10-Q

UNITED STATES

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 June 30, 2007

OR

¨ 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: 000-31135

INSPIRE PHARMACEUTICALS, INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware	04-3209022
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification No.)

4222 Emperor Boulevard, Suite 200 Durham, North Carolina	27703
(Address of Principal Executive Offices)	(Zip Code)

Registrant’s Telephone Number, Including Area Code: (919) 941-9777

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES  x    NO  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one)

Large Accelerated Filer   ¨    Accelerated Filer   x    Non-Accelerated Filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

YES  ¨    NO  x

As of June 30, 2007, there were 42,408,120 shares of Inspire Pharmaceuticals, Inc. common stock outstanding.

TABLE OF CONTENTS

		Page
PART I: FINANCIAL INFORMATION
Item 1.	Financial Statements (unaudited)	3
Condensed Balance Sheets – June 30, 2007 and December 31, 2006		3
Condensed Statements of Operations – Three and Six months ended June 30, 2007 and 2006		4
Condensed Statements of Cash Flows – Three and Six months ended June 30, 2007 and 2006		5
Notes to Condensed Financial Statements		6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	42
Item 4.	Controls and Procedures	42
PART II: OTHER INFORMATION
Item 1.	Legal Proceedings	44
Item 1A.	Risk Factors	45
Item 4.	Submission of Matters to a Vote of Security Holders	69
Item 6.	Exhibits	70
Signatures		71

2

PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

INSPIRE PHARMACEUTICALS, INC.

Condensed Balance Sheets

(in thousands, except per share amounts)

(Unaudited)

	June 30, 2007			December 31, 2006
Assets
Current assets:
Cash and cash equivalents	$	38,183		$	50,190
Investments		19,939			45,377
Receivables from Allergan		12,637			8,245
Prepaid expenses and other receivables		4,393			3,530
Inventories		1,094			—
Other assets		581			404
Total current assets		76,827			107,746
Property and equipment, net		2,454			1,754
Investments		10,508			6,714
Intangibles, net		18,734			—
Other assets		540			485
Total assets	$	109,063		$	116,699
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	6,564		$	6,297
Accrued expenses		11,085			8,359
Short-term debt and capital leases		8,309			3,435
Total current liabilities		25,958			18,091
Capital leases – noncurrent		57			267
Long-term debt		32,275			17,655
Other long-term liabilities		2,995			2,315
Total liabilities		61,285			38,328
Commitments and contingencies (See Note 7)
Stockholders’ equity: (See Note 8)
Preferred stock, $0.001 par value, 2,000 shares authorized; no shares issued and outstanding		—			—
Common stock, $0.001 par value, 100,000 shares authorized; 42,408 and 42,238 shares issued and outstanding, respectively		42			42
Additional paid-in capital		324,947			323,606
Accumulated other comprehensive loss		(94	)		(152	)
Accumulated deficit		(277,117	)		(245,125	)
Total stockholders’ equity		47,778			78,371
Total liabilities and stockholders’ equity	$	109,063		$	116,699

The accompanying notes are an integral part of these condensed financial statements.

3

INSPIRE PHARMACEUTICALS, INC.

Condensed Statements of Operations

(in thousands, except per share amounts)

(Unaudited)

	Three Months Ended						Six Months Ended
	June 30, 2007			June 30, 2006			June 30, 2007			June 30, 2006
Revenues:
Product co-promotion	$	15,361		$	13,437		$	22,565		$	17,655
Collaborative research and development		—			—			—			1,250
Total revenue		15,361			13,437			22,565			18,905
Operating expenses:
Research and development		7,975			9,173			30,740			18,282
Selling and marketing		10,347			6,457			17,868			13,553
General and administrative		3,127			4,334			6,766			8,780
Total operating expenses		21,449			19,964			55,374			40,615
Loss from operations		(6,088	)		(6,527	)		(32,809	)		(21,710	)
Other income (expense):
Interest income		827			1,185			1,888			2,393
Interest expense		(590	)		(28	)		(1,045	)		(58	)
Loss on investments		(26	)		(7	)		(26	)		(29	)
Other income, net		211			1,150			817			2,306
Net loss	$	(5,877	)	$	(5,377	)	$	(31,992	)	$	(19,404	)
Basic and diluted net loss per common share	$	(0.14	)	$	(0.13	)	$	(0.76	)	$	(0.46	)
Weighted average common shares used in computing basic and diluted net loss per common share		42,404			42,220			42,339			42,216

The accompanying notes are an integral part of these condensed financial statements.

4

INSPIRE PHARMACEUTICALS, INC.

Condensed Statements of Cash Flows

(in thousands)

(Unaudited)

	Six Months Ended
	June 30, 2007			June 30, 2006
Cash flows from operating activities:
Net loss	$	(31,992	)	$	(19,404	)
Adjustments to reconcile net loss to net cash used in operating activities:
Amortization expense		484			103
Depreciation of property and equipment		418			598
Loss on disposal of property and equipment		—			3
Loss on investments		26			29
Stock-based compensation expense		1,088			703
Changes in operating assets and liabilities:
Receivables from Allergan		(4,392	)		(6,397	)
Prepaid expenses and other receivables		(863	)		601
Inventories		(1,094	)		—
Other assets		—			(5	)
Accounts payable		267			943
Accrued expenses and other liabilities		3,006			603
Net cash used in operating activities		(33,052	)		(22,223	)
Cash flows from investing activities:
Purchase of investments		(19,237	)		(41,234	)
Proceeds from sale of investments		40,913			37,464
AzaSite milestone payment		(19,000	)		—
Purchase of property and equipment		(1,118	)		(633	)
Proceeds from sale of property and equipment		—			1
Net cash provided by (used in) investing activities		1,558			(4,402	)
Cash flows from financing activities:
Proceeds from long-term debt		20,000			—
Issuance of common stock, net		253			70
Debt issuance cost		(50	)		—
Payments on notes payable and capital lease obligations		(716	)		(262	)
Net cash used in financing activities		19,487			(192	)
Decrease in cash and cash equivalents		(12,007	)		(26,817	)
Cash and cash equivalents, beginning of period		50,190			65,018
Cash and cash equivalents, end of period	$	38,183		$	38,201

The accompanying notes are an integral part of these condensed financial statements.

5

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

1. Organization

Inspire Pharmaceuticals, Inc. (the “Company” or “Inspire”) was incorporated in October 1993 and commenced operations in March 1995. Inspire is located in Durham, North Carolina, adjacent to the Research Triangle Park.

Inspire has incurred losses and negative cash flows from operations since inception. The Company expects it has sufficient liquidity to continue its planned operations through 2008. The Company’s liquidity needs will largely be determined by key development and regulatory events. In order to continue its operations substantially beyond 2008 it will need to: (1) successfully commercialize AzaSite^TM (azithromycin ophthalmic solution) 1%, (2) obtain product candidate approvals, which would trigger milestone payments to the Company, (3) out-license rights to certain of its product candidates, pursuant to which the Company would receive income, (4) raise additional capital through equity or debt financings or from other sources, and/or (5) reduce expenditures and spending on one or more research and development programs. The Company currently receives revenue from its co-promotion of Elestat^® (epinastine HCl ophthalmic solution) 0.05% and Restasis^® (cyclosporine ophthalmic emulsion) 0.05%, and will begin to receive product revenue from sales of AzaSite when it launches the product. The Company will continue to incur operating losses until co-promotion and product revenues reach a level sufficient to support ongoing operations. Elestat and Restasis are trademarks owned by Allergan, Inc. (“Allergan”). AzaSite is a trademark owned by InSite Vision Incorporated (“InSite Vision”).

2. Basis of Presentation

The accompanying unaudited Condensed Financial Statements have been prepared in accordance with generally accepted accounting principles in the United States of America and applicable Securities and Exchange Commission (“SEC”) regulations for interim financial information. These financial statements do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. It is presumed that users of this interim financial information have read or have access to the audited financial statements from the preceding fiscal year contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair statement of the Company’s financial position and operations for the interim periods presented have been made. Operating results for the interim periods presented are not indicative of the results that may be expected for the full year.

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results will differ from those estimates.

Net Loss Per Common Share

Basic net loss per common share is computed by dividing net loss by the weighted average number of common shares outstanding. Diluted net loss per common share is computed by dividing net loss by the weighted average number of common shares outstanding and dilutive potential common shares then outstanding. Dilutive potential common shares consist of shares issuable upon the exercise of stock options and restricted stock units that are paid in shares of the Company’s stock upon conversion. The calculation of diluted earnings per share for the three months ended June 30, 2007 and 2006 does not include 453 and 449, respectively, and for the six months ended June 30, 2007 and 2006 does not include 502 and 455, respectively, of potential common shares, as their impact would be antidilutive.

6

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

Stock-Based Compensation

Effective January 1, 2006, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”), using the modified prospective transition method. Under this transition method, stock-based compensation expense for all periods presented includes (i) expense for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”); and (ii) expense for all share-based payments granted after January 1, 2006 is based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). The Company recognizes these compensation costs net of an expected forfeiture rate and recognizes the compensation costs on a straight-line basis for only those shares expected to vest over the requisite service period of the award, which is generally three to five years. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB No. 107”) regarding the SEC’s interpretation of SFAS No. 123(R) and the valuation of share-based payments for public companies. The Company has applied the provisions of SAB No. 107 in its adoption of SFAS No. 123(R). See Note 5 to the accompanying Condensed Financial Statements for a further discussion on stock-based compensation.

Risks from Third Party Manufacturing and Distribution Concentration

The Company relies on single source manufacturers for its commercial products and product candidates. Allergan is responsible for the manufacturing of both Elestat and Restasis and relies on single source manufacturers for the active pharmaceutical ingredients in both products, which are co-promoted by the Company. The Company relies on InSite Vision for supply of the active pharmaceutical ingredient for AzaSite which InSite Vision obtains from a single source manufacturer; however, the Company is responsible for the manufacture of AzaSite which is manufactured by a single source manufacturer. Additionally, the Company relies upon a single third party to provide distribution services for AzaSite. Accordingly, delays in the manufacture or distribution of any product or manufacture of any product candidate could adversely impact the marketing of the Company’s products or the development of the Company’s product candidates. Furthermore, the Company has no control over the manufacture, nor the overall product supply chain, of Elestat and Restasis products for which it is entitled to receive revenue.

Intangible Assets

Costs associated with obtaining and maintaining patents on the Company’s product candidates and license initiation and preservation fees, including milestone payments by the Company to its licensors, are evaluated based on the stage of development of the related product candidate and whether the underlying product candidate has an alternative use. Costs of these types incurred for product candidates not yet approved by the U.S. Food and Drug Administration (“FDA”) and for which no alternative future use exists are recorded as expense. In the event a product candidate has been approved by the FDA or an alternative future use exists for a product candidate, patent and license costs are capitalized and amortized over the expected life of the related product candidate. Milestone payments to the Company’s collaborators are recognized when the underlying requirement is met.

Upon FDA approval of AzaSite, the Company paid a $19,000 milestone as required by the license agreement entered into with InSite Vision in February 2007. The $19,000 is being amortized ratably on a straight-line basis through the term of the underlying patent coverage for AzaSite, which represents the expected period of commercial exclusivity ending in March 2019. As of June 30, 2007, the Company had $266 in accumulated amortization.

7

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

Inventories

The Company’s inventories are valued at the lower of cost or market using the first-in, first-out (i.e., FIFO) method. Cost includes materials, labor, overhead, shipping and handling costs. The Company’s inventories are subject to expiration dating. As of June 30, 2007, the Company’s inventories consisted of the following:

Raw Materials	$	390
Work-in-Process		704
Total Inventories	$	1,094

Significant Customers and Risk

All co-promotion revenues recognized and recorded for each of the six months ended June 30, 2007 and 2006, were from one collaborative partner. The Company is entitled to receive co-promotion revenue from net sales of Elestat and Restasis under the terms of its collaborative agreements with Allergan, and accordingly, all trade receivables are concentrated with Allergan. Due to the nature of these agreements, Allergan has significant influence over the commercial success of these products.

Revenue Recognition

The Company records all its revenue from product co-promotion activities and collaborative research agreements in accordance with Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements.”

Product Co-promotion Revenues

The Company recognizes co-promotion revenue based on net sales for Elestat and Restasis, as defined in the co-promotion agreements, and as reported to Inspire by Allergan. The Company actively promotes both Elestat and Restasis through its commercial organization and shares in any risk of loss due to returns and other allowances, as determined by Allergan. Accordingly, the Company’s co-promotion revenues are based upon Allergan’s revenue recognition policy and other accounting policies over which the Company has limited or no control and on the underlying terms of the co-promotion agreements. Allergan recognizes revenue from product sales when goods are shipped and title and risk of loss transfers to the customer. The co-promotion agreements provide for gross sales to be reduced by estimates of sales returns, credits and allowances, normal trade and cash discounts, managed care sales rebates and other allocated costs as defined in the agreements, all of which are determined by Allergan and are outside the Company’s control. The Company records a percentage of Allergan’s net sales for both Elestat and Restasis, reported to Inspire by Allergan, as co-promotion revenue. The Company receives monthly sales information from Allergan and performs analytical reviews and trend analyses using prescription information that it receives from IMS Health, an independent provider of pharmaceutical data. In addition, the Company exercises its audit rights under the contractual agreements with Allergan to annually perform an examination of Allergan’s sales records of both Elestat and Restasis. The Company makes no adjustments to the amounts reported to it by Allergan other than reductions in net sales to reflect the incentive programs managed by the Company. The Company offers and manages certain incentive programs associated with Elestat, which are utilized by it in addition to those programs managed by Allergan. The Company reduces revenue by estimating the portion of Allergan’s sales that are subject to these incentive programs based on information reported to it by a third-party administrator of the incentive program. For fiscal years 2006, 2005 and 2004, the amount of rebates associated with the Company’s incentive programs in each year was less than one-half of one percent of co-promotion revenues. The rebates associated with the programs that

8

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

the Company manages represent an insignificant amount, as compared to the rebate and discount programs administered by Allergan and as compared to the Company’s aggregate co-promotion revenue. Under the co-promotion agreement for Elestat, the Company is obligated to meet predetermined minimum calendar year net sales target levels. If the annual minimum is not satisfied, the Company records revenues using a reduced percentage of net sales based upon its level of achievement of predetermined calendar year net sales target levels. Amounts receivable from Allergan in excess of recorded co-promotion revenue are recorded as deferred revenue. The Company achieved its annual 2007 net sales target level during the three-month period ended June 30, 2007.

Collaborative Research and Development Revenues

The Company recognizes revenue under its collaborative research and development agreements when it has performed services under such agreements or when the Company or its collaborative partner have met a contractual milestone triggering a payment to the Company. The Company recognizes revenue from its research and development service agreements ratably over the estimated service period as related research and development costs are incurred and the services are substantially performed. Upfront non-refundable fees and milestone payments received at the initiation of collaborative agreements for which the Company has an ongoing research and development commitment are deferred and recognized ratably over the period in which the services are substantially performed. This period, if not defined in the collaborative agreement, is based on estimates by the Company’s management and the progress towards agreed upon development events as set forth in the collaborative agreements. These estimates are subject to revision as the Company’s development efforts progress and it gains knowledge regarding required additional development. Revisions in the commitment period are made in the period that the facts related to the change first become known. If the estimated service period is subsequently modified, the period over which the upfront fee or revenue related to ongoing research and development services is modified on a prospective basis. The Company is also entitled to receive milestone payments under its collaborative research and development agreements based upon the achievement of agreed upon development events that are substantively at-risk by its collaborative partners or the Company. This collaborative research revenue is recognized upon the achievement and acknowledgement of the Company’s collaborative partner of a development event, which is generally at the date payment is received from the collaborative partner or is reasonably assured. Accordingly, the Company’s revenue recognized under its collaborative research and development agreements may fluctuate significantly from period to period.

Accumulated Other Comprehensive Loss

Accumulated other comprehensive loss is comprised of unrealized gains and losses on marketable securities and is disclosed as a component of stockholders’ equity. The Company had $94 and $152 of unrealized losses on its investments that are classified as accumulated other comprehensive loss at June 30, 2007 and December 31, 2006, respectively. Comprehensive loss consists of the following components:

	Three Months Ended June 30,						Six Months Ended June 30,
	2007			2006			2007			2006
Net loss	$	(5,877	)	$	(5,377	)	$	(31,992	)	$	(19,404	)
Adjustment for realized losses in net loss		26			7			26			29
Change in unrealized gain/(losses) on investments		(28	)		(15	)		32			(78	)
Total comprehensive loss	$	(5,879	)	$	(5,385	)	$	(31,934	)	$	(19,453	)

9

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

3. Recent Accounting Pronouncements

In June 2007, the Emerging Issues Task Force (“EITF”) of the Financial Accounting Standards Board (“FASB”) reached consensus on Issue No. 07-3, “Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities” (“EITF Issue No. 07-3”). EITF Issue No. 07-3 addresses the issue of when to record nonrefundable advance payments for goods or services that will be used or rendered for research and development activities as expenses. The EITF has concluded that nonrefundable advance payments for future research and development activities should be deferred and recognized as an expense as the goods are delivered or the related services are performed. EITF Issue No. 07-3 is effective for fiscal years beginning after December 15, 2007. The Company has assessed the impact of EITF Issue No. 07-3 and expects no impact to its financial statements upon adoption of this guidance.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115,” (“SFAS No. 159”). SFAS No. 159 permits companies to elect to measure many financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis. Companies electing the fair value option would be required to recognize changes in fair value in earnings. The Company is currently evaluating the impact, if any, of SFAS No. 159 on its financial statements. If elected, SFAS No. 159 would be effective as of January 1, 2008.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” (“SFAS No. 157”). SFAS No. 157 establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within that fiscal year. The Company is currently evaluating the impact of adopting this statement.

4. Debt

In December 2006, the Company entered into a loan and security agreement with two participating financial institutions, which provided a term loan facility to the Company in an aggregate amount of $40,000. Any borrowings under the loan agreement are secured by substantially all of the Company’s assets, with the exception of its intellectual property but including all accounts, license and royalty fees and other revenues and proceeds arising from its intellectual property. In addition, the Company established and maintains its primary depository accounts and security accounts with one of the participating financial institutions and will keep a certain percentage of its cash and investments within these accounts depending upon its total cash and investment balances. An initial term loan advance of $20,000 was made to the Company in December 2006. The Company has subsequently borrowed the remaining $20,000 during the three months ended June 30, 2007.

In June 2007, the Company amended the loan and security agreement with the two participating financial institutions to enable the Company to draw upon a new supplemental term loan facility in the amount $20,000, effectively increasing the total term loan facility to $60,000. This amendment also adjusted the liquidity covenant to establish a lesser requirement level until December 31, 2007, at which time the liquidity requirement will revert back to the ratio established under the original loan and security agreement.

Subsequent borrowings under the new supplemental term loan facility are subject to certain conditions and may be requested by the Company in amounts not less than $1,000 each during the term of the commitment period, which ends on December 31, 2007. The maturity date for all loan advances under the original term loan facility and the supplemental term loan facility is March 2011. Interest accrues on the unpaid principal amount of each loan advance at a per annum rate equal to the five-year U.S Treasury note yield plus a predetermined percentage at the time each advance is made. Repayment of each advance will be made according to a schedule of six monthly installments of interest-only followed by equal monthly installments of principal and interest until the maturity date. During the term of the loan and security agreement, the Company is required to maintain minimum liquidity levels based on the

10

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

balance of the outstanding advances. In addition to maintaining other covenants within the agreement, the Company may not enter into certain transactions such as a merger, acquisition, additional indebtedness or dispose of certain assets of the business as defined in the agreement without written approval of the lenders. The Company has the right to prepay the principal of any advance in minimum incremental amounts of $1,000. Any prepayment of borrowings made under the original loan facility are not subject to a penalty; however, any prepayments of borrowings made under the new supplemental loan facility are subject to a 2% penalty, if prepaid within the first two years. All repayments of principal by the Company are subject to a final payment equal to 2% of the principal amount being repaid. Amounts cannot be reborrowed by the Company once repaid.

As of June 30, 2007, the Company had borrowings of $40,000 under the loan and security agreement that bears interest at a weighted average rate of 7.69%. The carrying amount of the debt of $40,000 approximates its fair value based on prevailing interest rates as of the balance sheet date.

5. Stock-Based Compensation

For the three months ended June 30, 2007 and 2006, the Company recognized total compensation expense of $642 and $343, respectively, and for the six months ended June 30, 2007 and 2006, the Company recognized total compensation expense of $1,088 and $703, respectively, related to its two equity compensation plans.

Total stock-based compensation was allocated as follows:

	Three Months Ended June 30,				Six Months Ended June 30,
	2007		2006		2007		2006
Research and development	$	189	$	134	$	315	$	288
Selling and marketing		182		59		297		110
General and administrative		271		150		476		305
Total stock-based compensation expense	$	642	$	343	$	1,088	$	703

Equity Compensation Plans

The Company has two stock-based compensation plans, the Amended and Restated 1995 Stock Plan (the “1995 Plan”) and the Amended and Restated 2005 Equity Compensation Plan (the “2005 Plan”), that allow for share-based payments to be granted to directors, employees and consultants. Non-qualified stock options and restricted stock may be granted under the 1995 Plan. Both incentive and non-qualified stock options, as well as stock appreciation rights, restricted stock and restricted stock units, may be granted under the 2005 Plan. The Board of Directors, or an appropriate committee of the Board of Directors, determines the terms, including the vesting schedule, of all options and other equity arrangements under both plans. The maximum term for any option grant under the 1995 Plan and the 2005 Plan are ten and seven years, respectively, from the date of the grant. Prior to July 2006, options granted to employees under both plans generally vested 25% upon completion of one full year of employment from date of grant and on a monthly basis over the following three years of their employment and the term of the options was the maximum permitted under the applicable plan. Beginning in July 2006, the Compensation Committee of the Company’s Board of Directors authorized stock option grants with a three-year vesting period and a maximum term of five years for all future issuances to non-executive employees. Under these new terms, options granted to non-executive employees will vest 33% upon completion of one full year of employment from date of grant and on a monthly basis over the following two years of their employment. The vesting period typically begins on the date of hire for new employees and on the date of grant for existing employees.

11

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

Also in July 2006, the Compensation Committee authorized the issuance of restricted stock units to each of the Company’s executive officers. The restricted stock units vest annually over five years from the date of grant or earlier upon the event of a change in control. Any restricted stock units that have not vested at the time of termination of service to the Company are forfeited. The restricted stock units do not have voting rights and the shares underlying the restricted stock units are not considered issued and outstanding until conversion. The total number of restricted stock units granted was 195 and will convert into an equivalent number of shares of common stock upon termination of employment with the Company.

On June 8, 2007, the Company’s stockholders’ approved certain amendments to the 2005 Plan, including increasing the number of shares of the Company’s common stock reserved for issuance under any form of stock award from 3,000 shares to 8,000 shares. At June 30, 2007, there were 97 and 5,132 shares available for grant as options or other forms of share-based payments under the 1995 Plan and 2005 Plan, respectively.

Basis for Fair Value Estimate of Share-Based Payments

Prior to fiscal 2007, the Company used a blended volatility calculation utilizing volatility of peer group companies with similar operations and financial structures in addition to the Company’s own historical volatility to estimate its future volatility for purposes of valuing the share-based payments granted during the twelve months ended December 31, 2006. In fiscal 2007, the Company began using only its own historical volatility to estimate its future volatility due to the lower expected life associated with the stock option grants with five-year terms that the Company began issuing in the second half of 2006 and the insignificant difference between its own historical volatility and the volatility of the peer group based on the new expected life period. However, actual volatility, and future changes in estimated volatility, may differ substantially from the Company’s current estimates.

In 2005, the Company adopted and began granting options under the 2005 Plan. Due to the lack of historical data with regard to exercise activity under the 2005 Plan, the Company adopted a simplified method of calculating the expected life of options for grants made to its employees in accordance with the guidance set forth in SAB No. 107. Prior to fiscal 2007, for options issued under the 1995 Plan, the Company utilized the historical data available regarding employee and director exercise activity to calculate an expected life of the options. Beginning in fiscal 2007, the Company began granting non-qualified stock options under the 1995 Plan with option terms similar to those granted under the 2005 Plan of five and seven years. Due to the lack of historical data with regard to these shorter option terms, the Company has used the guidance set forth in SAB No. 107 when calculating the expected life for new options granted to its employees under the 1995 Plan. For options granted to directors under the 2005 Plan or 1995 Plan, the Company uses the contractual term of seven years as the expected life of options. The Company will continue with these assumptions in determining the expected life of options under the 1995 Plan and the 2005 Plan until such time that adequate historical data is available.

The table below presents the weighted average expected life in years of options granted under the two plans described above. The risk-free rate of the stock options is based on the U.S. Treasury yield curve in effect at the time of grant, which corresponds with the expected term of the option granted. The fair value of share-based payments, granted during the period indicated, was estimated using the Black-Scholes option pricing model with the following assumptions and weighted average fair values as follows:

	Stock Options for
	Three Months Ended June 30,						Six Months Ended June 30,
	2007			2006			2007			2006
Risk-free interest rate		4.83	%		4.97	%		4.72	%		4.46	%
Dividend yield		0	%		0	%		0	%		0	%
Expected volatility		69	%		79	%		69	%		79	%
Expected life of options (years)		4.1			6.1			4.0			4.9
Weighted average fair value of grants	$	3.39		$	3.23		$	3.42		$	3.34

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INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

The following table summarizes the stock option activity for both the 1995 Plan and 2005 Plan:

	Shares		Weighted Average Exercise Price (per share)		Weighted Average Remaining Contractual Term (in Years)	Aggregate Intrinsic Value
Outstanding at December 31, 2006	6,606		$	9.90	5.7	$	5,534
Granted	1,280			6.26
Exercised	(170	)		1.49
Forfeited/cancelled/expired	(317	)		12.19
Outstanding at June 30, 2007	7,399		$	9.36	5.27	$	4,794
Vested and exercisable at June 30, 2007	4,951		$	11.14	5.23	$	3,200

The aggregate intrinsic value in the table above represents the total intrinsic value (the difference between the Company’s closing stock price on the last trading day of the second quarter of fiscal 2007 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on June 30, 2007. These amounts change based on the fair market value of the Company’s stock. Total intrinsic value of stock options exercised for the six months ended June 30, 2007 was $830. Cash received from stock option exercises for the six months ended June 30, 2007 was $254. Due to the Company’s net loss position, no windfall tax benefits have been realized during the six months ended June 30, 2007.

As of June 30, 2007, approximately $7,100 of total unrecognized compensation cost related to unvested stock options is expected to be recognized over a weighted-average period of 2.6 years.

The value of the restricted stock units is based on the closing market price of the Company’s common stock on the date of grant and is amortized on a straight-line basis over the five year requisite service period. At the date of grant, the restricted stock units had a total fair value of $811. As of June 30 2007, there was approximately $572 of unrecognized share-based compensation expense related to unvested restricted stock units, which is expected to be recognized over the next 4.1 years.

6. Income Taxes

In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (“FIN No. 48”). On January 1, 2007, the Company adopted the provisions of FIN No. 48. FIN No. 48 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax

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INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The amount recognized is measured as the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. At the adoption date of January 1, 2007, the Company had $110,008 of unrecognized deferred tax benefits, all of which was subject to a full valuation allowance, effectively reducing the deferred tax benefits to $0, since realization of these benefits could not be reasonably assured. As a result of implementing FIN No. 48, the Company has reduced its unrecognized deferred tax benefits by approximately $4,000. Consequently, the Company also reduced its full valuation allowance against the adjusted deferred tax benefits by the same amount. The Company expects that any future changes in the unrecognized tax benefit will have no impact on its financial statements due to the existence of the valuation allowance.

7. Contingencies

Litigation

On February 15, 2005, the first of five identical purported shareholder class action complaints was filed in the United States District Court for the Middle District of North Carolina against the Company and certain of its senior officers. Each complaint alleged violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and Securities and Exchange Commission Rule 10b-5, and focused on statements that are claimed to be false and misleading regarding a Phase 3 clinical trial of the Company’s dry eye product candidate, Prolacria^TM. Each complaint sought unspecified damages on behalf of a purported class of purchasers of the Company’s securities during the period from June 2, 2004 through February 8, 2005.

On March 27, 2006, following consolidation of the lawsuits into a single civil action and appointment of lead plaintiffs, the plaintiffs filed a Consolidated Class Action Complaint (the “CAC”). The CAC asserts claims against the Company and certain of its present or former senior officers or directors. The CAC asserts claims under sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 based on statements alleged to be false and misleading regarding a Phase 3 clinical trial of Prolacria, and also adds claims under sections 11, 12(a)(2) and 15 of the Securities Act of 1933. The CAC also asserts claims against certain parties that served as underwriters in the Company’s securities offerings during the period relevant to the CAC. The CAC seeks unspecified damages on behalf of a purported class of purchasers of the Company’s securities during the period from May 10, 2004 through February 8, 2005. In May 2006, the plaintiffs agreed to voluntarily dismiss their claims against the underwriters on the basis that they were time-barred. On June 30, 2006, the Company and other defendants moved that the court dismiss the CAC on the grounds that it fails to state a claim upon which relief can be granted and does not satisfy the pleading requirements under applicable law.

On May 14, 2007, Magistrate Judge Eliason, to whom the District Court had referred the motion, issued a Recommendation that the District Court grant Defendants’ motion to dismiss the CAC. The District Court may accept, reject, or modify this Recommendation. Plaintiffs filed objections to this Recommendation in which they argued that the District Court should not accept the Recommendation, and Defendants responded to Plaintiffs’ objections. Briefing is complete, and as of June 30, 2007 the matter was pending before the District Court. See Note 8, Subsequent Events, for the District Court’s recent decision.

The Company intends to defend the litigation vigorously. As with any legal proceeding, the Company cannot predict with certainty the eventual outcome of these lawsuits, nor can a reasonable estimate of the amounts of loss, if any, be made.

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INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

SEC Investigation

On August 30, 2005, the SEC notified the Company that it is conducting a formal, nonpublic investigation which the Company believes relates to its Phase 3 clinical trial of the Company’s dry eye product candidate, Prolacria. On October 19, 2006, the Company received a Wells Notice letter from the staff of the SEC, issued in connection with this investigation. The Company’s Chief Executive Officer and its Executive Vice President, Operations and Communications, also received Wells Notices.

The Wells Notices provide notification of the SEC staff’s determination that it intends to recommend to the SEC that it bring a civil action against the Company and the two officers regarding possible violations of Section 17(a) of the Securities Act of 1933, Sections 10(b) and 13(a) of the Securities Exchange Act of 1934 and SEC Rules 10b-5, 12b-20, 13a-1, 13a-11, 13a-13, and 13a-14 thereunder. Under the process established by the SEC, the Company and the two officers have the opportunity to respond in writing to the Wells Notice before the staff makes any formal recommendation to the SEC regarding what action, if any, should be brought by the SEC. The Company and the officers receiving these notices provided written submissions to the SEC in response to the Wells Notices during December 2006, and have had further meetings with the SEC staff.

The Company cannot predict with certainty the eventual outcome of this investigation, nor can a reasonable estimate of the costs that might result from the SEC’s investigation be made.

During the three months ended June 30, 2007, approximately $900 was received from the Company’s insurance provider as reimbursement of certain legal expenses incurred as a result of defending against the stockholder litigation and SEC investigation.

8. Subsequent Events

Warburg Pincus Transaction

On July 20, 2007, the Company sold approximately 140 shares of its Series A Exchangeable Preferred Stock, par value $0.001 per share (the “Exchangeable Preferred Stock”), to Warburg Pincus Private Equity IX, L.P. (“Warburg”) at a price per share of $535.00, for aggregate gross proceeds of $75,000 under a Securities Purchase Agreement. The purchase price was based on a $5.35 per share value for the Company’s common stock, par value $0.001 per share.

The Exchangeable Preferred Stock is exchangeable for shares of common stock, initially at a ratio of 1:100. The Exchangeable Preferred Stock is non-voting stock, except as required by law, and ranks senior to each other class of the Company’s equity securities with respect to dividend rights and rights upon liquidation, winding up or dissolution.

Pursuant to the Securities Purchase Agreement, Warburg has the right to designate one member for election to the Company’s Board of Directors. Pursuant to this right, effective July 20, 2007, the Company’s Board of Directors elected Jonathan Leff as a Class C member of the Board of Directors of the Company. The Securities Purchase Agreement also provides that Warburg will have subscription rights in respect of any future issuance by the Company of its equity securities (subject to certain exceptions set forth in the Securities Purchase Agreement) for so long as Warburg owns at least 10% of the Company’s outstanding common stock or shares of Exchangeable Preferred Stock exchangeable for at least 10% of the Company’s outstanding common stock. The Company has agreed to use its best efforts to file a registration statement to register the shares of common stock into which certain holders’ shares of Exchangeable Preferred Stock may be exchanged no later than 30 days after the exchange of the Exchangeable Preferred Stock into common stock. If the Exchangeable Preferred Stock has not been exchanged for Common Stock prior to July 20, 2008, the Company has agreed to file a registration statement to register the shares of Exchangeable Preferred Stock. The Company agreed to reimburse Warburg for its reasonable costs and expenses incurred in connection with this transaction.

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INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

Dividends on the Exchangeable Preferred Stock will be cumulative starting on July 20, 2008 and will accrue at an annual rate of 10% of the purchase price per share, compounded quarterly beginning with amounts accrued for the quarter ended September 30, 2008. Dividends will be payable until all or a portion of the Exchangeable Preferred Stock is exchanged for common stock or until the Exchangeable Preferred Stock is redeemed by the Company upon a liquidation, dissolution or change in control or is otherwise acquired by the Company. To the extent that it may lawfully do so, the Company is required to pay dividends in cash. In the event that the Company may not lawfully pay such dividends in cash, then such dividends will be cumulative and continue to accrue or, upon the affirmative vote of the holders of a majority of the shares of Exchangeable Preferred Stock then outstanding, the dividends will be paid in additional shares of Exchangeable Preferred Stock.

