increase in restricted cash and short-term investments
   
(1,307
)
 
-
 
Net cash used in investing activities
   
(1,770
)
 
(849
)
FINANCING ACTIVITIES:
             
Issuance of common stock from exercise of options, employee
             
Proceeds from employee stock option plan,employee stock
             
Purchase plan and exercise of warrants, net
   
20
   
493
 
Proceeds from issuance of notes payable, net of $4,701 debt issuance costs
   
55,299
   
-
 
Repayments of borrowings
   
-
   
(6,566
)
Payment of capital lease obligation
   
(10
)
 
(9
)
Net cash provided by (used in) financing activities
   
55,309
   
(6,082
)
Net increase in cash and cash equivalents
   
32,834
   
14,695
 
Cash and cash equivalents at beginning of period
   
11,532
   
986
 
Cash and cash equivalents at end of period
 
$
44,366
 
$
15,681
 
__________________________________________________________
See accompanying notes to condensed consolidated financial statements.

3

InSite Vision Incorporated
Notes to Condensed Consolidated Financial Statements
(Unaudited)

Note 1. Significant Accounting Policies and Use of Estimates
 
Basis of Presentation

The accompanying unaudited condensed consolidated financial statements include the accounts of InSite Vision Incorporated (Company) and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in the preparation of the condensed consolidated financial statements.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information. Accordingly, they do not include all of the information and footnotes required for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation have been included. Operating results for the three and nine month periods ended September 30, 2008, are not necessarily indicative of the results that may be expected for any future period.

The Company operates in one segment, using one measure of profitability to manage its business.  Revenues are primarily from the license of AzaSite to Inspire Pharmaceuticals, Inc.(“Inspire”), located in the United States, and all of the Company's long-lived assets are located in the United States.

These unaudited condensed consolidated financial statements and accompanying notes should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in its Annual Report on Form 10-K for the year ended December 31, 2007.
 
Use of Estimates

The preparation of condensed consolidated financial statements requires the Company to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
 
Revenue Recognition

The Company recognizes revenue when four basic criteria are met: persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; the amount is fixed or determinable; and collectibility is reasonably assured. For arrangements with multiple elements, the Company analyzes these to determine whether the elements can be separated and accounted for individually as separate units of accounting. The Company’s revenues are primarily related to licensing agreements, and such agreements may provide for various types of payments, including upfront payments, research funding and related fees during the term of the agreement, milestone payments based on the achievement of established development objectives, licensing fees, and royalties on product sales.

Upfront, non-refundable payments under licensing agreements are recorded as deferred revenues once received and recognized ratably over the period related activities are performed. Revenues from non-refundable milestones are recognized when the earnings process is complete and the payment is reasonably assured. Non-refundable milestone payments related to arrangements under which the Company has no continuing performance obligations are recognized in the period the milestone is achieved.
 
The Company receives royalties from licensees based on third-party sales. The royalties are recorded as earned in accordance with the contract terms when third-party results are reliably measured and collectibility is reasonably assured.

Restricted Cash and Short-Term Investments

At September 30, 2008, the Company had restricted cash and short-term investments of $1.4 million related to the issuance of $60.0 million of notes payable. These cash and short-term investments are restricted to payment of any remaining interest due on the notes payable after application of the AzaSite royalties from Inspire. The Company’s investment policy is to limit the risk of principal loss and to ensure safety of invested funds by generally attempting to limit market risk. Accordingly, the Company’s short-term investments of $1.0 million are currently invested in U.S.Treasury securities with original maturities of twelve months or less. They are classified as trading securities principally bought and held for the purpose of selling them in the near term, with unrealized gains and losses included in earnings. These unrealized gains and losses for the three and nine months ended September 30, 2008 were immaterial.

4

Fair Value Measurements

On January 1, 2008, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS No. 157”) which defines fair value, establishes a framework for using fair value to measure assets and liabilities, and expands disclosures about fair value measurements.  SFAS No. 157 applies whenever other statements require or permit assets or liabilities to be measured at fair value.  SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, except for nonfinancial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis, for which application has been deferred for one year. The levels of fair value measurements defined in SFAS No. 157 are:

Level 1
 
Inputs are unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date.
   
Level 2
 
Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; 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. The Company had no Level 2 assets or liabilities at September 30, 2008.
   
Level 3
 
Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. The Company had no material Level 3 assets or liabilities at September 30, 2008.

The following table summarizes the Company’s financial assets and liabilities measured at fair value on a recurring basis in accordance with SFAS No. 157 as of September 30, 2008 (in thousands):

   
Balance as of
September 30, 2008
 
Quoted Price in
Active Markets of
Identical Assets
(Level 1)
 
Assets:
         
Cash equivalents:
         
Treasury-backed money market funds
 
$
44,303
 
$
44,303
 
Restricted cash equivalents and short-term investments:
         
Treasury-backed money market funds
   
1,381
   
1,381
 
Total
 
$
45,684
 
$
45,684
 

The Company’s financial instruments consist mainly of cash equivalents, short-term accounts receivable, accounts payable and debt obligations. Short-term accounts receivable and accounts payable are reflected in the accompanying consolidated financial statements at cost, which approximates fair value due to the short-term nature of these instruments. While the Company believes its valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

Debt Issuance Costs

The Company capitalizes costs associated with the issuance of debt instruments and amortizes these costs over the term of the debt agreements using the constant interest method. Amortization expense of debt issuance cost for the three and nine month periods ended September 30, 2008 was $105,000 and $255,000, respectively.

5

Recent Accounting Pronouncements

In February 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FAS 157-2, “Effective Date of FASB Statement No. 157” (“FSP 157-2”), to partially defer SFAS No. 157. FSP 157-2 defers the effective date of SFAS 157 for nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), to fiscal years, beginning after November 15, 2008. The Company is currently evaluating the impact of FSP 157-2 on its consolidated financial position and results of operations.

In October 2008, the FASB issued Staff Position 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP FAS 157-3”), to clarify the application of the provisions of FAS 157 in an inactive market and how an entity would determine fair value in an inactive market. FSP FAS 157-3 was effective upon issuance and applies to the Company’s current financial statements. The application of the provisions of FSP FAS 157-3 did not materially affect the Company’s results of operations or financial condition as of and for the three and nine months ended September 30, 2008.

Note 2. Stock-Based Compensation
 
Our stock-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as expense over the requisite service period.

The effect of recording stock-based compensation for the three and nine month periods ended September 30, 2008 and 2007 was as follows (in thousands, except per share data):
 
   
Three months ended
September 30,
 
Nine months ended 
September 30,
 
   
2008
 
2007
 
2008
 
2007
 
Stock-based compensation expense by type of award:
                 
Employee stock options
 
$
225
 
$
252
 
$
708
 
$
670
 
Employee stock purchase plan
   
15
   
19
   
39
   
24
 
Non-employee stock options
   
2
   
7
   
11
   
15
 
Total stock-based compensation  
$
242
 
$
278
 
$
758
 
$
709
 
Impact on net income (loss) per share - basic and diluted
 
$
-
 
$
-
 
$
(0.01
)
$
(0.01
)

Employee Stock Purchase Plans  

The Company maintains an employee stock purchase plan (the “Purchase Plan”). During the three month and nine month periods ended September 30, 2008, zero and 43,488 shares were issued under the Purchase Plan, respectively. During the three and nine month periods ended September 30, 2007, zero and 34,798 shares were issued under the Purchase Plan, respectively. As of September 30, 2008, 624,646 shares were reserved for issuance under the Purchase Plan. As of September 30, 2008, the unrecorded deferred stock-based compensation balance related to the Purchase Plan was $49,000 and will be recognized over an estimated weighted average amortization period of approximately 1.2 years.

Employee Stock-Based Compensation

During the three month periods ended September 30, 2008 and 2007, respectively, the Company granted options to purchase 180,000 and 70,500 shares of common stock with an estimated total grant date fair value of $58,000 and $48,000, respectively. Of the $58,000 and $48,000, respectively, the Company estimated that the stock-based compensation for the awards not expected to vest was $6,000 and $9,000, respectively.

During the nine month periods ended September 30, 2008 and 2007, respectively, the Company granted options to purchase 329,000 and 831,000 shares of common stock with an estimated total grant date fair value of $116,000 and $818,000, respectively. Of the $116,000 and $818,000, respectively, the Company estimated that the stock-based compensation for the awards not expected to vest was $17,000 and $159,000, respectively.

6

As of September 30, 2008, the Company’s unrecorded deferred stock-based compensation balance related to stock options was $1.2 million net of forfeitures and will be recognized over an estimate weighted-average amortization period of 1.9 years.

Valuation Assumptions

The Company estimates the fair value of stock options and employee stock purchase plan using a Black-Scholes valuation model using the graded-vesting method with the following weighted-average assumptions:

   
Three months ended 
September 30,
 
Nine months ended 
September 30,
 
Stock Options
 
2008
 
2007
 
2008
 
2007
 
Risk-free interest rate
   
3.0
%
 
4.3
%
 
2.6%- 3.3%
 
 
4.3%-4.6%
 
Expected term (years)
   
5
   
5
   
5
   
5
 
Expected dividends
   
0.0
%
 
0.0
%
 
0.0%
 
 
0.0%
 
Volatility
   
73.7
%
 
73.0
%
 
73.8%
 
 
74.2%
 
                           
Employee Stock Purchase Plan
                 
 
     
Risk-free interest rate
   
3.3
%
 
4.6
%
 
3.3%
 
 
4.6%
 
Expected term (years)
   
1.5
   
1.5
   
1.5
   
1.5
 
Expected dividends
   
0.0
%
 
0.0
%
 
0.0%
 
 
0.0%
 
Volatility
   
73.5
%
 
74.3
%
 
73.5%
 
 
74.3%
 

The dividend yield of zero is based on the fact that the Company has never paid cash dividends and has no present intention to pay cash dividends. Expected volatility is based on the historical volatility of the Company’s common stock and the expected moderation in future volatility over the period commensurate with the expected life of the options and other factors. The risk-free interest rates are taken from the Daily Federal Yield Curve Rates as of the grant dates as published by the Federal Reserve and represent the yields on actively traded Treasury securities for terms equal to the expected term of the options. The expected term calculation is based on observed historical option exercise behavior and post-vesting forfeitures of options by the Company’s employees.