Each outstanding share of Exchangeable Preferred Stock will automatically be exchanged for such number of shares of common stock determined by dividing $535.00 by the exchange price of the Exchangeable Preferred Stock then in effect. The initial exchange price of the Exchangeable Preferred Stock is $5.35 per share, resulting in an initial exchange rate of 100 shares of common stock for each share of Exchangeable Preferred Stock. Upon any such exchange, all accrued but unpaid dividends on the Exchangeable Preferred Stock, if any, shall be paid in shares of common stock. The conversion of the Exchangeable Preferred Stock is subject to stockholder approval by the holders of the Company’s common stock (“Stockholder Approval”) and the expiration or termination of any waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (the “HSR Act”). If Stockholder Approval of the exchange is not obtained on or prior to July 20, 2008, the holders of the Exchangeable Preferred Stock will have no obligation and the Company will not have the option to exchange the Exchangeable Preferred Stock for common stock, in which case the Exchangeable Preferred Stock shall remain outstanding pursuant to its terms until Stockholder Approval is obtained. Under the Securities Purchase Agreement, the Company has agreed to use its reasonable best efforts to convene a meeting of its stockholders to approve the exchange of the Exchangeable Preferred Stock. The Company shall be deemed to have used its reasonable best efforts if the Company convenes such stockholder meeting before December 31, 2007.

If Stockholder Approval has been obtained prior to July 20, 2008 and prior to the expiration or termination of any waiting period under the HSR Act (the “HSR Approval”), then a portion of the then outstanding shares of Exchangeable Preferred Stock just below the threshold then in effect under the HSR Act will be automatically exchanged for shares of common stock. The shares of Exchangeable Preferred Stock that are not automatically exchanged will remain outstanding pursuant to their terms and will be automatically converted into shares of common stock upon the receipt of the HSR Approval. These shares will not be entitled to receive dividends, will not be redeemable at the option of the holder and will not have the right to consent to the Company’s issuance of any series of capital stock or convertible debt that has preference or priority over or on par with the Exchangeable Preferred Stock.

If the Exchangeable Preferred Stock remains outstanding on the fourth anniversary of the closing, both the Company and the holders of the outstanding Exchangeable Preferred Stock will have the right to cause the redemption of such stock, under certain circumstances, for cash in a per share amount equal to the greater of: (i) the sum of the purchase price per share for the Exchangeable Preferred Stock plus all accrued but unpaid dividends thereon (whether or not declared) through the date of such redemption and (ii) an amount equal to the average of the closing prices for the common stock on the Nasdaq Global Market for the 20 trading days immediately preceding the date which the Company or the holders of the outstanding Exchangeable Preferred Stock exercise such right multiplied by the then current exchange rate for the Exchangeable Preferred Stock (the “Redemption Price”); provided, however that to the extent Stockholder Approval is obtained but the HSR Approval is not obtained, the holders of the remaining shares of Exchangeable Preferred Stock that were not previously exchanged will not be entitled to cause the redemption of the remaining shares. In the event of a voluntary or involuntary liquidation, dissolution or winding up of the Company, the holders of the Exchangeable Preferred Stock will also be entitled to receive the Redemption Price per share of Exchangeable Preferred Stock.

16

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

The $75,000 received from the issuance of the Exchangeable Preferred Stock will be classified outside of the stockholders’ equity section, as temporary equity, on the Company’s Balance Sheet, based on the redemption rights that Warburg has been granted with regards to the Exchangeable Preferred Stock. If the HSR Approval and Stockholder Approval are obtained, then the Exchangeable Preferred Stock will be reclassified from temporary equity to stockholders’ equity.

In connection with the sale of the Exchangeable Preferred Stock, Warburg, certain of Warburg’s affiliates and the Company entered into a Standstill Agreement. Under the Standstill Agreement, Warburg and certain of its affiliates agreed, on behalf of themselves and their controlled affiliates, for three years not to increase their common stock holdings beyond the lesser of: (a) 32.5% of the Company’s voting securities on a fully diluted basis and (b) 34.9% of the then outstanding voting securities of the Company plus the outstanding Exchangeable Preferred Stock on an as exchanged to common stock basis.

Litigation

As disclosed above in Note 7, a CAC was filed on March 27, 2006 that asserted claims against the Company and certain of its present or former senior officers or directors. On June 30, 2006, the Company and other defendants moved that the court dismiss the CAC on the grounds that it failed to state a claim upon which relief could be granted and did not satisfy the pleading requirements under applicable law. On May 14, 2007, Magistrate Judge Eliason, to whom the District Court had referred the motion, issued a Recommendation that the District Court grant Defendants’ motion to dismiss the CAC. Plaintiffs filed objections to this Recommendation in which they argued that the District Court should not accept the Recommendation, and Defendants responded to Plaintiffs’ objections.

On July 26, 2007, the United States District Court for the Middle District of North Carolina accepted the Magistrate Judge’s Recommendation and granted the Company’s and the other defendants’ motion and dismissed the CAC with prejudice. The plaintiffs currently have a right of appeal to the United States Court of Appeals for the Fourth Circuit, which the plaintiffs may choose to exercise within the period established by rule. If appealed, the Company intends to defend the litigation vigorously. As with any legal proceeding, the Company cannot predict with certainty the eventual outcome of these lawsuits, nor can a reasonable estimate of the amounts of loss, if any, be made.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

CAUTIONARY STATEMENT

The discussion below contains forward-looking statements regarding our financial condition and our results of operations that are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted within the United States, as well as projections for the future. The preparation of these financial statements requires our management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We evaluate our estimates on an ongoing basis. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. The results of our estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.

We operate in a highly competitive environment that involves a number of risks, some of which are beyond our control. We are subject to risks common to biopharmaceutical companies, including risks inherent in our research, development and commercialization efforts, preclinical testing, clinical trials, uncertainty of regulatory actions and marketing approvals, reliance on collaborative partners, enforcement of patent and proprietary rights, the need for future capital, competition associated with products, potential competition associated with our product candidates and retention of key employees. In order for one of our product candidates to be commercialized, it will be necessary for us, or our collaborative partners, to conduct preclinical tests and clinical trials, demonstrate efficacy and safety of the product candidate to the satisfaction of regulatory authorities, obtain marketing approval, enter into manufacturing, distribution and marketing arrangements, obtain market acceptance and adequate reimbursement from government and private insurers. We cannot provide assurance that we will generate significant revenues or achieve and sustain profitability in the future. Statements contained in Management’s Discussion and Analysis of Financial Condition and Results of Operations which are not historical facts are, or may constitute, forward-looking statements. Forward-looking statements involve known and unknown risks that could cause our actual results to differ materially from expected results. These risks are discussed in the section entitled “Risk Factors,” as well as in our Annual Report on Form 10-K for the year ended December 31, 2006. Although we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements.

Our revenues are difficult to predict and depend on several factors. Our co-promotion revenues are based upon Allergan’s revenue recognition policy and other accounting policies, over which we have limited or no control, and on the underlying terms of our co-promotion agreements. Our co-promotion revenues are impacted by the number of governmental and commercial formularies upon which Restasis and Elestat are listed, the discounts and pricing under such formularies, as well as the estimated and actual amount of rebates, all of which are managed by Allergan. Other factors that are difficult to predict and that impact our co-promotion revenues are the extent and effectiveness of Allergan’s sales and marketing efforts as well as our own sales and marketing efforts, coverage and reimbursement under Medicare Part D and the marketing and sales activities of competitors, among others. We expect to launch AzaSite on August 13, 2007 and to begin to record product revenue for AzaSite in the third quarter of 2007. The effectiveness of our ability and the ability of third parties on which we rely to help us manufacture, distribute and market AzaSite, physician and patient acceptance of AzaSite, as well as competitor response to the launch of AzaSite are all factors, among others, that will impact the level of revenue recorded for AzaSite in 2007 and subsequent periods. Revenues related to development activities are dependent upon the progress toward and the achievement of developmental milestones by us or our collaborative partners.

Our operating expenses are also difficult to predict and depend on several factors. Research and development expenses, including expenses for development milestones, drug synthesis and manufacturing, preclinical testing and clinical research activities, depend on the ongoing requirements of our development programs, completion of business development transactions, availability of capital and direction from regulatory agencies, which are difficult to predict. Management may in some cases be able to control the timing of research and development expenses, in part by accelerating or decelerating preclinical testing, basic research activities, and clinical trial activities, but many of these expenditures will occur irrespective of whether our product candidates are approved when anticipated or at all. We have incurred and expect to continue to incur significant selling and marketing expenses to commercialize our products.

18

Once again, management may in some cases be able to control the timing and magnitude of these expenses. We have incurred and expect to incur significant costs related to the commercial launch of AzaSite. In addition, we have incurred and may incur additional general and administrative expenses as we work to resolve our current stockholder litigation and Securities and Exchange Commission, or SEC, investigation.

As a result of these factors, we believe that period to period comparisons are not necessarily meaningful and you should not rely on them as an indication of future performance. Due to all of the foregoing factors, it is possible that our operating results will be below the expectations of market analysts and investors. In such event, the prevailing market price of our common stock could be materially adversely affected.

OVERVIEW

We are a biopharmaceutical company dedicated to discovering, developing and commercializing prescription pharmaceutical products in disease areas with significant commercial potential or unmet medical needs. Our goal is to build and commercialize a sustainable pipeline of new treatments based upon our technical and scientific expertise, focusing in the ophthalmic and respiratory/allergy therapeutic areas. Our portfolio of products and product candidates include:

PRODUCTS AND PRODUCT CANDIDATES	THERAPEUTIC AREA/ INDICATION	COLLABORATIVE PARTNER (1)	CURRENT STATUS IN THE UNITED STATES
Products
Elestat®	Allergic conjunctivitis	Allergan	Co-promoting
Restasis®	Dry eye disease	Allergan	Co-promoting
AzaSite™	Bacterial conjunctivitis	InSite Vision	Expected launch on August 13, 2007 (2)
Product Candidates in Clinical Development
ProlacriaTM (diquafosol tetrasodium)	Dry eye disease	Allergan and Santen Pharmaceutical	Phase 3; Approvable (3)
Bilastine	Seasonal allergic rhinitis	FAES Farma (4)	Phase 3
Denufosol tetrasodium	Cystic fibrosis	None	Phase 3
Epinastine nasal spray	Allergic rhinitis	Boehringer Ingelheim	Entering Phase 3
INS115644	Glaucoma	Wisconsin Alumni Research Foundation	Phase 1

(1) See our Annual Report on Form 10-K for the year ended December 31, 2006 for a detailed description of our collaborative agreements with these collaborative partners. See also footnote 4 below.

(2) On April 27, 2007, AzaSite was approved by the FDA for the treatment of bacterial conjunctivitis.

(3) In June 2003, we filed an NDA with the FDA for Prolacria for the treatment of dry eye disease. We have received two approvable letters from the FDA (in December 2003 and December 2005).

(4) In June 2007, we amended our license agreement with FAES Farma. Under the terms of the amendment, FAES will be responsible, at its sole cost and expense, for using commercially reasonable efforts to conduct certain development activities relating to oral bilastine. Until the completion of such development activities, all our obligations with respect to the development and commercialization of oral bilastine products are suspended. We will continue to hold the U.S. IND application for oral bilastine and will work with FAES to evaluate the additional clinical data that will determine the appropriate NDA filing strategy.

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We employ a U.S. sales force for the promotion of AzaSite for bacterial conjunctivitis, Elestat for allergic conjunctivitis and Restasis for dry eye disease. AzaSite is a trademark owned by InSite Vision Incorporated, or InSite Vision. Elestat and Restasis are trademarks owned by Allergan, Inc., or Allergan.

Our ophthalmic products and product candidates are currently concentrated in the allergic conjunctivitis, bacterial conjunctivitis, dry eye disease, and glaucoma indications. Our respiratory/allergy product candidates are currently concentrated in the treatment of respiratory complications of cystic fibrosis and allergic rhinitis indications.

PRODUCTS

Elestat

Elestat (epinastine HCl ophthalmic solution) 0.05%, a topical antihistamine with mast cell stabilizing and anti-inflammatory activity, was developed by Allergan for the prevention of ocular itching associated with allergic conjunctivitis. Elestat was approved by the U.S. Food and Drug Administration, or FDA, in October 2003 and is indicated for adults and children at least three years old. Elestat is a seasonal product with product demand mirroring seasonal trends for topical allergic conjunctivitis products. Typically, demand is highest during the Spring months followed by moderate demand in the Summer and Fall months. The lowest demand is during the Winter months.

In December 2003, we entered into an agreement with Allergan to co-promote Elestat in the United States. Under the agreement, we have the responsibility for promoting and marketing Elestat to ophthalmologists, optometrists and allergists in the United States and paying the associated costs. In addition, we have the right to conduct, and from time-to-time do conduct, Phase 4 clinical trials and other studies in collaboration with Allergan relating to Elestat. We receive co-promotion revenue from Allergan on its U.S. net sales of Elestat. Allergan records sales of Elestat and is responsible for other product costs.

In February 2004, we launched Elestat in the United States and are promoting it to ophthalmologists, optometrists and allergists. In association with the launch of AzaSite, we will also promote Elestat to select pediatricians and primary care physicians. We work with Allergan collaboratively on overall product strategy and management in the United States. The commercial exclusivity period for Elestat under the Hatch-Waxman Act will expire in October 2008 at which time competitors will be able to submit to the FDA an abbreviated New Drug Application, or ANDA, or a 505(b)(2) application for a generic version of epinastine HCl ophthalmic solution. We cannot predict the time frame for FDA review of such applications, if any. We are aware that several generic pharmaceutical companies have expressed intent to commercialize the ocular form of epinastine after the commercial exclusivity period expires.

Restasis

Restasis (cyclosporine ophthalmic emulsion) 0.05% is the first approved prescription product in the United States for the treatment of dry eye disease. It is indicated to increase tear production in patients (adults and children at least 16 years old) whose tear production is presumed to be suppressed due to ocular inflammation associated with keratoconjunctivitis sicca, or dry eye disease. In December 2002, Restasis was approved for sale by the FDA and Allergan launched Restasis in the United States in April 2003.

In June 2001, we entered into an agreement with Allergan to develop and commercialize our product candidate, Prolacria^TM (diquafosol tetrasodium), for the treatment of dry eye disease. The agreement also provided us with a royalty on worldwide (except most Asian markets) net sales of Allergan’s Restasis and granted us the right to co-promote Restasis in the United States.

In January 2004, we began co-promotion of Restasis to eye care professionals and allergists in the United States. We began receiving co-promotion revenue on Allergan’s net sales of Restasis beginning in April 2004. The manufacture and sale of Restasis is protected in the United States under a use patent which expires in August 2009 and a formulation patent which expires in May 2014.

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For the three and six months ended June 30, 2007, Allergan recognized approximately $77 million and $156 million, respectively, of revenue from net sales of Restasis. In August 2007, Allergan confirmed guidance for 2007 net sales of Restasis to be in the range of $320-$340 million.

AzaSite

Overview. AzaSite (azithromycin ophthalmic solution) 1% is a topical anti-infective, in which azithromycin is formulated into an ophthalmic solution utilizing DuraSite^®, a novel ocular drug delivery system. Azithromycin is a semi-synthetic antibiotic that is derived from erythromycin and since 1992, has been available via oral administration by Pfizer Inc. under the trade name Zithromax^®. On April 27, 2007, AzaSite was approved by the FDA for the treatment of bacterial conjunctivitis in adults and pediatric patients one year old or older. We expect to launch AzaSite on August 13, 2007. We have expanded our existing sales force to a total of 98 representatives who will call on targeted specialists, select pediatricians and primary care providers.

Market Opportunity. The current ocular antibiotic market is approximately $600 million in annual sales in the United States based on data compiled by IMS Health as of December 31, 2006. This includes approximately $360 million for the single-entity product market, in which AzaSite will directly compete, and approximately $245 million in the combination products market. Total prescriptions in the ocular antibiotic market were approximately 15 million for the twelve months ended December 31, 2006, up 7% from the prior year according to data compiled from IMS Health.

Collaborative Agreement. On February 15, 2007, we entered into a license agreement with InSite Vision pursuant to which we licensed exclusive rights to commercialize AzaSite, as well as other potential topical anti-infective products containing azithromycin for use in the treatment of human ocular or ophthalmic indications. The license agreement also grants us exclusive rights to develop, make, use, market, commercialize and sell the product in the United States and Canada and their respective territories. Contemporaneously with our license agreement, InSite Vision entered into an exclusive license agreement with Pfizer for certain Pfizer patent rights relating to the treatment of ocular infection with azithromycin for certain products. In combination with the DuraSite patents held by InSite Vision, AzaSite is expected to have patent protection until 2019.

Pursuant to the license agreement, we paid InSite Vision an upfront license fee of $13.0 million, and an additional $19.0 million milestone related to the FDA approval of AzaSite. In addition, we are also obligated to pay a 20% royalty for the first two years of commercialization and a 25% royalty thereafter on net sales of AzaSite in the United States and Canada. We are obligated to pay royalties under the agreement for the longer of (i) eleven years from the launch of the subject product and (ii) the period during which a valid claim under a patent licensed from InSite Vision covers a subject product. Under the terms of the agreement, our obligation to pay royalties to InSite Vision is subject to annual minimum royalty payments which commence on the first quarter start date that is at least one year after the first commercial sale of any subject product, and may continue for a period of up to five years.

We exercised our option to negotiate a license from InSite Vision for AzaSite Plus^TM, a combination antibiotic/corticosteroid product formulated with DuraSite technology. The exclusive option period has expired; however, we are continuing discussions with InSite Vision related to AzaSite Plus as they define their clinical program and regulatory strategy.

In addition, we have entered into a supply agreement dated February 15, 2007 with InSite Vision for the active pharmaceutical ingredient azithromycin. InSite Vision previously entered into an agreement with Catalent Pharma Solutions, or Catalent, (formerly Cardinal Health PTS, LLC) for the manufacture of the finished product AzaSite. Under the terms of our license agreement, the parties have agreed to arrangements intended to facilitate our access to finished product manufactured by Catalent on an interim basis and to facilitate execution of a longer-term arrangement for finished product supply. On June 20, 2007, we entered into an exclusive distribution agreement with Cardinal Health 105, Inc. for distribution services for AzaSite.

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For a more detailed discussion of the risks associated with our products and products we co-promote, please see the Risk Factors described elsewhere in this report.

PRODUCT CANDIDATES IN CLINICAL DEVELOPMENT

Prolacria (diquafosol tetrasodium) for the treatment of dry eye disease

Overview. Diquafosol tetrasodium is a dinucleotide that we discovered, which functions as an agonist at the P2Y₂ receptor and is being developed for the treatment of dry eye disease. Prolacria, the proposed U.S. tradename for diquafosol tetrasodium ophthalmic solution 2%, is designed to stimulate the release of three components of natural tears – mucin, lipids and fluid.

We are developing Prolacria as an eye drop for dry eye disease. To date, we have completed four Phase 3 clinical trials of Prolacria for the treatment of dry eye disease. In total, we have conducted placebo-controlled clinical trials of Prolacria in more than 2,000 subjects. If approved, Prolacria could be the second FDA approved pharmacologically active agent to treat dry eye disease and the first one with this mechanism of action. Since Prolacria and Restasis have different mechanisms of action, we consider them complementary products and, if Prolacria is approved by the FDA, we believe there is commercial opportunity for both of these products.

Under our agreement with Allergan, we are responsible for the development of Prolacria. In 2003, we exercised our right to co-promote Prolacria with Allergan in the United States. If and when we receive FDA approval and Prolacria is launched, we expect to begin promoting this product. Pursuant to this agreement, Allergan is responsible for obtaining regulatory approval of diquafosol tetrasodium in Europe. In the United States, Prolacria is expected to have patent protection until 2017.

Development Status. In June 2003, we filed a New Drug Application, or NDA, with the FDA for Prolacria for the treatment of dry eye disease. In response to that NDA, we were granted a “Priority Review” designation and subsequently, received an approvable letter in December 2003. In June 2005, we submitted an amendment to our NDA for Prolacria and received a second approvable letter in December 2005. During 2006 and 2007, we have conducted several meetings with the FDA about Prolacria and dry eye disease. Based on those meetings, we have provided additional information to the FDA. We have utilized key experts and corneal specialists throughout this process to engage in a meaningful dialogue regarding the clinical aspects of the diagnosis and treatment of dry eye.

Based on our recent discussions with the FDA, we are working to identify a clinical trial design that we believe is reasonable and that the FDA agrees is appropriate. This work is focused on an endpoint based on staining scores in the central region of the cornea. We have been making progress on this front, but anticipate this process taking a few more months, most likely through the end of 2007. As we have indicated, if we are successful in coming to a mutually-acceptable agreement with the FDA, we anticipate conducting an additional clinical trial in 2008 and will likely request a Special Protocol Assessment prior to conducting such clinical trial.

Our partner, Santen Pharmaceutical Co., Ltd., or Santen, is currently developing diquafosol tetrasodium in Japan. Our agreement with Santen allows Santen to develop diquafosol tetrasodium for the therapeutic treatment of ocular surface diseases, such as dry eye disease, in Japan and nine other Asian countries and provides for certain milestones to be earned by us upon achievement of development milestones by Santen. In 2006, Santen began Phase 3 clinical trials in Japan for diquafosol tetrasodium.

Depending on the outcome of the validation process and discussions with the FDA, estimated subsequent costs necessary to amend our NDA submission for Prolacria and resubmit the application for commercial approval in the United States are projected to be in the range of $4 million to $10 million, depending on our approach to achieving NDA approval of the product candidate. This range includes costs for regulatory and consulting activities, conducting a validation exercise and related studies, completing one additional Phase 3 clinical trial, salaries for development personnel, and other unallocated development costs, but excludes the cost of pre-launch inventory which is Allergan’s

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responsibility. Currently, we have not initiated an additional Phase 3 clinical trial for Prolacria and we do not anticipate initiating an additional Phase 3 clinical trial until the validation process and discussions with the FDA are complete. If we are required to do more than one additional Phase 3 clinical trial, our costs will likely be higher than the projected range. The projected costs associated with Prolacria are difficult to determine due to the ongoing interaction with the FDA and the uncertainty of the FDA’s scientific review and interpretation of what is required to demonstrate safety and efficacy sufficient for approval. Actual costs could be materially different from our estimate. For a more detailed discussion of the risks associated with the development of Prolacria and our other development programs, including factors that could result in a delay of a program and increased costs associated with such a delay, please see the Risk Factors described elsewhere in this report.

Bilastine for seasonal allergic rhinitis

Overview. Bilastine is a non-sedating oral H1-antihistamine compound being developed for the treatment of allergic rhinitis. Rhinitis is a condition that primarily results from exposure to allergens, either at specific times of the year (seasonal allergic rhinitis) or year-round (perennial allergic rhinitis), or from exposure to irritants, such as cigarette smoke or perfume. Symptoms most often include nasal congestion or stuffiness, rhinorrhea (runny nose), sneezing, and ocular and nasal itching.

Collaborative Agreement. In October 2006, we entered into a license agreement with FAES Farma, S.A., or FAES, for the U.S. and Canadian development and commercialization of bilastine. We amended this agreement in June 2007. Under the terms of the amendment, FAES will be responsible, at its sole cost and expense, for using commercially reasonable efforts to conduct certain development activities relating to oral bilastine. Until the completion of such development activities, all our obligations with respect to the development and commercialization of oral bilastine products are suspended. Accordingly, we will incur significantly less development costs for our oral bilastine program in 2007 than originally expected, and the future advancement of the program will be largely dependent upon the initiatives of FAES.

Pursuant to the terms of the amendment, commencing on December 1, 2007, FAES may terminate such development activities prior to their completion by giving us 30 days notice. Also commencing on December 1, 2007, we may terminate the license agreement, in part or in its entirety, upon 30 days notice to FAES prior to the first commercial sale of an applicable bilastine product, or upon 180 days notice after the first commercial sale of an applicable bilastine product.

In addition, under the terms of the amendment, certain milestone payment obligations relating to an oral bilastine product candidate were amended. Specifically, we are no longer required to pay $8.0 million to FAES upon their submission to us of acceptable final QT/QTc clinical trial results. However, the milestone payment to be made by us to FAES upon regulatory approval in the United States of an applicable oral bilastine product for the treatment of allergic rhinitis with an acceptable primary label has been increased by $8.0 million. Also, our obligation to pay FAES a milestone payment of $2.0 million upon completion of the first Phase 3 clinical trial of an oral bilastine product candidate has been replaced with an obligation that we pay FAES $2.0 million upon our receipt of notice from the FDA that the NDA seeking regulatory approval of an oral bilastine product has been deemed acceptable for filing and filed by the FDA. In the United States, bilastine is covered by a composition of matter patent until 2017.

Development Status. A thorough QT/QTc clinical trial was completed in 2007 by FAES in the United States. Based on a meeting with the Pulmonary Division of the FDA in which the existing clinical data and QT/QTc trial results were discussed, and in consultation with us, FAES has agreed, pursuant to the terms of the amendment described above, to conduct additional clinical work and an expanded QT/QTc comparative trial, which will likely include an FDA-approved antihistamine. These additional clinical trials are intended to strengthen the overall clinical package, based on feedback from the FDA.

We will continue to hold the U.S. Investigational New Drug, or IND, application for oral bilastine and will work with FAES to evaluate the additional clinical data that will determine the appropriate NDA filing strategy. We plan to continue to fund the preclinical development of an ophthalmic formulation of bilastine for the treatment of allergic conjunctivitis.

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Prior to the completion of the additional clinical work by FAES, we expect to have minimal costs related to the oral bilastine program. Our future estimated subsequent costs necessary to submit an NDA for bilastine for the treatment of seasonal allergic rhinitis are contingent upon successful completion of certain development activities by FAES and are projected to be in the range of $4 million to $10 million. This range includes conducting a Phase 3 clinical trial in the United States which may be required, manufacturing bilastine for clinical trials, producing qualification lots consistent with current Good Manufacturing Practice, or cGMP, standards, salaries for development personnel, other unallocated development costs and regulatory preparation and filing costs, but excludes the cost of pre-launch inventory. These costs are difficult to project and actual costs could be materially different from our estimate. For a more detailed discussion of the risks associated with our development programs, please see the Risk Factors described elsewhere in this report.

Denufosol tetrasodium for the treatment of cystic fibrosis

Overview. We are developing denufosol tetrasodium as an inhaled product candidate for the treatment of cystic fibrosis. We believe that our product candidate could be the first FDA approved product that mitigates the underlying ion transport defect in the airways of patients with cystic fibrosis. If approved, we expect denufosol to be an early intervention therapy for cystic fibrosis. This product candidate has been granted orphan drug status and fast-track review status by the FDA, and orphan drug status by the European Medicines Agency, or EMEA. Denufosol is designed to enhance the lung’s innate mucosal hydration and mucociliary clearance mechanisms, which in cystic fibrosis patients are impaired due to a genetic defect. By hydrating airways and stimulating mucociliary clearance through activation of the P2Y₂ receptor, we expect denufosol to help keep the lungs of cystic fibrosis patients clear of thickened mucus, reduce infections and limit the damage that occurs as a consequence of the prolonged retention of thick and tacky infected secretions. In the United States, denufosol tetrasodium for the treatment of cystic fibrosis is expected to have patent protection until 2017.

Cystic fibrosis is a life-threatening disease involving a genetic mutation that disrupts the cystic fibrosis transmembrane regulator protein, an ion channel. In cystic fibrosis patients, a defect in this ion channel leads to poorly hydrated lungs and severely impaired mucociliary clearance. Chronic secondary infections invariably occur, resulting in progressive lung dysfunction and deterioration. Respiratory infections and complications account for more than 90% of the mortality associated with this disease. According to the U.S. Cystic Fibrosis Foundation, as published in 2006, the median life expectancy for patients is approximately 37 years.

Development Status. We have conducted Phase 1 and Phase 2 clinical trials of denufosol, including multiple clinical trials in cystic fibrosis patients, and various preclinical and toxicology testing. In January 2006, we had an End-of-Phase 2 meeting with the FDA and decided to initiate a Phase 3 program to advance denufosol for the treatment of cystic fibrosis. The focus of our Phase 3 program is to develop denufosol as an early intervention therapy for treatment of patients with mild lung disease (FEV₁ (Forced Expiratory Volume in one second) ³ 75% predicted). According to the U.S. Cystic Fibrosis Foundation’s 2004 Patient Registry, approximately two-thirds of cystic fibrosis patients have lung disease defined as mild as measured by the standard pulmonary function test, FEV₁ > 70% predicted. In the pediatric population under 18 years of age, approximately 80% of patients have mild or early lung disease.

Based on the End-of-Phase 2 meeting with the FDA, we plan to conduct two pivotal Phase 3 clinical trials in cystic fibrosis patients. The two Phase 3 clinical trials are designated TIGER-1 and TIGER-2. In July 2006, we initiated our TIGER-1 clinical trial, which is designed to be approximately one year in duration, with a 24-week efficacy treatment period, followed by a 24-week safety extension period. The efficacy portion of the clinical trial is a randomized, double-blind comparison of 60 mg of denufosol to placebo by inhalation three-times daily in approximately 350 patients with mild cystic fibrosis lung disease at approximately 70 clinical centers across North America. In March 2007, Health Canada approved our Clinical Trial Application so that we can conduct cystic fibrosis clinical trials in Canada. We are including Canadian sites in TIGER-1 and plan to include Canadian sites in TIGER-2. Based on current enrollment rates, we expect to complete enrollment in our TIGER-1 Phase 3 clinical trial in the fourth

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quarter of 2007. As TIGER-1 enrollment proceeds, the safety data will be reviewed by an independent data monitoring committee that we established for this clinical trial. We intend to unblind, analyze and announce the top-line results within two to three months following completion of the initial 24-week placebo-controlled efficacy portion of the clinical trial. We do not expect this unblinding of efficacy data to result in any statistical penalty. Based on the timing assumptions described above, we would expect to report TIGER-1 top-line results in the third quarter of 2008.

We intend to use TIGER-1 to fulfill the long-term safety regulatory requirement to study denufosol in a specified number of patients for one year. The primary efficacy endpoint is the change from baseline in FEV₁ (in liters) at the 24-week time point. Secondary endpoints include other lung function parameters, pulmonary exacerbations, requirements for concomitant cystic fibrosis medications and health related quality of life. The clinical trial is enrolling cystic fibrosis patients aged five years and above. Use of standard cystic fibrosis therapies approved by the FDA, including Pulmozyme^®, TOBI^®, macrolides and digestive enzymes, is permitted. The use of hypertonic saline is not permitted to be used by those patients enrolled in the clinical trial.

The size of the TIGER-1 clinical trial was based on multiple considerations including the need for adequate long-term safety exposure at the intended dose of 60 mg and sufficient statistical power required to detect meaningful treatment effects. The TIGER-1 clinical trial has statistical power of greater than 90% to detect at least a 75 ml treatment effect relative to placebo for the primary efficacy endpoint of change from baseline in FEV₁ (in liters). The statistical power calculation was based on numerous assumptions and does not represent a probability of success of the trial.

We expect that TIGER-2 will include approximately 350 patients and be 24 weeks in duration. In terms of timing, our strategy is to have a staged approach for the initiation of clinical sites for TIGER-2, beginning after enrollment is completed in TIGER-1. In 2008, the initial stage will focus on recruiting patients from select U.S. and Canadian sites, some of which participated in TIGER-1 and some new sites. Thereafter, we intend to expand outside of North America as individual countries become eligible to be included in TIGER-2 from a regulatory perspective and we are allowed to include sites in the related countries. We would expect to add international sites throughout the year in 2008, with international patient enrollment beginning in the second half of 2008.

In 2006, we completed a 52-week inhalation toxicology study in one animal species and we have submitted the final study report to the FDA. There were no signs of pulmonary or systemic toxicity at doses well above the Phase 3 clinical dose. In addition, in November 2006, we initiated the required two-year inhalation carcinogenicity study in rats and the study is ongoing. This carcinogenicity study must be completed prior to submitting an NDA filing. The time from initiation of this study to receipt of the final study report is expected to be up to three years. We expect to receive the final study report for this carcinogenicity study in the second half of 2009.

We recently initiated a small clinical trial to enhance the scientific data regarding the mechanism of action of denufosol. The single-dose clinical trial is designed as a double-blind, two-way crossover evaluation of the effects of 60 mg of denufosol on mucociliary clearance, compared to placebo, in 12 patients with cystic fibrosis lung disease. In addition, although not requested by the FDA, we may conduct further clinical trials to evaluate denufosol in patients with lower lung function, to gain a better understanding of the initial dose tolerability of denufosol in a patient population with more significant airflow obstruction.

Estimated subsequent costs necessary to submit an NDA for denufosol for the treatment of cystic fibrosis are projected to be in the range of $25 million to $45 million. This estimate includes any additional Phase 2 clinical trials, conducting the TIGER-1 and TIGER-2 clinical trials and any required toxicology and carcinogenicity studies, manufacturing denufosol for clinical trials, producing qualification lots consistent with current cGMP standards, salaries for development personnel, other unallocated development costs and regulatory preparation and filing costs, but excludes the cost of pre-launch inventory and any potential development milestones payable to the Cystic Fibrosis Foundation Therapeutics, Inc. These costs are difficult to project and actual costs could be materially different from our estimate. For example, clinical trials, toxicology and carcinogenicity studies may not proceed as planned, results from future clinical trials may change our planned development program, additional Phase 3 clinical trials may be necessary, other parties may assist in the funding of our development costs, and an anticipated NDA filing could be delayed. For a more detailed discussion of the risks associated with our development programs, please see the Risk Factors described elsewhere in this report.

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We intend to participate in the commercialization in North America for denufosol for the treatment of cystic fibrosis. We are seeking to secure a corporate partner to develop and commercialize this product candidate outside of North America. We would expect that a potential partner for development and commercialization outside of North America would provide assistance related to the design, funding and completion of future clinical trials conducted outside of North America.

Epinastine nasal spray for allergic rhinitis

Overview. Epinastine HCl is a topically active, direct H₁-receptor antagonist and inhibitor of histamine release from mast cells that is being developed by us as an intranasal treatment for allergic rhinitis.

In February 2006, we entered into a development and license agreement with Boehringer Ingelheim International GmbH, or Boehringer Ingelheim. The agreement grants us certain exclusive rights to develop and market an intranasal dosage form of epinastine, in the United States and Canada, for the treatment or prevention of rhinitis. Epinastine nasal spray, a dosage form not yet approved by the FDA, is not protected by a composition of matter patent in the United States. Upon filing an NDA for epinastine nasal spray that would rely on new clinical investigations, we would be eligible under the Federal Food, Drug and Cosmetic Act, as amended by the Hatch-Waxman Act, for a three-year period of market exclusivity for the product if those new clinical investigations are needed for FDA approval. With such exclusivity, the FDA would be barred from approving a 505(b)(2) application or an ANDA for that dosage form of epinastine for three years. However, the FDA would not be barred from approving a dosage form not protected by the exclusivity. In addition to this three-year commercial exclusivity period, we intend to pursue various possible forms of intellectual property protection to protect the commercial exclusivity of an intranasal epinastine product.