Equity Incentive Program  

Prior to October 15, 2007, the Company granted options under a stock option plan adopted in 1994 and amended thereafter (the “1994 Plan”), that allowed for the granting of non-qualified stock options, incentive stock options and stock purchase rights to the Company’s employees, directors, and consultants. On October 15, 2007, the Company’s stockholders approved a new equity incentive plan, the 2007 Performance Incentive Plan (the “2007 Plan”), that provides for grants of options and other equity-based awards to the Company’s employees, directors and consultants. The Company’s authority to grant new awards under the 1994 Plan terminated upon stockholder approval of the 2007 Plan. Options granted under these plans expire 10 years after the date of grant and become exercisable at such times and under such conditions as determined by the Company’s Board of Directors (generally with 25% vesting after one year and the balance vesting on a daily basis over the next three years of service). Upon termination of the optionee’s service, unvested options terminate, and vested options generally expire at the end of three months. Only nonqualified stock options have been granted under these plans to date. On January 1 of each calendar year during the term of the 2007 Plan, the shares of common stock available for issuance will be increased by the lesser of 2% of the total outstanding shares of common stock on December 31 of the preceding calendar year, or 3,000,000 shares. The following is a summary of activity under these plans for the indicated periods:

7
 
   
Number of
shares
 
Weighted-Average
Exercise Price
 
Weighted-Average
Remaining Contractual
Term (Years)
 
Aggregate
Intrinsic Value
(in thousands)
 
Outstanding at December 31, 2007
   
7,005,105
 
$
1.09
             
Granted
   
329,000
   
0.57
             
Exercised
   
-
   
0.00
             
Canceled
   
(316,193
)
 
1.20
             
Outstanding at September 30, 2008
   
7,017,912
 
$
1.06
   
5.48
 
$
17
 
Options vested and exerciseable and expected to be exercisable at September 30, 2008
   
6,827,823
 
$
1.05
   
5.40
 
$
17
 
                           
Options vested and exerciseable at September 30, 2008
   
5,465,389
 
$
1.03
   
4.70
 
$
17
 
 
At September 30, 2008, the Company had 3,872,726 shares of common stock available for grant under the 2007 Plan. The weighted average grant date fair value of options granted during the nine months ended September 30, 2008 and 2007 was $0.35 and $1.00, respectively. No options were exercised during the three and nine month periods ended September 30, 2008. The total intrinsic value of options exercised during the nine months ended September 30, 2007 was $75,000.
 
The following table summarizes information concerning outstanding and exercisable options as of September 30, 2008:
 
   
Options Outstanding
 
Options Vested and Exercisable
 
       
Weighted-Average
         
Range of Exercise Prices
 
Number
Outstanding
 
Contractual
Life
 
Exercise Price
 
Number
Exercisable
 
Weighted-
Average
Exercise Price
 
$0.41 -    $0.60
   
539,250
   
6.32
 
$
0.48
   
281,395
 
$
0.41
 
$0.63 -   $0.63
   
1,927,967
   
6.12
 
$
0.63
   
1,685,970
 
$
0.63
 
$0.64 -   $0.75
   
750,193
   
4.52
 
$
0.72
   
672,879
 
$
0.72
 
$0.82 -   $0.93
   
702,753
   
3.71
 
$
0.89
   
702,753
 
$
0.89
 
$1.02 -   $1.45
   
808,477
   
2.38
 
$
1.19
   
686,523
 
$
1.20
 
$1.46 -   $1.46
   
20,001
   
8.50
 
$
1.46
   
20,001
 
$
1.46
 
$1.50 -   $1.50
   
1,320,043
   
7.10
 
$
1.50
   
887,208
 
$
1.50
 
$1.56 -   $1.63
   
803,728
   
7.04
 
$
1.60
   
383,160
 
$
1.60
 
$1.64 -   $5.25
   
135,500
   
0.80
 
$
3.52
   
135,500
 
$
3.52
 
$5.88 -   $5.88
   
10,000
   
1.98
 
$
5.88
   
10,000
 
$
5.88
 
     
7,017,912
   
5.48
 
$
1.06
   
5,465,389
 
$
1.03
 
 
Note 3.   Net Income (Loss) per Share

Basic net income (loss) per share has been computed using the weighted-average number of common shares outstanding during the period. Dilutive net income (loss) per share is computed using the sum of the weighted-average number of common shares outstanding and the potential number of dilutive common shares outstanding during the period. For loss periods, all potential common shares would be antidilutive and are, therefore, not included in the weighted-average common shares outstanding for the purpose of computing dilutive loss per share. Potential common shares consist of the shares issuable upon exercise of stock options and warrants.

8
 
The following table sets forth the computation of basic and diluted net income (loss) per share:
 
   
Three months ended 
September 30,
 
Nine months ended 
September 30,
 
(in thousands, except per share amounts)
 
2008
 
2007
 
2008
 
2007
 
Numerator:
                         
Net income (loss)
 
$
(7,950
)
$
3,575
 
$
(12,742
)
$
3,159
 
Denominator:
                         
Weighted-average shares outstanding
   
94,629
   
94,551
   
94,600
   
94,002
 
Effect of dilutive securities:
                         
Stock options and warrants
   
-
   
7,467
   
-
   
8,869
 
Weighted-average shares outstanding for diluted income (loss) per share
   
94,629
   
102,018
   
94,600
   
102,871
 
                           
Net income (loss) per share:
                         
Basic
 
$
(0.08
)
$
0.04
 
$
(0.13
)
$
0.03
 
Diluted
 
$
(0.08
)
$
0.04
 
$
(0.13
)
$
0.03
 

The following is a summary of potential common shares during the respective periods that have been excluded in the calculation of diluted net loss per share as their inclusion would have been antidilutive:
 
   
Three months ended 
September 30,
 
Nine months ended 
September 30,
 
   
2008
 
2007
 
2008
 
2007
 
Stock option
   
7,017,912
   
3,004,615
   
7,017,912
   
2,513,886
 
Warrants
   
15,339,903
   
958,015
   
15,339,903
   
958,015
 
     
22,357,815
   
3,962,630
   
22,357,815
   
3,471,901
 

Note 4.   License Agreements

In May 2008, the Company entered into a licensing and distribution agreement for AzaSite with Essex Bio-Technology in the People’s Republic of China. Under the terms of the agreement, the Company granted exclusive rights to Essex to commercialize AzaSite for ocular bacterial infection in the People’s Republic of China.

In April 2008, the Company entered into a licensing and distribution agreement for AzaSite with Biem Pharmaceuticals in Turkey. Under the terms of the agreement, the Company granted exclusive rights to Biem Pharmaceuticals to commercialize AzaSite for ocular bacterial infection in Turkey.

In March 2008, the Company entered into a licensing and distribution agreement for AzaSite with Bioceutica S.A. in Argentina. Under the terms of the agreement, the Company granted exclusive rights to Bioceutica to commercialize AzaSite for ocular bacterial infection in Argentina, Chile, Paraguay and Uruguay.

In all of these agreements, the licensee is responsible for obtaining regulatory approval and will generally pay the Company a double digit royalty on net sales of AzaSite in these countries, if approved by regulatory authorities. The Company will be responsible for providing AzaSite inventory to these licensees at a fee per respective agreed upon licensing agreement.

Note 5.   Secured Notes Payable

In February 2008, the Company’s wholly-owned subsidiary, Azithromycin Royalty Sub, LLC issued $60.0 million in aggregate principal amount of non-convertible, non-recourse promissory notes due 2019. Net proceeds from the financing were approximately $55.3 million after transaction costs of approximately $4.7 million. In addition, approximately $5.0 million of the proceeds was set aside for interest reserves, of which $1.4 millions remains as of September 30, 2008. The annual interest rate on the notes is 16% with interest payable quarterly in arrears beginning May 15, 2008. The notes are secured by, and will be repaid from, royalties to be paid to the Company by Inspire Pharmaceuticals from sales of AzaSite in the United States and Canada. The secured notes payable are non-recourse to InSite Vision Incorporated. When the AzaSite royalties received for any quarter exceed the interest payments and certain expenses due that quarter, the excess will be applied to the repayment of principal of the notes until the notes have been paid in full. Any shortfall of interest payments from the royalty payments will be paid out of the interest reserves. The notes may be redeemed at the Company’s option, subject to the payment of a redemption premium through May 2012. As of September 30, 2008, the $60.0 million of secured notes payable is classified as long-term.

9

Note 6.   Common Stock

The following table shows outstanding warrants as of September 30, 2008. All of the outstanding warrants, except for those issued in March and June, 2004, with an exercise price of $0.75, have cashless exercise provisions. All warrants are exercisable for common stock.
 
Date Issued
 
Warrant Shares
 
Exercise Price
 
Expiration Date
 
Potential Total
Cash if Exercised
 
September 22, 2003
   
81,967
 
$
0.6100
   
September 21, 2008
 
$
50,000
 
March 26, 2004
   
989,401
 
$
0.7500
   
March 25, 2009
   
742,051
 
June 14, 2004
   
7,414,569
 
$
0.7500
   
June 13, 2009
   
5,560,927
 
June 14, 2004
   
351,640
 
$
0.5500
   
June 13, 2009
   
193,402
 
May 26, 2005
   
3,818,175
 
$
0.6325
   
May 25, 2010
   
2,414,996
 
May 26, 2005
   
366,136
 
$
0.6325
   
May 25, 2010
   
231,581
 
December 30, 2005
   
860,000
 
$
0.8200
   
December 29, 2010
   
705,200
 
December 30, 2005
   
100,000
 
$
0.8200
   
December 29, 2010
   
82,000
 
January 11,2006
   
400,000
 
$
0.8200
   
January 10, 2011
   
328,000
 
August 16, 2006
   
958,015
 
$
1.5100
   
August 15, 2011
   
1,446,603
 
Total
   
15,339,903
             
$
11,754,760
 
Weighted-average exercise price
                   
$
0.77
 
 
Note 6.   Subsequent Event

On October 31, 2008, S. Kumar Chandrasekaran, Ph.D. was relieved of his position as President and Chief Executive Officer of InSite Vision Incorporated (the “Company”). Also effective October 31, 2008, the Board appointed Louis Drapeau, age 64, as interim Chief Executive Officer in addition to his current position as Vice President and Chief Financial Officer.

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
 
Except for the historical information contained herein, the discussion in this Quarterly Report on Form 10-Q contains certain forward-looking statements within the meaning of the federal securities laws that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. The cautionary statements made in this document should be read as applicable to all related forward-looking statements wherever they appear in this document. Our actual results could differ materially from those discussed herein. Factors that could cause or contribute to such differences include those discussed below in "Risk Factors," as well as those discussed elsewhere herein. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to update any forward- looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence or identification of unanticipated events.

The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto included in this Quarterly Report and the audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2007.

10

Overview

We are an ophthalmic product development company focused on ophthalmic pharmaceutical products based on our proprietary DuraSite ® drug delivery technology. Our intent is to continue to solidify our franchise in ocular anti-infective topical therapies and to investigate new product opportunities in the field of ophthalmology.

Our DuraSite ® sustained delivery technology is a proven, patented synthetic polymer-based formulation designed to extend the residence time of a drug relative to conventional topical therapies. It enables topical delivery of a solution, gel or suspension and can be customized for delivering a wide variety of potential drug candidates. We are currently focusing our research and development and commercial efforts on the following topical anti-infective and anti-inflammatory products that formulate the antibiotic azithromycin with our DuraSite ® drug delivery technology.

·
AzaSite ® (azithromycin ophthalmic solution) 1%, a DuraSite formulation of azithromycin, was developed to serve as a broad spectrum ocular antibiotic; approved by the FDA in April 2007 to treat bacterial conjunctivitis (pink eye); and launched by Inspire Pharmaceuticals in August 2007. AzaSite’s key advantages are a significantly reduced dosing regimen designed to lead to better compliance and outcome, with a broad spectrum antibiotic, and a lowered probability of bacterial resistance based on achieving a high tissue concentration of the antibiotic.
·
ISV-502, a DuraSite formulation of azithromycin and a corticosteroid is under development for ocular inflammation and infection, particularly blepharoconjunctivitis, for which there is currently no FDA approved indicated treatment. We initiated a Phase 3(a) trial in December 2007 and completed enrollment for this trial in September 2008.

Major Developments

Our major developments for the first nine months of 2008 included:

·
supporting increasing sales of AzaSite by Inspire in the United States;
·
completed enrollment of our Phase 3(a) trial for ISV-502;
·
a licensing agreement with Essex Bio-Technology in May 2008 to commercialize AzaSite for ocular bacterial infection in China including the Mainland, Hong Kong and Macao;
·
a licensing agreement with Biem Pharmaceuticals in April 2008 to commercialize AzaSite for ocular bacterial infection in Turkey;
·
a licensing agreement with Bioceutica in March 2008 to commercialize AzaSite for ocular bacterial infection in Argentina, Chile, Paraguay and Uruguay; and
·
the February 2008 issuance of $60 million in aggregate principal amount of non-convertible, non-recourse promissory notes due in 2019 (the “AzaSite Notes”).

We decided to discontinue the pre-clinical development of AzaSite Otic (ISV-016) as the product formulation did not meet our expected product profile.

11

Results of Operations

Revenues.
 
We had total revenues in the third quarters of 2008 and 2007 of $1.0 million and $8.3 million, respectively, and $12.2 million and $15.8 million for the nine months ended September 30, 2008 and 2007, respectively. Revenues in the three months ended September 30, 2008 consisted primarily of AzaSite royalties. Revenues in the nine months ended September 30, 2008 consisted primarily of the non-cash amortization of the license fee for AzaSite. The amortization period for the license fee from Inspire for AzaSite ended in April 2008. Of the revenues in the three and nine month periods ended September 30, 2008, $0.9 million and $2.1 million, respectively, represented royalties from the sale of AzaSite by Inspire. AzaSite royalties increased 16% in the third quarter of 2008 over the second quarter of 2008 and 147% over the first quarter of 2008 due principally to increased unit sales of AzaSite in the United States and a modest price increase by Inspire, which was effective in the second quarter. The remaining revenue in the nine months ended September 30, 2008 represented contract services provided to Inspire related to its AzaSite activities.

Revenues in the three and nine months ended September 30, 2007 consisted primarily of a $7.4 million and $14.6 million non-cash amortization of the license fee from Inspire for AzaSite that we had received. The remainder of our 2007 revenues represented sales of materials to Inspire under the Supply Agreement and contract services provided to Inspire.

Cost of revenues.
 
Cost of revenues was $167,000 and $450,000 in the third quarter s of 2008 and 2007, respectively, and $376,000 and $713,000 for the nine months ended September 30, 2008 and 2007, respectively. Cost of revenues for the three and nine months ended September 30, 2008 were comprised of royalties accrued for third parties, including Pfizer, based on the royalty report provided to us by Inspire. Cost of revenues for the three and nine months ended September 30, 2007 reflects primarily the cost of the azithromycin supplied to Inspire under the supply agreement and royalties accrued for third parties including Pfizer based on the royalty report provided to us by Inspire.
 
Research and development expenses.

Our research and development, R&D, expenses for the three and nine month periods ended September 30, 2008 and 2007 were:

R&D Cost by Program
(in millions)
 
   
Three months ended September 30,
 
Nine months ended September 30,
 
Program
 
2008
 
2007
 
2008
 
2007
 
AzaSite
 
$
0.1
 
$
0.2
 
$
0.4
 
$
1.6
 
ISV-502 (Plus)
   
3.1
   
1.7
   
9.6
   
3.7
 
ISV-016 (Otic)
   
0.1
   
0.5
   
1.4
   
0.7
 
ISV-405 (Xtra)
   
-
   
0.1
   
0.5
   
0.1
 
New product opportunities and other
   
0.4
   
0.2
   
0.8
   
0.5
 
Total
 
$
3.7
 
$
2.7
 
$
12.7
 
$
6.6
 

In the three and nine month periods ended September 30, 2008, our ISV-502 program expenses consisted primarily of the ongoing Phase 3(a) clinical trial and preparation for the production of ISV-502 registration batches at our contract manufacturing site. Our expenses related to our ISV-016 program mainly consisted of preclinical testing prior to its discontinuation in July 2008. Our ISV-405 expenses also mainly related to preclinical experiments. Further development of this program has been deferred.
 
General and administrative expenses.
 
General and administrative expenses increased to $2.7 million in the third quarter of 2008 from $1.5 million in the third quarter of 2007. General and administrative expenses increased to $6.3 million in the nine months ended September 30, 2008 from $5.2 million in the nine months ended September and 2007. The increase in both the third quarter and the nine months ended September 30, 2008 reflects legal and other expenses related to our proxy contest.

12

Interest (expense) and other income, net.
 
Interest (expense) and other income, net was an expense of $2.3 million in the third quarter of 2008 compared to an expense of $2,000 in the third quarter of 2007. This $2.3 million increase reflects interest expense on the $60 million AzaSite Notes that we issued in February 2008. Additionally, in February 2008, we began to amortize the debt issuance costs incurred from our issuance of the AzaSite Notes. The increase in interest expense was partially offset by the interest income on our higher cash and cash equivalents and short-term investments balance during the third quarter of 2008.

Interest (expense) and other income, net was an expense of $5.5 million in the nine months ended 2008 compared to an expense of $106,000 for the nine months ended 2007. This increase was mainly due to the interest expense on the $60 million on the AzaSite Notes issued in February 2008.

Liquidity and Capital Resources

We have financed our operations in the last year primarily from the issuance of the AzaSite Notes and from payments under our agreements with Inspire. At September 30, 2008, our cash and cash equivalents, restricted cash and short term investments balance was $45.7 million. It is our policy to invest our cash and cash equivalents in highly liquid securities, such as interest-bearing money market funds, treasury and federal agency notes and corporate debt.

Net cash used in operating activities was $20.7 million for the nine months ended September 30, 2008. Cash provided by operating activities was $21.6 million for the nine months ended September 30, 2007. The decrease mainly reflects the license fee for AzaSite we received in the first nine months of 2007 as part of the Inspire license. Additionally, we made $4.6 million in interest payments on AzaSite Notes during the nine months ended September 30, 2008.

Net cash used in investing activities was $1.8 million and $849,000 for the nine months ended September 30, 2008 and 2007, respectively. The increase was primarily due to a $1.3 million increase in restricted cash and short-term investments related to funding an interest reserve account required pursuant to the AzaSite Notes.
 
Net cash provided by financing activities was $55.3 million for the nine months ended 2008, reflecting the net proceeds from the issuance of the AzaSite Notes. Net cash used in financing activities was $6.1 million for the nine months ended September 30, 2007. The 2007 use reflects the repayment of $6.6 million of short-term notes in February 2007. In the first nine months of 2007, we also received net proceeds of $493,000 from the exercise of warrants and options.

Our future capital expenditures and requirements will depend on numerous factors, including the progress of our clinical testing, research and development programs and preclinical testing, the time and costs involved in obtaining regulatory approvals, our partners’ ability to successfully commercialize AzaSite, ISV-502 and any other products that we may launch in the future, our ability to establish collaborative arrangements, the ability of our licensees to generate royalty-bearing sales, the cost of filing, prosecuting, defending and enforcing patent claims and other intellectual property rights, competing technological and market developments, changes in our existing collaborative and licensing relationships, acquisition of new businesses, products and technologies, the completion of commercialization activities and arrangements, and the purchase of additional property and equipment.