Development Status. In October 2006, our IND application for epinastine nasal spray was filed with the FDA and we began Phase 2 clinical trials. The Phase 2 program included several clinical and toxicology studies to determine the optimal formulation and dose.

In May 2007, we announced the results of a Phase 2 clinical trial to evaluate epinastine nasal spray for the treatment of seasonal allergic rhinitis. This Phase 2 clinical trial was a 14-day, randomized, double-blind comparison of two doses of epinastine nasal spray (0.05% and 0.1%) to placebo in 569 subjects who had a documented history of seasonal allergic rhinitis to mountain cedar pollen. Of the subjects randomized in the clinical trial, 95% completed the clinical trial and no serious adverse events were reported. While the most common adverse event observed was bitter taste, it was only reported by 4% of subjects in the 0.05% group and by 5% of subjects in the 0.1% group.

The primary endpoint of the clinical trial was the daily reflective change from baseline for total nasal symptom score, or TNSS, averaged over the 14-day treatment period. The endpoint of TNSS conforms to the FDA draft guidance document for seasonal allergic rhinitis and includes runny nose, nasal congestion, itchy nose and sneezing. Results of the clinical trial demonstrated statistically significant improvement (p < 0.05) in reflective TNSS for the 0.1% dose group, compared to placebo. Changes in TNSS for the 0.05% dose group were not statistically significant.

There were multiple secondary endpoints in this clinical trial. Among these, statistically significant improvements (p < 0.05) compared to placebo were demonstrated in the 0.1% dose group for the secondary endpoints of non-nasal symptom score (itchy eyes, watery eyes, and itchy throat/palate) and for total symptom score (TNSS plus non-nasal symptom score).

Based on the results of this clinical trial and our End-of-Phase 2 meeting with the FDA, we plan to proceed to a Phase 3 clinical program to evaluate epinastine nasal spray for the treatment of allergic rhinitis. The Phase 3 program is expected to consist of three pivotal Phase 3 clinical trials, including two seasonal allergic rhinitis, or SAR, clinical trials and one perennial allergic rhinitis, or PAR, clinical trial. We expect to initiate the first Phase 3 clinical trial in the fourth quarter of 2007 during the mountain cedar season, with results anticipated in the second quarter of 2008.

We are in the process of initiating the required 6-month intranasal toxicology study of epinastine in a single animal species and expect to have results by mid-2008. These results are necessary to begin the PAR clinical trial, which will include one-year safety results required for a potential NDA. We intend to initiate the second SAR clinical trial and the PAR clinical trial in 2008.

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During our End-of-Phase 2 meeting, the FDA indicated that standard cardiac safety monitoring would be required in at least one Phase 3 clinical trial but that it would not be necessary to conduct a thorough QT/QTc clinical trial.

Estimated subsequent costs necessary to submit an NDA for epinastine nasal spray for the treatment of allergic rhinitis are projected to be in the range of $25 million to $45 million. This estimate includes conducting three planned Phase 3 clinical trials and any required toxicology studies, manufacturing epinastine for clinical trials, producing qualification lots consistent with current cGMP standards, salaries for development personnel, other unallocated development costs and regulatory preparation and filing costs, but excludes the cost of pre-launch inventory. These costs are difficult to project and actual costs could be materially different from our estimate. For example, clinical trials and toxicology studies may not proceed as planned, results from future clinical trials may change our planned development program, additional Phase 2 or Phase 3 clinical trials may be necessary, and an anticipated NDA filing could be delayed. For a more detailed discussion of the risks associated with our development programs, please see the Risk Factors described elsewhere in this report.

INS115644 for glaucoma

Overview. In November 2004, we licensed several patents for use in developing and commercializing new treatments for glaucoma from Wisconsin Alumni Research Foundation, or WARF. Under the technology licensed from WARF, we are evaluating new and existing compounds, including INS115644, that are active in disrupting the acto-cytoskeleton of the trabecular meshwork as potential treatments for glaucoma. The scientific hypothesis is that the mechanism of action may result in reduction of intraocular pressure by affecting the primary outflow pathway for aqueous humor.

Development Status. We have filed an IND for the first compound in a series of compounds and in the first quarter of 2007, we initiated a Phase 1 proof-of-concept dose-ranging clinical trial in glaucoma patients to evaluate the safety and tolerability of INS115644, as well as changes in intraocular pressure. The clinical trial is designed with three cohorts of patients receiving increasing dosage levels of the compound. Enrollment is ongoing in this clinical trial. We have completed dosing in the first of three cohorts and expect to begin the second cohort this fall. Based upon progress to date, we expect top line results from this clinical trial in the first half of 2008. Given the limited data available and the early stage of development of this program, we are currently unable to reasonably project the future dates and costs that may be associated with clinical trials or a prospective NDA filing.

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RESULTS OF OPERATIONS

Three Months Ended June 30, 2007 and 2006

Revenues

Co-promotion revenues for the three months ended June 30, 2007 were approximately $15.4 million, as compared to approximately $13.4 million for the same period in 2006. Co-promotion revenue from net sales of Elestat for the three months ended June 30, 2007 was approximately $9.7 million, as compared to approximately $9.4 million for the same period in 2006. The 3% increase in 2007 co-promotion revenue for Elestat was primarily due to a reduction in rebates and discounts and a price increase for Elestat that became effective during the first quarter of 2007, partially offset by a decline in market share for Elestat. Co-promotion revenue from net sales of Restasis for the three months ended June 30, 2007 was approximately $5.7 million, as compared to approximately $4.0 million for the same period in 2006. The increase in 2007 co-promotion revenue for Restasis of approximately $1.7 million, or 41%, was primarily due to increased patient usage of Restasis, based on the increase of prescriptions year-over-year, and a price increase that became effective during the first quarter of 2007. In addition, in April 2007, there was a final scheduled increase of the percentage of net sales of Restasis to which we were entitled. Restasis is currently the only approved prescription product indicated for dry eye disease.

All of our revenue related to Elestat is from net sales in the United States according to the terms of our collaborative agreement with Allergan. Elestat is a seasonal product with product demand mirroring seasonal trends for topical allergic conjunctivitis products. Typically, demand is highest during the Spring months followed by moderate demand in the Summer and Fall months. The lowest demand is during the Winter months.

Competition from the introduction of a new branded product and a new generic has caused a decline in 2007 market share for Elestat. Based upon national prescription data from IMS Health, for the three months ended June 30, 2007, Elestat represented approximately 8% of the total U.S. allergic conjunctivitis market, as compared to approximately 9% for the same period in 2006.

In regards to co-promotion revenue from net sales of Elestat, we are entitled to an escalating percentage of net sales based upon predetermined calendar year net sales target levels. During a fiscal year, we recognize product co-promotion revenue associated with targeted net sales levels for Elestat achieved during that time period and defer revenue in excess of the sales level achieved. During the three month period ended June 30, 2007, we achieved the annual 2007 net sales target level which allowed us to recognize $2.4 million of previously deferred 2007 product co-promotion revenue for Elestat. Similarly, during the three month period ended June 30, 2006, we achieved the annual 2006 net sales target level which allowed us to recognize $1.8 million previously deferred 2006 product co-promotion revenue for Elestat.

Since the launch of Elestat, Allergan has secured coverage on formularies of certain commercial and government plans. This coverage provides Allergan and us an opportunity to enhance or maintain prescription market share, but generally requires price concessions through rebate programs which impact the level of co-promotion revenue that we receive from net sales of Elestat. Due to the large number of competing products in the allergic conjunctivitis market, some of these price concessions have been significant. Since the beginning of 2006 when Medicare Part D became effective, there has been a decrease in prescriptions for Elestat reimbursed by state Medicaid programs which were partially offset by an increase of prescriptions reimbursed under Medicare Part D plans and to a lesser extent, commercial plans. This shift to Medicare Part D plans has resulted in lesser amounts of rebates than under Medicaid programs. On an annual basis, Allergan negotiates for coverage under states’ Medicaid programs and coverage under commercial and Medicare programs. These activities can result in either maintaining, losing or gaining Medicaid, Medicare and commercial formulary coverage. During 2006, we lost Elestat coverage under several state Medicaid plans which was not anticipated. While the loss of these coverages did not significantly impact our portion of the co-promotion revenue due to the large price concessions associated with these particular states, future loss of coverage under additional states or commercial plans may have a negative impact on our co-promotion revenue.

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The commercial marketing exclusivity period for Elestat provided under the Hatch-Waxman Act will expire in October 2008, at which time competitors will be able to submit to the FDA an abbreviated New Drug Application or a 505(b)(2) application for a generic version of epinastine HCl ophthalmic solution. We cannot predict the time frame for FDA review of such applications, if any. Elestat could face generic or over-the-counter competition if there is no other intellectual property or marketing exclusivity protection covering Elestat. We are aware that several generic pharmaceutical companies have expressed intent to commercialize the ocular form of epinastine after the commercial exclusivity period expires. While we are exploring various possible forms of additional intellectual property coverage to protect the commercialization of Elestat in the United States, there can be no assurance that any form of intellectual property protection covering Elestat will be possible in the United States after the expiration of the commercial exclusivity period under the Hatch-Waxman Act in October 2008. If a generic form of Elestat is introduced into the market, our agreement with Allergan to co-promote Elestat will no longer be in effect, and our revenues attributable to Elestat will cease. Loss of our co-promotion revenue from Elestat will materially impact our results of operations and cash flows.

All of our revenue from Restasis is based on worldwide net sales of Restasis according to the terms of our collaborative agreement with Allergan. However, less than 2% of our co-promotion revenue from Restasis is derived from sales of Restasis outside of the United States. Restasis, in terms of prescription volume, has grown significantly since it was first launched in April 2003. Total prescriptions, as reported by IMS Health, were approximately 835,000 for the three months ended June 30, 2007, a 18% increase over the same period in 2006. Our entitled percentage of net sales of Restasis increased for the last time in April 2007. For the three months ended June 30, 2007, Allergan recorded approximately $77 million of revenue from net sales of Restasis, as compared to approximately $66 million in the three months ended June 30, 2006.

We expect to launch AzaSite on August 13, 2007. Beginning in July 2007, we started receiving and processing orders for AzaSite as we begin to load the supply chain in preparation of the launch of AzaSite. These initial orders, received and processed prior to launch, are being offered with special terms as stocking incentives for wholesalers. The special terms are only being offered for a specified period of time of approximately one month prior to the launch of AzaSite. Sales with these special terms will be accounted for using the consignment model, which requires that we defer revenue until such time that the product is resold further into the supply chain or the product is no longer subject to the special terms. Sales made subsequent to this specified time period will include payment terms and return rights that are customary in the industry. For these orders, we plan on recording revenue at the date of shipment, when title and substantially all the risks and rewards of ownership has transferred to the customer. See the Critical Accounting Policies and Estimates section of Management’s Discussion and Analysis of Financial Condition and Results of Operations for a detailed discussion of revenue recognition as it relates to sales of AzaSite.

Research and Development Expenses

Research and development expenses were approximately $8.0 million for the three months ended June 30, 2007, as compared to approximately $9.2 million for the same period in 2006. The decrease in research and development expenses of approximately $1.2 million, or 13%, for the three months ended June 30, 2007, as compared to the same period in 2006, was primarily due to less spending on our INS50589 Antiplatelet and oral antiplatelet programs and our denufosol for retinal disease program, all of which development was discontinued in 2006, as well as positive and negative fluctuations in spending on our active development programs. In addition, the overall decrease in expense was partially offset by spending on two new programs initiated subsequent to June 2006: (i) AzaSite for bacterial conjunctivitis and (ii) bilastine for seasonal allergic rhinitis.

Research and development expenses include all direct and indirect costs, including salaries for our research and development personnel, consulting fees, clinical trial costs, sponsored research costs, clinical trial insurance, upfront license fees, milestone and royalty payments relating to research and development, and other fees and costs related to the development of product candidates. Research and development expenses vary according to the number of programs in preclinical and clinical development and the stage of development of our clinical programs. Later stage clinical programs tend to cost more than earlier stage programs due to the length of the clinical trial and the number of patients enrolled in later stage clinical trials.

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Selling and Marketing Expenses

Selling and marketing expenses were approximately $10.3 million for the three months ended June 30, 2007, as compared to approximately $6.5 million for the same period in 2006. The increase in selling and marketing expenses of approximately $3.8 million, or 60%, for the three months ended June 30, 2007, as compared to the same period in 2006, resulted from an increase in various expenses associated with the pre-launch activities related to AzaSite, including the expansion of our sales force from 64 to 98 sales representatives and other marketing and promotional activities. We have also incurred a general increase in the costs associated with our sales force including increased salary, personnel related expenses and stock-based compensation expense.

Our commercial organization currently focuses its promotional efforts for Elestat and Restasis on approximately 8,500 highly prescribing ophthalmologists, optometrists and allergists in our target universe. In launching AzaSite, we have expanded our existing sales force to a total of 98 representatives who will call on eye care professionals, who we currently call on, and select high prescribing pediatricians and primary care physicians. Our selling and marketing expenses include all direct costs associated with the commercial organization, which include our sales force and marketing programs. Our sales force expenses include salaries, training and educational program costs, product sample costs, fleet management and travel. Our marketing and promotion expenses include product management, promotion, advertising, public relations, Phase 4 clinical trial costs, physician training and continuing medical education and administrative expenses.

General and Administrative Expenses

General and administrative expenses were approximately $3.1 million for the three months ended June 30, 2007, as compared to approximately $4.3 million for the same period in 2006. The decrease in general and administrative expenses of approximately $1.2 million, or 28%, for the three months ended June 30, 2007, as compared to the same period in 2006, was primarily due to less legal and administrative expenses associated with our stockholder litigation and SEC investigation. In June 2007, we received a reimbursement from our insurance provider of approximately $900,000 related to legal fees we have incurred as a result of defending against the stockholder litigation and SEC investigation.

Our general and administrative expenses consist primarily of personnel, facility and related costs for general corporate functions, including business development, finance, accounting, legal, human resources, quality/compliance, facilities and information systems.

Other Income (Expense)

Other income, net was approximately $211,000 for the three months ended June 30, 2007, as compared to approximately $1.2 million for the same period in 2006. Other income fluctuates from year to year and from period to period based upon fluctuations in the interest income earned on variable cash and investment balances and realized gains and losses on investments offset by interest expense on debt and capital lease obligations. The decrease in other income of approximately $1.0 million, or 82%, for the three months ended June 30, 2007, as compared to the same period in 2006, was primarily due to an increase in interest expense of approximately $562,000 associated with borrowing $20.0 million of debt in December 2006 and additional borrowings of $20.0 million in the three months ended June 30, 2007, as well as a decrease in interest income resulting from lower average cash and investment balances.

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Six Months Ended June 30, 2007 and 2006

Revenues

Total revenues were approximately $22.6 million for the six months ended June 30, 2007, as compared to approximately $18.9 million for the same period in 2006. The increase in 2007 revenue of approximately $3.7 million, or 19%, was due to increased co-promotion revenue from net sales of Elestat and Restasis in 2007, as compared to 2006. Total revenues for the 2006 period also included the recognition of a development milestone of $1.25 million from Santen for diquafosol tetrasodium in accordance with our development, license and supply agreement.

Co-promotion revenue from net sales of Elestat and Restasis for the six months ended June 30, 2007 was approximately $12.1 million and approximately $10.5 million, respectively, as compared to approximately $10.7 million and approximately $6.9 million, respectively, for the same period in 2006. Based upon national prescription data from IMS Health, for the six months ended June 30, 2007 and 2006, Elestat represented approximately 9% of the total U.S. allergic conjunctivitis market. For the six months ended June 30, 2007, Allergan recorded approximately $156 million of revenue from net sales of Restasis, as compared to approximately $132 million in the six months ended June 30, 2006.

Our future revenue will depend on various factors including the continued commercial success of Elestat and Restasis, pricing, rebates, discounts and returns for both products, the effect of competing products, coverage and reimbursement under commercial or government plans, seasonality of sales of Elestat and duration of market exclusivity of Elestat and Restasis. If Allergan significantly under-estimates or over-estimates rebate amounts, there could be a material effect on our revenue. In addition to the continuing co-promotion revenue from sales of Elestat and Restasis, our future revenue will also depend on the effectiveness of our commercial launch and continued commercialization of AzaSite, our ability to enter into additional collaboration agreements, and to achieve milestones under existing or future collaboration agreements, as well as whether we obtain regulatory approvals for our product candidates.

Research and Development Expenses

Research and development expenses were approximately $30.7 million for the six months ended June 30, 2007, as compared to approximately $18.3 million for the same period in 2006. The increase in research and development expenses of approximately $12.4 million, or 68%, for the six months ended June 30, 2007, as compared to the same period in 2006, was primarily due to approximately $13.9 million incurred related to AzaSite, including the payment of a $13.0 million upfront licensing fee upon the execution of the agreement with InSite Vision for the exclusive right to commercialize AzaSite in the United States and Canada. Costs associated with our other product candidates’ research and development activities for the six months ended June 30, 2007 were approximately $16.8 million and were primarily associated with our denufosol for cystic fibrosis and our epinastine nasal spray for allergic rhinitis programs.

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Our research and development expenses for the six months ended June 30, 2007 and 2006 and from the respective project’s inception are shown below and includes the percentage of overall research and development expenditures for the periods listed.

	(In thousands)
	Six Months Ended June 30,						Cumulative from Inception to June 30, 2007
	2007		%	2006		%			%
AzaSite (1)	$	13,937	45	$	—	—	$	13,937	6
Denufosol tetrasodium for cystic fibrosis		5,416	18		5,646	31		37,964	16
Epinastine nasal spray for allergic rhinitis (2)		4,162	13		3,744	21		12,637	5
INS115644 for glaucoma		1,416	5		1,300	7		5,059	2
Bilastine for seasonal allergic rhinitis		1,162	4		—	—		8,301	3
Prolacria (diquafosol tetrasodium) for dry eye disease		844	3		627	3		39,982	16
INS50589 for use in acute cardiac care (3)		76	—		2,418	13		13,045	5
Denufosol tetrasodium for retinal disease (3)		31	—		896	5		9,136	4
Other research, preclinical and development costs (4)		3,696	12		3,651	20		105,492	43
Total	$	30,740	100	$	18,282	100	$	245,553	100

(1) Includes a $13.0 million upfront licensing fee upon the signing of the license agreement with InSite Vision.

(2) Expense in 2006 includes a $2.5 million upfront licensing fee upon the signing of the license and development agreement with Boehringer Ingelheim.

(3) As of June 30, 2007, this program was not in active development.

(4) Other research, preclinical and development costs represent all unallocated research and development costs or those costs allocated to preclinical programs, discontinued and/or inactive programs. These unallocated costs include personnel costs of our research, preclinical programs, internal and external general research costs and other internal and external costs of other research, preclinical and development programs.

Our future research and development expenses will depend on the results and magnitude or scope of our clinical, preclinical and research activities and requirements imposed by regulatory agencies. Accordingly, our research and development expenses may fluctuate significantly from period to period. In addition, if we in-license or out-license rights to product candidates, our research and development expenses may fluctuate significantly from prior periods.

Selling and Marketing Expenses

Selling and marketing expenses were approximately $17.9 million for the six months ended June 30, 2007, as compared to approximately $13.6 million for the same period in 2006. The increase in selling and marketing expenses of approximately $4.3 million, or 32%, for the six months ended June 30, 2007, as compared to the same period in 2006, resulted from an overall increase in various expenses associated with the pre-launch activities related to AzaSite, including the expansion of our sales force and other marketing and promotional activities. We have also incurred a general increase in the costs associated with our sales force including increased salary, personnel related expenses and stock-based compensation expense.

Future selling and marketing expenses will depend on the level of our future commercialization activities. We expect selling and marketing expenses will increase in periods that immediately precede and follow product launches, including the periods surrounding our launch of AzaSite in the third quarter of 2007.

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General and Administrative Expenses

General and administrative expenses were approximately $6.8 million for the six months ended June 30, 2007, as compared to approximately $8.8 million for the same period in 2006. The decrease in general and administrative expenses of approximately $2.0 million, or 23%, for the six months ended June 30, 2007, as compared to the same period in 2006, was primarily due to less legal and administrative expenses associated with our stockholder litigation and SEC investigation. In June 2007, we received a reimbursement from our insurance provider of approximately $900,000 related to legal fees incurred as a result of defending against the stockholder litigation and SEC investigation. Legal fees, excluding amounts reimbursed, were approximately $1.1 million for the six months ended June 30, 2007, as compared to approximately $2.5 million for the same period in 2006.

Future general and administrative expenses will depend on the level of our future research and development and commercialization activities, as well as the level of legal and administrative expenses incurred to resolve our SEC investigation and stockholder litigation, and to the extent our legal expenses associated with the stockholder litigation and SEC investigation are reimbursed by insurance.

Other Income (Expense)

Other income, net was approximately $817,000 for the six months ended June 30, 2007, as compared to approximately $2.3 million for the same period in 2006. Other income fluctuates from year to year and from period to period based upon fluctuations in the interest income earned on variable cash and investment balances and realized gains and losses on investments offset by interest expense on debt and capital lease obligations. The decrease in other income of approximately $1.5 million, or 65%, for the six months ended June 30, 2007, as compared to the same period in 2006, was primarily due to an increase in interest expense of approximately $987,000 associated with borrowing $20.0 million of debt in December 2006 and additional borrowings of $20.0 million in the three months ended June 30, 2007 as well as a decrease in interest income resulting from lower average cash and investment balances. Future other income will depend on our future cash and investment balances, the return and change in fair market value on these investments, as well as levels of debt and the associated interest rates.

LIQUIDITY AND CAPITAL RESOURCES

We have financed our operations primarily through the sale of equity securities, including private sales of preferred stock and public offerings of common stock. In December 2006, we entered into a loan and security agreement in order to obtain debt financing of up to $40.0 million to fund in-licensing opportunities and related development, including the in-licensing of bilastine from FAES in November 2006 and AzaSite from InSite Vision in February 2007. In June 2007, we amended the loan and security agreement to enable us to draw upon a new supplemental term loan facility in the amount of $20.0 million. We have borrowed a total of $40.0 million under this agreement. All loan advances made under the agreement mature in March 2011. The commitment period during which we can draw upon the new supplemental term loan facility ends on December 31, 2007. We also currently receive revenue from net sales of Elestat and Restasis, and expect to receive revenue from net sales of AzaSite beginning in the third quarter of 2007, but do not expect this revenue to exceed our 2007 operating expenses.

At June 30, 2007, we had net working capital of approximately $50.9 million, a decrease of approximately $38.8 million from approximately $89.7 million at December 31, 2006. The decrease in working capital was principally due to $32.0 million in milestone payments related to AzaSite, as described below, as well as the use of funds for our normal operating expenses, which exceeded the revenue we recognized. Our principal sources of liquidity at June 30, 2007 were approximately $38.2 million in cash and cash equivalents and approximately $29.7 million in investments, which are considered available-for-sale, and the potential to borrow an additional $20.0 million under our amended loan and security agreement.

On July 20, 2007, we completed a sale of preferred stock with Warburg Pincus Private Equity IX, L.P., or Warburg, pursuant to which we agreed sold 140,186 shares of our Series A Exchangeable Preferred Stock, or Exchangeable Preferred Stock, to Warburg at a price per share of $535.00, for gross proceeds of $75.0 million. Each

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share of the Exchangeable Preferred Stock will be exchangeable for 100 shares of our common stock. We plan to use the proceeds from the financing to fund the commercialization of AzaSite and our ongoing research and development activities as well as for working capital and general corporate purposes.

Dividends on the Exchangeable Preferred Stock, if not exchanged, will be cumulative starting on July 20, 2008 and will accrue at an annual rate of 10% of the purchase price per share, compounded quarterly beginning with amounts accrued for the quarter ended September 30, 2008. Dividends will be payable until all or a portion of the Exchangeable Preferred Stock is exchanged for common stock or until the Exchangeable Preferred Stock is redeemed by us upon a liquidation, dissolution or change in control or is otherwise acquired by us. The conversion of the Exchangeable Preferred Stock is subject to stockholder approval by the holders of our common stock and the expiration or termination of any waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976. We have agreed to use our reasonable best efforts to convene a meeting of our stockholders to approve the exchange of the Exchangeable Preferred Stock. We shall be deemed to have used our reasonable best efforts if we convene such stockholder meeting before December 31, 2007. If the Exchangeable Preferred Stock remains outstanding on the fourth anniversary of the closing, both we and the holders of the outstanding Exchangeable Preferred Stock will have the right to cause the redemption of such stock for cash in a per share amount equal to the greater of: (i) the sum of the purchase price per share for the Exchangeable Preferred Stock plus all accrued but unpaid dividends through the date of such redemption and (ii) an amount equal to the average of the closing prices for the common stock on the Nasdaq Global Market for the 20 trading days immediately preceding the date which we or the holders of the outstanding Exchangeable Preferred Stock exercise such right multiplied by the then current exchange rate for the Exchangeable Preferred Stock.

On February 15, 2007, we signed an exclusive license agreement with InSite Vision for U.S. and Canadian commercialization of AzaSite, a treatment for bacterial conjuctivitis. In conjunction with this license agreement, we paid InSite Vision an upfront license fee of $13.0 million. On April 27, 2007, AzaSite was approved by the FDA for the treatment of bacterial conjunctivitis. In conjunction with the FDA approval, we paid InSite Vision an additional $19.0 million milestone. The $19.0 million milestone has been capitalized and is being amortized on a straight-line basis over the term of the patent coverage. In addition, we are also obligated to pay InSite Vision a 20% royalty for the first two years of commercialization and a 25% royalty thereafter on net sales of AzaSite in the United States and Canada.

Our working capital requirements may fluctuate in future periods depending on many factors, including: the number, magnitude, scope and timing of our development programs; the costs related to the commercialization of AzaSite; the costs related to the potential FDA approval of our other product candidates; the cost, timing and outcome of regulatory reviews, regulatory investigations, and changes in regulatory requirements; the costs of obtaining patent protection for our product candidates; the timing and terms of business development activities; the rate of technological advances relevant to our operations; the timing, method and cost of the commercialization of our product candidates; the efficiency of manufacturing processes developed on our behalf by third parties; the level of required administrative and legal support; the availability of capital to support product candidate development programs we pursue; the commercial potential of our products and product candidates; legal and administrative costs associated with resolving and satisfying any potential outcome of our stockholder litigation and SEC investigation; and any expansion of facility space.

Our actual 2007 financial results will be largely dependent on the commercialization of AzaSite, as well as the clinical and regulatory developments and timing of our epinastine nasal spray, denufosol, Prolacria and glaucoma programs. Based upon current Elestat and Restasis trends and the anticipated launch of AzaSite, we expect to record 2007 aggregate revenue in the range of $47-$57 million. Based on projected operating plans and activities completed in the first six months, we expect 2007 total operating expenses to be in the range of $115-$130 million. Costs of goods sold, amortization of the $19.0 million approval milestone, and royalty obligations to InSite Vision on any sales of AzaSite are expected to be in the range of $3-$6 million. Total estimated selling and marketing, and general and administrative, expenses are estimated to be in the range of $42-$48 million and $15-$19 million, respectively. Research and development expenses have been revised to reflect (a) reduced spending associated with the bilastine program for 2007 and (b) the latest project plans associated with the further development of our product candidates,

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and are now estimated to be in the range of $55-$65 million. The expected cash usage for the remaining six months of 2007 is expected to be in the range of $30-$45 million, excluding any additional borrowings under our debt facility and/or other financing transactions. The expected cash usage does not adjust for the $75.0 million of gross proceeds received from the Warburg transaction which closed in July 2007.

Included within our operating expenses guidance are projected stock-based compensation costs of approximately $3 million. This estimate is based on the unvested portion of stock options and restricted stock units outstanding as of June 30, 2007, our current stock price, and an anticipated level of share-based payments granted during 2007, including the hiring of additional employees needed to support the launch of AzaSite in 2007. For the six months ended June 30, 2007, we recognized non-cash stock-based compensation expense of approximately $1.1 million.

Our 2007 forecasted results will be largely dependent on the effectiveness of our commercialization of AzaSite and key development and regulatory events. We may have to adjust our guidance throughout 2007 as additional information concerning these events is obtained. The actual amount of operating expenses could differ significantly should our anticipated development plans change based upon program progress and events associated with our portfolio of product candidates, including the out-licensing or partnering of any of our programs.

We expect to have sufficient liquidity to continue our planned operations through 2008, considering the proceeds received from the Warburg transaction that closed in July 2007. Our liquidity needs will largely be determined by key development and regulatory events. In order for us to continue operations substantially beyond 2008 we will need to: (1) successfully commercialize AzaSite, (2) obtain additional product candidate approvals, which would trigger milestone payments to us, (3) out-license rights to certain of our product candidates, pursuant to which we would receive income, (4) raise additional capital through equity or debt financings or from other sources and/or (5) reduce expenditures and spending on one or more research and development programs. We currently have the ability to draw upon an additional $20.0 million of debt under our existing loan facility. Additionally, we currently have the ability to sell approximately $13.9 million of common stock under an effective shelf registration statement, which we filed with the SEC on April 16, 2004 and $130 million of securities, including common stock, preferred stock, debt securities, depositary shares and securities warrants from an additional effective shelf registration statement which we filed with the SEC on March 9, 2007. The loan and security agreement that we entered into in December 2006, as amended in June 2007, contains a financial covenant that requires us to maintain certain levels of liquidity based on our cash, investment and account receivables balances, as well as negative covenants that may limit us from assuming additional indebtedness and entering into other transactions as defined in the agreement.

Our ability to remain within our operating expense target range is subject to several other risks including unanticipated cost overruns, the need to expand the magnitude or scope of existing development programs, the need to change the number or timing of clinical trials, unanticipated regulatory requirements, costs to successfully commercialize our products and product candidates, commercial success of our products and product candidates, unanticipated professional fees or settlements associated with our stockholder litigation or SEC investigation and other factors described under the Risk Factors located elsewhere in this report.

Litigation

On February 15, 2005, the first of five identical purported shareholder class action complaints was filed in the United States District Court for the Middle District of North Carolina against us and certain of our senior officers. Each complaint alleged violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and Securities and Exchange Commission Rule 10b-5, and focused on statements that are claimed to be false and misleading regarding a Phase 3 clinical trial of our dry eye product candidate, Prolacria. Each complaint sought unspecified damages on behalf of a purported class of purchasers of our securities during the period from June 2, 2004 through February 8, 2005.

On March 27, 2006, following consolidation of the lawsuits into a single civil action and appointment of lead plaintiffs, the plaintiffs filed a Consolidated Class Action Complaint, or CAC. The CAC asserts claims against us and

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certain of our present or former senior officers or directors. The CAC asserts claims under sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 based on statements alleged to be false and misleading regarding a Phase 3 clinical trial of Prolacria, and also adds claims under sections 11, 12(a)(2) and 15 of the Securities Act of 1933. The CAC also asserts claims against certain parties that served as underwriters in our securities offerings during the period relevant to the CAC. The CAC seeks unspecified damages on behalf of a purported class of purchasers of our securities during the period from May 10, 2004 through February 8, 2005. In May 2006, the plaintiffs agreed to voluntarily dismiss their claims against the underwriters on the basis that they were time-barred. On June 30, 2006, we and other defendants moved that the court dismiss the CAC on the grounds that it fails to state a claim upon which relief can be granted and does not satisfy the pleading requirements under applicable law. On May 14, 2007, Magistrate Judge Eliason, to whom the District Court had referred the motion, issued a Recommendation that the District Court grant Defendants’ motion to dismiss the CAC. Plaintiffs filed objections to this Recommendation in which they argued that the District Court should not accept the Recommendation, and Defendants responded to Plaintiffs’ objections.

On July 26, 2007, the United States District Court for the Middle District of North Carolina accepted the Magistrate Judge’s Recommendation and granted our and the other defendants’ motion and dismissed the CAC with prejudice. The plaintiffs currently have a right of appeal to the United States Court of Appeals for the Fourth Circuit, which the plaintiffs may choose to exercise within the period established by rule. If appealed, we intend to defend the litigation vigorously.

As with any legal proceeding, we cannot predict with certainty the eventual outcome of these lawsuits, nor can a reasonable estimate of the amounts of loss, if any, be made. Furthermore, we will have to incur expenses in connection with these lawsuits, which may be substantial. Moreover, responding to and defending the pending litigation will result in a diversion of management’s attention and resources and an increase in professional fees. We have various insurance policies related to the risk associated with our business, including directors and officers insurance. However, there is no assurance that our insurance coverage will be sufficient or that our insurance companies will cover all the matters claimed. In the event of an adverse outcome, our business as well as our future results of operations, financial position and/or cash flows could be materially affected to the extent that our insurance fails to cover such costs.

SEC Investigation

On August 30, 2005, the SEC notified us that it is conducting a formal, nonpublic investigation which we believe relates to our Phase 3 clinical trial of our dry eye product candidate, Prolacria. On October 19, 2006, we received a Wells Notice letter from the staff of the SEC, issued in connection with this investigation. Our Chief Executive Officer and our Executive Vice President, Operations and Communications, also received Wells Notices.

The Wells Notices provide notification of the SEC staff’s determination that it intends to recommend to the SEC that it bring a civil action against us and the two officers regarding possible violations of Section 17(a) of the Securities Act of 1933, Sections 10(b) and 13(a) of the Securities Exchange Act of 1934 and SEC Rules 10b-5, 12b-20, 13a-1, 13a-11, 13a-13, and 13a-14 thereunder. Under the process established by the SEC, we and the two officers have the opportunity to respond in writing to the Wells Notice before the staff makes any formal recommendation to the SEC regarding what action, if any, should be brought by the SEC. We and the officers receiving these notices provided written submissions to the SEC in response to the Wells Notices during December 2006, and have had further meetings with the SEC staff.