Contractual Obligations

As of September 30, 2008, our contractual obligations increased to $76.2 million from $25.3 million at December 31, 2007 mainly due to the issuance of the AzaSite Notes which are due in 2019. We believe there have been no other significant changes in our payments due under contractual obligations as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2007.

13

Recent Accounting Pronouncements

In February 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FAS 157-2, “Effective Date of FASB Statement No. 157” (“FSP 157-2”), to partially defer SFAS No. 157. FSP 157-2 defers the effective date of SFAS 157 for nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), to fiscal years beginning after November 15, 2008. We are currently evaluating the impact of FSP 157-2 on its consolidated financial position and results of operations.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The securities in our investment portfolio are not leveraged, are classified as cash and cash equivalents or short-term investments and are, due to their short-term nature, subject to minimal interest rate risk. We currently do not hedge interest rate exposure. Because of the short-term maturities of our investments, we do not believe that a change in market rates would have a significant negative impact on the value of our investment portfolio. While a hypothetical decrease in market interest rates by 10 percent from the September 30, 2008 levels would cause a decrease in interest income, it would not result in loss of principal.

The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. In the current economic environment to achieve this objective, we maintain our portfolio in cash equivalents, including obligations of U.S. government-sponsored enterprises and money market funds. These securities are classified as cash and cash equivalents and consequently are recorded on the balance sheet at fair value. We do not utilize derivative financial instruments to manage our interest rate risks.

Item 4. Controls and Procedures

(a) Evaluation of disclosure controls and procedures. Our principal executive and our principal financial officer, Louis Drapeau, reviewed and evaluated the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e) and 15(d)-15(e)) as of the end of the period covered by this Form 10-Q (the “Evaluation Date”). Based on that evaluation, Mr. Drapeau concluded that our disclosure controls and procedures were effective as of the Evaluation Date in providing him with material information relating to us in a timely manner, as required to be disclosed in the reports we file under the Exchange Act.

(b) Changes in internal control over financial reporting. There was no change in our internal control over financial reporting that occurred during the period covered by this Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Part II OTHER INFORMATION

Item 1.   Legal Proceedings.

None.

14

Item 1A. Risk Factors
 
The following description of the risk factors associated with our business includes any material changes to and supersedes the description of the risk factors associated with our business previously disclosed in Item 1A of our annual report on Form 10-K for the fiscal year ended December 31, 2007.
 
Risks Relating to Our Business
 
It is difficult to evaluate our business because we are in an early stage of commercial development of AzaSite and successful development of pharmaceutical products is highly uncertain and requires significant expenditures and time.
 
We are in the early stages of developing our business, particularly with respect to commercializing our products. We received U.S. regulatory approval for AzaSite in April 2007 and commercial sales of AzaSite began in the third quarter of 2007. We must receive approval in other countries prior to marketing AzaSite in such countries. Before regulatory authorities grant us marketing approval for additional products, we need to conduct significant additional research and development and preclinical and clinical testing and submit a New Drug Application, or NDA. Successful development of pharmaceutical products is highly uncertain. Products that appear promising in research or development, including ISV-502, may be delayed or fail to reach later stages of development or the market for several reasons, including:
 
 
§
preclinical tests may show the product to be toxic or lack efficacy in animal models;
 
 
§
clinical trial results may show the product to be less effective than desired or to have harmful or problematic side effects;
 
 
§
failure to receive the necessary U.S. and international regulatory approvals or a delay in receiving such approvals. Among other things, such delays may be caused by slow enrollment in clinical studies; extended length of time to achieve study endpoints; additional time requirements for data analysis or BLA or NDA preparation; discussions with the United States (U.S.) Food and Drug Administration (FDA) or international regulatory bodies; FDA requests for additional preclinical or clinical data; analyses or changes to study design; or unexpected safety, efficacy, or manufacturing issues;
 
 
§
there may be difficulties in formulating the product, scaling the manufacturing process, or getting approval for manufacturing;
 
 
§
even if safe and effective, manufacturing costs, pricing, or reimbursement issues, or other factors may make the product uneconomical;
 
 
§
proprietary rights of others and their competing products and technologies may prevent the product from being developed or commercialized; or
 
 
§
the product may not be able to compete with superior, equivalent, more cost-effective or more effectively promoted products offered by competitors.
 
Therefore, our research and development activities, including ISV-502, may not result in any commercially viable products.
 
We have a history of operating losses and we expect to continue to have losses in the future.
 
We have incurred significant operating losses since our inception in 1986 and have pursued numerous drug development candidates that did not prove to have commercial potential. We expect to incur net losses for the foreseeable future or until we are able to achieve significant royalties or other revenues from sales of our products. Attaining significant revenue or profitability depends upon our ability, alone or with third parties, to develop our potential products successfully, conduct clinical trials, obtain required regulatory approvals and manufacture and market our products successfully. We may not ever achieve or be able to maintain significant revenue or profitability, including with respect to AzaSite our lead product which has not yet been approved or commercially launched outside the United States.

15
 
Clinical trials are expensive, time-consuming and difficult to design and implement and it is unclear whether the results of such clinical trials will be favorable.
 
We have begun our first Phase 3(a) clinical trial for our ISV-502 product candidate. Human clinical trials for product candidates are very expensive and difficult to design and implement, in part because they are subject to rigorous regulatory requirements. The clinical trial process is also time-consuming. We estimate that clinical trials for ISV-502 and any other product candidates may take over a year to complete. Furthermore, we could encounter problems that cause us to abandon or repeat clinical trials resulting in additional expense, further delays and potentially preventing the completion of such trials. The commencement and completion of clinical trials may be delayed or terminated due to several factors, including:
 
 
§
unforeseen safety issues;
 
 
§
lack of effectiveness during clinical trials;
 
 
§
difficulty in determining dosing and trial protocols;
 
 
§
slower than expected rates of patient recruitment;
 
 
§
inability to monitor patients adequately during or after treatment; and
 
 
§
inability or unwillingness of clinical investigators to follow our clinical protocols.
 
In addition, we or the FDA may suspend our clinical trials at any time if it appears that we are exposing participants to unacceptable health risks or if the FDA finds deficiencies in our submissions or the conduct of these trials. In any such case, we may not be able to obtain regulatory approval for our product candidates in which case we would not obtain any benefit from our substantial investment in developing the product and conducting clinical trials for such products.
 
The results of our clinical trials may not support our product candidate claims.
 
Even if our clinical trials are completed as planned, we cannot be certain that the results will support our product candidate claims. Even if pre-clinical testing and early clinical trials for a product candidate are successful, this does not ensure that later clinical trials will be successful, and we cannot be sure that the results of later clinical trials will replicate the results of prior clinical trials and pre-clinical testing or meet our expectations. Clinical trials may fail to demonstrate that our product candidates are safe for humans or effective for indicated uses. In addition, our clinical trials involve relatively small patient populations. Because of the small sample size, the results of these clinical trials may not be indicative of future results. Any such failure would likely cause us to abandon the product candidate and may delay development of other product candidates. Any delay in, or termination of, our clinical trials will delay or preclude the filing of our NDAs with the FDA and, ultimately, our ability to commercialize our product candidates and generate product revenues.
 
Our strategy for commercialization of our products requires us to enter into successful arrangements with corporate collaborators.
 
We generally intend to enter into partnering and collaborative arrangements with respect to the commercialization of our product candidates, such as ISV-502. However, we cannot assure you that we will be able to enter into such arrangements or that they will be beneficial to us. The success of our partnering and collaboration arrangements will depend upon many factors, including:
 
 
§
the progress and results of our preclinical and clinical testing and research and development programs;
 
 
§
the time and cost involved in obtaining regulatory approvals;
 
 
§
our ability to negotiate favorable terms with potential collaborators;
 
 
§
the efforts and success of our collaborators in marketing the product;
 
16
 
 
§
our ability to prosecute, defend and enforce patent claims and other intellectual property rights;
 
 
§
the outcome of possible future legal actions; and
 
 
§
competing technological and market developments.
 
We may not be able to conclude arrangements with third parties to support the commercialization of our products on acceptable terms, or at all, and may not be able to maintain any arrangement that we do enter into.
 
The commercial success of our products is dependent on the diligent efforts of our corporate collaborators.
 
Because we generally rely on third parties for the marketing and sale of our products, revenues that we receive will be highly dependent on the efforts of these third parties, particularly Inspire. These collaborators may terminate their relationships with us and may not diligently or successfully market or sell our products. These collaborators may also pursue alternative or competing technologies or develop alternative products either on their own or in collaboration with others, including our competitors. In addition, marketing consultants and contract sales organizations that we may use in the future for our products may market products that compete with our products, or may fail to effectively sell our products, and we must rely on their efforts and ability to market and sell our products effectively.
 
If we fail to enter into future collaborations or our current collaborations are terminated, we will need to enter into new collaborations or establish our own sales and marketing organization.
 
We may not be able to enter into or maintain collaborative arrangements with third parties. If we are not successful in entering into future collaborations or maintaining our existing collaborations, particularly with Inspire, we may be required to find new corporate collaborators or establish our own sales and marketing organization. Under the terms of the Inspire License, Inspire may terminate the agreement at any time. We have no experience in sales, marketing or distribution and establishing such an organization will be costly. Moreover, there is no guarantee that our sales and marketing organization would be successful once established.   If we are unable to enter into additional collaborations or successfully market our products ourselves, our revenues and financial results would be significantly harmed.
 
Our future success depends on our ability to engage third parties to assist us with the development of new products, new indications for existing products, and in the conduct of our clinical trials to achieve regulatory approval for commercialization and any failure or delay by those parties to fulfill their obligations could adversely affect our development and commercialization plans.
 