We cannot predict with certainty the eventual outcome of this investigation, nor can a reasonable estimate of the costs that might result from the SEC’s investigation be made. Responding to this investigation will result in a diversion of management’s attention and resources and an increase in professional fees. We have various insurance policies related to the risk associated with our business, including directors and officers insurance. However, there is no assurance that our insurance coverage will be sufficient or that our insurance companies will cover all the matters claimed. In the event of an adverse outcome, our business as well as our future results of operations, financial position and/or cash flows could be materially affected to the extent that our insurance fails to cover such costs.

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The accompanying discussion and analysis of our financial condition and results of operations are based upon our financial statements and the related disclosures, which have been prepared in accordance with generally accepted accounting principles. The preparation of these financial statements require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. We evaluate our estimates, judgments and the policies underlying these estimates on a periodic basis as situations change, and regularly discuss financial events, policies, and issues with members of our audit committee and our independent registered public accounting firm. In addition, recognition of revenue from product co-promotion is affected by certain estimates and judgments made by Allergan on which we rely in recording this revenue. We routinely evaluate our estimates and policies regarding revenue recognition, taxes, clinical trial, preclinical/toxicology, manufacturing, research and other service liabilities.

We believe the following policies to be the most critical to an understanding of our financial condition and results of operations because they require us to make estimates and judgments about matters that are inherently uncertain.

Revenue Recognition

We record all of our revenue from product co-promotion activities and collaborative research agreements and plan to record product revenues from sales of AzaSite in accordance with SEC’s Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements,” or SAB No. 104. SAB No. 104 states that revenue should not be recognized until it is realized or realizable and earned. Revenue is realized or realizable and earned when all of the following criteria are met: 1) persuasive evidence of an arrangement exists; 2) delivery has occurred or services have been rendered; 3) the seller’s price to the buyer is fixed or determinable; and 4) collectibility is reasonably assured.

Product Revenues

We plan on recognizing revenue for sales of AzaSite when title and substantially all the risks and rewards of ownership have transferred to the customer, which generally occurs on the date of shipment, with the exception of product stocking incentives offered for approximately one month prior to the product’s launch. In the United States, we plan to sell AzaSite primarily to wholesalers and distributors, who, in turn, will sell to pharmacies and Federal, State and commercial healthcare organizations. Accruals, or reserves, for estimated rebates, discounts, wholesaler chargebacks and other sales incentives (collectively “sales incentives”) will be recorded in the same period that the related sales are recorded and will be recognized as a reduction in sales of AzaSite. The sales incentive reserves will be recorded in accordance with Emerging Issues Task Force, or EITF, Issue No. 01-9, “Accounting for Consideration Given by a Vendor to a Customer,” which states that cash consideration given by a vendor to a customer is presumed to be a reduction of the selling price of the vendor’s product or services and therefore should be characterized as a reduction of the revenue recognized in the vendor’s income statement. Sales incentive accruals, or reserves, will be based on reasonable estimates of the amounts earned or claimed on the sales of AzaSite. These estimates will take into consideration current contractual and statutory requirements, specific known market events and trends, internal and external historical data and experience and forecasted customer buying patterns. Amounts accrued, or reserved, for sales incentives will be adjusted for actual results and when trends or significant events indicate that an adjustment is appropriate.

In addition to SAB No. 104, our ability to recognize revenue for sales of AzaSite is subject to the requirements of Statement of Financial Accounting Standards, or SFAS, No. 48, “Revenue Recognition When Right of Return Exists,” or SFAS No. 48, as issued by the Financial Accounting Standards Board, or FASB. SFAS No. 48 states that revenue from sales transactions where the buyer has the right to return the product shall be recognized at the time of sale only if (1) the seller’s price to the buyer is substantially fixed or determinable at the date of sale, (2) the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product, (3) the buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product, (4) the buyer acquiring the product for resale has economic substance apart from that provided by the

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seller, (5) the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer, and (6) the amount of future returns can be reasonably estimated. Customers will be able to return short-dated or expired AzaSite that meet the guidelines set forth in our return goods policy. Returns will be accepted from both wholesalers and retail pharmacies. Consistent with industry standards, our return goods policy will allow for returns of AzaSite within an eighteen-month period, from six months prior to the expiration date to up to twelve months after the expiration date. In accordance with SFAS No. 48, we are required to estimate the level of sales that will ultimately be returned pursuant to our return policy and to record a related reserve at the time of sale. These amounts are deducted from our gross sales of AzaSite in determining our net sales. Since AzaSite is a new product, we will be utilizing the return data of several comparative products with ocular indications that are subject to similar return policies and wholesaler relationships as a basis for our initial return estimates, including our own experience with Elestat and Restasis as well as another drug indicated for bacterial conjunctivitis. Future estimated returns of AzaSite will be based primarily on the return data for these comparative products and our own historical experience with AzaSite. We will also consider other factors that could impact sales returns of AzaSite. These factors include levels of inventory in the distribution channel, estimated remaining shelf life, price changes of competitive products, and current and projected product demand that could be impacted by introductions of generic products and introductions of competitive new products, among others.

Immediately preceding the launch of AzaSite, we plan to offer wholesalers with stocking incentives that allow for extended payment terms, product discounts, and guaranteed sale provisions (collectively, “special terms”). These special terms are only being offered during a specified time period of approximately one month prior to the launch of AzaSite. We have determined that any sales of AzaSite made under these special term provisions will be accounted for using a consignment model since substantially all the risks and rewards of ownership do not transfer upon shipment. Under the consignment model, we will not recognize revenue upon shipment of AzaSite purchased with the special terms, but will record deferred revenue at gross invoice sales price and classify inventory of AzaSite held by the wholesalers as consignment inventory. We will recognize the revenue from such sales the earlier of when the inventory of AzaSite held by the wholesalers is sold through to the wholesalers’ customers or when such inventory of AzaSite is no longer subject to the special terms. All sales subsequent to this specified time period will include payment terms and return rights that are customary in the industry. For these sales, we plan on recording revenue on the date of shipment, as discussed above.

We plan on utilizing data from external sources to help us estimate our gross to net sales adjustments as they relate to the sales incentives and recognition of revenue for AzaSite sold under the special term provisions. External sourced data will include among others, information obtained from certain wholesalers with respect to their inventory levels and sell-through to customers and data from IMS Health, a supplier of market research data to the pharmaceutical industry. We also plan to use such data to help estimate and identify prescription trends, patient demand and average selling prices.

Product Co-promotion Revenues

We recognize co-promotion revenue based on net sales for Elestat and Restasis, as defined in the co-promotion agreements, and as reported to us by Allergan. We actively promote both Elestat and Restasis through our commercial organization and share in any risk of loss due to returns and other allowances, as determined by Allergan. Accordingly, our co-promotion revenues are based upon Allergan’s revenue recognition policy and other accounting policies over which we have limited or no control and on the underlying terms of our co-promotion agreements. Allergan recognizes revenue from product sales when goods are shipped and title and risk of loss transfers to the customer. The co-promotion agreements provide for gross sales to be reduced by estimates of sales returns, credits and allowances, normal trade and cash discounts, managed care sales rebates and other allocated costs as defined in the agreements, all of which are determined by Allergan and are outside our control. We record a percentage of Allergan’s net sales for both Elestat and Restasis, reported to us by Allergan, as co-promotion revenue. We receive monthly net sales information from Allergan and perform analytical reviews and trend analyses using prescription information that we receive from IMS Health. In addition, we exercise our audit rights under the contractual agreements with Allergan to annually perform an examination of Allergan’s sales records of both Elestat and Restasis. We make no adjustments to the amounts reported to us by Allergan other than reductions in net sales to reflect the incentive programs managed

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by us. We offer and manage certain incentive programs associated with Elestat, which are utilized by us in addition to those programs managed by Allergan. We reduce revenue by estimating the portion of sales that are subject to these incentive programs based on information reported to us by our third-party administrator of the incentive programs. For fiscal years 2006, 2005 and 2004, the amount of rebates associated with our incentive programs in each year was less than one-half of one percent of our co-promotion revenues. The rebates associated with the programs we manage represent an insignificant amount, as compared to the rebate and discount programs administered by Allergan and as compared to our aggregate co-promotion revenue. Under the co-promotion agreement for Elestat, we are obligated to meet predetermined minimum calendar year net sales target levels. If the annual minimum is not satisfied, we record revenues using a reduced percentage of net sales based upon our level of achievement of predetermined calendar year net sales target levels. Amounts receivable from Allergan in excess of recorded co-promotion revenue are recorded as deferred revenue.

Collaborative Research and Development Revenues

We recognize revenue under our collaborative research and development agreements when we have performed services under such agreements or when we or our collaborative partner have met a contractual milestone triggering a payment to us. We recognize revenue from our research and development service agreements ratably over the estimated service period as related research and development costs are incurred and the services are substantially performed. Upfront non-refundable fees and milestone payments received at the initiation of collaborative agreements for which we have an ongoing research and development commitment are deferred and recognized ratably over the period in which the services are substantially performed. This period, if not defined in the collaborative agreement, is based on estimates by management and the progress towards agreed upon development events as set forth in our collaborative agreements. These estimates are subject to revision as our development efforts progress and we gain knowledge regarding required additional development. Revisions in the commitment period are made in the period that the facts related to the change first become known. If the estimated service period is subsequently modified, the period over which the upfront fee or revenue related to ongoing research and development services is modified on a prospective basis. We are also entitled to receive milestone payments under our collaborative research and development agreements based upon the achievement of agreed upon development events that are substantively at-risk by our collaborative partners or us. This collaborative research revenue is recognized upon the achievement and acknowledgement of our collaborative partner of a development event, which is generally at the date payment is received from the collaborative partner or is reasonably assured. Accordingly, our revenue recognized under our collaborative research and development agreements may fluctuate significantly from period to period.

Inventories

Our inventories are valued at the lower of cost or market using the first-in, first-out (i.e., FIFO) method. Cost includes materials, labor, overhead, shipping and handling costs. Our inventories are subject to expiration dating. We plan to regularly evaluate the carrying value of our inventories and provide valuation reserves for any estimated obsolete or unmarketable inventories. Our determination that a valuation reserve might be required, in addition to the quantification of such reserve, requires us to utilize significant judgment. We will base our analysis, in part, on the level of inventories on hand in relation to our estimated forecast of product demand, production requirements for forecasted product demand, expected market conditions and the expiration dates or remaining shelf life of inventories.

Income Taxes

We account for uncertain tax positions in accordance with FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” an interpretation of FASB Statement No. 109, “Accounting for Income Taxes.” Significant management judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against net deferred tax assets. We have recorded a valuation allowance against all potential tax assets due to uncertainties in our ability to utilize deferred tax assets, primarily consisting of certain net operating losses carried forward, before they expire. The valuation allowance is based on estimates of taxable income in each of the jurisdictions in which we operate and the period over which our deferred tax assets will be recoverable.

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Liabilities

We generally enter into contractual agreements with third-party vendors to provide clinical, preclinical/toxicology, manufacturing, research and other services in the ordinary course of business. Many of these contracts are subject to milestone-based invoicing and services are completed over an extended period of time. We record liabilities under these contractual commitments when we determine an obligation has been incurred, regardless of the timing of the invoice. We monitor all significant research and development, manufacturing, promotion and marketing and other service activities and the progression of work related to these activities. We estimate the underlying obligation for each activity based upon our estimate of the amount of work performed and compare the estimated obligation against the amount that has been invoiced. Because of the nature of certain contracts and related delay in the contract’s invoicing, the obligation to these vendors may be based upon management’s estimate of the underlying obligation. We record the larger of our estimated obligation or invoiced amounts for completed service. In all cases, actual results may differ from our estimate.

Stock-Based Compensation Expense

As of January 1, 2006, we adopted SFAS No. 123(R), which requires us to measure compensation cost for share-based payment awards at fair value and recognize compensation expense over the service period for awards expected to vest. Upon adoption, we implemented the modified prospective method in recognizing stock-based compensation expense in future periods. We have selected the Black-Scholes option-pricing model as the most appropriate fair-value method for our awards and will recognize compensation expense on a straight-line basis over the vesting periods of our awards. The estimation of share-based payment awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Prior to 2007, we used a blended volatility calculation utilizing volatility of peer group companies with similar operations and financial structures in addition to our own historical volatility. In 2007, we began using only our own historical volatility as a basis for determining expected volatility. Significant management judgment is required in determining estimates of future stock price volatility, forfeitures and expected life to be used in the valuation of the options. Actual results, and future changes in estimates, may differ substantially from our current estimates. For stock options granted to non-employees, we have recognized compensation expense in accordance with the requirements of SFAS No. 123 “Accounting for Stock-Based Compensation,” or SFAS No. 123. SFAS No. 123 required that companies recognize compensation expense based on the estimated fair value of options granted to non-employees over their vesting period, which is generally the period during which services are rendered by such non-employees.

Total stock-based compensation for the three and six months ended June 30, 2007 and 2006 was allocated as follows (in thousands):

	Three Months Ended June 30,				Six Months Ended June 30,
	2007		2006		2007		2006
Research and development	$	189	$	134	$	315	$	288
Selling and marketing		182		59		297		110
General and administrative		271		150		476		305
Total stock-based compensation expense	$	642	$	343	$	1,088	$	703

As of June 30, 2007, approximately $7.1 million and $572,000 of total unrecognized compensation cost related to unvested stock options and restricted stock units, respectively, is expected to be recognized over a weighted-average period of 2.6 years and 4.1 years, respectively. We currently estimate total stock-based compensation expense will be

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approximately $3 million in 2007. This estimate is based on the unvested portion of stock options and restricted stock units outstanding as of June 30, 2007, our current stock price, and an anticipated level of share-based payments granted during 2007, including the hiring of additional employees needed to support the launch of AzaSite in 2007. Should our stock price change significantly from its current level, and/or if our anticipated headcount changes, particularly to support the AzaSite launch, actual stock-based compensation expense could change significantly from this projection. However, the actual amount of stock-based compensation expense recognized in the future will largely depend on levels of share-based payments granted in future periods and changes in our stock price.

Impact of Inflation

Although it is difficult to predict the impact of inflation on our costs and revenues in connection with our products, we do not anticipate that inflation will materially impact our costs of operation or the profitability of our products when marketed.

Impact of Recently Issued Accounting Pronouncements

In June 2007, the EITF of the FASB reached consensus on Issue No. 07-3, “Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities,” or EITF Issue No. 07-3. EITF Issue No. 07-3 addresses the issue of when to record nonrefundable advance payments for goods or services that will be used or rendered for research and development activities as expenses. The EITF has concluded that nonrefundable advance payments for future research and development activities should be deferred and recognized as an expense as the goods are delivered or the related services are performed. EITF Issue No. 07-3 is effective for fiscal years beginning after December 15, 2007. We have assessed the impact of EITF Issue No. 07-3 and expect no impact to our financial statements upon adoption of this guidance.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115,” or SFAS No. 159. SFAS No. 159 permits companies to elect to measure many financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis. Companies electing the fair value option would be required to recognize changes in fair value in earnings. We are currently evaluating the impact, if any, of SFAS No. 159 on our financial statements. If elected, SFAS No. 159 would be effective as of January 1, 2008.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” or SFAS No. 157. SFAS No. 157 establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within that fiscal year. We are currently evaluating the impact of adopting this statement.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Sensitivity

We are subject to interest rate risk on our investment portfolio, capital leases, other short-term debt obligations and future borrowings under our term loan facility.

We maintain an investment portfolio consisting of United States government and government agency obligations, money market and mutual fund investments, municipal and corporate notes and bonds and asset or mortgage-backed securities. Our portfolio has a current average maturity of less than 12 months, using the stated maturity or reset maturity dates associated with individual maturities as the basis for the calculation.

Our exposure to market risk for changes in interest rates relates to the increase or decrease in the amount of interest income we can earn on our investment portfolio, changes in the market value of investments due to changes in interest rates, the increase or decrease in realized gains and losses on investments and the amount of interest expense we must pay with respect to various outstanding debt instruments. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. We ensure the safety and preservation of invested principal funds by limiting default risk, market risk and reinvestment risk. We reduce default risk by investing in investment grade securities. Our investment portfolio includes only marketable securities and instruments with active secondary or resale markets to help ensure portfolio liquidity and we have implemented guidelines limiting the duration of investments. A hypothetical 100 basis point drop in interest rates along the entire interest rate yield curve would not significantly affect the fair value of our interest sensitive financial instruments. At June 30, 2007, our portfolio of available-for-sale investments consisted of approximately $19.9 million of investments maturing within one year and approximately $9.8 million of investments maturing after one year but within 36 months. In addition, we have $515,000 of our long-term investments that are held in a restricted account that collateralizes a letter of credit with a financial institution. We generally have the ability to hold our fixed-income investments to maturity and therefore do not expect that our operating results, financial position or cash flows will be affected by a significant amount due to a sudden change in interest rates.

Our risk associated with fluctuating interest expense is limited to capital leases, other short-term debt obligations and future borrowings under the term loan facility. The interest rate on our long-term debt is fixed on outstanding borrowings under the term loan facility, but future draws on the facility will assume interest based upon current market interest rates at the time of borrow. Assuming other factors are held constant, an increase in interest rates from the fixed rate on our debt generally results in a decrease in the fair value of our long-term debt, and a decrease in interest rates generally results in an increase in the fair value of our long-term debt. However, neither an increase nor a decrease in interest rates will impact the carrying value of the long-term debt. As of June 30, 2007, the fair value of our long-term debt borrowings approximate their carrying value of $40.0 million.

Strategic Investment Risk

In addition to our normal investment portfolio, we have a strategic investment in Parion Sciences, Inc. valued at $200,000 as of June 30, 2007. This investment is in the form of unregistered common stock and is subject to higher investment risk than our normal investment portfolio due to the lack of an active resale market for the investment.

Item 4. Controls and Procedures

Our management is responsible for establishing and maintaining an adequate system of internal control over our financial reporting. The design, monitoring and revision of the system of internal accounting controls involves, among other items, management’s judgments with respect to the relative cost and expected benefits of specific control measures. The effectiveness of the control system is supported by the selection, retention and training of qualified personnel and an organizational structure that provides an appropriate division of responsibility and formalized procedures. The system of internal accounting controls is periodically reviewed and modified in response to changing conditions. Internal audit consultants regularly monitor the adequacy and effectiveness of internal accounting controls.

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In addition to the system of internal accounting controls, management maintains corporate policy guidelines that help monitor proper overall business conduct, possible conflicts of interest, compliance with laws and confidentiality of proprietary information. Our Chief Executive Officer and Chief Financial Officer have reviewed and evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that our current disclosure controls and procedures are effective. There were no changes in our internal control over financial reporting during such period that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II: OTHER INFORMATION

Item 1. Legal Proceedings

On February 15, 2005, the first of five identical purported shareholder class action complaints was filed in the United States District Court for the Middle District of North Carolina against us and certain of our senior officers. Each complaint alleged violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and Securities and Exchange Commission Rule 10b-5, and focused on statements that are claimed to be false and misleading regarding a Phase 3 clinical trial of our dry eye product candidate, Prolacria. Each complaint sought unspecified damages on behalf of a purported class of purchasers of our securities during the period from June 2, 2004 through February 8, 2005.

On March 27, 2006, following consolidation of the lawsuits into a single civil action and appointment of lead plaintiffs, the plaintiffs filed a Consolidated Class Action Complaint, or CAC. The CAC asserts claims against us and certain of our present or former senior officers or directors. The CAC asserts claims under sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 based on statements alleged to be false and misleading regarding a Phase 3 clinical trial of Prolacria, and also adds claims under sections 11, 12(a)(2) and 15 of the Securities Act of 1933. The CAC also asserts claims against certain parties that served as underwriters in our securities offerings during the period relevant to the CAC. The CAC seeks unspecified damages on behalf of a purported class of purchasers of our securities during the period from May 10, 2004 through February 8, 2005. In May 2006, the plaintiffs agreed to voluntarily dismiss their claims against the underwriters on the basis that they were time-barred. On June 30, 2006, we and other defendants moved that the court dismiss the CAC on the grounds that it fails to state a claim upon which relief can be granted and does not satisfy the pleading requirements under applicable law. On May 14, 2007, Magistrate Judge Eliason, to whom the District Court had referred the motion, issued a Recommendation that the District Court grant Defendants’ motion to dismiss the CAC. Plaintiffs filed objections to this Recommendation in which they argued that the District Court should not accept the Recommendation, and Defendants responded to Plaintiffs’ objections.

On July 26, 2007, the United States District Court for the Middle District of North Carolina accepted the Magistrate Judge’s Recommendation and granted our and the other defendants’ motion and dismissed the CAC with prejudice. The plaintiffs currently have a right of appeal to the United States Court of Appeals for the Fourth Circuit, which the plaintiffs may choose to exercise within the period established by rule. If appealed, we intend to defend the litigation vigorously.

As with any legal proceeding, we cannot predict with certainty the eventual outcome of these lawsuits, nor can a reasonable estimate of the amounts of loss, if any, be made.

On August 30, 2005, the SEC notified us that it is conducting a formal, nonpublic investigation which we believe relates to our Phase 3 clinical trial of our dry eye product candidate, Prolacria. On October 19, 2006, we received a Wells Notice letter from the staff of the SEC, issued in connection with this investigation. Our Chief Executive Officer and our Executive Vice President, Operations and Communications, also received Wells Notices.

The Wells Notices provide notification of the SEC staff’s determination that it intends to recommend to the SEC that it bring a civil action against us and the two officers regarding possible violations of Section 17(a) of the Securities Act of 1933, Sections 10(b) and 13(a) of the Securities Exchange Act of 1934 and SEC Rules 10b-5, 12b-20, 13a-1, 13a-11, 13a-13, and 13a-14 thereunder. Under the process established by the SEC, we and the two officers have the opportunity to respond in writing to the Wells Notice before the staff makes any formal recommendation to the SEC regarding what action, if any, should be brought by the SEC. We and the officers receiving these notices provided written submissions to the SEC in response to the Wells Notices during December 2006, and have had further meetings with the SEC staff.

We cannot predict with certainty the eventual outcome of this investigation, nor can a reasonable estimate of the costs that might result from the SEC’s investigation be made.

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Item 1A. Risk Factors.

RISK FACTORS

An investment in the shares of our common stock involves a substantial risk of loss. You should carefully read this entire report and should give particular attention to the following risk factors. You should recognize that other significant risks may arise in the future, which we cannot foresee at this time. Also, the risks that we now foresee might affect us to a greater or different degree than expected. There are a number of important factors that could cause our actual results to differ materially from those indicated by any forward-looking statements in this document. These factors include, without limitation, the risk factors listed below and other factors presented throughout this document and any other documents filed by us with the SEC.

Risks Related to Product Commercialization

Failure to adequately market and commercialize AzaSite will limit our revenues.

The commercial success of AzaSite will largely depend on a number of factors, including:

• The scope of the product’s launch into the United States;

• Acceptance by patients and physicians;

• The effectiveness of our sales and marketing efforts;

• Ability to differentiate AzaSite relative to our competitors’ products;

• Ability to further develop clinical information to support AzaSite;

• A knowledgeable sales force;

• Adequate market penetration;

• Adequate pricing and reimbursement under commercial or governmental plans;

• Successfully contracting for manufacturing capability to meet demand;

• The manufacturer’s successful building and sustaining of such manufacturing capability;

• Our ability to enter into managed care and governmental agreements; and

• Any competitor’s ability to successfully commercialize competing therapies.

We expect to launch AzaSite on August 13, 2007. The effectiveness of the launch of AzaSite is dependent upon a number of factors, including entering into contracts related to supply chain management, managed care and third-party payors. The implementation of these and other steps related to a product launch will take significant time and resources. We are responsible for all aspects of the commercialization of this product, including determination of formularies upon which AzaSite is listed, manufacturing, distribution, marketing and sales. If AzaSite is not successfully commercialized, our revenues will be limited.

We have had limited experience in commercialization of products.

We have established a sales force to market and promote AzaSite, Elestat and Restasis, as well as other potential products. Although the members of our sales force have had experience in sales with other companies, prior to 2004 we did not have a sales force and we may experience difficulties maintaining our sales force. We have incurred substantial expenses in establishing and maintaining our sales force, including substantial additional expenses for the training and management of personnel and the infrastructure to enable our sales force to be effective and compliant with the multiple laws and regulations affecting sales and promotion of pharmaceutical products. We expect to continue to incur substantial expenses in the future.

As part of our AzaSite launch preparation, we have expanded our sales force to a total of 98 sales representatives who will call on eye care professionals, who we currently call on, and select high prescribing pediatricians and primary care physicians. We have no prior experience calling on pediatricians and primary care physicians. A large number of pharmaceutical companies, including those with competing products, much larger sales

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forces and financial resources, and those with products for indications that are completely unrelated to those of our products, compete for the time and attention of pediatricians and primary care physicians. Furthermore, if additional products are approved, we will consider substantially expanding our sales force. We may not be able to successfully continue to attract and retain the desired number of qualified sales personnel necessary to support the commercialization of AzaSite, or for other future needs. The costs of maintaining our sales force may exceed our product revenues.

In addition, we have no prior experience in product pricing, negotiating managed care agreements and government contracts, or managing regulatory-related compliance activities such as pharmacovigilance, all of which are our responsibility as they relate to AzaSite.

Failure to successfully market and co-promote Allergan’s Restasis and Elestat will negatively impact our revenues.

Although we co-promote Restasis in the United States, Allergan is primarily responsible for marketing and commercializing Restasis. Accordingly, our revenues on the net sales of Restasis are largely dependent on the actions and success of Allergan, over whom we have no control.

The manufacture and sale of Restasis is protected under a use patent which expires in August 2009 and a formulation patent which expires in May 2014. If and when we experience competition, including generics, for Restasis, our revenues attributable to Restasis will be significantly impacted. Our agreement with Allergan provides that we have the responsibility for promoting and marketing Elestat in the United States and paying the associated costs. There can be no assurances that revenues associated with Elestat and Restasis will exceed the related selling, promoting and marketing expenses associated with co-promotion activities for these products during the year ending December 31, 2007 or any future period. Our revenues will be impacted from time to time by the number of formularies upon which these products are listed, the discounts and pricing under such formularies, as well as the estimated and actual amount of rebates. Allergan is responsible for determining the formularies upon which Elestat and Restasis are listed and making the appropriate regulatory and other filings. Inclusion on certain formularies may require price concessions through rebate programs that impact the level of co-promotion revenue that we receive on a product. The need to give price concessions can be particularly acute where a greater number of competing products are listed on the same formulary. Presently, there are a large number of competing products in the allergic conjunctivitis area. On an annual basis, Allergan negotiates for coverage under states’ Medicaid programs and coverage under commercial and Medicare programs. These activities can result in either maintaining, losing or gaining Medicaid, Medicare and commercial formulary coverage. During 2006, we lost Elestat coverage under several state Medicaid plans which was not anticipated. While the loss of these coverages did not significantly impact our portion of the co-promotion revenue due to the large price concessions associated with these particular states, future loss of coverage under additional states or commercial plans may have a negative impact on our co-promotion revenue.

The commercial marketing exclusivity period for Elestat provided under the Hatch-Waxman Act will expire in October 2008, after which time Elestat could face generic or over-the-counter competition if there is no other intellectual property or marketing exclusivity protection covering Elestat. We are aware that several generic pharmaceutical companies have expressed intent to commercialize the ocular form of epinastine after the commercial exclusivity period expires. While we are exploring various possible forms of additional intellectual property coverage to protect the commercialization of Elestat in the United States, there can be no assurance that any form of intellectual property protection covering Elestat will be possible in the United States after the expiration of the commercial exclusivity period under the Hatch-Waxman Act in October 2008. If a generic form of Elestat is introduced into the market, our agreement with Allergan to co-promote Elestat will no longer be in effect, and our revenues attributable to Elestat will cease. Loss of our co-promotion revenue from Elestat will materially impact our results of operations and cash flows.

New branded products and generics have recently been introduced into the allergic conjunctivitis market. The introduction of these new products has increased the competition for Elestat and has taken market share from Elestat, which has had, and may continue to have, a negative impact on our revenues.

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Our present revenues depend solely upon and our future revenues will depend, at least in part, upon the acceptance of Elestat and Restasis by eye-care professionals, allergists and patients. Factors that could affect the acceptance of Elestat and Restasis include:

• Satisfaction with existing alternative therapies;

• Perceived efficacy relative to other available therapies;

• Extent and effectiveness of our promotion and marketing efforts;

• Extent and effectiveness of Allergan’s sales and marketing efforts;

• Changes in, or the levels of, third-party reimbursement of product costs;

• Coverage and reimbursement under Medicare Part D, other state government sponsored plans and commercial plans;

• Cost of treatment;

• Marketing and sales activities of competitors;

• Duration of market exclusivity of Elestat and Restasis;

• Pricing and availability of alternative products, including generic or over-the-counter products;

• Shifts in the medical community to new treatment paradigms or standards of care;

• Relative convenience and ease of administration;

• Prevalence and severity of adverse side effects; and

• Regulatory approval in other jurisdictions.

We cannot predict the potential long-term patient acceptance of, or the effects of competition and managed health care on, sales of either product.

If we are unable to contract with third parties for the synthesis of active pharmaceutical ingredients required for preclinical testing, for the manufacture of drug products for clinical trials, or for the large-scale manufacture of any approved products, we may be unable to develop or commercialize our drug products.

The manufacturing of sufficient quantities of new and/or approved product candidates is a time-consuming and complex process. We have no experience or capabilities to conduct the large-scale manufacture of any of our product candidates. In order to successfully commercialize AzaSite and continue to develop our product candidates, we need to contract or otherwise arrange for the necessary manufacturing. There are a limited number of manufacturers that operate under the FDA’s cGMP regulations capable of manufacturing for us or our collaborators. With the exception of (i) AzaSite for which we have contracted with InSite Vision for the active pharmaceutical ingredients, or APIs, and for which we are responsible for contracting with a third-party manufacturer to manufacture and supply AzaSite in finished product form, (ii) Santen, for which we are required to supply bulk APIs, and (iii) bilastine for which we will be responsible for contracting with a third-party manufacturer to manufacture and supply bilastine in finished product form, all of our partners are responsible for making their own arrangements for the manufacture of drug products, including arranging for the manufacture of bulk APIs. Our dependence upon third parties for the manufacture of both drug substance and finished drug products may adversely affect our ability to develop and deliver such products on a timely and competitive basis. Similarly, our dependence on our partners to arrange for their own supplies of finished drug products may adversely affect our operations and revenues. If we, or our partners, are unable to engage or retain third-party manufacturers on commercially acceptable terms, our products may not be commercialized as planned. Our strategy of relying on third parties for manufacturing capabilities presents the following risks:

• The manufacturing processes for most of our APIs and finished products have not been validated at the scale required for commercial sales;

• Delays in scale-up to commercial quantities and any change at the site of manufacture could delay clinical trials, regulatory submissions and ultimately the commercialization of our products, which could harm our reputation in the medical and scientific communities;

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• Manufacturers of our products are subject to the FDA’s cGMP regulations, and similar foreign standards that apply, and we do not necessarily have full control over compliance with these regulations by third-party manufacturers;

• A potential NDA approval may be contingent upon the results of an FDA inspection to confirm cGMP compliance and adherence to the specifications submitted to the FDA;

• Manufacturing facilities are subject to ongoing post-approval FDA inspections to ensure continued compliance with cGMP regulations. If the manufacturing facility does not maintain cGMP compliance after NDA approval, the FDA has the authority to seize product produced under such conditions and may seek to enjoin further manufacture and distribution, as well as other equitable remedies such as mandatory recall;

• Without satisfactory long-term agreements with manufacturers, we will not be able to develop or commercialize our product candidates as planned or at all;

• We may not have intellectual property rights, or may have to share intellectual property rights, to any improvements in the manufacturing processes or new manufacturing processes for our product candidates; and

• If we are unable to engage or retain an acceptable third-party manufacturer for any of our product candidates, we would either have to develop our own manufacturing capabilities or delay the development of such product candidate.

Reliance on a single party to manufacture and supply either finished product or the bulk active pharmaceutical ingredients for a product or product candidates could adversely affect us.

Under our agreements with Allergan, Allergan is responsible for the manufacture and supply of Elestat, Restasis, and Prolacria, if approved by the FDA. It is our understanding that Allergan relies upon an arrangement with a single third party for the manufacture and supply of APIs for each of Elestat, Restasis, and for Prolacria. Allergan then completes the manufacturing process to yield finished product.

We are responsible for the manufacture of AzaSite pursuant to regulatory requirements. Under our supply agreement with InSite Vision, InSite Vision is responsible for supplying us with azithromycin, the API used in AzaSite. InSite Vision, in turn, relies upon an arrangement with a single third party for the manufacture and supply of such API. We are responsible for producing the finished product form of AzaSite, which we currently anticipate will be manufactured by a single party. There can be no assurance that such manufacturer will be able to produce sufficient quantities of finished product in a timely manner to support the commercialization of AzaSite. In the event we are unable to continue to obtain sufficient quantities of AzaSite in finished product form, the long-term supply chain and distribution of AzaSite may be affected and our revenues may be negatively impacted.

In the event a third-party manufacturer is unable to supply Allergan and InSite Vision (as the case may be), if such supply is unreasonably delayed, or if Allergan or our finished product contract partner are unable to complete the manufacturing cycle, sales of the applicable product could be adversely impacted, which would result in a reduction in any applicable product revenue. In addition, if Allergan or the third-party manufacturers do not maintain cGMP compliance, the FDA could require corrective actions or take enforcement actions that could affect production and availability of the applicable product, thus adversely affecting sales.

In addition, we have relied upon supply agreements with third parties for the manufacture and supply of the bulk APIs for our product candidates for purposes of preclinical testing and clinical trials. We presently depend upon one vendor as the sole manufacturer of our supply of APIs for Prolacria, denufosol, and epinastine nasal spray. We intend to contract with these vendors, as necessary, for commercial scale manufacturing of our products where we are responsible for such activities. In the case of Prolacria, we expect Allergan to purchase commercial quantities of bulk APIs from a sole manufacturer, including initial launch quantities should the product candidate receive FDA approval. Delays in any aspect of implementing the manufacturing process could cause significant development delays and increased costs.

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In addition, if Allergan, FAES or any third-party manufacturer does not maintain cGMP compliance, the FDA could require corrective actions or take enforcement actions that could affect production and availability of the product thus adversely affecting sales. We presently depend on sole manufacturers of APIs for our product candidates and it would be time consuming and costly to identify and qualify new sources. If our vendors were to terminate our arrangement or fail to meet our supply needs we might be forced to delay our development programs and/or be unable to supply products to the market which could delay or reduce revenues and result in loss of market share.

We may not be able to successfully compete with other biotechnology companies and established pharmaceutical companies.

The biotechnology and pharmaceutical industries are intensely competitive and subject to rapid and significant technological change. There are many companies seeking to develop products for the same indications that we are working on. Our competitors in the United States and elsewhere are numerous and include, among others, major multinational pharmaceutical and chemical companies, specialized biotechnology firms and universities and other research institutions. Competitors in our core therapeutic areas include: Allergan; Alcon, Inc.; Bausch & Lomb, Inc.; ISTA Pharmaceuticals, Inc.; Lantibio, Inc.; MedPointe Pharmaceuticals; Merck & Co, Inc.; Nascent Pharmaceuticals, Inc.; Novagali Pharma; Novartis; Otsuka America Pharmaceutical, Inc.; Pfizer, Inc.; Santen Senju Pharmaceutical Co. Ltd.; Sirion Therapeutics, Inc.; Sucampo Pharmaceuticals, Inc.; Vistakon Pharmaceuticals, LLC (ophthalmic); Gilead Sciences, Inc.; Genaera Corporation; Genentech, Inc.; Novartis; Pharmaxis Ltd.; Predix Pharmaceuticals Holdings, Inc.; Vertex Pharmaceuticals Inc. (cystic fibrosis); AstraZeneca PLC; GlaxoSmithKline plc; MedPointe Pharmaceuticals; Pfizer; Sanofi-Aventis; and Schering-Plough Corporation (allergic rhinitis). Most of these competitors have greater resources than us, including greater financial resources, larger research and development staffs and more experienced marketing and manufacturing organizations.

In addition, most of our competitors have greater experience than we do in conducting preclinical and clinical trials and obtaining FDA and other regulatory approvals. Accordingly, our competitors may succeed in obtaining FDA or other regulatory approvals for product candidates more rapidly than we do. Companies that complete clinical trials, obtain required regulatory approvals, and commence commercial sale of their drugs before we do may achieve a significant competitive advantage, including patent and FDA marketing exclusivity rights that would delay our ability to market products. Drugs resulting from our research and development efforts, or from our joint efforts with our collaborative partners, may not compete successfully with competitors’ existing products or products under development.

Acquisitions of competing companies and potential competitors by large pharmaceutical companies or others could enhance financial, marketing and other resources available to such competitors. Academic and government institutions have become increasingly aware of the commercial value of their research findings and are more likely to enter into exclusive licensing agreements with commercial enterprises to market commercial products. Many of our competitors have far greater financial, technical, human and other resources than we do and may be better able to afford larger license fees and milestones attractive to those institutions. Our competitors may also develop technologies and drugs that are safer, more effective, or less costly than any we are developing or which would render our technology and future drugs obsolete and non-competitive. In addition, alternative approaches, such as gene therapy, to treating diseases that we have targeted, such as cystic fibrosis, may make our product candidates obsolete.

We will rely on third parties to market, distribute and sell some of our products and those third parties may not perform.

We have developed a commercialization organization to co-promote Elestat and Restasis, and to market and commercialize AzaSite. We are dependent on Allergan, or other third parties, to perform or assist us in the marketing, distribution or sale of these products. In addition, we may not identify acceptable partners or enter into favorable agreements with them for our other product candidates. We will rely on the services of a single source, third-party distributor to deliver AzaSite to our customers. In addition to the physical storage and distribution of AzaSite, this third-party distributor will be maintaining and providing us with information and data with regard to our inventory, AzaSite orders, billings and receivables, chargebacks and returns, among others, on which our accounting estimates will

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be based. If third parties do not successfully carry out their contractual duties, meet expected sales goals, or maximize the commercial potential of our products, we may be required to hire or expand our own staff and sales force to compete successfully, which may not be possible. If Allergan or other third parties do not perform, or assist us in performing these functions, or if there is a delay or interruption in the distribution of our products, it could have an adverse effect on product revenue, accounting estimates and our overall operations.

We will depend on three wholesalers for the vast majority of our AzaSite revenues in the United States, and the loss of any of these wholesalers would negatively impact our revenues.

The prescription drug wholesaling industry in the United States is highly concentrated, with a vast majority of all sales made by three major full-line companies. Those companies are Cardinal Health, McKesson Corporation and AmerisourceBergen. It is expected that the majority of our AzaSite revenues will come from sales to these three companies. The loss of any of these wholesalers could have a negative impact on our launch and continued commercialization 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 result in or cause us to incur higher product distribution costs, lower margins or the need to find alternative methods of distributing our products. Such alternative methods may not exist or may not be economically feasible.

If physicians and patients do not accept our product candidates, they will not be commercially successful.

Even if regulatory authorities approve our product candidates, those product candidates may not be commercially successful. Acceptance of and demand for any new products will depend largely on the following:

• Acceptance by physicians and patients of the product as a safe and effective therapy;

• Reimbursement of drug and treatment costs by government programs and third-party payors;

• In the case of Prolacria, effectiveness of Allergan’s sales and marketing efforts;

• Effectiveness of our sales and marketing efforts;

• Marketing and sales activities of competitors;

• Safety, effectiveness and pricing of alternative products; and

• Prevalence and severity of side effects associated with the new product.

In addition, to achieve broad market acceptance of our product candidates, in many cases we will need to develop, alone or with others, convenient methods for administering the products. For example, we intend that Prolacria will be applied from a vial containing a single day’s dosage of non-preserved medication. Patients may prefer to purchase preserved medication for multiple doses. We have not yet established a plan to develop a multi-dose formulation. Although our partner, Santen, is developing a multi-dose formulation for use in its licensed territories, a multi-dose formulation has not been developed by our other partner, Allergan, for use in the remainder of the world. In addition, denufosol for the treatment of cystic fibrosis is administered by a standard nebulizer three times-a-day but patients may prefer a smaller, more portable, hand-held device. Similar challenges may exist in identifying and perfecting convenient methods of administration for our other product candidates.

Failure to timely and adequately market and commercialize our other product candidates will limit our revenues.

Even if clinical trials for our product candidates, including Prolacria, are successful, we cannot predict when, or if, the FDA or other regulatory authorities will approve such product candidates and allow their commercialization. Even if a product candidate is approved, we will need to timely and adequately market and commercialize such product, including the training and possible hiring of an appropriate sales and marketing staff for such product.

Our revenue on net sales of Prolacria, if any, would be largely dependent on the actions and success of Allergan, over whom we have no control. In the event Prolacria is approved by the FDA, we plan to co-promote Prolacria within the United States; however, Allergan is primarily responsible for launching and marketing Prolacria in the United States and other major worldwide pharmaceutical markets, excluding certain Asian markets.

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If Prolacria and other product candidates are not successfully commercialized following approval, our revenues may be limited.

Risks Related to Product Development

If the FDA does not conclude that our product candidates meet statutory requirements for safety and efficacy, we will be unable to obtain regulatory approval for marketing in the United States.

To achieve profitable operations, we must, alone or with others, successfully identify, develop, introduce and market products. We have not received marketing approval for any of our product candidates, except AzaSite, which was in-licensed from InSite Vision. We have one product candidate, Prolacria, for which we have received two approvable letters from the FDA. There is no guarantee that the FDA will approve Prolacria and allow the commercialization of the product in the United States. It will be necessary to undertake at least one additional Phase 3 clinical trial in support of the NDA for Prolacria and there can be no guarantee that any such additional clinical trial would be successful or that the FDA would approve Prolacria even if such additional clinical trial was successful. If additional Phase 3 clinical trials for Prolacria are required by the FDA, we may decide not to conduct those clinical trials, which would result in the inability to obtain FDA approval of the product candidate.

We have licensed bilastine, an oral antihistamine compound for the treatment or prevention of allergic rhinitis, from FAES, for development and commercialization in the United States and Canada. FAES has conducted a thorough QT/QTc clinical trial in the United States of an oral formulation of bilastine to confirm the cardiac safety profile of this product candidate. Following a meeting with the FDA and in consultation with Inspire, FAES has agreed to conduct additional clinical work and an expanded QT/QTc comparative trial, which will likely include an FDA-approved antihistamine. If the strength of the overall clinical data is not sufficient to support FDA approval, it is unlikely that we will be able to commercialize bilastine in the United States or Canada. Although FAES previously conducted two large, potentially pivotal Phase 3 seasonal allergic rhinitis clinical trials of an oral tablet formulation of bilastine outside the United States, other than the QT/QTc clinical trial, no other clinical trials have been conducted in the United States. It may be necessary to conduct additional clinical trials in the United States in support of an NDA filing. There can be no guarantee that any additional clinical trials will be successful, or that the FDA would approve bilastine even if such clinical trials are successful.

In addition to Prolacria and the oral tablet formulation of bilastine, we have other product candidates in clinical and preclinical development. A substantial amount of work will be required to advance these product candidates through clinical testing and ultimately to commercial approval. We will have to conduct significant additional development activities, non-clinical and clinical tests and obtain regulatory approval before our product candidates can be commercialized. Product candidates that may appear to be promising at early stages of development may not successfully reach the market for a number of reasons. The results of preclinical and clinical testing of our product candidates under development may not necessarily indicate the results that will be obtained from later or more extensive testing. Accordingly, some or all of our preclinical candidates may not advance to clinical development. Additionally, companies in the pharmaceutical and biotechnology industries, including us, have suffered significant setbacks in advanced clinical trials, even after obtaining promising results in earlier clinical trials. Our ongoing clinical trials might be delayed or halted for various reasons, including:

• The measure of efficacy of the drug is not statistically significant compared to placebo;

• Patients experience severe side effects or serious adverse events during treatment;

• Patients die during the clinical trial because their disease is too advanced or because they experience medical problems that may or may not relate to the drug being studied;

• Patients do not enroll in the clinical trials at the rate we expect;

• We decide to modify the drug during testing;

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• Clinical investigator conduct or misconduct leads the FDA to stop the clinical trial or to take other action that could delay or impede progress of a clinical trial;

• Our commercial partners, or future commercial partners, delay, amend or change our development plan or strategy;

• We allocate our limited financial and other resources to other clinical and preclinical programs; and

• Weather events, natural disasters, malicious activities or other unforeseen events occur.

Additionally, the introduction of our products in foreign markets will subject us to foreign regulatory clearances, the receipt of which may be unpredictable, uncertain and may impose substantial additional costs and burdens which we or our partners in such foreign markets may be unwilling or unable to fund. As with the FDA, foreign regulatory authorities must be satisfied that adequate evidence of safety and efficacy of the product has been presented before marketing authorization is granted. The foreign regulatory approval process includes all of the risks associated with obtaining FDA marketing approval. Approval by the FDA does not ensure approval by other regulatory authorities.

Since some of our clinical candidates utilize new or different mechanisms of action and in some cases there may be no regulatory precedents, conducting clinical trials and obtaining regulatory approval may be difficult, expensive and prolonged, which would delay any commercialization of our products.

To complete successful clinical trials, our product candidates must demonstrate safety and provide substantial evidence of efficacy. The FDA generally evaluates efficacy based on the statistical significance of a product candidate meeting predetermined clinical endpoints. The design of clinical trials to establish meaningful endpoints is done in collaboration with the FDA prior to the commencement of clinical trials. We establish these endpoints based on guidance from the FDA, including FDA guidance documents applicable to establishing the efficacy, safety and tolerability measures required for approval of products. However, since some of our product candidates utilize new or different mechanisms of action, the FDA may not have established guidelines for the design of our clinical trials and may take longer than average to consider our product candidates for approval. The FDA could change its view on clinical trial design and establishment of appropriate standards for efficacy, safety and tolerability and require a change in clinical trial design, additional data or even further clinical trials before granting approval of our product candidates. We could encounter delays and increased expenses in our clinical trials if the FDA concludes that the endpoints established for a clinical trial do not adequately predict a clinical benefit.

We have one product candidate for the treatment of dry eye disease, Prolacria, for which we have received two approvable letters from the FDA. The FDA has not published guidelines on the approval of a product for the treatment of dry eye disease. Furthermore, to date, only one prescription product, Restasis, has been approved by the FDA for the treatment of dry eye disease, and such product has a different mechanism of action from Prolacria. It will be necessary to undertake at least one additional Phase 3 clinical trial in support of our NDA for Prolacria and there can be no guarantee that any such additional clinical trial would be successful or that the FDA would approve Prolacria even if such additional clinical trial was successful.

We are developing denufosol tetrasodium as an inhaled product designed to enhance the lung’s innate mucosal hydration and mucociliary clearance mechanisms by mitigating the underlying ion transport defect in the airways of patients with cystic fibrosis. The FDA has not published guidance on the drug approval process associated with such a product candidate. Furthermore, we are not aware of any FDA approved product that mitigates the underlying ion transport defect in the airways of patients with cystic fibrosis. We cannot predict or guarantee the outcome or timing of our Phase 3 program for denufosol for cystic fibrosis. A significant amount of work will be required to advance denufosol through clinical testing, including satisfactory completion of additional clinical trials, toxicology and carcinogenicity studies. We may later decide to change the focus or timing of a Phase 3 program. The Phase 3 clinical trials for denufosol for cystic fibrosis may not be successful or unexpected safety concerns may emerge that would negatively change the risk/benefit profile for this product candidate.

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Estimated development costs are difficult to project and may change frequently prior to regulatory approval.

While all new compounds require standard regulated phases of testing, the actual type and scope of testing can vary significantly among different product candidates which may result in significant disparities in total costs required to complete the respective development programs.

The number and type of studies that may be required by the FDA, or other regulatory authorities, for a particular compound are based on the compound’s clinical profile compared to existing therapies for the targeted patient population. Factors that affect the costs of a clinical trial include:

• The number of patients required to participate in clinical trials to demonstrate statistical significance for a drug’s safety and efficacy and the number and geographical location of clinical trial sites necessary to enroll such patients;

• The time required to enroll the targeted number of patients in clinical trials, which may vary depending on the size and availability of the targeted patient population and the perceived benefit to the clinical trial participants; and

• The number and type of required laboratory tests supporting clinical trials.

Other activities required before submitting an NDA include regulatory preparation for submission, biostatistical analyses, scale-up synthesis, and validation of commercial product. In addition, prior to product launch, production of a certain amount of commercial grade drug product inventory meeting FDA cGMP standards is required, and the manufacturing facility must pass a pre-approval inspection conducted by the FDA to determine whether the product can be consistently manufactured to meet cGMP requirements and to meet specifications submitted to the FDA.

Also, ongoing development programs and associated costs are subject to frequent, significant and unpredictable changes due to a number of factors, including:

• Data collected in preclinical or clinical trials may prompt significant changes, delays or enhancements to an ongoing development program;

• Commercial partners and the underlying contractual agreements may require additional or more involved clinical or preclinical activities;

• The FDA, or other regulatory authorities, may direct the sponsor to change or enhance its ongoing development program based on developments in the testing of similar compounds or related compounds;

• Unexpected regulatory requirements, changes in regulatory policy or review standards, or interim reviews by regulatory agencies may cause delays or changes to development programs; and

• Anticipated manufacturing costs may change significantly due to necessary changes in manufacturing processes, variances from anticipated manufacturing process yields or changes in the cost and/or availability of starting materials, and other costs to ensure the manufacturing facility is in compliance with cGMP requirements and is capable of consistently producing the product candidate in accordance with established specifications submitted to the FDA.

Clinical trials may take longer to complete and cost more than we expect, which would adversely affect our ability to commercialize product candidates and achieve profitability.

Clinical trials are expensive and are often lengthy. They require appropriate identification of optimal treatment regimens and relevant patient population, adequate supplies of drug product, and sufficient patient enrollment. Patient enrollment is a function of many factors, including:

• The size and availability of the relevant patient population;

• The nature of the protocol;

• The proximity of patients to clinical sites;

• The eligibility criteria for the clinical trial; and

• The perceived benefit of participating in a clinical trial.

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Delays in patient enrollment can result in increased costs and longer development times. The timing of our Phase 3 program for denufosol for the treatment of cystic fibrosis will be impacted by a number of variables, including clinical development decisions regarding identifying the optimal treatment regimens, patient population, competition for clinical trial participants, approval of other products during our clinical trials, number and length of clinical trials, parallel versus sequential timing of our clinical trials, regulatory requirements of the FDA and/or foreign regulatory authorities, the exclusion criteria for the clinical trials and use of therapies such as hypertonic saline. Our cystic fibrosis clinical trials will present some unique challenges due to the early-intervention approach we are taking with regard to the clinical trials. This approach will require studying mild patients and usually younger patients who do not typically participate in clinical trials since new products are generally focused on the sicker patient population. In addition, due to the age group of these mild patients, many will be in school and will be required to take the medication three times-a-day. Even if we successfully complete clinical trials, we may not be able to submit any required regulatory submissions in a timely manner and we may not receive regulatory approval for the product candidate. In addition, if the FDA or foreign regulatory authorities require additional clinical trials, we could face increased costs and significant development delays.

The timing of the review and approval process with the FDA to obtain marketing approval of the oral formulation of bilastine for the treatment and prevention of allergic rhinitis may be impacted by the outcome of clinical studies. FAES has conducted a thorough QT/QTc clinical trial in the United States of an oral formulation of bilastine to confirm the cardiac safety profile of this product candidate. Following a meeting with the FDA and in consultation with Inspire, FAES has agreed to conduct additional clinical work and an expanded QT/QTc comparative trial, which will likely include an FDA-approved antihistamine. The results of this additional clinical data could result in significant development delays or result in the cancellation of the program.

From time to time, we conduct clinical trials in different countries around the world and are subject to the risks and uncertainties of doing business internationally. Disruptions in communication and transportation, changes in governmental policies, civil unrest and currency exchange rates may affect the time and costs required to complete clinical trials in other countries.

Changes in regulatory policy or new regulations could also result in delays or rejection of our applications for approval of our product candidates. Product candidates designated as “fast track” products by the FDA may not continue to qualify for expedited review. Even if some of our product candidates receive “fast track” designation, the FDA may not approve them at all or any sooner than other product candidates that do not qualify for expedited review.

If we fail to reach milestones or to make annual minimum payments or otherwise breach our obligations under our license agreements, our licensors may terminate our agreements with them.

We currently have collaboration agreements with several collaborators, including Allergan, Boehringer Ingelheim, FAES, InSite Vision and Santen. If we fail to meet payment obligations, performance milestones relating to the timing of regulatory filings, development and commercial diligence obligations, fail to make milestone payments in accordance with applicable provisions, or fail to pay the minimum annual payments under our respective licenses, our licensors may terminate the applicable license.

It may be necessary in the future for us to obtain additional licenses to avoid infringement of third-party patents. Additionally, we may enter into license arrangements with other third parties as we build our product portfolio. We do not know the terms on which such licenses may be available, if at all.

Risks Related to Governmental Regulation

Failure to comply with all applicable regulations, including those that require us to obtain and maintain governmental approvals for our product candidates, may result in fines and restrictions, including the withdrawal of a product from the market.

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Pharmaceutical companies are subject to significant regulation by a number of national, state and local agencies, including the FDA. Failure to comply with applicable regulatory requirements could, among other things, result in fines, suspensions or delays of product manufacture or distribution or both, product recalls, delays in marketing activities and sales, withdrawal of marketing approvals, and civil or criminal sanctions including possible exclusion from eligibility for payment of our products by Medicare, Medicaid, and other third-party payors.

After initial regulatory approval, the manufacturing and marketing of drugs, including our products, are subject to continuing FDA and foreign regulatory review, and subsequent discovery of previously unknown problems with a product, manufacturing process or facility may result in restrictions, including withdrawal of the product from the market. The FDA is permitted to revisit and change its prior determinations and based on new information it may change its position with regard to the safety or effectiveness of our products. The FDA is authorized to impose post-marketing requirements such as:

• Testing and surveillance to monitor the product and its continued compliance with regulatory requirements;

• Submitting products for inspection and, if any inspection reveals that the product is not in compliance, the prohibition of the sale of all products from the same lot;

• Requiring us or our partners to conduct long-term safety studies after approval;

• Requiring corrective actions and/or suspending manufacturing;

• Withdrawing marketing approval;

• Seizing adulterated, misbranded or otherwise violative products;

• Seeking to enjoin the manufacture or distribution, or both, of an approved product, or seeking an order to recall an approved product, that is found to be adulterated or misbranded; and

• Seeking monetary fines and penalties, including disgorgement of profits, if a court finds that we are in violation of applicable law.

Even before any formal regulatory action, we, or our collaborative partners, could voluntarily decide to cease distribution and sale, or recall, any of our products if concerns about safety or effectiveness develop, if certain cGMP deviations are found, or if economic conditions support such action.

In its regulation of advertising, the FDA may issue correspondence to pharmaceutical companies alleging that its advertising or promotional materials are false, misleading or deceptive. The FDA has the power to impose a wide array of sanctions on companies for such advertising practices and if we were to receive correspondence from the FDA alleging these practices it may be necessary for us to:

• Incur substantial expenses, including fines, penalties, legal fees and costs to conform to the FDA’s limits on such promotion;

• Change our methods of marketing, promoting and selling products;

• Take corrective action, which could include placing advertisements or sending letters to physicians rescinding previous advertisements or promotion; or

• Disrupt the distribution of products and stop sales until we are in compliance with the FDA’s interpretation of applicable laws and regulations.

In addition, in recent years, some alleged violations of FDA requirements regarding off-label promotion of products by manufacturers have been alleged also to violate the federal civil False Claims Act, resulting in substantial monetary settlements. Also, various legislative proposals have been offered in Congress and in some state legislatures that include major changes in the health care system. These proposals have included price or patient reimbursement constraints on medicines and restrictions on access to certain products. We cannot predict the outcome of such initiatives and it is difficult to predict the future impact of the broad and expanding legislative and regulatory requirements affecting us.

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Medicare prescription drug coverage legislation and future legislative or regulatory reform of the healthcare system may affect our or our partner’s ability to sell products profitably.

In both the United States and some foreign jurisdictions, there have been a number of legislative and regulatory changes to the healthcare system that could affect our ability to sell our products profitably. In the United States, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 established a voluntary outpatient prescription drug benefit under Part D of the Social Security Act. The program, which went into effect January 1, 2006, is administered by the Centers for Medicare & Medicaid Services, or CMS, within the Department of Health and Human Services, or HHS, and is implemented and operated by private sector Part D plan sponsors. CMS has issued extensive regulations and other subregulatory guidance documents to assist Part D plan sponsors with implementing the new benefit. Moreover, the HHS Office of Inspector General has issued regulations and other guidance in connection with the program. The federal government can be expected to continue to issue guidance and regulations regarding the obligations of Part D sponsors and their subcontractors. Allergan is responsible for the implementation of the Medicare Part D program as it relates to Elestat and Restasis and has contracted with Part D plan sponsors to cover such drugs under the Part D benefit. We are responsible for contracting with Part D plan sponsors with respect to AzaSite.

Each participating drug plan is permitted by regulation to develop and establish its own unique drug formulary that may exclude certain drugs from coverage and negotiate payment levels for drugs which may be lower than reimbursement levels available through private health plans or other payers. Moreover, beneficiary co-insurance requirements could influence which products are recommended by physicians and selected by patients. There is no assurance that any drug that we co-promote or sell will be covered by drug plans participating under the Medicare Part D program or, if covered, what the terms of any such coverage will be, or that the drugs will be reimbursed at amounts that reflect current or historical payment levels. Our results of operations could be materially adversely affected by the reimbursement changes emerging in 2007 and in future years from the Medicare prescription drug coverage legislation or from changes in the formularies or price negotiations with Part D drug plans. To the extent that private insurers or managed care programs follow Medicare coverage and payment developments, the adverse effects of lower Medicare payment may be magnified by private insurers adopting similar lower payment. New federal or state drug payment changes or healthcare reforms in the United States and in foreign countries may be enacted or adopted in the future that could further lower payment for our products.

We are subject to “fraud and abuse” and similar government laws and regulations, and a failure to comply with such laws and regulations, or an investigation into our compliance with such laws and regulations, or a failure to prevail in any litigation related to noncompliance, could harm our business.

Pharmaceutical pricing, sales, and marketing programs and arrangements, and related business practices in the health care industry generally are under increasing scrutiny from federal and state regulatory, investigative, prosecutorial, and administrative entities. These entities include the Department of Justice and its United States Attorneys Offices, the Office of Inspector General of the Department of Health and Human Services, the FDA, the Federal Trade Commission, and various state Attorneys General offices. Many health care laws, including the federal and state anti-kickback laws and statutory and common law false claims laws, have been construed broadly by the courts and permit government entities to exercise considerable discretion. In the event that any of these government entities believed that wrongdoing had occurred, one or more of them could institute civil or criminal proceedings which, if instituted and resolved unfavorably, could subject us to substantial fines, penalties, and injunctive and administrative remedies, including exclusion from government reimbursement programs. We cannot predict whether any investigations would affect our marketing or sales practices. Any such result could have a material adverse impact on our results of operations, cash flows, financial condition, and our business. Such investigations, which also could be instituted as the result of the filing of a qui tam or whistleblower suit by a private relator, could be costly, divert management’s attention from our business, and result in damage to our reputation. We cannot guarantee that measures that we have taken to prevent violations, including our corporate compliance program, will protect us from future violations, lawsuits or investigations. If any such actions are instituted against us, and we are not successful in defending ourselves or asserting our rights, those actions could have a significant negative impact on our business, including the imposition of significant fines or other sanctions.

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Failure to adequately control compliance with all applicable laws and regulations may adversely affect our business, and we may become subject to investigative or enforcement actions.

There are extensive state, federal and foreign laws and regulations applicable to public pharmaceutical companies engaged in the discovery, development and commercialization of medicinal products. There are laws and regulations that govern areas including financial controls, clinical trials, testing, manufacturing, labeling, safety, packaging, shipping, distribution and promotion of pharmaceuticals, including those governing interactions with prescribers and healthcare professionals in a position to prescribe, recommend, or arrange for the provision of our products. While we have implemented corporate quality, ethics and compliance programs based on current best practices, we cannot guarantee against all possible transgressions. Moreover, pharmaceutical manufacturers in recent years have been the targets of extensive whistleblower actions in which the person bringing an action alleges a variety of violations of the civil False Claims Act, in such areas as pricing practices, off-label product promotion, sales and marketing practices, improper relationships with physicians and other healthcare professionals, among others. The potential ramifications are far-reaching if there are areas identified as out of compliance by regulatory agencies including, but not limited to, significant financial penalties, manufacturing and clinical trial consent decrees, commercialization restrictions or other restrictions and litigation. Furthermore, there can be no assurance that we will not be subject to a whistleblower or other investigative or enforcement action at some time in the future.

Risks Associated with Our Business and Industry

We have been named as a defendant in litigation that could result in substantial damages and costs and divert management’s attention and resources.

On February 15, 2005, the first of five identical purported shareholder class action complaints was filed in the United States District Court for the Middle District of North Carolina against us and certain of our senior officers. Each complaint alleged violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and Securities and Exchange Commission Rule 10b-5, and focused on statements that are claimed to be false and misleading regarding a Phase 3 clinical trial of our dry eye product candidate, Prolacria. Each complaint sought unspecified damages on behalf of a purported class of purchasers of our securities during the period from June 2, 2004 through February 8, 2005.

On March 27, 2006, following consolidation of the lawsuits into a single civil action and appointment of lead plaintiffs, the plaintiffs filed a Consolidated Class Action Complaint, or CAC. The CAC asserted claims against us and certain of our present or former senior officers or directors. The CAC asserted claims under sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 based on statements alleged to be false and misleading regarding a Phase 3 clinical trial of Prolacria, and also adds claims under sections 11, 12(a)(2) and 15 of the Securities Act of 1933. The CAC also asserted claims against certain parties that served as underwriters in our securities offerings during the period relevant to the CAC. The CAC sought unspecified damages on behalf of a purported class of purchasers of our securities during the period from May 10, 2004 through February 8, 2005. In May 2006, the plaintiffs agreed to voluntarily dismiss their claims against the underwriters on the basis that they were time-barred. On June 30, 2006, we and the other defendants moved that the court dismiss the CAC on the grounds that it fails to state a claim upon which relief can be granted and does not satisfy the pleading requirements under applicable law. On May 14, 2007, Magistrate Judge Eliason, to whom the District Court had referred the motion, issued a Recommendation that the District Court grant Defendants’ motion to dismiss the CAC. Plaintiffs filed objections to this Recommendation in which they argued that the District Court should not accept the Recommendation, and Defendants responded to Plaintiffs’ objections.

On July 26, 2007, the United States District Court for the Middle District of North Carolina accepted the Magistrate Judge’s Recommendation and granted our and the other defendants’ motion and dismissed the CAC with prejudice. The plaintiffs currently have a right of appeal to the United States Court of Appeals for the Fourth Circuit, which the plaintiffs may choose to exercise within the period established by rule. If appealed, we intend to defend the litigation vigorously. No assurance can be made that we will

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be successful in our defense of the pending claims. If we are not successful in our defense of the claims, we could be forced to, among other ramifications, make significant payments to resolve the claims and such payments could have a material adverse effect on our business, future results of operations, financial position and/or cash flows if not covered by our insurance carriers or if damages exceed the limits of our insurance coverage. Furthermore, regardless of our success in defending against the litigation, the litigation itself has resulted, and may continue to result, in substantial costs, use of resources and diversion of the attention of management and other employees, which could adversely affect our business. We have various insurance policies related to the risk associated with our business, including directors and officers insurance. However, there is no assurance that our insurance coverage will be sufficient or that our insurance companies will cover all the matters claimed. In the event of an adverse outcome, our business as well as our future results of operations, financial position and/or cash flows could be materially affected to the extent that our insurance fails to cover such costs.

The investigation by the U.S. Securities and Exchange Commission could have a material adverse effect on our business.

On August 30, 2005, the SEC notified us that it is conducting a formal, nonpublic investigation which we believe relates to our Phase 3 clinical trial of our dry eye product candidate, Prolacria. On October 19, 2006, we received a Wells Notice letter from the staff of the SEC, issued in connection with this investigation. Our Chief Executive Officer and our Executive Vice President, Operations and Communications, also received Wells Notices.

The Wells Notices provide notification of the SEC staff’s determination that it intends to recommend to the SEC that it bring a civil action against us and the two officers regarding possible violations of Section 17(a) of the Securities Act of 1933, Sections 10(b) and 13(a) of the Securities Exchange Act of 1934 and SEC Rules 10b-5, 12b-20, 13a-1, 13a-11, 13a-13, and 13a-14 thereunder. Under the process established by the SEC, we and the two officers have the opportunity to respond in writing to the Wells Notice before the staff makes any formal recommendation to the SEC regarding what action, if any, should be brought by the SEC. We and the officers receiving these notices provided written submissions to the SEC in response to the Wells Notices during December 2006, and have had further meetings with the SEC staff.

We are unable to predict the outcome of the investigation and no assurance can be made that the investigation will be concluded favorably. In the event of an adverse outcome, our business, future results of operations, financial position and/or cash flows could be materially affected. Furthermore, regardless of the outcome of the investigation, the investigation itself has resulted, and may continue to result, in substantial uninsured costs, use of resources and diversion of the attention of management and other employees, which could adversely affect our business. We have various insurance policies related to the risk associated with our business, including directors and officers insurance. However, there is no assurance that our insurance coverage will be sufficient or that our insurance companies will cover all the matters claimed. In the event of an adverse outcome, our business as well as our future results of operations, financial position and/or cash flows could be materially affected to the extent that our insurance fails to cover such costs.

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Our co-promotion revenues are based, in part, upon Allergan’s revenue recognition policy and other accounting policies over which we have limited or no control.

We recognize co-promotion revenue based on Allergan’s net sales for Elestat and Restasis as defined in the co-promotion agreements and as reported to us by Allergan. Accordingly, our co-promotion revenues are based upon Allergan’s revenue recognition policy and other accounting policies over which we have limited or no control and the underlying terms of our co-promotion agreements. Allergan’s filings with the SEC indicate that Allergan maintains disclosure controls and procedures in accordance with applicable laws, which are designed to provide reasonable assurance that the information required to be reported by Allergan in its Exchange Act filings is reported timely and in accordance with applicable laws, rules and regulations. We are not entitled to review Allergan’s disclosure controls and procedures. All of our co-promotion revenues are currently derived from Allergan’s net sales of Elestat and Restasis as reported to us by Allergan. Management has concluded that our internal control over financial reporting was effective as of June 30, 2007, and these internal controls allow us to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; however, we are unable to provide complete assurance that Allergan will not revise reported revenue amounts in the future. If Allergan’s reported revenue amounts were inaccurate, it could have a material impact on our financial statements, including financial statements for previous periods.

Revenues in future periods could vary significantly and may not cover our operating expenses.

We recognize milestone revenue under our collaborative research and development agreements when we have performed services under such agreements or when we or our collaborative partner has met a contractual milestone triggering a payment to us. In the year ended December 31, 2006, we recognized milestone revenue of $1.25 million from Santen associated with the completion of Phase 2 clinical testing of diquafosol tetrasodium in Japan. We or our collaborative partners did not reach any such contractual milestones in 2004 and 2005. There can be no assurances that we or our collaborative partners will reach any additional contractual milestones during 2007 or at any later date.

Additionally, our revenues may fluctuate from period to period due in part to:

• Fluctuations in future sales of Elestat, Restasis and AzaSite and other future licensed or co-promoted products due to competition, manufacturing difficulties, reimbursement and pricing under commercial or government plans, seasonality, or other factors that affect the sales of a product;

• Deductions from gross sales relating to estimates of sales returns, credits and allowances, normal trade and cash discounts, managed care sales rebates and other allocated costs;

• The effectiveness of the commercial launch of AzaSite;

• The duration of market exclusivity of Elestat, Restasis and AzaSite;

• The timing of approvals, if any, for other possible future products;

• The progress toward and the achievement of developmental milestones by us or our partners;

• The initiation of new contractual arrangements with other companies;

• The failure or refusal of a collaborative partner to pay royalties or milestone payments;

• The expiration or invalidation of our patents or licensed intellectual property; or

• Fluctuations in foreign currency exchange rates.

If we are not able to obtain sufficient additional funding to meet our expanding capital requirements, we may be forced to reduce or eliminate research programs and product candidate development.