For our business model to succeed, we must continually develop new products or discover new indications for our existing products. As part of that process, we rely on third parties such as clinical research organizations, clinical investigators and outside testing labs for development activities such as Phase 2 and/or Phase 3 clinical testing and to assist us in obtaining regulatory approvals for our product candidates. We rely heavily on these parties for successful execution of their responsibilities, but have no control over how these parties manage their businesses and cannot assure you that such parties will diligently or effectively   perform their activities . For example, the clinical investigators conducting our clinical trials, including our current Phase 3(a) trial for ISV-502, are not our employees. However, we are responsible for ensuring that each of our clinical trials is conducted in accordance with applicable protocols, rules and regulations or in accordance with the general investigational plan and protocols for the trial as well as the various rules and regulations governing clinical trials in the U.S. and abroad. Any failure by those parties to perform their duties effectively and on a timely basis could harm our ability to develop and commercialize new products and harm our business.
 
Physicians and patients may not accept and use our products.
 
Even if the FDA or international regulatory bodies approve our product candidates, physicians and patients may not accept and use them. Acceptance and use of our products will depend upon a number of factors including:
 
 
§
perceptions by members of the health care community, including physicians, about the safety and effectiveness of our drugs;
 
 
§
pricing of our products relative to competing products;
 
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§
actual or perceived benefits of competing products or treatments;
 
 
§
physicians’ comfort level and prior experience with and use of competing products;
 
 
§
availability of reimbursement for our products from government or other healthcare payers; and
 
 
§
effectiveness of marketing and distribution efforts by us and our licensees and distributors.
 
We may require additional licenses or be subject to expensive and uncertain patent litigation in order to sell our products.
 
A number of pharmaceutical and biotechnology companies and research and academic institutions have developed technologies, filed patent applications or received patents on various technologies that may be related to our business. Some of these technologies, applications or patents may conflict with our technologies or patent applications. As is common in the pharmaceutical and biotech industry, from time to time we receive notices from third parties alleging various challenges to our patent rights, and we investigate the merits of each allegation that we receive. Such conflicts, if proven, could invalidate our issued patents, limit the scope of the patents, if any, that we may be able to obtain, result in the denial of our patent applications or block our rights to exploit our technology. If the U.S. Patent and Trademark Office, or USPTO, or foreign patent agencies have issued or in the future issue patents to other companies that cover our activities, we may not be able to obtain licenses to these patents at a reasonable cost, or at all, or be able to develop or obtain alternative technology. If we do not obtain such licenses, we could encounter delays in or be precluded altogether from introducing products to the market. If we are required to obtain additional licenses from third parties with respect to the AzaSite Notes in the United States and Canada, we will be required to pay such amounts from our existing cash.
 
We may need to litigate in order to defend against claims of infringement by others, to enforce patents issued to us or to protect trade secrets or know-how owned or licensed by us. Litigation could result in substantial cost to and diversion of effort by us, which may harm our business, prospects, financial condition, and results of operations. Such costs can be particularly harmful to companies such as ours without significant existing revenue streams or cash resources. We have also agreed to indemnify our licensees against infringement claims by third parties related to our technology, which could result in additional litigation costs and liability for us. In addition, our efforts to protect or defend our proprietary rights may not be successful or, even if successful, may result in substantial cost to us, thereby utilizing our limited resources for purposes other than product development and commercialization.
 
If our products, methods, processes and other technologies infringe the proprietary rights of other parties, we could incur substantial costs and we may have to:
 
 
§
obtain licenses, which may not be available on commercially reasonable terms, if at all;
 
 
§
redesign our products or processes to avoid infringement;
 
 
§
stop using the subject matter claimed in the patents held by others, which could preclude us from commercializing our products;
 
 
§
pay damages; or
 
 
§
defend litigation or administrative proceedings which may be costly whether we win or lose, and which could result in a substantial diversion of our valuable management resources.
 
Our business depends upon our proprietary rights, and we may not be able to protect, enforce or secure our intellectual property rights adequately.
 
Our future success will depend in large part on our ability to obtain patents, protect trade secrets, obtain and maintain rights to technology developed by others, and operate without infringing upon the proprietary rights of others. A substantial number of patents in the field of ophthalmology and genetics have been issued to pharmaceutical, biotechnology and biopharmaceutical companies. Moreover, competitors may have filed patent applications, may have been issued patents or may obtain additional patents and proprietary rights relating to products or processes competitive with ours. Our patent applications may not be approved. We may not be able to develop additional proprietary products that are patentable. Even if we receive patent issuances, those issued patents may not be able to provide us with adequate protection for our inventions or may be challenged by others.

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Furthermore, the patents of others may impair our ability to commercialize our products. The patent positions of firms in the pharmaceutical and genetic industries generally are highly uncertain, involve complex legal and factual questions, and have recently been the subject of significant litigation. The USPTO and the courts have not developed, formulated, or presented a consistent policy regarding the breadth of claims allowed or the degree of protection afforded under pharmaceutical and genetic patents. Despite our efforts to protect our proprietary rights, others may independently develop similar products, duplicate any of our products or design around any of our patents. In addition, third parties from which we have licensed or otherwise obtained technology may attempt to terminate or scale back our rights.
 
We also depend upon unpatented trade secrets to maintain our competitive position. Others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets. Our trade secrets may also be disclosed, and we may not be able to protect our rights to unpatented trade secrets effectively. To the extent that we, our consultants or our research collaborators use intellectual property owned by others, disputes also may arise as to the rights in related or resulting know-how and inventions.
 
In certain circumstances, we may lose the potential to receive future royalty payments after the AzaSite Notes are repaid in full or we may be required to pay damages for breaches of representations, warranties or covenants under certain of the AzaSite note financing agreements.
 
In February 2008, through a wholly-owned subsidiary, we issued $60 million in aggregate principal amount of AzaSite Notes, which are secured principally by royalty payments from future sales of AzaSite in North America, but not the right to receive such payments, and by a pledge by us of all the outstanding equity interest in our subsidiary. If the AzaSite royalty payments are insufficient to repay the AzaSite Notes or if an event of default occurs under the indenture governing the AzaSite Notes, in certain circumstances, the royalty payments and our equity interest in our subsidiary may be foreclosed upon and we would lose the potential to receive future royalty payments after the AzaSite Notes are repaid in full and our intellectual property and other rights related to AzaSite. In addition, in connection with the issuance of the AzaSite Notes, we have made certain representations, warranties and covenants to our subsidiary and the holders of the AzaSite Notes, or the Noteholders. If we breach these representations, warranties or covenants, such breach could trigger an event of default under the indenture and we could also be liable to our subsidiary or the Noteholders for substantial damages in respect of any such breach, which could harm our financial condition and ability to conduct our business as currently planned. See “Business-Recent Events” and Note 12 to the Consolidated Financial Statements included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007 and Note 5 to the Condensed Consolidated Financial Statements included herein for a more complete description of the terms of the AzaSite Notes.
 
Inspire’s failure to successfully market and commercialize AzaSite would harm sales of AzaSite and, therefore, would delay or prevent repayment of the AzaSite Notes, which would delay or prevent us from receiving future revenue from sales of AzaSite.
 
The AzaSite Notes issued by our subsidiary will be repaid solely from royalties on net sales of AzaSite in the United States and Canada by Inspire under the Inspire Agreement. Inspire has assumed full control of all promotional, sales and marketing activities for AzaSite and has sole control over the pricing of AzaSite. Accordingly, royalty payments in respect of net sales of AzaSite in the United States and, upon regulatory approval, in Canada, will be entirely dependent on the actions, efforts and success of Inspire, over whom neither we nor our subsidiary have control. The success of Inspire’s commercialization of AzaSite and the time of repayment of the AzaSite Notes will depend on a number of factors, including:

 
·
the scope of Inspire’s launch of AzaSite in the United States and Canada;
 
 
·
the effectiveness and extent of Inspire’s promotional, sales and marketing efforts;
 
 
·
Inspire’s ability to build, train and retain an effective sales force;
 
 
·
Inspire’s ability to successfully sell AzaSite to physicians and patients;
 
 
·
Inspire’s pricing decisions regarding AzaSite;
 
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·
Inspire’s marketing and selling of any current or future competing products;
 
 
·
Inspire’s ability to compete against larger and more experienced competitors;
 
 
·
the discovery of any side effects or negative efficacy findings for AzaSite;
 
 
·
product recalls or product liability claims relating to AzaSite;
 
 
·
the introduction of branded generic competition;
 
 
·
if competing products for the treatment of bacterial conjunctivitis obtain more favorable formulary status than AzaSite; and
 
 
·
the relevant parties’ ability to adequately maintain or enforce the intellectual property rights relevant to AzaSite.
 
Inspire has only recently established its sales force for AzaSite. Inspire has reported that it has incurred substantial expenses in establishing and maintaining its sales force for AzaSite, including substantial additional expenses for the training and management of personnel and the infrastructure to enable its sales force to be effective and compliant with the multiple laws and regulations affecting sales and promotion of pharmaceutical products. Although individual members of the sales force have experience in sales with other companies, Inspire did not have a sales force prior to 2004 and may experience difficulties building and maintaining its sales force, which could harm sales of AzaSite.

Inspire is promoting AzaSite to select eye care professionals, pediatricians and primary care providers. However, Inspire has no prior experience calling on pediatricians and primary care physicians. A large number of pharmaceutical companies, including those with competing products, much larger sales forces and much greater financial resources, and those with products for indications that are completely unrelated to AzaSite, compete for the time and attention of pediatricians and primary care physicians. Neither we nor our subsidiary have any control over how Inspire manages and operates its sales force, how effective Inspire’s sales efforts will be or Inspire’s pricing decisions regarding AzaSite.

In addition, Inspire depends on three pharmaceutical wholesalers for the vast majority of its AzaSite sales in the United States. These companies are Cardinal Health, McKesson Corporation and AmerisourceBergen. The loss of any of these wholesalers could harm sales of AzaSite. It is also possible that these wholesalers, or others, could decide to change their policies or fees, or both, in the future. This could cause Inspire to incur higher product distribution costs, which would result in lower net sales of AzaSite.

Inspire could experience financial or other difficulties unrelated to AzaSite that could adversely affect the marketing or sale of AzaSite. Moreover, Inspire could change its commercial strategy and deemphasize or sell or sublicense its rights to AzaSite. Neither we nor our subsidiary can ensure that Inspire effectively maximizes the potential sales of AzaSite nor can we prevent Inspire from exercising its right to terminate the Inspire License Agreement at any time. Our subsidiary’s ability to pay amounts due on the AzaSite Notes may be materially harmed to the extent Inspire fails or is unable to successfully market and sell AzaSite. Our ability to receive future revenue from sales of AzaSite is dependent on our subsidiary repaying the AzaSite Notes in a timely fashion. If our subsidiary takes longer than anticipated to repay the AzaSite Notes, or if it defaults on the AzaSite Notes, in each case due to lower sales of AzaSite by Inspire for any of the reasons described above, or due to other unforeseen events, we may not receive future revenue from AzaSite as currently planned, or at all.

Royalties under the Inspire License Agreement may not be sufficient for our subsidiary to meet its payment obligations under the AzaSite Notes.
 
Inspire’s obligation to pay royalties on net sales of AzaSite under the Inspire Agreement expires on a country-by-country basis upon the later of 11 years from the first commercial sale of AzaSite, which, in the United States, is August 13, 2018, or when the last valid claim under one of our licensed patents covering a subject product under the Inspire Agreement in the United States and Canada expires. While our subsidiary will be entitled to minimum royalties under the Inspire Agreement from Inspire for five years after the first year of a commercial sale, such minimum royalties will not be sufficient for our subsidiary to meet its payment obligations under the AzaSite Notes and, therefore, it will be dependent on Inspire’s successful sales and marketing efforts for AzaSite in order for it to receive royalties in excess of these minimum amounts. In addition, Inspire’s obligation to pay minimum royalties is suspended during any period in which (i) the FDA or any other applicable regulatory authority has required any Inspire licensed product to be withdrawn from the market or the marketing thereof otherwise to be suspended in the United States or (ii) Inspire is unable, despite use of commercially reasonable efforts, to obtain supply of any Inspire licensed product in finished form in commercially reasonable amounts necessary to launch or market such Inspire licensed product in the United States.

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Royalties under the Inspire Agreement are subject to a cumulative reduction or offset in the event of patent invalidity, generic competition, uncured material breaches by us or in the event that Inspire is required to pay royalties, milestone payments or license fees to third parties for the continued use of AzaSite. The applicable royalty rate is also subject to reduction by up to 50% in any country during any period in which AzaSite does not have patent protection. These cumulative reductions or offsets could result in our subsidiary receiving significantly reduced or no royalties under the Inspire Agreement, which would delay repayment of the AzaSite Notes, or result in a default under the AzaSite Notes. In such circumstances we may not receive future revenue from AzaSite as currently planned, or at all.
 
If the Inspire Agreement is terminated in whole or in part while the AzaSite Notes remain outstanding, we will be forced to find a new third party collaborator for AzaSite, pursue commercialization efforts ourselves or else we will lose our right to certain intellectual property rights related to AzaSite to our subsidiary.
 
In February 2008, in connection with our subsidiary’s issuance of the AzaSite Notes, we entered into the Residual License Agreement with our subsidiary. Under the terms of the Residual License Agreement, if the Inspire Agreement is terminated in the United States or Canada while the AzaSite Notes are outstanding, all of our rights to AzaSite in such country or countries will be licensed to our subsidiary and we have three months under the terms of the Interim Sublicense, which is a part of the Residual License, to find a new third party collaborator to undertake commercialization efforts with respect to AzaSite or pursue commercialization efforts ourselves in such country or countries. Inspire can terminate the Inspire Agreement unilaterally in a variety of circumstances, including at any time in its discretion. If the Inspire Agreement is terminated, our efforts to find a new third party collaborator or pursue direct commercialization efforts ourselves will divert the attention of senior management from our current business operations, which could delay the development or licensing of our other product candidates. If we elect to commercialize AzaSite ourselves, we may expend significant resources as we currently have no sales, marketing or distribution capabilities or experience, and have no current plans to establish any such resources, which could harm our financial condition and results of operation.

If we are unsuccessful in finding a new third party collaborator for AzaSite or elect not to pursue commercialization efforts ourselves, the Interim Sublicense will terminate and our subsidiary will retain all rights to the intellectual property with respect to AzaSite in the related country or countries in which the Inspire Agreement was terminated. If the Interim Sublicense terminates in accordance with the Residual License Agreement, our subsidiary may grant a sublicense under the license granted under the Residual License Agreement or pursue commercialization efforts itself. In any such circumstances, our subsidiary will remit for payment on the AzaSite Notes any royalties and other payments arising from the exercise of the license under the Residual License Agreement. As all economic value arising from the intellectual property subject to the Inspire Agreement shall remain with our subsidiary (whether or not the Inspire Agreement remains in effect and whether or not our subsidiary continues to be owned by us or our equity in the subsidiary is foreclosed upon by the Noteholders), while the AzaSite Notes are outstanding and following repayment thereof, we may never receive any future royalties or economic benefit from AzaSite and may lose rights to the intellectual property relating thereto.

We rely on a sole source for the supply of the active pharmaceutical ingredient for AzaSite.
 
We currently have a single supplier for azithromycin, the active drug incorporated into AzaSite. Under the Inspire License Agreement and the Inspire Supply Agreement, we have agreed to provide a supply of azithromycin to Inspire for the manufacture of AzaSite in the Territory, which we currently arrange through one supplier. The supplier of azithromycin has a drug master file on the compound with the FDA and is subject to the FDA’s review and oversight. The supplier’s manufacturing facility is subject to potential natural disasters, including earthquakes, hurricanes, tornadoes, floods, fires or explosions, and other interruptions in operation due to factors including labor unrest or strikes, failures of utility services or microbial or other contamination. If the supplier failed or refused to continue to supply us, if the FDA were to identify issues in the production of azithromycin that the supplier was unable to resolve quickly and cost-effectively, or if other issues were to arise that impact production, Inspire’s ability to manufacture and commercialize AzaSite could be interrupted, and our subsidiary’s ability to pay amounts due on the AzaSite Notes may be materially harmed, which could prevent or delay our ability to receive future revenue from AzaSite. Additional suppliers for azithromycin exist, but qualification of an alternative source could be time consuming and expensive and, during such qualification process, could negatively impact the sales of AzaSite. There is also no guarantee that these additional suppliers can supply sufficient quantities or quality product at a reasonable price, or at all. While we are required to maintain a certain level of inventory of azithromycin to support Inspire’s manufacturing needs, this amount may not be sufficient to prevent an interruption in the availability of AzaSite.

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In addition, certain of the raw materials that we use in formulating DuraSite, the drug delivery system used in AzaSite, are available only from Lubrizol Advanced Materials, Inc., or Lubrizol. Although we do not have a current supply agreement with Lubrizol, we have not encountered any difficulties obtaining necessary materials from Lubrizol. Any significant interruption in the supply of these raw materials could delay sales of AzaSite, which could then harm our subsidiary’s ability to pay amounts due on the AzaSite Notes and affect our ability to receive future revenue from AzaSite.
 
We have experienced senior management departures, which could harm our ability to attract and retain key employees.
 
Dr. S. Kumar Chandrasekaran, our former chief executive officer and president, concluded his employment with us in October 2008 and Louis Drapeau, our vice president and chief financial officer, was appointed to succeed him in the position of interim chief executive officer. The new Board of Directors elected September 23, 2008 has commenced a search for a new chief executive officer. There is no guarantee that they will be successful. Although Mr. Drapeau is an experienced pharmaceutical executive and can manage the Company ably while the search proceeds, there is no guarantee that Mr. Drapeau will remain at the company until a new chief executive officer can be recruited. We are currently highly dependent on Mr. Drapeau, and the loss of Mr. Drapeau’s services prior to the recruitment of a new chief executive officer might significantly delay or prevent the achievement of planned development objectives. Furthermore, the changes in the composition of our Board of Directors and chief executive officer may cause us to lose additional employees and may harm the ability of our senior management team to coalesce, motivate our employees and address challenges faced by our Company. We are also highly dependent on Dr. Lyle Bowman, our vice president, development. We do not carry a life insurance policy on Mr. Drapeau or on Dr. Bowman.
 
A critical factor to our success will be recruiting and retaining additional qualified personnel, particularly due to the changes that might occur as the result of our new Board of Directors and change in our chief executive officer. Competition for skilled individuals in the biotechnology business, particularly in the San Francisco Bay Area is highly intense, and we may not be able to continue to attract and retain personnel necessary for the development of our business. Our ability to attract and retain such individuals may be reduced by our current financial situation and the challenges faced by our Company The loss of key personnel, the failure to recruit additional personnel, particularly a new chief executive officer, or to develop needed expertise would harm our business.
 
We may not successfully manage growth.
 
Our success will depend upon the expansion of our operations and the effective management of our growth, which will place a significant strain on our management and on our administrative, operational and financial resources. To manage this growth, we will have to expand our facilities, augment our operational, financial and management systems and hire and train additional qualified personnel, all of which will cause us to incur significant additional expense and may not be accomplished effectively. If we are unable to manage our growth effectively, our business would be harmed.
 
Our products are subject to government regulations and approvals which may delay or prevent the marketing of potential products and impose costly procedures upon our activities.
 