We have used substantial amounts of cash to fund our research and development activities. Our operating expenses were approximately $55.4 million in the six months ended June 30, 2007 as compared to approximately $83.7 million for the year ended December 31, 2006. Our cash, cash equivalents and investments totaled approximately $68.6 million on June 30, 2007 which includes $40.0 million of debt financing we received under our debt facility.

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We expect that our capital and operating expenditures will continue to exceed our revenue over the next several years as we conduct our research and development activities, clinical trials and commercial activities. Many factors will influence our future capital needs, including:

• The number, breadth and progress of our research and development programs;

• The size and scope of our marketing programs;

• Our ability to attract collaborators for our products and establish and maintain those relationships;

• Achievement of milestones under our existing or future collaborations and licensing agreements;

• Progress by our collaborators with respect to the development of product candidates;

• The level of activities relating to commercialization of our products;

• Competing technological and market developments;

• The timing and terms of any business development activities;

• The timing and amount of debt repayment requirements;

• The costs involved in defending any litigation claims against us;

• The costs involved in responding to SEC investigations;

• The costs involved in enforcing patent claims and other intellectual property rights including costs associated with enhancing market exclusivity for Elestat; and

• The costs and timing of regulatory approvals.

In addition, our capital requirements will depend upon:

• The receipt of revenue from Allergan on net sales of Elestat and Restasis;

• Receipt of revenue from wholesalers and other customers on net sales of AzaSite;

• The ability to generate sufficient sales of AzaSite;

• The receipt or payment of milestone payments under our collaborative agreements;

• The ability to obtain approval from the FDA for Prolacria;

• Our ability to obtain approval from the FDA for any of our other product candidates; and

• Payments from existing and future collaborators.

In the event that we do not receive timely regulatory approvals, we may need substantial additional funds to fully develop, manufacture, market and sell all of our other potential products and support our product commercialization and co-promotion efforts. We may seek such additional funding through public or private equity offerings and debt financings. Additional financing may not be available when needed. If available, such financing may not be on terms favorable to us or our stockholders. Stockholders’ ownership will be diluted if we raise additional capital by issuing equity securities. If we raise funds through collaborations and licensing arrangements, we may have to give up rights to our technologies or product candidates which are involved in these future collaborations and arrangements or grant licenses on unfavorable terms. If adequate funds are not available, we would have to scale back or terminate research programs and product development and we may not be able to successfully commercialize any product candidate.

If we are unable to make the scheduled principal and interest payments on the term loan facility or maintain minimum liquidity levels or compliance with other debt covenants as defined in the loan and security agreement, we may default on our debt.

In December 2006, we entered into a loan and security agreement for up to $40.0 million. In June 2007, we amended the loan and security agreement to expand the principal we are able to borrow by an additional $20.0 million, as well as revise the minimum liquidity we are required to maintain under the facility. The $60 million facility is secured by substantially all of our assets, except for our intellectual property, but including all accounts, license and royalty fees and other revenues and proceeds arising from our intellectual property. Under the agreement, we are required to maintain minimum liquidity levels based on the balance of the outstanding advances. The agreement may affect our operations in several ways, including the following:

• A portion of our cash flow from operations will be dedicated to the payment of the principal and interest on our indebtedness;

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• Our future cash flow may be insufficient to meet our required principal and interest payments;

• We may need to raise additional capital in order to remain in compliance with the loan covenants;

• Our ability to enter into certain transactions may be limited; or

• We may need to delay or reduce planned expenditures or clinical trials as well as other development and commercial activities if our current operations are not sufficient enough to service our debt.

We may not be able to borrow additional funds under this agreement if we are not able to maintain various negative and financial covenants. Events of default are not limited to, but include the following:

• Payment default;

• Covenant default;

• A material adverse change in Inspire;

• Breach of our agreements with Allegan;

• Breach of agreement with FAES; or

• Judgments against us over a certain dollar amount.

In case of an uncured default, the following actions may be taken against us by the lending institutions:

• All outstanding obligations associated with the term loan facility would be immediately due and payable;

• Any future advancement of credit under the term loan facility would cease;

• Any of our balances and deposits held by the lending institutions would be applied to the obligation;

• Balances and accounts at other financial institutions could be “held” or exclusive control be transferred to the lending institutions; and

• All collateral, as defined in the agreement, could be seized and disposed of.

If we continue to incur operating losses for a period longer than anticipated, or in an amount greater than anticipated, we may be unable to continue our operations.

We have experienced significant losses since inception. We incurred net losses of approximately $32.0 million for the six months ended June 30, 2007, and approximately $42.1 million for the year ended December 31, 2006. As of June 30, 2007, our accumulated deficit was approximately $277.1 million. We currently expect to incur significant operating losses over the next several years and expect that cumulative losses may increase in the near-term due to expanded research and development efforts, preclinical studies, clinical trials and commercialization efforts. We expect that losses will fluctuate from quarter to quarter and that such fluctuations may be substantial. Such fluctuations will be affected by the following:

• Commercialization activities to support co-promotion efforts for Elestat and Restasis and the launch and continuing commercialization support for AzaSite; and

• Timing of regulatory approvals of our product candidates;

• The level of patient demand for our products and any licensed products;

• Timing of payments to and from licensors and corporate partners;

• Product candidate development activities in order to achieve regulatory approval;

• Timing of investments in new technologies and product candidates;

• The costs involved in defending any litigation claims against, or government investigations of, us.

To achieve and sustain profitable operations, we must, alone or with others, develop successfully, obtain regulatory approval for, manufacture, introduce, market and sell our products. The time frame necessary to achieve market success is long and uncertain. We may not generate sufficient product revenues to become profitable or to sustain profitability. If the time required to achieve profitability is longer than we anticipate, we may not be able to continue our business.

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Our dependence on collaborative relationships may lead to delays in product development, lost revenues and disputes over rights to technology.

Our business strategy depends to some extent upon the formation of research collaborations, licensing and/or marketing arrangements. We currently have collaboration agreements with several collaborators, including Allergan, Boehringer Ingelheim, FAES, InSite Vision and Santen. The termination of any collaboration will result in the loss of any unmet development or commercial milestone payments, may lead to delays in product development and disputes over technology rights, and may reduce our ability to enter into collaborations with other potential partners. In the event we breach an agreement with a collaborator, the collaborator is entitled to terminate our agreement with them in the event we do not cure the breach within a specified period of time, which is typically 60 or 90 days from the notice date. With respect to the Allergan collaboration, in the event we become an affiliate of a third party that manufactures, markets or sells any then currently promoted prescription ophthalmic product, Allergan will have the right to terminate our Elestat Co-Promotion Agreement, which right must be exercised within 3 months of the occurrence of such event. If we do not maintain our current collaborations, or establish additional research and development collaborations or licensing arrangements, it will be difficult to develop and commercialize potential products. Any future collaborations or licensing arrangements may not be on terms favorable to us.

Our current or any future collaborations or licensing arrangements ultimately may not be successful. Under our current strategy, and for the foreseeable future, we do not expect to develop or market products outside North America without a collaborative partner or outside our therapeutic areas of focus. We are currently pursuing the out-licensing of certain rights related to our cystic fibrosis program. We may be unsuccessful in out-licensing this program or we may out-license this program on terms that are not favorable to us.

We will continue to depend on collaborators and contractors for the preclinical study and clinical development of therapeutic products and for manufacturing and marketing of potential products. Our agreements with collaborators typically allow them some discretion in electing whether to pursue such activities. If any collaborator were to breach or terminate its agreement with us or otherwise fail to conduct collaborative activities in a timely and successful manner, the preclinical or clinical development or commercialization of product candidates or research programs would be delayed or terminated. Any delay or termination in clinical development or commercialization would delay or eliminate potential product revenues relating to our product candidates.

Disputes may arise in the future over the ownership of rights to any technology developed with collaborators. These and other possible disagreements between us and our collaborators could lead to delays in the collaborative development or commercialization of therapeutic or diagnostic products. Such disagreement could also result in litigation or require arbitration to resolve.

Failure to hire and retain key personnel or to identify, appoint and elect qualified directors, may hinder our product development programs and our business efforts.

We depend on the principal members of management and scientific staff, including Christy L. Shaffer, Ph.D., our President and Chief Executive Officer and a director, and Thomas R. Staab, II, our Chief Financial Officer and Treasurer. If these people leave us, we may have difficulty conducting our operations. We have not entered into agreements with any officers or any other members of our management and scientific staff that bind them to a specific period of employment. We also depend upon the skills and guidance of the independent members of our Board of Directors. There can be no assurance that we can identify, appoint and elect qualified candidates to serve as members of the Board of Directors. Our future success will depend in part on our ability to attract, hire or appoint, and retain additional personnel skilled or experienced in the pharmaceutical industry. There is intense competition for such qualified personnel. We may not be able to attract and retain such personnel.

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If our patent protection is inadequate, the development and any possible sales of our product candidates could suffer or competitors could force our products completely out of the market.

Our business and competitive position depends on our ability to continue to develop and protect our products and processes, proprietary methods and technology. Except for patent claims covering new chemical compounds, most of our patents are use patents containing claims covering methods of treating disorders and diseases by administering therapeutic chemical compounds. Use patents, while providing adequate protection for commercial efforts in the United States, may afford a lesser degree of protection in other countries due to their patent laws. Besides our use patents, we have patents and patent applications covering compositions (new chemical compounds), pharmaceutical formulations and processes for large-scale manufacturing. Many of the chemical compounds included in the claims of our use patents and process applications were known in the scientific community prior to our patent applications. None of our composition patents or patent applications covers these previously known chemical compounds, which are in the public domain. As a result, competitors may be able to commercialize products that use the same previously known chemical compounds used by us for the treatment of disorders and diseases not covered by our use patents. Such competitors’ activities may reduce our revenues.

If we must defend a patent suit, or if we choose to initiate a suit to have a third-party patent declared invalid, we may need to make considerable expenditures of money and management time in litigation. We believe that there is significant litigation in the pharmaceutical and biotechnology industry regarding patent and other intellectual property rights. A patent does not provide the patent holder with freedom to operate in a way that infringes the patent rights of others. While we are not aware of any patent that we are infringing, nor have we been accused of infringement by any other party, other companies may have, or may acquire, patent rights, which we might be accused of infringing. A judgment against us in a patent infringement action could cause us to pay monetary damages, require us to obtain licenses, or prevent us from manufacturing or marketing the affected products. In addition, we may need to initiate litigation to enforce our proprietary rights against others. Should we choose to do this, as with the above, we may need to make considerable expenditures of money and management time in litigation. Further, we may have to participate in interference proceedings in the United States Patent and Trademark Office, or USPTO, to determine the priority of invention of any of our technologies.

Our ability to develop sufficient patent rights in our pharmaceutical, biopharmaceutical and biotechnology products to support commercialization efforts is uncertain and involves complex legal and factual questions. For instance, the USPTO examiners may not allow our claims in examining our patent applications. If we have to appeal a decision to the USPTO’s Appeals Board for a final determination of patentability, we could incur significant legal fees.

Since we rely upon trade secrets and agreements to protect some of our intellectual property, there is a risk that unauthorized parties may obtain and use information that we regard as proprietary.

We rely upon the laws of trade secrets and non-disclosure agreements and other contractual arrangements to protect our proprietary compounds, methods, processes, formulations and other information for which we are not seeking patent protection. We have taken security measures to protect our proprietary technologies, processes, information systems and data, and we continue to explore ways to further enhance security. However, despite these efforts to protect our proprietary rights, unauthorized parties may obtain and use information that we regard as proprietary. Employees, academic collaborators and consultants with whom we have entered confidentiality and/or non-disclosure agreements may improperly disclose our proprietary information. In addition, competitors may, through a variety of proper means, independently develop substantially the equivalent of our proprietary information and technologies, gain access to our trade secrets, or properly design around any of our patented technologies.

Use of our products may result in product liability claims for which we may not have adequate insurance coverage.

Clinical trials or manufacturing, marketing and sale of our potential products may expose us to liability claims from the use of those products. Product liability claims could result in the imposition of substantial liability on us, a recall of products, or a change in the indications for which they may be used. Although we carry clinical trial liability insurance and product liability insurance, we, or our collaborators, may not maintain sufficient insurance to cover these potential claims. We do not have the financial resources to self-insure and it is unlikely that we will have these financial resources in the foreseeable future. If we are unable to protect against potential product liability claims adequately, we may find it difficult or impossible to continue to commercialize our products or the product candidates we develop. If claims or losses exceed our liability insurance coverage, we may go out of business.

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Insurance coverage is increasingly more costly and difficult to obtain or maintain.

While we currently have insurance for our business, property, directors and officers, and our products, insurance is increasingly more costly and narrower in scope, and we may be required to assume more risk in the future. If we are subject to claims or suffer a loss or damage in excess of our insurance coverage, we will be required to share that risk in excess of our insurance limits. If we are subject to claims or suffer a loss or damage that is outside of our insurance coverage, we may incur significant uninsured costs associated with loss or damage that could have an adverse effect on our operations and financial position. Furthermore, any claims made on our insurance policies may impact our ability to obtain or maintain insurance coverage at reasonable costs or at all.

Our operations involve a risk of injury from hazardous materials, which could be very expensive to us.

Our research and development activities involve the controlled use of hazardous materials and chemicals. We cannot completely eliminate the risk of accidental contamination or injury from these materials. If such an accident were to occur, we could be held liable for any damages that result and any such liability could exceed our resources. In addition, we are subject to laws and regulations governing the use, storage, handling and disposal of these materials and waste products. The costs of compliance with these laws and regulations are substantial.

Our commercial insurance and umbrella policies include limited coverage designated for pollutant clean-up and removal and limited general liability coverage per occurrence and in the aggregate. The cost of these policies is significant and there can be no assurance that we will be able to maintain these policies or that coverage amounts will be sufficient to insure potential losses.

Risks Related to Our Stock

Our common stock price has been volatile and your investment in our stock may decline in value.

The market price of our common stock has been volatile. These fluctuations create a greater risk of capital losses for our stockholders as compared to less volatile stocks. Factors that have caused volatility and could cause additional volatility in the market price of our common stock include among others:

• Announcements regarding the commercialization of AzaSite;

• Announcements regarding FDA approval of any of our own or in-licensed product candidates;

• Announcements regarding the NDA for Prolacria;

• Announcements made by us concerning results of clinical trials with our product candidates;

• Market acceptance and market share of Elestat, Restasis and AzaSite;

• Duration of market exclusivity of Elestat, Restasis and AzaSite;

• Volatility in other securities including pharmaceutical and biotechnology securities;

• Changes in government regulations;

• Regulatory actions and/or investigations, including our ongoing SEC investigation;

• Changes in the development priorities of our collaborators that result in changes to, or termination of, our agreements with such collaborators;

• Developments concerning proprietary rights including patents by us or our competitors;

• Variations in our operating results;

• FDA approval of other treatments for the same indication as any one of our product candidates;

• Business development activities;

• Litigation;

• Terrorist attacks; and

• Military actions.

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Extreme price and volume fluctuations occur in the stock market from time to time that can particularly affect the prices of biotechnology companies. These extreme fluctuations are sometimes unrelated to the actual performance of the affected companies.

Our existing principal stockholders hold a substantial amount of our common stock and may be able to influence significant corporate decisions, which may conflict with the interest of other stockholders.

As of June 30, 2007, our current 5% stockholders and their affiliates beneficially owned approximately 35% of our outstanding common stock. These stockholders, if they act together, may be able to influence the outcome of matters requiring approval of the stockholders, including the election of our directors and other corporate actions such as:

• a merger or corporate combination with or into another company;

• a sale of substantially all of our assets; and

• amendments to our certificate of incorporation.

The decisions of these stockholders may conflict with our interests or those of our other stockholders.

Warburg Pincus will be able to exercise substantial control over our business.

On July 17, 2007, we entered into a Securities Purchase Agreement with Warburg Pincus Private Equity IX, L.P., or Warburg, pursuant to which we sold an aggregate of 140,186 shares of Series A Exchangeable Preferred Stock, or the Exchangeable Preferred Stock. Pursuant to the terms of the Exchangeable Preferred Stock, upon the later of (i) the approval, on or prior to July 20, 2008, of holders of our common stock as required by applicable rules of the Nasdaq Global Market and (ii) the expiration or termination of any waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, each share of Exchangeable Preferred Stock will be automatically exchanged for 100 shares of our common stock (subject to appropriate adjustment in the event of any stock split, stock dividend and the like affecting our common stock).

If the shares of Exchangeable Preferred Stock held by Warburg are exchanged for shares of common stock, Warburg will control approximately 25% of the voting power of our outstanding common stock, based on the number of shares of common stock and Exchangeable Preferred Stock outstanding as of July 20, 2007 and an exchange ratio of 100:1 for the Exchangeable Preferred Stock. Furthermore, we have amended the terms of our stockholder rights plan, which will allow Warburg and its affiliates to acquire the lesser of: (x) 32.5% of our voting securities on a fully diluted basis and (y) 34.9% of our outstanding voting securities plus outstanding Exchangeable Preferred Stock on an as exchanged to common stock basis, without triggering the provisions of the stockholder rights plan.

Pursuant to the Securities Purchase Agreement, Warburg has the right to designate one member for election to our Board of Directors for so long as Warburg owns a significant percentage of our securities. We are obligated to nominate and use our reasonable best efforts to cause the designated director to be elected to our Board of Directors and, at Warburg’s request, will cause the designated director to be a member of each principal committee of our Board of Directors. Pursuant to this right, effective July 20, 2007, the our Board of Directors elected Jonathan Leff as a Class C member of the Board of Directors.

As a result of the foregoing, Warburg will be able to exercise substantial influence over our business, policies and practices.

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If our shares of Exchangeable Preferred Stock are not exchanged for common stock and remain outstanding, they will be entitled to accrued dividends and we may be forced to redeem all such shares, which could require substantial cash outlay and would adversely affect our financial position.

Upon the later to occur of (i) the approval by the holders of our common stock of the exchange of the Exchangeable Preferred Stock into our common stock as required by the applicable rules of The Nasdaq Global Market and (ii) the expiration or termination of any waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, or the HSR Act, each share of Exchangeable Preferred Stock will be automatically exchanged for shares of our common stock. If stockholder approval has been obtained prior to July 20, 2008 and prior to the expiration or termination of any waiting period under the HSR Act, a portion of the then outstanding shares of Exchangeable Preferred Stock will be automatically exchanged for shares of our common stock upon receipt of the stockholder approval, and the remaining shares of Exchangeable Preferred Stock will exchange upon later approval or as otherwise permitted under the HSR Act. If stockholder approval of the exchange is not obtained on or prior to July 20, 2008, the holders of the Exchangeable Preferred Stock will have no obligation and we will not have the option to exchange the Exchangeable Preferred Stock for our common stock.

Generally, dividends on each share of Exchangeable Preferred Stock will be cumulative and will begin to accrue starting on July 20, 2008, at an annual rate of 10% of the purchase price per share, compounded quarterly. Dividends will be payable until all or a portion of the Exchangeable Preferred Stock is exchanged for common stock or until we redeem or otherwise acquire the Exchangeable Preferred Stock. To the extent that we may lawfully do so, we are required to pay dividends in cash. If we may not lawfully pay such dividends in cash, then such dividends will be cumulative and continue to accrue or, upon the affirmative vote of the holders of a majority of the shares of outstanding Exchangeable Preferred Stock, the dividends will be paid in additional shares of Exchangeable Preferred Stock. In the event we fail for any reason to pay dividends on the Exchangeable Preferred Stock when lawfully permitted to do so or fail to redeem all shares of the Exchangeable Preferred Stock within 30 days after receipt of a redemption demand notice, the dividend rate on the Exchangeable Preferred Stock will be increased to 20% per annum.

If the Exchangeable Preferred Stock remains outstanding as of July 20, 2011, holders of the outstanding Exchangeable Preferred Stock may cause us, at any time thereafter, to redeem all shares of Exchangeable Preferred Stock for cash in a per share amount equal to the greater of: (i) the sum of the purchase price per share for the Exchangeable Preferred Stock plus all accrued but unpaid dividends thereon (whether or not declared) through the date of such redemption and (ii) an amount equal to the average of the closing prices for the common stock on the Nasdaq Global Market for the 20 trading days immediately preceding the date of such redemption multiplied by the then current exchange rate for the Exchangeable Preferred Stock. Such redemption would require us to expend substantial cash resources and could have a material adverse affect on our financial position. In addition, our cash reserves at the time of such redemption may be insufficient to satisfy such redemption, in which case we may not be able to continue as a going concern if we are unable to support our operations or cannot otherwise raise the necessary funds to support our operations.

Future sales of securities may cause our stock price to decline.

Future sales of our common stock by current stockholders into the public market could cause the market price of our stock to fall. As of June 30, 2007, there were 42,408,120 shares of common stock outstanding. Of these outstanding shares of common stock, approximately 21,500,000 shares were sold in public offerings and are freely tradable without restriction under the Securities Act, unless purchased by our affiliates. In addition, we have the ability to issue additional shares of common stock under an active shelf registration statement, which we filed with the SEC on April 16, 2004. On March 9, 2007, we filed with the SEC an additional shelf registration statement on Form S-3. This shelf registration statement has been declared effective and allows us to sell up to $130 million of securities, including common stock, preferred stock, debt securities, depositary shares and securities warrants, from time to time at prices and on terms to be determined at the time of sale. Up to 15,178,571 shares of our common stock are issued or issuable upon exercise of stock options that have been, or stock options, stock appreciation rights, stock awards and restricted stock units that may be, issued pursuant to our Amended and Restated 1995 Stock Plan and our Amended and Restated 2005 Equity Compensation Plan. Except with respect to 5,000,000 additional shares of common stock issuable under our Amended and Restated 2005 Equity Compensation Plan that was approved by our stockholders on June 8, 2007, which we intend to register in 2007, the shares underlying existing stock options and restricted stock units and possible future stock options, stock appreciation rights and stock awards have been registered pursuant to registration statements on Form S-8. In addition, in connection with the sale of the Exchangeable Preferred Stock, we agreed to register for resale all 14,018,600 shares of common stock into which the Exchangeable Preferred Stock may be exchanged. The remaining shares of common stock outstanding are not registered under the Securities Act and may be resold in the public market only if registered or if there is an exemption from registration, such as Rule 144.

If some or all of such shares are sold into the public market over a short period of time, the value of all publicly traded shares is likely to decline, as the market may not be able to absorb those shares at then-current market prices. Such sales may make it more difficult for us to sell equity securities or equity-related securities in the future at a time and price that our management deems acceptable, or at all. As of June 30, 2007, our 4 largest stockholders and their affiliates beneficially owned approximately 35% of our outstanding common stock.

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Further, we may issue additional shares:

• To employees, directors and consultants;

• In connection with corporate alliances;

• In connection with acquisitions; and

• To raise capital.

Based upon our closing stock price of $6.32 on June 30, 2007, there were outstanding options, which were exercisable and in-the-money, to purchase 1,026,584 shares of our common stock. This amount combined with the total common stock outstanding at June 30, 2007 is 43,434,704 shares of common stock. As a result of these factors, a substantial number of shares of our common stock could be sold in the public market at any time causing fluctuations or reductions in our stock price.

Our Rights Agreement, the provisions of our Change in Control Severance Benefit Plan and our Change in Control Agreements with management, the anti-takeover provisions in our Restated Certificate of Incorporation and Amended and Restated Bylaws, and our right to issue preferred stock, may discourage a third party from making a take-over offer that could be beneficial to us and our stockholders and may make it difficult for stockholders to replace our Board of Directors and effect a change in our management if they desire to do so.

In October 2002, we entered into a Rights Agreement with Computershare Trust Company. The Rights Agreement could discourage, delay or prevent a person or group from acquiring 15% or more of our common stock. The Rights Agreement provides that if a person acquires 15% or more of our common stock without the approval of our Board of Directors, all other stockholders will have the right to purchase securities from us at a price that is less than its fair market value, which would substantially reduce the value of our common stock owned by the acquiring person. As a result, our Board of Directors has significant discretion to approve or disapprove a person’s efforts to acquire 15% or more of our common stock. In connection with the transaction with Warburg, we and Computershare entered into a First Amendment to Rights Agreement dated July 17, 2007. The First Amendment to Rights Agreement provides that Warburg and its affiliates will be exempt from the definition of an “Acquiring Person” under the Rights Agreement, unless Warburg or certain of its affiliates becomes the beneficial owner of the lesser of: (x) 32.5% of our voting securities on a fully diluted basis and (y) 34.9% of the then outstanding voting securities of our plus the outstanding Exchangeable Preferred Stock on an as exchanged to common stock basis. In addition to Warburg’s ability to exercise substantial control over our business, the First Amendment to Rights Agreement could further discourage, delay or prevent a person or group from acquiring 15% or more of our common stock.

Effective as of January 28, 2005, the Compensation Committee of the Board of Directors of Inspire adopted a Change in Control Severance Benefit Plan, or the CIC Plan, which provides severance benefits to certain employees of the Company as of the date on which a Change in Control occurs. Under the CIC Plan and the Change in Control Agreements discussed below, a Change in Control occurs upon a determination by the Board of Directors or upon certain specified events such as merger and consolidation. The CIC Plan covers any regular full-time or part-time employee, other than employees who are parties to employment agreements or who are parties to any severance plan or agreement with us (other than the CIC Plan) that provides for the payment of severance benefits in connection with a Change in Control. Under the CIC Plan, if a Change in Control occurs and a participant’s employment is involuntarily terminated within two years, the participant will be entitled to certain payments and benefits based on the participant’s salary range and years of service with us. All of our executive officers are parties to individual agreements with us regarding a Change in Control (as defined in the agreement) and as a result, are not covered by the CIC Plan. Each Change in Control Agreement provides that upon the executive officer’s termination of employment following a Change in Control, unless such termination is for “cause,” because of death or disability or by the executive officer without “good reason,” within 24 months following such Change in Control, the executive officer will be entitled to a lump sum payment equal to a multiple of the sum of (i) the highest annual base salary received by the executive officer in any of the three most recently completed fiscal years prior to the Change in Control and (ii) the higher of the highest annual bonus received by the executive officer in any of the three most recently completed fiscal years preceding the date of the executive officer’s termination, the three most recent completed fiscal years preceding

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the Change in Control, or the maximum of the bonus opportunity range for the executive officer immediately prior to the date of termination. The multiples used to determine the amount of a lump sum payment range from two to three. The Change in Control Agreements also provide for ongoing benefits, the vesting of outstanding stock options, and gross-up payments. The CIC Plan and the Change in Control Agreements would increase the acquisition costs to a purchasing company that triggers the change in control provisions. As a result, the CIC Plan and the Change in Control Agreements may delay or prevent a change in control.

Our Restated Certificate of Incorporation and Amended and Restated Bylaws contain provisions which could delay or prevent a third party from acquiring shares of our common stock or replacing members of our Board of Directors. Our Restated Certificate of Incorporation allows our Board of Directors to issue shares of preferred stock. Our Board of Directors can determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. As a result, our Board of Directors could make it difficult for a third party to acquire a majority of our outstanding voting stock. Since management is appointed by the Board of Directors, any inability to effect a change in the Board of Directors may result in the entrenchment of management.

The rights, preferences and privileges of the Exchangeable Preferred Stock are set forth in the Certificate of Designations, Number, Voting Powers, Preferences and Rights of Series A Exchangeable Preferred Stock of Inspire Pharmaceuticals, Inc. filed with the Secretary of State, which constitutes part of our Restated Certificate of Incorporation. The Exchangeable Preferred Stock contain certain rights, preferences and privileges that could discourage, delay or prevent a person or group from acquiring a substantial number of our shares of capital stock. Specifically, dividends on the Exchangeable Preferred Stock will be cumulative starting on July 20, 2008 and will accrue at an annual rate of 10% of the purchase price per share, or, in the event that we fail for any reason to pay dividends on the Exchangeable Preferred Stock when lawfully permitted to do so or we fail to redeem all shares of the Exchangeable Preferred Stock within 30 days after receipt of a redemption demand notice, the dividend rate on the Exchangeable Preferred Stock will be increased to 20% per annum. Upon any applicable exchange in shares of Series A Exchangeable Preferred Stock into our common stock, all accrued but unpaid dividends (whether or not declared) on the Exchangeable Preferred Stock, if any, shall be paid in shares of our common stock. If stockholder approval of the exchange is not obtained on or prior to July 20, 2008, the holders of the Exchangeable Preferred Stock will have no obligation and we will not have the option to exchange the Exchangeable Preferred Stock for our common stock.

Furthermore, for so long as no shares of Exchangeable Preferred Stock have been exchanged for shares of our common stock, we may not, without the prior consent of the holders of a majority of the outstanding shares of Exchangeable Preferred Stock, pay any dividend upon our common stock or the shares of any other class or series of our equity securities, or purchase, redeem or otherwise acquire such other equity securities. In addition, if we declare, set aside for or pay any dividends or make any distributions on shares of such other equity securities, the holders of the Exchangeable Preferred Stock then outstanding will be entitled to simultaneously receive such dividend or distribution on a pro rata basis as if the shares of Exchangeable Preferred Stock then outstanding had been exchanged. If the Exchangeable Preferred Stock remains outstanding on July 20, 2011, both we and the holders of the outstanding Exchangeable Preferred Stock will have the right to cause the redemption of such stock, under certain circumstances, for cash in a per share amount equal to the greater of: (i) the sum of the purchase price per share for the Exchangeable Preferred Stock plus all accrued but unpaid dividends thereon (whether or not declared) through the date of such redemption and (ii) an amount equal to the average of the closing prices for our common stock on the Nasdaq Global Market for the 20 trading days immediately preceding the date which we or the holders of the outstanding Exchangeable Preferred Stock exercise such right multiplied by the then current exchange rate for the Exchangeable Preferred Stock; provided, however that to the extent stockholder approval is obtained but HSR approval is not obtained, the holders of the remaining shares of Exchangeable Preferred Stock that were not previously exchanged will not be entitled to cause the redemption of the remaining shares. In the event of our voluntary or involuntary liquidation, dissolution or winding up, the holders of the Exchangeable Preferred Stock will also be entitled to receive such redemption price per share of Exchangeable Preferred Stock.

Our Restated Certificate of Incorporation also provides that the members of the Board will be divided into three classes. Each year, the terms of approximately one-third of the directors will expire. Our Amended and Restated Bylaws include director nomination procedures and do not permit our stockholders to call a special meeting of stockholders. Under the Bylaws, only our Chief Executive Officer, President, Chairman of the Board, Vice-Chairman of the Board or a majority of the Board of Directors are able to call special meetings. The staggering of directors’ terms of office, the director nomination procedures and the inability of stockholders to call a special meeting may make it difficult for stockholders to remove or replace the Board of Directors should they desire to do so. The director nomination requirements include a provision that requires stockholders give advance notice to our Secretary of any nominations for director or other business to be brought by stockholders at any stockholders’ meeting. Our directors may be removed from our Board of Directors only for cause. These provisions may delay or prevent changes of control or management, either by third parties or by stockholders seeking to change control or management.

We are also subject to the anti-takeover provisions of section 203 of the Delaware General Corporation Law. Under these provisions, if anyone becomes an “interested stockholder,” we may not enter a “business combination” with that person for three years without special approval, which could discourage a third party from making a take-over offer and could delay or prevent a change of control. For purposes of section 203, “interested stockholder” means, generally, someone owning 15% or more of our outstanding voting stock or an affiliate of ours that owned 15% or more of our outstanding voting stock during the past three years, subject to certain exceptions as described in section 203. In connection with the sale of the Exchangeable Preferred Stock, we agreed to waive Warburg’s acquisition of the Exchangeable Preferred Stock from the provisions of section 203 of the Delaware General Corporation Law.

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

On June 8, 2007, we held our annual meeting of stockholders. The results of the proposals submitted for vote at this meeting were as follows:

1. Election of two directors (there were no abstentions or broker non-votes in connection with the election of directors).

	For:	Withheld:
Christy L. Shaffer, Ph.D.	32,205,286	1,721,727
Richard S. Kent, M.D.	31,032,396	2,894,617

2. Ratification of the appointment of PricewaterhouseCoopers LLP as our independent registered public accounting firm for the fiscal year ending December 31, 2007 (there were no broker non-votes in connection with the ratification of our independent registered public accounting firm).

For:	Against:	Abstain:
33,670,901	234,054	22,058

3. Approval of a proposal to ratify and approve our Amended and Restated 2005 Equity Compensation Plan (there were no broker non-votes in connection with the approval of our Amended and Restated 2005 Equity Compensation Plan).

For:	Against:	Abstain:
19,646,560	5,157,346	91,370

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Item 6. Exhibits

Exhibit No.	Description of Exhibit
3.1	Amended and Restated Certificate of Incorporation (Incorporated by reference to Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q filed on August 8, 2006).
3.2	Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.3 to the Company’s Quarterly Report on Form 10-Q filed on August 9, 2005).
10.1	Executive Officer Annual Cash Bonus Plan (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on June 13, 2007).
10.2**	Letter Amendment to License Agreement by and between Inspire Pharmaceuticals, Inc. and FAES Farma, S.A., dated as of June 19, 2007.
10.3	First Amendment to Loan and Security Agreement by and among Merrill Lynch Capital, Silicon Valley Bank, and Inspire Pharmaceuticals, Inc., dated as of June 27, 2007.
10.4	Amended and Restated 2005 Equity Compensation Plan.
31.1	Certification of the President & Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934.
31.2	Certification of the Chief Financial Officer & Treasurer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934.
32.1	Certification of the President & Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of the Chief Financial Officer & Treasurer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

** Confidential treatment has been requested with respect to a portion of this Exhibit.

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SIGNATURES

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

	Inspire Pharmaceuticals, Inc.
Date: August 9, 2007	By:	/s/ Christy L. Shaffer
		Christy L. Shaffer
		President & Chief Executive Officer (principal executive officer)
Date: August 9, 2007	By:	/s/ Thomas R. Staab, II
		Thomas R. Staab, II
		Chief Financial Officer & Treasurer
		(principal financial and chief accounting officer)

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EXHIBIT INDEX

Exhibit No.	Description of Exhibit
3.1	Amended and Restated Certificate of Incorporation (Incorporated by reference to Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q filed on August 8, 2006).
3.2	Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.3 to the Company’s Quarterly Report on Form 10-Q filed on August 9, 2005).
10.1	Executive Officer Annual Cash Bonus Plan (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on June 13, 2007).
10.2**	Letter Amendment to License Agreement by and between Inspire Pharmaceuticals, Inc. and FAES Farma, S.A., dated as of June 19, 2007.
10.3	First Amendment to Loan and Security Agreement by and among Merrill Lynch Capital, Silicon Valley Bank, and Inspire Pharmaceuticals, Inc., dated as of June 27, 2007.
10.4	Amended and Restated 2005 Equity Compensation Plan.
31.1	Certification of the President & Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934.
31.2	Certification of the Chief Financial Officer & Treasurer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934.
32.1	Certification of the President & Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of the Chief Financial Officer & Treasurer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

** Confidential treatment has been requested with respect to a portion of this Exhibit.

EX-10.2

EXHIBIT 10.2

[NOTE: CERTAIN PORTIONS OF THIS DOCUMENT HAVE BEEN MARKED TO INDICATE THAT CONFIDENTIAL INFORMATION HAS BEEN OMITTED. CONFIDENTIAL TREATMENT HAS BEEN REQUESTED FOR THIS CONFIDENTIAL INFORMATION. THE CONFIDENTIAL PORTIONS HAVE BEEN PROVIDED SEPARATELY TO THE SECURITIES AND EXCHANGE COMMISSION.]