The FDA and comparable agencies in state and local jurisdictions and in foreign countries impose substantial requirements upon preclinical and clinical testing, manufacturing and marketing of pharmaceutical products. Lengthy and detailed preclinical and clinical testing, validation of manufacturing and quality control processes, and other costly and time-consuming procedures are required. Satisfaction of these requirements typically takes several years and the time needed to satisfy them may vary substantially, based on the type, complexity and novelty of the pharmaceutical product. The effect of government regulation may be to delay or to prevent marketing of potential products for a considerable period of time and to impose costly procedures upon our activities. The FDA or any other regulatory agency may not grant approval on a timely basis, or at all, for any products we develop. Success in preclinical or early stage clinical trials does not assure success in later stage clinical trials. Data obtained from preclinical and clinical activities are susceptible to varying interpretations that could delay, limit or prevent regulatory approval. If regulatory approval of a product is granted, such approval may impose limitations on the indicated uses for which a product may be marketed. Further, even after we have obtained regulatory approval, later discovery of previously unknown problems with a product may result in restrictions on the product, including withdrawal of the product from the market. Moreover, the FDA has recently reduced previous restrictions on the marketing, sale and prescription of products for indications other than those specifically approved by the FDA. Accordingly, even if we receive FDA approval of a product for certain indicated uses, our competitors, including our collaborators, could market products for such indications even if such products have not been specifically approved for such indications. If the FDA determines regulatory approval is required any delay in obtaining or failure to obtain regulatory approvals would make it difficult or impossible to market our products and would harm our business, prospects, financial condition, and results of operations.

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The FDA’s policies may change and additional government regulations may be promulgated which could prevent or delay regulatory approval of our potential products. Moreover, increased attention to the containment of health care costs in the United States could result in new government regulations that could harm our business. Adverse governmental regulation might arise from future legislative or administrative action, either in the United States or abroad. See “Uncertainties regarding healthcare reform and third-party reimbursement may impair our ability to raise capital, form collaborations and sell our products.”
 
We have no experience in commercial manufacturing and if contract manufacturing is not available to us or does not satisfy regulatory requirements, we will have to establish our own regulatory compliant manufacturing capability and may not have the financial resources to do so.
 
We have no experience manufacturing products for Phase 3 and commercial purposes at our own facility. We have a pilot facility licensed by the State of California to manufacture a number of our products for Phase 1 and Phase 2 clinical trials but not for late stage clinical trials or commercial purposes. Any delays or difficulties that we may encounter in establishing and maintaining a relationship with qualified manufacturers to produce, package and distribute our finished products may harm our clinical trials, regulatory filings, market introduction and subsequent sales of our products.
 
Contract manufacturers must adhere to current Good Manufacturing Practices regulations that are strictly enforced by the FDA on an ongoing basis through the FDA’s facilities inspection program. Contract manufacturing facilities must pass a pre-approval plant inspection before the FDA will approve a new drug application. Some of the material manufacturing changes that occur after approval are also subject to FDA review and clearance or approval. While the FDA has approved the AzaSite manufacturing process and facility, the FDA or other regulatory agencies may not approve the process or the facilities by which any of our other products may be manufactured. Our dependence on third parties to manufacture our products may harm our ability to develop and deliver products on a timely and competitive basis. Should we be required to manufacture products ourselves, we:
 
 
§
will be required to expend significant amounts of capital to install a manufacturing capability;
 
 
§
will be subject to the regulatory requirements described above;
 
 
§
will be subject to similar risks regarding delays or difficulties encountered in manufacturing any such products; and
 
 
§
will require substantially more additional capital than we otherwise may require.
 
Therefore, we may not be able to manufacture any products successfully or in a cost-effective manner.
 
We compete in highly competitive markets and our competitors’ financial, technical, marketing, manufacturing and human resources may surpass ours and limit our ability to develop and/or market our products and technologies.
 
Our success depends upon developing and maintaining a competitive advantage in the development of products and technologies in our areas of focus. We have many competitors in the United States and abroad, including pharmaceutical, biotechnology and other companies with varying resources and degrees of concentration in the ophthalmic market. Our competitors may have existing products or products under development which may be technically superior to ours or which may be less costly or more acceptable to the market. Our competitors may obtain cost advantages, patent protection or other intellectual property rights that would block or limit our ability to develop our potential products. Competition from these companies is intense and is expected to increase as new products enter the market and new technologies become available. Many of our competitors have substantially greater financial, technical, marketing, manufacturing and human resources than we do, particularly in light of our current financial condition. In addition, they may succeed in developing technologies and products that are more effective, safer, less expensive or otherwise more commercially acceptable than any that we have or will develop. Our competitors may also obtain regulatory approval for commercialization of their products more effectively or rapidly than we will. If we decide to manufacture and market our products by ourselves, we will be competing in areas in which we have limited or no experience such as manufacturing efficiency and marketing capabilities.

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If we cannot compete successfully for market share against other drug companies, we may not achieve sufficient product revenues and our business will suffer.
 
The market for our product candidates is characterized by intense competition and rapid technological advances. If our product candidates receive FDA approval, they will compete with a number of existing and future drugs and therapies developed, manufactured and marketed by others. Existing or future competing products may provide greater therapeutic convenience or clinical or other benefits for a specific indication than our products, or may offer comparable performance at a lower cost. If our products fail to capture and maintain market share, we may not achieve sufficient product revenues and our business will be harmed.
 
We will compete against fully integrated pharmaceutical companies and smaller companies that are collaborating with larger pharmaceutical companies, academic institutions, government agencies and other public and private research organizations. Many of these competitors have products competitive with AzaSite already approved or in development, including Zymar and Ocuflox by Allergan, Vigamox and Ciloxan by Alcon, and Quixin by Johnson & Johnson. In addition, many of these competitors, either alone or together with their collaborative partners, operate larger research and development programs and have substantially greater financial resources than we do, as well as significantly greater experience in:
 
 
§
developing drugs;
 
 
§
undertaking pre-clinical testing and human clinical trials;
 
 
§
obtaining FDA and other regulatory approvals of drugs;
 
 
§
formulating and manufacturing drugs;
 
 
§
launching, marketing and selling drugs; and
 
 
§
attracting qualified personnel, parties for acquisitions, joint ventures or other collaborations.
 
Uncertainties regarding healthcare reform and third-party reimbursement may impair our ability to raise capital, form collaborations and sell our products.
 
The continuing efforts of governmental and third-party payers to contain or reduce the costs of healthcare through various means may harm our business. For example, in some foreign markets the pricing or profitability of health care products is subject to government control. In the United States, there have been, and we expect there will continue to be, a number of federal and state proposals to implement similar government control. The implementation or even the announcement of any of these legislative or regulatory proposals or reforms could harm our business by reducing the prices we or our partners are able to charge for our products impeding our ability to achieve profitability, raise capital or form collaborations. In addition, the availability of reimbursement from third-party payers determines, in large part, the demand for healthcare products in the United States and elsewhere. Examples of such third-party payers are government and private insurance plans. Significant uncertainty exists as to the reimbursement status of newly approved healthcare products, and third-party payers are increasingly challenging the prices charged for medical products and services. If we succeed in bringing one or more products to the market, reimbursement from third-party payers may not be available or may not be sufficient to allow us to sell our products on a competitive or profitable basis.

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Our insurance coverage may not adequately cover our potential product liability exposure.
 
We are exposed to potential product liability risks inherent in the development, testing, manufacturing, marketing and sale of human therapeutic products. Product liability insurance for the pharmaceutical industry is expensive. Although we believe our current insurance coverage is adequate to cover likely claims we may encounter given our current stage of development and activities, our present product liability insurance coverage will not be adequate to cover all potential claims we may encounter, particularly as AzaSite is commercialized outside the United States and Canada. Once AzaSite is commercialized in other countries, we may have to increase our coverage, which will be expensive and we may not be able to obtain or afford adequate insurance coverage against potential claims in sufficient amounts or at a reasonable cost.
 
Our use of hazardous materials may pose environmental risks and liabilities which may cause us to incur significant costs.
 
Our research, development and manufacturing processes involve the controlled use of small amounts of hazardous solvents used in pharmaceutical development and manufacturing, including acetic acid, acetone, acrylic acid, calcium chloride, chloroform, dimethyl sulfoxide, ethyl alcohol, hydrogen chloride, nitric acid, phosphoric acid and other similar solvents. We retain a licensed outside contractor that specializes in the disposal of hazardous materials used in the biotechnology industry to properly dispose of these materials, but we cannot completely eliminate the risk of accidental contamination or injury from these materials. Our cost for the disposal services rendered by our outside contractor was approximately $13,400 and $11,800 for the years ended 2007 and 2006, respectively. In the event of an accident involving these materials, we could be held liable for any damages that result, and any such liability could exceed our resources. Moreover, as our business develops we may be required to incur significant costs to comply with federal, state and local environmental laws, regulations and policies, especially to the extent that we manufacture our own products.
 
If we engage in acquisitions, we will incur a variety of costs, and the anticipated benefits of the acquisitions may never be realized.
 
We may pursue acquisitions of companies, product lines, technologies or businesses that our management believes are complementary or otherwise beneficial to us. Any of these acquisitions could have a negative effect on our business. Future acquisitions may result in substantial dilution to our stockholders, the expenditure of our current cash resources, the incurrence of additional debt and amortization expenses related to goodwill, research and development and other intangible assets. In addition, acquisitions would involve many risks for us, including:
 
 
§
assimilating employees, operations, technologies and products from the acquired companies with our existing employees, operations, technologies and products;
 
 
§
diverting our management’s attention from day-to-day operation of our business;
 
 
§
entering markets in which we have no or limited direct experience; and
 
 
§
potentially losing key employees from the acquired companies.
 
If we fail to adequately manage these risks we may not achieve the intended benefits from our acquisitions.
 
Management and principal stockholders may be able to exert significant control on matters requiring approval by our stockholders.
 
As of September 30, 2008, our management and principal stockholders (those owning more than 5% of our outstanding shares) together beneficially owned approximately 34% of shares of common stock. In addition, investors in our March/June 2004 and May 2005 private placements, as a group, owned approximately 13% of our outstanding shares of common stock as of September 30, 2008. If such investors were to exercise the warrants they currently hold, assuming no additional acquisitions, sales or distributions, such investors would own approximately 23% of our outstanding shares of common stock based on their ownership percentages as of September 30, 2008. As a result, these two groups of stockholders, acting together or as individual groups, may be able to exert significant control on matters requiring approval by our stockholders, including the election of all or at least a majority of our Board of Directors, amendments to our charter, and the approval of business combinations and certain financing transactions. A group of our stockholders recently prevailed in a proxy contest that resulted in the replacement of all members of our Board of Directors.