Faes Farma, S.A.

Maximo Aguirre, 14

48940 Leioa, Vizcaya, Spain

June 19, 2007

Dear Mr. Quintanilla,

Reference is made to the License Agreement dated as of October 31, 2006 between Inspire Pharmaceuticals, Inc. and Faes Farma, S.A. (the “Agreement”). Inspire and Faes acknowledge and agree as follows, effective as of the date hereof:

1. Capitalized terms used in this letter shall have the meaning specified in the Agreement, unless otherwise defined herein. References to Sections and Schedules in this letter are references to Sections and Schedules of the Agreement.

2. Notwithstanding the provisions of Section 3.2, (i) Faes will be responsible for undertaking, at its sole cost and expense, and for using Commercially Reasonable Efforts to conduct the development activities described in the Supplemental Development Plan (as defined below), and such activities will be deemed to be part of the Development Plan, and (ii) until the completion of such activities, all obligations of Inspire with respect to development and commercialization of the Principal Products shall be suspended in all respects, including without limitation under Sections 3.2 and 3.3. Commencing upon December 1, 2007, Faes may terminate its development activities described in the Supplemental Development Plan prior to their completion at any time upon thirty (30) days advance written notice to Inspire. A supplemental development plan has been agreed to by the Parties describing the development activities to be undertaken by Faes pursuant to this letter agreement (the “Supplemental Development Plan”).

3. Section 9.2 is hereby amended to read in its entirety as follows:

“9.2 Voluntary Termination by Inspire. Notwithstanding any other provision herein, commencing upon December 1, 2007, Inspire may terminate this Agreement for its convenience either (i) on a country-by-country basis or Inspire Licensed Product-by-Inspire Licensed Product basis (such termination, a “Partial Termination”), or (ii) in its entirety, such termination requiring the following notice: (x) prior to the First Commercial Sale of an Inspire Licensed Product, upon thirty (30) days advance written notice to Faes, or (y) after the First Commercial Sale of an Inspire Licensed Product, upon one hundred eighty (180) days advance written notice to Faes.”

4. Section 4.2(a) (“Milestone Payments — Acceptable QT Study Results”), Schedule 4.2(a) (“QT Study Results Guidelines”), and Section 9.8 (“Consequences if QT Study Milestone Payment not Made”) are hereby deleted and shall have no further force or effect, and Inspire shall not be obligated to make any payment or take any action under such deleted Sections.

5. Section 4.2(b) is hereby amended to read in its entirety as follows:

“(b) United States NDA Filing. Two Million U.S. Dollars ($2,000,000) upon receipt by Inspire (or its Affiliate or sublicensee) of written notice from the FDA that Inspire’s (or its Affiliate’s or sublicensee’s) NDA seeking Regulatory Approval in the United States of a Principal Product comprising an oral tablet formulation for the Primary Indication has been deemed acceptable for filing and filed by the FDA pursuant to 21 C.F.R. § 314.101.”

6. Section 4.2(c)(i)(A) (“Milestone Payments — Regulatory Approvals — Primary Indication”) is hereby amended to read in its entirety as follows:

“(A) [CONFIDENTIAL] upon receipt by Inspire (or its Affiliate or sublicensee) of Regulatory Approval in the United States of a Principal Product comprising an oral tablet formulation for the Primary Indication with an Acceptable Primary Label.”

7. On the date that is sixty (60) days after Faes has completed its development activities described in the Supplemental Development Plan and Inspire has received from Faes all of the final, audited study reports, each in compliance with applicable guidelines and suitable for submission to the FDA, with respect to the clinical studies conducted by Faes under the Supplemental Development Plan, Inspire’s obligations with respect to development and commercialization of the Principal Products under the Agreement shall no longer be suspended as contemplated in paragraph 2 above.

8. Except as provided in this letter, the Agreement shall remain in full force and effect. In the event of any inconsistency between the Agreement and this letter agreement, the terms of this letter agreement shall control.

If the foregoing accurately reflects our agreement on these matters, please sign a copy of this letter in the space below and return it to us.

Very truly yours,

/s/ Christy L. Shaffer

Christy L. Shaffer

President and CEO

Acknowledged and agreed to by:

Faes Farma, S.A.
By:	/s/ Francisco Quintanilla
Name:	Francisco Quintanilla
Title:	Managing Director

EX-10.3

EXHIBIT 10.3

FIRST AMENDMENT TO

LOAN AND SECURITY AGREEMENT

THIS FIRST AMENDMENT TO LOAN AND SECURITY AGREEMENT (this “Amendment”) is entered into this 27^th day of June, 2007, by and among MERRILL LYNCH CAPITAL, a division of Merrill Lynch Business Financial Services Inc. (“Merrill Lynch”), SILICON VALLEY BANK (“SVB”) (SVB and Merrill Lynch each individually a “Lender”, and collectively the “Lenders”), SVB in its capacity as agent for the Lenders (in such capacity, “Agent”), SVB and Merrill Lynch in their capacities as joint lead arrangers (in such capacity, the “Arrangers”), and INSPIRE PHARMACEUTICALS, INC., a corporation organized and in good standing under the laws of the State of Delaware (“Borrower”), provides the terms on which Lenders shall lend to Borrower and Borrower shall repay Lenders.

RECITALS

A. Agent, Lenders and Borrower have entered into that certain Loan and Security Agreement dated as of December 22, 2006, (as the same may from time to time be further amended, modified, supplemented or restated, the “Loan Agreement”).

B. Lenders have extended credit to Borrower for the purposes permitted in the Loan Agreement.

C. Borrower has requested that Agent and Lenders amend the Loan Agreement to (i) add a new term loan facility in the principal amount of Twenty Million Dollars ($20,000,000), (ii) revise certain financial covenants, and (iii) make certain other revisions to the Loan Agreement as more fully set forth herein.

D. Agent and Lenders have agreed to so amend certain provisions of the Loan Agreement, but only to the extent, in accordance with the terms, subject to the conditions and in reliance upon the representations and warranties set forth below.

AGREEMENT

NOW, THEREFORE, in consideration of the foregoing recitals and other good and valuable consideration, the receipt and adequacy of which is hereby acknowledged, and intending to be legally bound, the parties hereto agree as follows:

1. Definitions. Capitalized terms used but not defined in this Amendment shall have the meanings given to them in the Loan Agreement.

2. Amendments to Loan Agreement.

2.1 Section 2.1.2 (Supplemental Term Loan). The following provisions are added to the Loan Agreement immediately after Section 2.1.1 as Sections 2.1.2 and 2.1.3:

2.1.2 Supplemental Term Loan Facility.

(a) Availability. Subject to the terms and conditions of this Agreement, Lenders agree, severally and not jointly, to lend to Borrower, prior to the expiration of the Supplemental Draw Period, advances (each a “Supplemental Term Loan Advance” and collectively, the “Supplemental Term Loan Advances”) in an aggregate amount equal to the Supplemental Term Loan Commitment according to each Lender’s pro rata share of the Supplemental Term Loan Commitment (based upon the respective Commitment Percentage of each Lender). The Supplemental Term Loan Commitment shall be available during the Supplemental Draw Period if at the time of the request for each such Supplemental Term Loan Advance no Default or Event of Default has occurred and is continuing. Each Supplemental Term Loan Advance shall be in a minimum amount of One Million Dollars ($1,000,000). When repaid, a Supplemental Term Loan Advance may not be re-borrowed.

(b) Borrowing Procedure. To obtain a Supplemental Term Loan Advance, unless otherwise agreed by Agent and Lenders, Borrower must notify Agent by facsimile by 12:00 p.m. Eastern Time three (3) Business Days prior to the date the Supplemental Term Loan Advance is to be made by delivering to Agent a completed Payment Advance Form signed by two (2) Responsible Officers. On the Funding Date, each Lender shall credit and/or transfer (as applicable) to Borrower’s deposit account with SVB, an amount equal to its Commitment Percentage multiplied by the amount of the Supplemental Term Loan Advance. Each Lender may make the Supplemental Term Loan Advance under this Agreement based on instructions from two (2) Responsible Officers or his or her designee or without instructions if the Supplemental Term Loan Advance is necessary to meet Obligations which have become due. Each Lender may rely on any facsimile notice given by a person whom such Lender believes is a Responsible Officer or designee. Borrower shall indemnify each Lender and Agent for any loss Lender or Agent suffers due to such reliance.

2.1.3 Repayment of Credit Extensions.

(a) Principal and Interest Payments on Supplemental Payment Dates.

Each Supplemental Term Loan Advance is payable in monthly installments of interest only for six (6) months, commencing on the first (1^st) Business Day of the first month after the Funding Date and continuing on the first (1^st) Business Day of each month thereafter (each a “Supplemental Payment Date”) until the Supplemental Conversion Date. Commencing on the seventh (7^th) month after each Funding Date (the “Supplemental Conversion Date”), on each Supplemental Payment Date, Borrower shall repay the unpaid principal amount of each Supplemental Term Loan Advance in equal monthly payments of principal and interest which would fully amortize the amount of such Supplemental Term Loan Advance from the Supplemental Conversion Date until the Maturity Date at the applicable Supplemental Basic Rate. All unpaid principal and accrued interest is due and payable in full on the Maturity Date. A Supplemental Term Loan Advance may only be prepaid in accordance with Sections 2.1.3(d) and 2.1.3(e). Payments received after 12:00 noon Eastern Time are considered received at the opening of business on the next Business Day.

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(b) Interest Rate. Borrower shall pay interest on each Supplemental Payment Date on the unpaid principal amount of each Supplemental Term Loan Advance until the Supplemental Term Loan Advance has been paid in full, at the per annum rate of interest equal to the Supplemental Basic Rate determined by Agent as of the Funding Date for each Supplemental Term Loan Advance in accordance with the definition of the Supplemental Basic Rate. Interest is computed on the basis of a 360 day year for the actual number of days elapsed. For the avoidance of doubt, subsections 2.3(b)(ii) and 2.3(b) (iii) shall apply to interest on each Supplemental Term Loan Advance.

(c) Final Payment. On the Maturity Date or at the time of any mandatory or permitted prepayment of any Supplemental Term Loan Advance, Borrower shall pay, in addition to the unpaid principal and accrued interest and all other amounts due on such date with respect to such Supplemental Term Loan Advance, an amount equal to the Supplemental Final Payment.

(d) Mandatory Prepayment upon an Acceleration. If the Supplemental Term Loan is accelerated following the occurrence of an Event of Default or otherwise, Borrower shall immediately pay to Lenders an amount equal to the sum of: (i) all payments of principal plus accrued interest due and owing on such date and not yet paid, plus (ii) all remaining payments of principal, plus (iii) the Supplemental Final Payment, plus (iv) the Make Whole Premium, plus (v) all other sums, if any, that shall have become due and payable, including interest at the Default Rate with respect to any past due amounts.

(e) Permitted Prepayment of Loans. Borrower shall have the option to prepay Supplemental Term Loan Advances in whole or in part from time to time advanced by any Lender under this Agreement, without penalty or premium, in minimum incremental amounts of One Million Dollars ($1,000,000), provided Borrower (i) provides written notice to Agent of its election to prepay Supplemental Term Loan Advances at least fifteen (15) days prior to such prepayment, and (ii) pays, on the date of such prepayment (A) the principal amount of such prepayment, plus accrued interest due and owing thereon on such date, plus (B) the Supplemental Final Payment, plus (C) the Make Whole Premium, plus (D) all other sums, if any, that shall have become due and payable, including interest at the Default Rate with respect to any past due amounts.

2.2 Section 2.2 (Termination of Commitment to Lend). Section 2.2 of the Loan Agreement is amended and restated in its entirety as follows:

2.2 Termination of Commitment to Lend.

Without limiting Lenders’ other rights hereunder, each Lender’s obligation to lend the undisbursed portion of the Term Loan Commitment and the Supplemental Term Loan Commitment shall terminate if, in such Lender’s good faith business judgment, there has been a Material Adverse Change.

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2.3 Section 2.4 (Fees). Subsection 2.4(d) of the Loan Agreement is amended and restated in its entirety as follows:

(d) Unused Commitment Fee.

On the Business Day the Draw Period expires, Borrower shall pay to Agent for the ratable benefit of the Lenders, a fee in an amount equal to one percent (1.00%) of the unused portion of the Term Loan Commitment as determined by Agent. In addition, on the Business Day the Supplemental Draw Period expires, Borrower shall pay to Agent for the ratable benefit of the Lenders, a fee in an amount equal to one percent (1.00%) of the unused portion of the Supplemental Term Loan Commitment as determined by Agent.

2.4 Section 6.6 (Primary Accounts). Section 6.6 of the Loan Agreement is amended and restated in its entirety as follows:

6.6 Primary Accounts.

(a) In order to permit Agent to monitor Borrower’s financial performance and condition, Borrower, and all Borrower’s Subsidiaries, shall maintain Borrower’s, and such Subsidiaries’, primary depository and operating accounts and securities accounts with SVB or SVB’s Affiliates, which accounts shall represent at least (i) fifty percent (50%) of Borrower’s unrestricted cash, cash equivalents and marketable securities (“Cash Balances”) held at any financial institution when Borrower’s total cash and investments is greater than or equal to One Hundred Twenty Million Dollars ($120,000,000), (ii) sixty percent (60%) of Borrower’s Cash Balances held at any financial institution when Borrower’s total cash and investments is greater than One Hundred Million Dollars ($100,000,000) but less than One Hundred Twenty Million Dollars ($120,000,000), (iii) seventy-five percent (75%) of Borrower’s Cash Balances held at any financial institution when Borrower’s total cash and investments is greater than or equal to Eighty Million Dollars ($80,000,000), but less than One Hundred Million Dollars ($100,000,000), and (iv) eighty-five percent (85%) of Borrower’s Cash Balances held at any financial institution when Borrower’s total cash and investments is less than Eighty Million Dollars ($80,000,000). All such accounts at SVB or SVB’s Affiliates shall constitute part of the Collateral.

(b) Borrower shall identify to Agent, in writing, any bank or securities account opened by Borrower or any Guarantor with any institution other than Agent. In addition, for each such account that Borrower or any Guarantor at any time opens or maintains, Borrower shall, at Agent’s request, cause the depository bank or securities intermediary to agree that such account is the Collateral of Agent, on behalf of Lenders, pursuant to the terms of a control agreement in form and substance reasonably acceptable to the Lenders, Agent and such depository bank or securities intermediary; provided, however, (i) Agent shall not require a control agreement with respect to Borrower’s demand deposit account held at Wachovia Bank, National Association so long as the value of the cash and other assets in such account does not exceed Five Million Dollars ($5,000,000), and Borrower is not in violation of the Liquidity Ratio covenant set forth in Section 6.8, and (ii) the provisions of this sentence shall not apply to deposit accounts

4

exclusively used for, and the balance in the Wachovia Bank, National Association deposit account referenced in clause (i) above shall be deemed to exclude amounts allocated for, payroll, payroll taxes and other employee wage and benefit payments to or for the benefit of Borrower’s employees.

2.5 Section 6.8 (Financial Covenant). Section 6.8 of the Loan Agreement is amended and restated in its entirety as follows:

6.8 Financial Covenant.

Borrower shall maintain at all times, a minimum Liquidity Ratio of not less than the following amounts during the following periods:

Period	Liquidity Ratio
June 27th, 2007 through December 31, 2007	1.00:1.00
January 1, 2008 and thereafter	1.35:1.00

2.6 Consent to Additional Equity. Borrower has advised Agent and Lenders that it contemplates closing on an equity round in an amount of up to Seventy Five Million Dollars ($75,000,000) of Borrower’s preferred stock (the “New Equity”), which may be entitled to an annual dividend in an amount not to exceed ten percent (10%) of the purchase price of the New Equity (the “Dividend”). Borrower has requested that Agent, and each Lender, consent to the New Equity and the Dividend. Agent and each Lender consent to the New Equity and the Dividend and agree that after giving effect to the consent in this Section 2.6 the New Equity and the Dividend shall not violate any of the terms of the Loan Agreement, subject to the following conditions: (a) at the time of the New Equity and after giving effect to any Dividend, no Event of Default has occurred and is continuing (it being understood and agreed by the Agent and the Lenders that the payment of the Dividend shall not constitute a violation of Section 7.6(ii) of the Loan Agreement), (b) the New Equity and the Dividend are on terms consistent with those described in this Section 2.6 and such other terms as may be expressly permitted under the Loan Agreement, and (c) the purchasers of the New Equity are acceptable to Agent and each Lender in their reasonable discretion.

2.7 Section 13 (Definitions).

(a) The following terms and their respective definitions set forth in Section 13.1 are amended in their entirety and replaced with the following:

“Funding Date” shall mean any date on which a Term Loan Advance or Supplemental Term Loan Advance, as applicable, is made to or on account of Borrower.

“Liquidity” shall mean Borrower’s unrestricted cash, cash equivalents, interest and dividends accrued on Borrower’s Investments and marketable securities, plus eighty percent (80%) of Borrower’s Eligible Accounts.

(b) The following terms and their respective definitions are hereby added to Section 13.1 of the Loan Agreement:

“Liquidity Ratio” shall mean a ratio of (i) Borrower’s Liquidity to (ii) the sum of the outstanding Term Loan Advance, plus up to Eight Million Dollars ($8,000,000) of outstanding Supplemental Term Loan Advances; provided, however, if Borrower closes on and has received proceeds from a Thirty Five Million Dollar ($35,000,000) round of new equity financing then from and after January 1, 2008, all outstanding Supplemental Term Loan Advances will be excluded from the calculation of the Liquidity Ratio.

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“Make Whole Premium” shall mean an amount equal to two percent (2.0%) of the amount of any prepayment of any Supplemental Term Loan Advance, if the prepayment is made on or before the second (2^nd ) anniversary of the Funding Date of such Supplemental Term Loan Advance and if the prepayment is made on or after the second anniversary of the Funding Date of such Supplemental Term Loan Advance, then the Make Whole Premium is zero percent (0.0%).

“Supplemental Basic Rate” shall mean, as of the Funding Date the per annum rate of interest (based on a year of 360 days) equal to the sum of (a) U.S. Treasury note yield to maturity for a term equal to sixty (60) months as quoted in the Wall Street Journal on the Funding Date, plus (b) four and one half percent (4.50%).

“Supplemental Conversion Date” shall have the meaning set forth in Section 2.1.3(a).

“Supplemental Draw Period” shall mean the period of time from the Closing Date through the earliest to occur of (a) December 31, 2007, (b) an Event of Default has occurred and is continuing, or (c) the existence of any Default.

“Supplemental Final Payment” shall mean a payment (in addition to and not in substitution for the regular monthly payments of principal plus accrued interest) due on the Maturity Date or date of any mandatory or optional prepayment of any Supplemental Term Loan Advance, or part thereof, equal to the amount of such Supplemental Term Loan Advance subject to payment multiplied by the Supplemental Final Payment Percentage.

“Supplemental Final Payment Percentage” shall mean two percent (2.0%).

“Supplemental Payment Date” shall have the meaning set forth in Section 2.1.3(a).

“Supplemental Term Loan” shall mean Supplemental Term Loan Advances in an aggregate amount not to exceed Twenty Million Dollars ($20,000,000).

“Supplemental Term Loan Advance” or “Supplemental Term Loan Advances” shall have the meaning set forth in Section 2.1.2(a).

“Supplemental Term Loan Commitment” shall mean with respect to each Lender, the total amount of the Supplemental Term Loan Advances which may be made under the Supplemental Term Loan. With respect to SVB this means an amount of up to Ten Million Dollars ($10,000,000), with respect to Merrill Lynch this means an amount of up to Ten Million Dollars ($10,000,000).

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(c) The definition of “Unused Facility Fee” set forth in Section 13.1 is deleted in its entirety.

2.8 Compliance Certificate. The Compliance Certificate attached to the Loan Agreement is replaced in its entirety with the Compliance Certificate attached hereto as Exhibit C.

3. Limitation of Amendments.

3.1 The amendments set forth in Section 2, above, are effective for the purposes set forth herein and shall be limited precisely as written and shall not be deemed to (a) be a consent to any amendment, waiver or modification of any other term or condition of any Loan Document, or (b) otherwise prejudice any right or remedy which Agent and any Lender may now have or may have in the future under or in connection with any Loan Document.

3.2 This Amendment shall be construed in connection with and as part of the Loan Documents and all terms, conditions, representations, warranties, covenants and agreements set forth in the Loan Documents, except as herein amended, are hereby ratified and confirmed and shall remain in full force and effect.

4. Representations and Warranties. To induce Agent and each Lender to enter into this Amendment, Borrower hereby represents and warrants to Agent and each Lender as follows:

4.1 Immediately after giving effect to this Amendment (a) the representations and warranties contained in the Loan Documents are true, accurate and complete in all material respects as of the date hereof (except to the extent such representations and warranties relate to an earlier date, in which case they are true and correct as of such date), and (b) no Event of Default has occurred and is continuing;

4.2 Borrower has the power and authority to execute and deliver this Amendment and to perform its obligations under the Loan Agreement, as amended by this Amendment;

4.3 The organizational documents of Borrower delivered to Agent on December 20, 2006 remain true, accurate and complete and have not been amended, supplemented or restated and are and continue to be in full force and effect;

4.4 The execution and delivery by Borrower of this Amendment and the performance by Borrower of its obligations under the Loan Agreement, as amended by this Amendment, have been duly authorized;

4.5 The execution and delivery by Borrower of this Amendment and the performance by Borrower of its obligations under the Loan Agreement, as amended by this Amendment, do not and will not contravene in any manner which reasonably could be expected

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to cause a Material Adverse Change (a) any law or regulation binding on or affecting Borrower, (b) any contractual restriction with a Person binding on Borrower, (c) any order, judgment or decree of any court or other governmental or public body or authority, or subdivision thereof, binding on Borrower, or (d) the organizational documents of Borrower;

4.6 The execution and delivery by Borrower of this Amendment and the performance by Borrower of its obligations under the Loan Agreement, as amended by this Amendment, do not require any order, consent, approval, license, authorization or validation of, or filing, recording or registration with, or exemption by any governmental or public body or authority, or subdivision thereof, binding on Borrower, except (a) as already has been obtained or made and (b) such orders, consents, approvals, licenses, authorizations, validations, filings, recordings, registrations, or exemptions the failure of which to obtain or make would not be reasonably expected to cause a Material Adverse Change; and

4.7 This Amendment has been duly executed and delivered by Borrower and is the binding obligation of Borrower, enforceable against Borrower in accordance with its terms, except as such enforceability may be limited by bankruptcy, insolvency, reorganization, liquidation, moratorium or other similar laws of general application and equitable principles relating to or affecting creditors’ rights.

5. Counterparts. This Amendment may be executed in any number of counterparts and all of such counterparts taken together shall be deemed to constitute one and the same instrument.

6. Effectiveness. This Amendment shall be deemed effective upon (a) the due execution and delivery to Agent and each Lender of this Amendment by each party hereto, (b) Borrower’s payment of a non refundable amendment fee to the Agent for the ratable benefit of the Lenders in an amount equal to Fifty Thousand Dollars ($50,000), and (c) payment of Agent’s and each Lender’s legal fees and expenses in connection with the negotiation and preparation of this Amendment.

[Signature page follows.]

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IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be duly executed and delivered as of the date first written above.

BORROWER:
INSPIRE PHARMACEUTICALS, INC.
By:	/s/ Thomas R. Staab, II
Name:	Thomas R. Staab, II
Title:	CFO & Treasurer
AGENT:
SILICON VALLEY BANK
By:	/s/ Win Bear
Name:	Win Bear
Title:	Team Leader
LENDERS:
MERRILL LYNCH CAPITAL, a division of Merrill Lynch Business Financial Services Inc.
By:	/s/ Chris York
Name:	Chris York
Title:	VP
SILICON VALLEY BANK
By:	/s/ Win Bear
Name:	Win Bear
Title:	Team Leader

EXHIBIT C

Compliance Certificate

TO: SILICON VALLEY BANK as Agent

FROM: INSPIRE PHARMACEUTICALS, INC.

The undersigned authorized officer of Inspire Pharmaceuticals, Inc. certifies that under the terms and conditions of the Loan and Security Agreement among Borrower, Lenders and Agent (the “Agreement”), (i) Borrower is in compliance for the period ending                                          with all required covenants except as noted below and no Default or Event of Default has occurred and is continuing and (ii) all representations and warranties in the Agreement are true and correct in all material respects on this date (except for those representations and warranties expressly referring to a specific date, which were true and correct in all respects as of that date). Attached are the required documents supporting the certification. In addition, the undersigned certifies that (1) Borrower has timely filed all required tax returns and paid, or made adequate provision to pay, all material taxes, except those being contested in good faith with adequate reserves under GAAP and (2) no liens have been levied or claims made against Borrower relating to unpaid employee payroll or benefits which Borrower has not previously notified in writing to Agent. The Officer certifies that these are prepared in accordance with Generally Accepted Accounting Principles (GAAP) consistently applied from one period to the next except as explained in an accompanying letter or footnotes. The Officer acknowledges that no borrowings may be requested at any time or date of determination that Borrower is not in compliance with any of the terms of the Agreement, and that compliance is determined not just at the date this certificate is delivered.

Please indicate compliance status by circling Yes/No under “Complies” column.

Reporting Covenant	Required	Complies
Monthly financial statements with Compliance Certificate.	Monthly within 30 days	Yes	No
Annual (CPA Audited)	FYE within earlier of 120 days or 5 days after filing with SEC	Yes	No
Financial Projections approved by Board	Annually at least 30 days prior to fiscal year end	Yes	No
Financial Covenant	Required	Complies
Unrestricted cash, cash equivalents and marketable securities with Agent	50% when total cash and investments is greater than or equal to $120,000,000 60% when total cash and investments greater than $100,000,000 but less than $120,000,000 75% when total cash and investments greater than or equal to $80,000,000 but less than $100,000,000 85% when total cash and investments is less than $80,000,000	Yes	No
Liquidity Ratio		Yes	No
June 30, 2007 through December 31, 2007	1.00:1.00
January 31, 2008 and thereafter	1.35:1.00	Yes	No

Comments Regarding Exceptions: See Attached.   Sincerely,   Signature   Title   Date BANK USE ONLY   Received by:                                                                       AUTHORIZED SIGNER   Date:                                                                                        Verified:                                                                               AUTHORIZED SIGNER   Date:                                                                                        Compliance Status:                Yes ¨                No ¨

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EX-10.4

EXHIBIT 10.4

INSPIRE PHARMACEUTICALS, INC.

AMENDED AND RESTATED

2005 EQUITY COMPENSATION PLAN

The purpose of the Inspire Pharmaceuticals, Inc. Amended and Restated 2005 Equity Compensation Plan (the “Plan”) is to provide (i) designated employees of Inspire Pharmaceuticals, Inc. (the “Company”) and its parents and subsidiaries, (ii) certain consultants and advisors who perform services for the Company or its parents or subsidiaries, and (iii) non-employee members of the Board of Directors of the Company (the “Board”) with the opportunity to receive grants of incentive stock options, nonqualified stock options, stock awards, and stock appreciation rights. The Company believes that the Plan will encourage the participants to contribute materially to the growth of the Company, thereby benefiting the Company’s stockholders, and will align the economic interests of the participants with those of the stockholders. The Plan is effective as of the date it is ratified and approved by the Company’s stockholders.

1. Administration

(a) Committee. The Plan shall be administered and interpreted by the members of the Compensation Committee of the Board (the “Committee”), which consists of “outside directors” as defined under Section 162(m) of the Internal Revenue Code of 1986, as amended (the “Code”), and related Treasury regulations, and “non-employee directors” as defined under Rule 16b-3 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). However, the Board may ratify or approve any grants as it deems appropriate, and the Board shall approve and administer all grants made to non-employee directors. The Committee may delegate authority to one (1) or more delegates as it deems appropriate.

(b) Committee Authority. The Committee or its delegate shall have the sole authority to (i) determine the individuals to whom grants shall be made under the Plan; (ii) determine the type, size, and terms of the grants to be made to each such individual; (iii) determine the time when the grants will be made and the duration of any applicable exercise or restriction period, including the criteria for exercisability and the acceleration of exercisability; (iv) amend the terms of any previously issued grant; and (v) deal with any other matters arising under the Plan. Any delegation of any or all of the aforementioned authority with respect to the Inspire Pharmaceuticals, Inc. Amended and Restated 1995 Stock Plan, as amended (the “1995 Plan”), shall be effective with respect to this Plan. Notwithstanding anything in this Plan to the contrary, but subject to adjustments as described in Section 3(b) below, in no event may the Board, the Committee or its or their delegate (A) amend or modify an Option (as defined below) in a manner that would reduce the Exercise Price (as defined below) of such Option; (B) substitute an Option for another Option with a lower Exercise Price; (C) cancel an Option and issue a new Option with a lower Exercise Price to the holder of the cancelled Option within six (6) months following the date of the cancellation of the cancelled Option; or (D) cancel an outstanding Option that is under water (i.e., for which the Fair Market Value, as defined below, of the underlying Shares are less than the Option’s Exercise Price) for the purpose of granting a replacement Grant (as defined below) of a different type within six (6) months following the date of cancellation of the cancelled Option.

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(c) Committee Determinations. The Committee shall have full power and authority to administer and interpret the Plan, to make factual determinations and to adopt or amend such rules, regulations, agreements, and instruments for implementing the Plan and for the conduct of its business as it deems necessary or advisable, in its sole discretion. The Committee’s interpretations of the Plan and all determinations made by the Committee pursuant to the powers vested in it hereunder shall be conclusive and binding on all persons having any interest in the Plan or in any awards granted hereunder. All powers of the Committee shall be executed in its sole discretion, in the best interest of the Company, not as a fiduciary, and in keeping with the objectives of the Plan and need not be uniform as to similarly situated individuals.

(d) Other Equity Awards. The terms of this Plan shall not impact or govern the administration by the Company or the rights of any holders of an option or stock award granted pursuant to the 1995 Plan. Unless otherwise provided by the Company and agreed to by the recipient of an award under the 1995 Plan, all awards granted pursuant to the 1995 Plan shall continue to be governed by the terms of the 1995 Plan.

2. Grants

(a) Awards under the Plan may consist of grants of incentive stock options as described in Section 5 below (“Incentive Stock Options”), nonqualified stock options as described in Section 5 below (“Nonqualified Stock Options”) (Incentive Stock Options and Nonqualified Stock Options are collectively referred to as “Options”), stock awards as described in Section 6 below (“Stock Awards”) and stock appreciation rights described in Section 7 below (“SARs”) (hereinafter collectively referred to as “Grants”). All Grants shall be subject to the terms and conditions set forth herein and to such other terms and conditions consistent with this Plan and as specified in the individual grant instrument or an amendment to the grant instrument (the “Grant Instrument”). All Grants shall be made conditional upon the Grantee’s (as defined below) acknowledgement, in writing or by acceptance of the Grant, that all decisions and determination of the Company shall be final and binding on the Grantee, his or her beneficiaries and any other person having or claiming an interest under such Grant. Grants under a particular Section of the Plan need not be uniform as among the Grantees.

3. Shares Subject to the Plan

(a) Shares Authorized. Subject to adjustment as described in Section 3(d) below, the maximum aggregate number of shares of common stock of the Company (“Company Stock”) that may be issued or transferred under any form of Grant under the Plan is eight million (8,000,000) shares (the “Total Share Pool”, which is comprised of the “Original Share Pool”, and the “New Share Pool”, as described in Sections 3(b) and 3(c) below). The maximum aggregate number of shares of Company Stock that may be granted as Incentive Stock Options under the Plan is eight million (8,000,000) shares, and the maximum aggregate number of shares of Company Stock that shall be subject to Grants made under the Plan to any individual during any calendar year shall be three hundred thousand (300,000) shares, subject to adjustment as described in Section 3(d) below. The shares may be authorized but unissued shares of Company Stock or reacquired shares of Company Stock, including shares purchased by the Company on the open market for purposes of the Plan. Any shares of Company Stock issued in connection with Grants shall reduce the Total Share Pool by one (1) for each Option or SAR and two (2) for

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each Stock Award or Restricted Unit (as defined in Section 6(h)) issued in connection with such Grant or by which the Grant is valued by reference. Shares of Company Stock issued in connection with Grants shall be issued from the Original Share Pool, and upon its depletion, shall be issued from the New Share Pool, in the manner described in Sections 3(b) and 3(c) below.

(b) Original Share Pool. The Original Share Pool contains a number of shares of Company Stock equal to all shares of Company Stock issued in connection with Grants that are outstanding as of the date of ratification and approval of the Plan by the Company’s stockholders, to the extent those shares of Company Stock have not become available for reissuance under the Original Share Pool, as described below. If and to the extent Grants originating from the Original Share Pool terminate, expire, or are canceled, forfeited, exchanged, or surrendered without having been exercised or if any Stock Awards (including restricted Stock Awards received upon the exercise of Options) or Restricted Units are forfeited, the shares subject to such Grants shall be available for Grants from the New Share Pool, and shall increase the New Share Pool (and consequently, the amount of shares that are available under the Total Share Pool) by one (1) share of Company stock for each share of Company Stock issued in connection with such Grant or by which the Grant is valued by reference.

(c) New Share Pool. The New Share Pool contains the shares of Company Stock in the Total Share Pool which are not in the Original Share Pool. If and to the extent Options or SARs originating from the New Share Pool terminate, expire, or are canceled, forfeited, exchanged, or surrendered without having been exercised or if any Stock Awards (including restricted Stock Awards received upon the exercise of Options) or Restricted Units are forfeited, the shares subject to such Grants shall again be available for Grants under the New Share Pool, and shall increase the New Share Pool (and consequently, the amount of shares that are available under the Total Share Pool) by one (1) for each Option or SAR and two (2) for each Stock Award or Restricted Unit issued in connection with such Grant or by which the Grant is valued by reference.

(d) Adjustments. If there is any change in the number or kind of shares of Company Stock outstanding (i) by reason of a stock dividend, spin-off, recapitalization, stock split, or combination or exchange of shares; (ii) by reason of a merger, reorganization, or consolidation; (iii) by reason of a reclassification or change in par value; or (iv) by reason of any other extraordinary or unusual event affecting the outstanding Company Stock as a class without the Company’s receipt of consideration, or if the value of outstanding shares of Company Stock is substantially reduced as a result of a spin-off or the Company’s payment of an extraordinary dividend or distribution, the maximum number of shares of Company Stock available for Grants under both the Original Share Pool or the New Share Pool, the maximum number of shares of Company Stock that any individual participating in the Plan may be granted in any year, the number of shares covered by outstanding Grants, the kind of shares issued under the Plan, and the price per share of such Grants shall be appropriately adjusted by the Company to reflect any increase or decrease in the number of, or change in the kind or value of, issued shares of Company Stock to preclude, to the extent practicable, the enlargement or dilution of rights and benefits under such Grants; provided, however, that any fractional shares resulting from such adjustment shall be rounded down to the nearest whole share. Any adjustments determined by the Company shall be final, binding, and conclusive.

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4. Eligibility for Participation

(a) Eligible Persons. All employees of the Company and its parents or subsidiaries (“Employees”), including Employees who are officers or members of the Board, and members of the Board who are not Employees (“Non-Employee Directors”) shall be eligible to participate in the Plan. Consultants and advisors who perform services for the Company or any of its parents or subsidiaries (“Key Advisors”) shall be eligible to participate in the Plan if the Key Advisors render bona fide services to the Company or its parents or subsidiaries, the services are not in connection with the offer and sale of securities in a capital-raising transaction, and the Key Advisors do not directly or indirectly promote or maintain a market for the Company’s securities.

(b) Selection of Grantees. The Company shall select the Employees, Non-Employee Directors, and Key Advisors to receive Grants and shall determine the number of shares of Company Stock subject to a particular Grant. Employees, Non-Employee Directors, and Key Advisors who receive Grants under this Plan shall hereinafter be referred to as “Grantees.”

5. Granting of Options

The Company may grant an Option to an Employee, Non-Employee Director, or Key Advisor. The following provisions are applicable to Options.

(a) Number of Shares. The Company shall determine the number of shares of Company Stock that will be subject to each Grant of Options to Employees, Non-Employee Directors, and Key Advisors.

(b) Type of Option and Price.

(i) Incentive Stock Options are intended to satisfy the requirements of Section 422 of the Code. Nonqualified Stock Options are not intended to so qualify. Incentive Stock Options may be granted only to employees of the Company or its parents or subsidiaries, as defined in Section 424 of the Code. Nonqualified Stock Options may be granted to Employees, Non-Employee Directors, and Key Advisors.

(ii) The purchase price (the “Exercise Price”) of Company Stock subject to an Option may be equal to or greater than the Fair Market Value of a share of Company Stock on the date the Option is granted; provided, however, that (A) the Exercise Price of an Incentive Stock Option shall be equal to, or greater than, the Fair Market Value of a share of Company Stock on the date the Incentive Stock Option is granted and (B) an Incentive Stock Option may not be granted to an Employee who, at the time of grant, owns or beneficially owns stock possessing more than ten percent (10%) of the total combined voting power of all classes of stock of the Company or any parent or subsidiary of the Company, unless the Exercise Price per share is not less than one hundred ten percent (110%) of the Fair Market Value of Company Stock on the date of grant.

(iii) So long as the Company Stock is publicly traded, the Fair Market Value per share shall be determined as follows: (A) if the principal trading market for the Company Stock is a national securities exchange or the Nasdaq National Market, the last reported sale

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price thereof on the relevant date or (if there were no trades on that date) the latest preceding date upon which a sale was reported, or (B) if the Company Stock is not principally traded on such exchange or market, the mean between the last reported “bid” and “asked” prices of Company Stock on the relevant date, as reported on Nasdaq or, if not so reported, as reported by the National Daily Quotation Bureau, Inc. or as reported in a customary financial reporting service, as applicable and as the Company determines. If the Company Stock is not publicly traded or, if publicly traded, is not subject to reported transactions or “bid” or “asked” quotations as set forth above, the Fair Market Value per share shall be as determined by the Company.

(c) Option Term. The term of any Option shall not exceed seven (7) years from the date of grant. However, an Incentive Stock Option that is granted to an Employee who, at the time of grant, owns or beneficially owns stock possessing more than ten percent (10%) of the total combined voting power of all classes of stock of the Company, or any parent or subsidiary of the Company, may not have a term that exceeds five (5) years from the date of grant.

(d) Exercisability of Options.

(i) Options shall become exercisable in accordance with such terms and conditions of the Plan and specified in the Grant Instrument. The Company may accelerate the exercisability of any or all outstanding Options at any time for any reason.

(ii) The Company may provide in a Grant Instrument that the Grantee may elect to exercise part or all of an Option before it otherwise has become exercisable. Any shares so purchased shall be restricted shares and shall be subject to a repurchase right in favor of the Company during a specified restriction period, with the repurchase price equal to the lesser of (A) the Exercise Price or (B) the Fair Market Value of such shares at the time of repurchase, and (C) any other restrictions determined by the Company.

(e) Grants to Non-Exempt Employees. Options granted to persons who are non-exempt employees under the Fair Labor Standards Act of 1938, as amended, shall not be exercisable for at least six (6) months after the date of grant (except that such Options may become exercisable upon the Grantee’s death, Disability (as defined below) or retirement, or upon a Change in Control (as defined below) or other circumstances permitted by applicable regulations).

(f) Termination of Employment, Disability, or Death.

(i) Except as provided below, an Option may only be exercised while the Grantee is employed by, or providing service to, the Employer (as defined below) as an Employee, Key Advisor or member of the Board. In the event that a Grantee ceases to be employed by, or provide service to, the Employer for any reason other than Disability, death, termination for Misconduct (as defined below), or as set forth in Section 5(f)(v) of this Plan, any Option which is otherwise exercisable by the Grantee shall terminate unless exercised within ninety (90) days after the date on which the Grantee ceases to be employed by, or provide service to, the Employer (or within such other period of time as may be specified by the Company), but in any event no later than the date of expiration of the Option term. Except as otherwise provided, any of the Grantee’s Options that are not otherwise exercisable as of the date on which the Grantee ceases to be employed by, or provide service to, the Employer shall terminate as of such date.

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(ii) In the event the Grantee ceases to be employed by, or provide service to, the Employer on account of a termination by the Employer for Misconduct, any Option held by the Grantee shall terminate as of the thirtieth (30^th) day after the date on which the Grantee ceases to be employed by, or provide service to, the Employer or the date on which such Option would otherwise expire, if earlier. In addition, notwithstanding any other provisions of this Section 5, if the Company determines that the Grantee has engaged in conduct that constitutes Misconduct at any time while the Grantee is employed by, or providing service to, the Employer or after the Grantee’s termination of employment or service, any Option held by the Grantee shall terminate as of the thirtieth (30^th) day after the date on which such Misconduct first occurred, or the date on which such Option would otherwise expire, if earlier. Upon any exercise of an Option, the Company may withhold delivery of share certificates pending resolution of an inquiry that could lead to a finding resulting in a forfeiture.

(iii) In the event the Grantee ceases to be employed by, or provide service to, the Employer because the Grantee is Disabled, any Option which is otherwise exercisable by the Grantee shall terminate unless exercised within one (1) year after the date on which the Grantee ceases to be employed by, or provide service to, the Employer (or within such other period of time as may be specified by the Company), but in any event no later than the date of expiration of the Option term. Except as otherwise provided, any of the Grantee’s Options that are not otherwise exercisable as of the date on which the Grantee ceases to be employed by, or provide service to, the Employer shall terminate as of such date.

(iv) If the Grantee dies while employed by, or providing service to, the Employer, all of the unexercised outstanding Options of Grantee shall become immediately exercisable and remain exercisable for a period of one (1) year from his or her date of death, but in no event later than the date of expiration of the Option term. If the Grantee dies within ninety (90) days after the date on which the Grantee ceases to be employed or provide service on account of a termination specified in Section 5(f)(i) above (or within such other period of time as may be specified by the Company), any Option that is otherwise exercisable by the Grantee shall terminate unless exercised within one (1) year after the date on which the Grantee ceases to be employed by, or provide service to, the Employer (or within such other period of time as may be specified), but in any event no later than the date of expiration of the Option term. Except as otherwise provided, any of the Grantee’s Options that are not otherwise exercisable as of the date on which the Grantee ceases to be employed by, or provide service to, the Employer shall terminate as of such date.

(v) Notwithstanding anything herein to the contrary, to the extent that any Company-sponsored plan, policy or arrangement, or any agreement to which the Company is a party provides for a longer exercise period for a Grantee’s Options under applicable circumstances than the exercise period that is provided for in this Section 5(f) under those circumstances, then the exercise period set forth in such plan, policy, arrangement or agreement applicable to such circumstances shall apply in lieu of the exercise period provided for in this Section 5(f).

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(vi) For purposes of this Section 5(f) and Section 6 below:

(A) “Employer” shall mean the Company and its parent and subsidiary corporations or other entities, as determined by the Board.

(B) “Employed by, or provide service to, the Employer” shall mean employment or service as an Employee, Key Advisor or member of the Board (so that, for purposes of exercising Options or SARs and satisfying conditions with respect to Stock Awards, a Grantee shall not be considered to have terminated employment or service until the Grantee ceases to be an Employee, Key Advisor or member of the Board).

(C) “Disability” shall mean a Grantee’s becoming disabled within the meaning of the Employer’s long-term disability plan applicable to the Grantee, as determined in the sole discretion of the Committee or its delegate.

(D) “Misconduct” means (i) willful and continued failure by the Grantee to substantially perform the Grantee’s duties with the Company (other than any such failure resulting from the Grantee’s incapacity due to physical or mental illness) or (ii) the willful engaging by the Grantee in conduct which is demonstrably injurious to the Company, monetarily or otherwise. For purposes of this definition, no act, or failure to act, on the Grantee’s part shall be deemed “willful” unless done, or omitted to be done, by the Grantee not in good faith or without reasonable belief that the Grantee’s act, or failure to act, was in the best interest of the Company.

(g) Exercise of Options. A Grantee may exercise an Option that has become exercisable, in whole or in part, by delivering a notice of exercise to the Company. The Grantee shall pay the Exercise Price for an Option as specified by the Company (i) in cash, (ii) payment through a broker in accordance with procedures permitted by Regulation T of the Federal Reserve Board, or (iii) by such other method as the Company may approve. Shares of Company Stock used to exercise an Option shall have been held by the Grantee for the requisite period of time to avoid adverse accounting consequences to the Company with respect to the Option. The Grantee shall pay the Exercise Price and the amount of any withholding tax due (pursuant to Section 8 below).

(h) Limits on Incentive Stock Options. Each Incentive Stock Option shall provide that, if the aggregate Fair Market Value of the Company Stock on the date of the grant with respect to which Incentive Stock Options are exercisable for the first time by a Grantee during any calendar year, under the Plan or any other stock option plan of the Company or a parent or subsidiary, exceeds One Hundred Thousand Dollars ($100,000), then the Option, as to the excess, shall be treated as a Nonqualified Stock Option. An Incentive Stock Option shall not be granted to any person who is not an employee of the Company or a parent or subsidiary (within the meaning of Section 424(f) of the Code) of the Company.

6. Stock Awards

The Company may transfer shares of Company Stock or cash to an Employee, Non-Employee Director, or Key Advisor under a Stock Award. The following provisions are applicable to Stock Awards.

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(a) General Requirements. Shares of Company Stock issued or transferred pursuant to Stock Awards may be issued or transferred for consideration or for no consideration, and subject to restrictions or no restrictions. Restrictions on Stock Awards shall lapse over a period of time or according to such other criteria as set forth in the Grant Instrument. The period of time during which the Stock Award will remain subject to restrictions will be designated in the Grant Instrument as the “Restriction Period.”

(b) Number of Shares. The Grant Instrument shall set forth the number of shares of Company Stock to be issued or transferred pursuant to a Stock Award and the restrictions applicable to such shares.

(c) Requirement of Employment or Service. If the Grantee ceases to be employed by, or provide service to, the Employer (as defined in Section 5(f) above) during a period designated in the Grant Instrument as the Restriction Period, or if other specified conditions are not met, the Stock Award shall terminate as to all shares covered by the Stock Award as to which the restrictions have not lapsed, and those shares of Company Stock must be immediately returned to the Company. The Company may, however, provide for complete or partial exceptions to this requirement as it deems appropriate.

(d) Restrictions on Transfer and Legend on Stock Certificate. During the Restriction Period, a Grantee may not sell, assign, transfer, pledge, or otherwise dispose of the shares of the Stock Award except to a successor under Section 9(a) below. Each certificate for Stock Awards shall contain a legend giving appropriate notice of the restrictions in the Grant. The Grantee shall be entitled to have the legend removed from the stock certificate covering the shares subject to restrictions when all restrictions on such shares have lapsed. The Company may determine that it will not issue certificates for Stock Awards until all restrictions on such shares have lapsed, or that the Company will retain possession of certificates for Stock Awards until all restrictions on such shares have lapsed.

(e) Right to Vote and to Receive Dividends. During the Restriction Period, the Grantee shall not have the right to vote shares subject to Stock Awards or to receive any dividends or other distributions paid on such shares.

(f) Lapse of Restrictions. All restrictions imposed on Stock Awards shall lapse upon the expiration of the applicable Restriction Period and the satisfaction of all conditions. The Company may determine, as to any or all Stock Awards, that the restrictions shall lapse without regard to any Restriction Period.

(g) Designation as Qualified Performance-Based Compensation. The Committee may determine that Stock Awards granted to an Employee shall be considered “qualified performance-based compensation” under Section 162(m) of the Code. The provisions of this paragraph (g) shall apply to Stock Awards that are to be considered “qualified performance-based compensation” under Section 162(m) of the Code.

(i) Performance Goals. When Stock Awards that are to be considered “qualified performance-based compensation” are granted, the Committee shall establish in writing (A) the objective performance goals that must be met, (B) the performance period during

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which the performance goals must be met (the “Performance Period”), (C) the threshold, target and maximum amounts that may be paid if the performance goals are met, and (D) any other conditions that the Committee deems appropriate and consistent with the Plan and Section 162(m) of the Code. The performance goals may relate to the Employee’s business unit or the performance of the Company and its parents and subsidiaries as a whole, or any combination of the foregoing. The Committee shall use objectively determinable performance goals based on one (1) or more of the following criteria: stock price, earnings per share, net earnings, operating earnings, return on assets, stockholder return, return on equity, growth in assets, unit volume, sales, market share, or strategic business criteria consisting of one (1) or more objectives based on meeting specified revenue goals, market penetration goals, geographic business expansion goals, cost targets or goals relating to acquisitions or divestitures.

(ii) Establishment of Goals. The Committee shall establish the performance goals in writing either before the beginning of the Performance Period or during a period ending no later than the earlier of (A) ninety (90) days after the beginning of the Performance Period or (B) the date on which twenty-five percent (25%) of the Performance Period has been completed, or such other date as may be required or permitted under applicable regulations under Section 162(m) of the Code. The performance goals shall satisfy the requirements for “qualified performance-based compensation,” including the requirement that the achievement of the goals be substantially uncertain at the time they are established and that the goals be established in such a way that a third party with knowledge of the relevant facts could determine whether and to what extent the performance goals have been met. The Committee shall not have discretion to increase the amount of compensation that is payable upon achievement of the designated performance goals.

(iii) Maximum Payment. If Stock Awards, measured with respect to the Fair Market Value of Company Stock, are granted, not more than one hundred thousand (100,000) shares of Company Stock may be granted to an Employee under the Stock Award for any Performance Period.

(iv) Announcement of Grants. The Committee shall certify and announce the results for each Performance Period to all Grantees immediately following the announcement of the Company’s financial results for the Performance Period. If and to the extent that the Committee does not certify that the performance goals have been met, the grants of Stock Awards for the Performance Period shall be forfeited or shall not be made, as applicable.

(v) Death, Disability or Other Circumstances. The Committee may provide that Stock Awards shall be payable or restrictions on Stock Awards shall lapse, in whole or in part, in the event of the Grantee’s death or Disability during the Performance Period, or under other circumstances consistent with the Treasury regulations and rulings under Section 162(m) of the Code.

(h) Restricted Stock Units. The Committee or its delegate may grant restricted stock units (“Restricted Units”) to an Employee or Key Advisor. Each Restricted Unit shall represent the right of the Grantee to receive an amount in cash or Company Stock (as determined by the Committee or its delegate) based on the value of the Restricted Unit, if performance goals established by the Committee are met or upon the lapse of a specified vesting period. A

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Restricted Unit shall be based on the Fair Market Value of a share of Company Stock or on such other measurement base as the Committee or its delegate deems appropriate. The Committee or its delegate shall determine the number of Restricted Units to be granted and the requirements applicable to such Restricted Units.

7. Stock Appreciation Rights

The Company may grant SARs to an Employee, Non-Employee Director, or Key Advisor. The following provisions are applicable to SARs.

(a) General Requirements. The Company may grant SARs to an Employee, Non-Employee Director or Key Advisor separately or in tandem with any Option (for all or a portion of the applicable Option). Tandem SARs may be granted either at the time the Option is granted or at any time thereafter while the Option remains outstanding; provided, however, that, in the case of an Incentive Stock Option, SARs may be granted only at the time of the grant of the Incentive Stock Option. Unless otherwise specified in the Grant Instrument, the base amount of each SAR shall be equal to the per share Exercise Price of the related Option or, if there is no related Option, the Fair Market Value of a share of Company Stock as of the date of grant of the SAR.

(b) Tandem SARs. In the case of tandem SARs, the number of SARs granted to a Grantee that shall be exercisable during a specified period shall not exceed the number of shares of Company Stock that the Grantee may purchase upon the exercise of the related Option during such period. Upon the exercise of an Option, the SARs relating to the Company Stock covered by such Option shall terminate. Upon the exercise of SARs, the related Option shall terminate to the extent of an equal number of shares of Company Stock.

(c) Exercisability. A SAR shall be exercisable during the period specified in the Grant Instrument and shall be subject to such vesting and other restrictions as may be specified. The Company may accelerate the exercisability of any or all outstanding SARs at any time for any reason. SARs may only be exercised while the Grantee is employed by, or providing service to, the Employer or during the applicable period after termination of employment or service as described in Section 5(f) above. A tandem SAR shall be exercisable only during the period when the Option to which it is related is also exercisable. The term of any SAR shall not exceed seven (7) years from the date of grant.

(d) Grants to Non-Exempt Employees. Notwithstanding the foregoing, SARs granted to persons who are non-exempt employees under the Fair Labor Standards Act of 1938, as amended, shall have a base amount not less than one hundred percent (100%) of the Fair Market Value of the Company Stock on the date of grant, and may not be exercisable for at least six (6) months after the date of grant (except that such SARs may become exercisable, as determined by the Committee, upon the Grantee’s death, Disability or retirement, or upon a Change of Control or other circumstances permitted by applicable regulations).

(e) Value of SARs. When a Grantee exercises SARs, the Grantee shall receive in settlement of such SARs an amount equal to the value of the stock appreciation for the number of SARs exercised, payable in Company Stock. The stock appreciation for a SAR is the amount

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by which the Fair Market Value of the underlying Company Stock on the date of exercise of the SAR exceeds the base amount of the SAR as described in Section 7(a) above. For purposes of calculating the number of shares of Company Stock to be received, shares of Company Stock shall be valued at their Fair Market Value on the date of exercise of the SAR. Notwithstanding anything to the contrary, the Company may pay the appreciation of a SAR in the form of cash, shares of Company Stock, or a combination of the two (2), so long as the ability to pay such amount in cash does not result in the Grantee incurring taxable income related to the SAR prior to the Grantee’s exercise of the SAR.

(f) Number of SARs Authorized for Issuance. For purposes of Section 3(a) of the Plan, SARs to be settled in shares of Company Stock shall be counted in full against the number of shares of Company Stock available for award under the Plan, regardless of the number of exercise gain shares issued upon the settlement of the SAR.

8. Withholding of Taxes

(a) Required Withholding. All Grants under the Plan shall be subject to applicable federal (including FICA), state, and local tax withholding requirements. The Employer may require that the Grantee or other person receiving or exercising Grants pay to the Employer the amount of any federal, state, or local taxes that the Employer is required to withhold with respect to such Grants, or the Employer may deduct from other wages paid by the Employer the amount of any withholding taxes due with respect to such Grants.

(b) Election to Withhold Shares. If the Company so permits, a Grantee may elect to satisfy the Employer’s income tax withholding obligation with respect to a Grant by having shares withheld up to an amount that does not exceed the Grantee’s minimum applicable withholding tax rate for federal (including FICA), state, and local tax liabilities. The election must be in a form and manner prescribed by the Company.

9. Transferability of Grants

(a) Nontransferability of Grants. Except as provided below, only the Grantee may exercise rights under a Grant during the Grantee’s lifetime. A Grantee may not transfer those rights except (i) by will or by the laws of descent and distribution or (ii) with respect to SARs and Option grants other than Incentive Stock Options, pursuant to a domestic relations order or otherwise as permitted by the Company. When a Grantee dies, the personal representative or other person entitled to succeed to the rights of the Grantee may exercise such rights. Any such successor must furnish proof satisfactory to the Company of his or her right to receive the Grant under the Grantee’s will or under the applicable laws of descent and distribution.

(b) Transfer of Nonqualified Stock Options. Notwithstanding the foregoing, the Grant Instrument may provide that a Grantee may transfer Nonqualified Stock Options to family members, or one (1) or more trusts or other entities for the benefit of or owned by family members, consistent with applicable securities laws, provided that the Grantee receives no consideration for the transfer of an Option and the transferred Option shall continue to be subject to the same terms and conditions as were applicable to the Option immediately before the transfer.

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10. Change in Control of the Company

(a) “Change in Control” means the determination (which may be made effective as of a particular date specified by the Board) by the Board, made by a majority vote that a change in control has occurred, or is about to occur. Such a change shall not include, however, a restructuring, reorganization, merger or other change in capitalization in which the Persons who own an interest in the Company on the date hereof (the “Current Owners”) (or any individual or entity which receives from a Current Owner an interest in the Company through will or the laws of descent and distribution) maintain more than a fifty percent (50%) interest in the resultant entity. Regardless of the vote of the Board or whether or not the Board votes, a Change in Control will be deemed to have occurred as of the first day any one (1) or more of the following subsections shall have been satisfied:

(b) Any Person (as defined below) (other than the Person in control of the Company as of the date of this Plan, or other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company, or a company owned directly or indirectly by the stockholders of the Company in substantially the same proportions as their ownership of stock of the Company), becomes the beneficial owner, directly or indirectly, of securities of the Company representing more than thirty-five percent (35%) of the combined voting power of the Company’s then outstanding securities; or

(c) The stockholders of the Company approve:

(i) A plan of complete liquidation of the Company;

(ii) An agreement for the sale or disposition of all or substantially all of the Company’s assets; or

(iii) A merger, consolidation or reorganization of the Company with or involving any other company, other than a merger, consolidation or reorganization that would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) at least fifty percent (50%) of the combined voting power of the voting securities of the Company (or such surviving entity) outstanding immediately after such merger, consolidation or reorganization.

(d) However, in no event shall a Change in Control be deemed to have occurred, with respect to a Grantee, if the Grantee is part of a purchasing group which consummates the Change in Control transaction. A Grantee shall be deemed “part of the purchasing group” for purposes of the preceding sentence if the Grantee is an equity participant or has agreed to become an equity participant in the purchasing company or group (except for (i) passive ownership of less than five percent (5%) of the voting securities of the purchasing company; or (ii) ownership of equity participation in the purchasing company or group which is otherwise deemed not to be significant, as determined prior to the Change in Control by a majority of the continuing Non-Employee Directors).

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(e) For purposes of this Section 10:

(i) The term “Person” shall have the meaning given in Section 3(a)(9) of the Exchange Act, as modified and used in Sections 13(d) and 14(d) thereof, except that such term shall not include (A) the Company or any of its subsidiaries; (B) a trustee or other fiduciary holding securities under an employee benefit plan of the Company or any of its subsidiaries; (C) an underwriter temporarily holding securities pursuant to an offering of such securities; (D) a corporation owned, directly or indirectly, by the stockholders of the Company in substantially the same proportions as their ownership of stock of the Company; or (E) an entity or entities which are eligible to file and have filed a Schedule 13G under Rule 13d-l(b) of the Exchange Act, which Schedule indicates beneficial ownership of fifteen percent (15%) or more of the outstanding shares of common stock of the Company or the combined voting power of the Company’s then outstanding securities.

11. Consequences of a Change in Control

(a) Notice and Acceleration. Upon a Change in Control, unless the Company determines otherwise, (i) the Company shall provide each Grantee with outstanding Grants written notice of such Change in Control, (ii) all outstanding Options and SARs shall automatically accelerate and become fully exercisable, and (iii) the restrictions and conditions on all outstanding Stock Awards shall immediately lapse.

(b) Assumption of Grants. Upon a Change in Control where the Company is not the surviving corporation (or survives only as a subsidiary of another corporation), each Grantee shall have the right to elect within thirty (30) days of receiving the notice described in paragraph (a) immediately above one (1) of the following methods of treating his or her outstanding Options, SARs, and Stock Awards: (i) all outstanding Options and SARs that are not exercised shall be assumed by, or replaced with comparable options or stock appreciation rights by, the surviving corporation (or a parent or subsidiary of the surviving corporation), and outstanding Stock Awards shall be converted to comparable stock awards of the surviving corporation (or a parent or subsidiary of the surviving corporation); or (ii) each Grantee may surrender his or her outstanding Options, SARs, or Stock Awards in exchange for a payment by the Company, in cash or Company Stock (as elected by the Grantee) in an amount equal to the amount by which the then Fair Market Value of the shares of Company Stock underlying the Option or SAR exceeds the Exercise Price of the Grantee’s unexercised Options or the base amount of the Grantee’s unexercised SARs or for the then Fair Market Value of shares of Company Stock underlying the Grantee’s Stock Awards.

12. Requirements for Issuance or Transfer of Shares

(a) Limitations on Issuance or Transfer of Shares. No Company Stock shall be issued or transferred in connection with any Grant hereunder unless and until all legal requirements applicable to the issuance or transfer of such Company Stock have been complied with. Any Grant made shall be conditioned on the Grantee’s undertaking in writing to comply with such restrictions on his or her subsequent disposition of such shares of Company Stock, and certificates representing such shares may be legended to reflect any such restrictions. Certificates representing shares of Company Stock issued or transferred under the Plan will be subject to such stop-transfer orders and other restrictions as may be required by applicable laws, regulations and interpretations, including any requirement that a legend be placed thereon.

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(b) Lock-Up Period. If so requested by the Company or any representative of the underwriters (the “Managing Underwriter”) in connection with any underwritten offering of securities of the Company under the Securities Act of 1933, as amended (the “Securities Act”), a Grantee (including any successor or assigns) shall not sell or otherwise transfer any shares or other securities of the Company during the thirty (30) day period preceding and the one hundred eighty (180)-day period following the effective date of a registration statement of the Company filed under the Securities Act for such underwriting (or such shorter period as may be requested by the Managing Underwriter and agreed to by the Company) (the “Market Standoff Period”). The Company may impose stop-transfer instructions with respect to securities subject to the foregoing restrictions until the end of such Market Standoff Period.

13. Amendment and Termination of the Plan

(a) Amendment. The Board or its delegate may amend or terminate the Plan at any time; provided, however, that neither the Board nor its delegate shall have the authority to amend the Plan without stockholder approval if such approval is required in order to comply with the Code or other applicable laws, or to comply with applicable stock exchange requirements.

(b) Termination of Plan. The Plan shall terminate on the day immediately preceding the tenth (10^th) anniversary of its effective date, unless the Plan is terminated earlier by the Company or is extended by the Company with the approval of the stockholders.

(c) Termination and Amendment of Outstanding Grants. A termination or amendment of the Plan that occurs after a Grant is made shall not materially impair the rights of a Grantee unless the Grantee consents or unless the Company acts under Section 19(b) below. The termination of the Plan shall not impair the power and authority of the Company with respect to an outstanding Grant. Whether or not the Plan has terminated, an outstanding Grant may be terminated or amended under Section 19(b) below or may be amended by agreement of the Company and the Grantee consistent with the Plan.

(d) Governing Document. The Plan shall be the controlling document. No other statements, representations, explanatory materials or examples, oral or written, may amend the Plan in any manner. The Plan shall be binding upon and enforceable against the Company and its successors and assigns.

14. Funding of the Plan

This Plan shall be unfunded. The Company shall not be required to establish any special or separate fund or to make any other segregation of assets to assure the payment of any Grants under this Plan. In no event shall interest be paid or accrued on any Grant, including unpaid installments of Grants.

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15. Rights of Participants

Nothing in this Plan shall entitle any Employee, Non-Employee Director, Key Advisor, or other person to any claim or right to be granted a Grant under this Plan. Neither this Plan nor any action taken hereunder shall be construed as giving any individual any rights to be retained by or in the employ of the Employer or any other employment rights.

16. No Fractional Shares

No fractional shares of Company Stock shall be issued or delivered pursuant to the Plan or any Grant. The Company shall determine whether cash, other awards or other property shall be issued or paid in lieu of such fractional shares or whether such fractional shares or any rights thereto shall be forfeited or otherwise eliminated.

17. Headings

Section headings are for reference only. In the event of a conflict between a title and the content of a Section, the content of the Section shall control.

18. Effective Date of the Plan

The Plan shall be effective on June 10, 2005.

19. Miscellaneous

(a) Grants in Connection with Corporate Transactions and Otherwise. Nothing contained in this Plan shall be construed to (i) limit the right of the Company to make Grants under this Plan in connection with the acquisition, by purchase, lease, merger, consolidation or otherwise, of the business or assets of any corporation, firm or association, including Grants to employees thereof who become Employees, or for other proper corporate purposes, or (ii) limit the right of the Company to grant stock options or make other awards outside of this Plan. Without limiting the foregoing, the Company may make a Grant to an employee of another corporation who becomes an Employee by reason of a corporate merger, consolidation, acquisition of stock or property, reorganization or liquidation involving the Company, the parent or any of their subsidiaries in substitution for a stock option or stock award grant made by such corporation. The terms and conditions of the substitute grants may vary from the terms and conditions required by the Plan and from those of the substituted stock incentives. The Company shall prescribe the provisions of the substitute grants.

(b) Compliance with Law. The Plan, the exercise of Options and SARs, and the obligations of the Company to issue or transfer shares of Company Stock under Grants shall be subject to all applicable laws and to approvals by any governmental or regulatory agency as may be required. With respect to persons subject to Section 16 of the Exchange Act it is the intent of the Company that the Plan and all transactions under the Plan comply with all applicable provisions of Rule 16b-3 or its successors under the Exchange Act. In addition, it is the intent of the Company that the Plan and applicable Grants under the Plan comply with the applicable provisions of Section 162(m) of the Code and Section 422 of the Code. To the extent that any legal requirement of Section 16 of the Exchange Act or Section 162(m) or Section 422 of the

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Code as set forth in the Plan ceases to be required under Section 16 of the Exchange Act or Section 162(m) or Section 422 of the Code, that Plan provision shall cease to apply. The Company may revoke any Grant if it is contrary to law or modify a Grant to bring it into compliance with any valid and mandatory government regulation. The Company may also adopt rules regarding the withholding of taxes on payments to Grantees. The Company may, in its sole discretion, agree to limit its authority under this Section 19(b).

(c) Employees Subject to Taxation Outside the United States. With respect to Grantees who are subject to taxation in countries other than the United States, Grants may be made on such terms and conditions as the Company deems appropriate to comply with the laws of the applicable countries, and the Company may create such procedures, addenda and subplans and make such modifications as may be necessary or advisable to comply with such laws.

(d) Governing Law. The validity, construction, interpretation, and effect of the Plan and Grant Instruments issued under the Plan shall be governed and construed by and determined in accordance with the laws of the State of Delaware, without giving effect to the conflict of laws provisions thereof.

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EX-31.1

Exhibit 31.1

INSPIRE PHARMACEUTICALS, INC.

CERTIFICATIONS

I, Christy L. Shaffer, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Inspire Pharmaceuticals, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: August 9, 2007	/s/ Christy L. Shaffer
	Christy L. Shaffer
	President & Chief Executive Officer
	(principal executive officer)

EX-31.2

Exhibit 31.2

INSPIRE PHARMACEUTICALS, INC.

CERTIFICATIONS

I, Thomas R. Staab, II, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Inspire Pharmaceuticals, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: August 9, 2007	/s/ Thomas R. Staab, II
	Thomas R. Staab, II
	Chief Financial Officer & Treasurer
	(principal financial officer)

EX-32.1

Exhibit 32.1

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the quarterly report of Inspire Pharmaceuticals, Inc. (the “Company”) on Form 10-Q for the period ended June 30, 2007, as filed with the Securities and Exchange Commission (the “Report”), I, Christy L. Shaffer, President & Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: August 9, 2007	/s/ Christy L. Shaffer
	Christy L. Shaffer President & Chief Executive Officer (principal executive officer)

EX-32.2

Exhibit 32.2

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the quarterly report of Inspire Pharmaceuticals, Inc. (the “Company”) on Form 10-Q for the period ended June 30, 2007, as filed with the Securities and Exchange Commission (the “Report”), I, Thomas R. Staab, II, Chief Financial Officer & Treasurer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: August 9, 2007	/s/ Thomas R. Staab, II
	Thomas R. Staab, II
	Chief Financial Officer & Treasurer (principal financial officer)