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Our business could be negatively affected as a result of the election of a new Board of Directors following a proxy contest.

As a result of a proxy contest led by Pinto Technology Ventures, L.P., a new slate of directors was elected at our annual meeting on September 22, 2008. The new Board of Directors has initiated a search for a new chief executive officer. There is a risk that the new board may not be able to recruit an appropriate chief executive officer. Although Mr. Drapeau is an experienced pharmaceutical executive and can manage the Company ably while the search proceeds, there is no guarantee that Mr. Drapeau will remain at the company until a new chief executive officer can be recruited. Further, we incurred substantial costs associated with the proxy contest, the proxy contest was disruptive to our operations and perceived uncertainties as to our future direction may result in the loss of potential acquisitions, collaborations or other opportunities, and may make it more difficult to attract and retain qualified personnel and business partners.

The market prices for securities of biopharmaceutical and biotechnology companies such as ours have been and are likely to continue to be highly volatile due to reasons that are related and unrelated to our operating performance and progress.
 
The market prices for securities of biopharmaceutical and biotechnology companies, including ours, have been highly volatile. The market has from time to time experienced significant price and volume fluctuations that are unrelated to the operating performance of particular companies. In addition, future announcements and circumstances, the status of our relationships or proposed relationships with third-party collaborators, the results of testing and clinical trials, the exercise of outstanding options and warrants that could result in dilution to our current holders of common stock, developments in patent or other proprietary rights of us or our competitors, our or Inspire’s failure to meet analyst expectations, any litigation regarding the same, technological innovations or new therapeutic products, governmental regulation, or public concern as to the safety of products developed by us or others and general market conditions, concerning us, our competitors or other biopharmaceutical companies, may have a significant effect on the market price of our common stock. For example, in the twelve months ended September 30, 2008, our closing stock price fluctuated from a high of $1.32 to a low of $0.43. Such fluctuations can lead to securities class action litigation. Securities litigation against us could result in substantial costs and a diversion of our management’s attention and resources, which could have an adverse effect on our business.
 
We have not paid any cash dividends on our common stock, and we do not anticipate paying any dividends on our common stock in the foreseeable future.
 
We have adopted and are subject to anti-takeover provisions that could delay or prevent an acquisition of our Company and could prevent or make it more difficult to replace or remove current management.
 
Provisions of our certificate of incorporation and bylaws may constrain or discourage a third party from acquiring or attempting to acquire control of us. Such provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. In addition, such provisions could also prevent or make it more difficult for our stockholders to replace or remove current management and could adversely affect the price of our common stock if they are viewed as discouraging takeover attempts, business combinations or management changes that stockholders consider in their best interest. Our Board of Directors has the authority to issue up to 5,000,000 shares of preferred stock, or Preferred Stock. Our Board of Directors has the authority to determine the price, rights, preferences, privileges and restrictions, including voting rights, of the remaining unissued shares of Preferred Stock without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any Preferred Stock that may be issued in the future. The issuance of Preferred Stock, while providing desirable flexibility in connection with possible financings, acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock, even if the transaction might be desired by our stockholders. Provisions of Delaware law applicable to us could also delay or make more difficult a merger, tender offer or proxy contest involving us, including Section 203 of the Delaware General Corporation Law, which prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years unless conditions set forth in the Delaware General Corporation Law are met. The issuance of Preferred Stock or Section 203 of the Delaware General Corporation Law could also be deemed to benefit incumbent management to the extent these provisions deter offers by persons who would wish to make changes in management or exercise control over management. Other provisions of our certificate of incorporation and bylaws may also have the effect of delaying, deterring or preventing a takeover attempt or management changes that our stockholders might consider in their best interest. For example, our bylaws limit the ability of stockholders to remove directors and fill vacancies on our Board of Directors. Our bylaws also impose advance notice requirements for stockholder proposals and nominations of directors and prohibit stockholders from calling special meetings or acting by written consent.

26

If earthquakes and other catastrophic events strike, our business may be negatively affected.
 
Our corporate headquarters, including our research and development and pilot plant operations, are located in the San Francisco Bay area, a region known for seismic activity. A significant natural disaster such as an earthquake would have a material adverse impact on our business, results of operations, and financial condition. If we were able to schedule use of the equipment at our contract manufacturing site we could conduct our pilot plant operations however, we would incur significant additional costs and delays in our product development time-lines.

We face the risk of a decrease in our cash balances and losses in our investment portfolio .

Our investment policy is structured to limit credit risk and manage interest rate risk. By policy, we only invest in what we view as very high quality debt securities, such as U.S. Government securities. However, the recent uncertainties in the credit markets could prevent us from liquidating our positions in securities that we currently believe constitute high quality investments and could also result in the loss of some or all of our principal if the issuer of such securities defaults on its credit obligations.  Following completion of our $60.0 million financing on February 21, 2008, investment income will likely become a more substantial component of our net income. The ability to achieve our investment objectives is affected by many factors, some of which are beyond our control. Our interest income will be affected by changes in interest rates, which are highly sensitive to many factors, including governmental monetary policies and domestic and international economic and political conditions.   The outlook for our investment income is dependent on the future direction of interest rates and the amount of cash flows from operations, if any, that are available for investment. Any significant decline in our investment income or the value of our investments as a result of falling interest rates, deterioration in the credit of the securities in which we have invested, or general market conditions, could harm our ability to liquidate our investments, our cash position and our net income.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

None.

Item 3. Defaults Upon Senior Securities.

None.

Item 4. Submission of Matters to a Vote of Security Holders .

The following matters were voted upon at the Annual Meeting of Stockholders held on September 22, 2008, and received the votes set forth below:

(1)   The election of Rick D. Anderson, Timothy P. Lynch, Timothy McInerney, Evan S. Melrose, M.D., Robert O’Holla and Anthony J. Yost to our Board of Directors to serve until the next annual meeting or until their successors are elected and qualified. The following directors received the number of votes set opposite their respective names:

27
 
Name
 
For
 
Withheld
 
               
S. Kumar Chandrasekaran, Ph.D.
   
20,807,479
   
1,560,920
 
Francis Chen, PH.D.
   
21,594,967
   
912,932
 
Mitchell H. Friedlaender, M.D.
   
21,999,412
   
508,487
 
John L. Mattana
   
19,184,797
   
3,183,602
 
Jon S. Saxe
   
21,570,918
   
936,981
 
Anders P. Wiklund
   
21,534,010
   
973,889
 
               
Rick D. Anderson
   
41,037,602
   
342,218
 
Timothy P. Lynch
   
39,144,880
   
2,095,440
 
Timothy McInerney
   
39,428,302
   
1,812,018
 
Evan S. Melrose, M.D.
   
40,498,124
   
881,696
 
Robert O'Holla
   
40,277,690
   
962,630
 
Anthony J. Yost
   
39,435,380
   
1,804,940
 

(2) The ratification of our audit committee’s appointment of Burr, Pilger & Mayer LLP as our independent public accountants for the fiscal year ending December 31, 2008. Such proposal received 62,611,832 votes for ratification, 650,512 votes against ratification and 346,375 abstentions.  
 
Item 5. Other Information.

None.

Item 6. Exhibits.

The exhibits listed on the Exhibit Index (following the signature page of this Quarterly Report) are included or incorporated by reference, in this Quarterly Report.

28

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 
INSITE VISION INCORPORATED
     
Dated: November 7, 2008
by:
/s/ Louis C. Drapeau
     
  Louis C. Drapeau
  Chief Financial Officer
  (Principal Financial Officer)

29

EXHIBIT INDEX

Number
 
Exhibit Table
     
3.1 1
 
Restated Certificate of Incorporation.
3.2 2
 
Certificate of Designations, Preferences and Rights of Series A Convertible Preferred Stock as filed with the Delaware Secretary of State on September 11, 1997.
3.3 2
 
Certificate of Correction of the Certificate of Designations, Preferences and Rights of Series A Convertible Preferred Stock as filed with the Delaware Secretary of State on September 26, 1997.
3.4 3
 
Certificate of Designations, Preferences and Rights of Series A-1 Preferred Stock as filed with the Delaware Secretary of State on July 3, 2002.
3.5 4
 
Certificate of Amendment to Restated Certificate of Incorporation as filed with the Delaware Secretary of State on June 3, 1994.
3.6 5
 
Amended and Restated Bylaws.
3.7 6
 
Certificate of Amendment to Restated Certificate of Incorporation as filed with the Delaware Secretary of State on July 20, 2000.
3.8 6
 
Certificate of Amendment to Restated Certificate of Incorporation as filed with the Delaware Secretary of State on June 1, 2004.
3.9 7
 
Certificate of Amendment to Restated Certificate of Incorporation as filed with the Delaware Secretary of State on October 23, 2006.
4.1
 
Reference is made to Exhibits 3.1 through 3.9.
31.1*
 
Certificate of Interim Chief Executive Officer and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1*
 
Certification of Interim Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
* Filed herewith.
 
1
Incorporated by reference to an exhibit in the Company's Annual Report on Form 10-K for the year ended December 31, 1993.
   
2
Incorporated by reference to exhibits in the Company's Registration Statement on Form S-3 (Registration No. 333-36673) as filed with the Securities and Exchange Commission on September 29, 1997.
   
3
Incorporated by reference to an exhibit in Amendment No. 1 the Company's Registration Statement on Form S-1 (Registration No. 33-68024) as filed with the Securities and Exchange Commission on September 16, 1993.
   
4
Incorporated by reference to an exhibit to the Company’s Registration Statement on Form S-3 (File Number 333-126084) as filed with the Securities and Exchange Commission on June 23, 2005.
   
5
Incorporated by reference to an exhibit in the Company's Current Report on Form 8-K as filed with the Security and Exchange Commission on June 6, 2008.
   
6
Incorporated by reference to an exhibit in the Company's Annual Report on Form 10-K for the year ended December 31, 2006.
   
7
Incorporated by reference to an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2006.
   
8
Incorporated by reference to an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2008.

30
 
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