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 September 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 October 31, 2007, there were 56,439,001 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 – September 30, 2007 and December 31, 2006	3
Condensed Statements of Operations – Three and Nine months ended September 30, 2007 and 2006	4
Condensed Statements of Cash Flows – Three and Nine months ended September 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	19
Item 3. Quantitative and Qualitative Disclosures about Market Risk	42
Item 4. Controls and Procedures	43
PART II: OTHER INFORMATION
Item 1. Legal Proceedings	44
Item 1A. Risk Factors	45
Item 6. Exhibits	68
Signatures	69

2

PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

INSPIRE PHARMACEUTICALS, INC.

Condensed Balance Sheets

(in thousands, except per share amounts)

(Unaudited)

	September 30, 2007			December 31, 2006
Assets
Current assets:
Cash and cash equivalents	$	83,561		$	50,190
Investments		37,153			45,377
Trade receivables		13,518			8,245
Prepaid expenses and other receivables		5,044			3,530
Inventories		910			—
Other assets		791			404
Total current assets		140,977			107,746
Property and equipment, net		2,529			1,754
Investments		10,677			6,714
Intangibles, net		18,336			—
Other assets		432			485
Total assets	$	172,951		$	116,699
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	7,104		$	6,297
Accrued expenses		13,898			8,359
Deferred revenue		1,059			—
Short-term debt and capital leases		9,617			3,435
Total current liabilities		31,678			18,091
Capital leases – noncurrent		20			267
Long-term debt		29,623			17,655
Other long-term liabilities		2,973			2,315
Total liabilities		64,294			38,328
Commitments and contingencies (See Note 8)
Series A Exchangeable Preferred Stock, net (See Note 9)		73,605			—
140 and no shares issued and outstanding, respectively
Stockholders’ equity:
Preferred stock, $0.001 par value, 2,000 shares authorized		—			—
Common stock, $0.001 par value, 100,000 shares authorized; 42,414 and 42,238 shares issued and outstanding, respectively		42			42
Additional paid-in capital		325,813			323,606
Accumulated other comprehensive income/(loss)		8			(152	)
Accumulated deficit		(290,811	)		(245,125	)
Total stockholders’ equity		35,052			78,371
Total liabilities and stockholders’ equity	$	172,951		$	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						Nine Months Ended
	September 30, 2007			September 30, 2006			September 30, 2007			September 30, 2006
Revenues:
Product sales, net	$	1,122		$	—		$	1,122		$	—
Product co-promotion		11,091			9,702			33,656			27,357
Collaborative research and development		—			—			—			1,250
Total revenue		12,213			9,702			34,778			28,607
Operating expenses:
Cost of sales		603			—			603			—
Research and development		8,071			8,209			38,811			26,491
Selling and marketing		14,313			6,210			32,181			19,763
General and administrative		3,614			3,633			10,380			12,413
Total operating expenses		26,601			18,052			81,975			58,667
Loss from operations		(14,388	)		(8,350	)		(47,197	)		(30,060	)
Other income (expense):
Interest income		1,584			1,203			3,472			3,596
Interest expense		(890	)		(28	)		(1,935	)		(86	)
Loss on investments		—			—			(26	)		(29	)
Other income, net		694			1,175			1,511			3,481
Net loss	$	(13,694	)	$	(7,175	)	$	(45,686	)	$	(26,579	)
Basic and diluted net loss per common share	$	(0.32	)	$	(0.17	)	$	(1.08	)	$	(0.63	)
Weighted average common shares used in computing basic and diluted net loss per common share		42,413			42,238			42,364			42,223

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

4

INSPIRE PHARMACEUTICALS, INC.

Condensed Statements of Cash Flows

(in thousands)

(Unaudited)

	Nine Months Ended
	September 30, 2007			September 30, 2006
Cash flows from operating activities:
Net loss	$	(45,686	)	$	(26,579	)
Adjustments to reconcile net loss to net cash used in operating activities:
Amortization expense		1,042			155
Depreciation of property and equipment		649			914
Loss on disposal of property and equipment		—			3
Loss on investments		26			29
Stock-based compensation expense		1,989			1,120
Changes in operating assets and liabilities:
Trade receivables		(5,273	)		(4,704	)
Prepaid expenses and other receivables		(1,174	)		(63	)
Inventories		(910	)		—
Other assets		—			10
Accounts payable		595			1,110
Accrued expenses and other liabilities		5,457			1,517
Deferred revenue		1,059			—
Net cash used in operating activities		(42,226	)		(26,488	)
Cash flows from investing activities:
Purchase of investments		(47,350	)		(45,778	)
Proceeds from sale of investments		51,845			44,374
Restricted cash transfer		(100	)		—
Approval milestone payment		(19,000	)		—
Purchase of property and equipment		(1,424	)		(698	)
Proceeds from sale of property and equipment		—			1
Net cash used in investing activities		(16,029	)		(2,101	)
Cash flows from financing activities:
Proceeds from long-term debt		20,000			—
Proceeds from issuance of notes payable		—			782
Proceeds from issuance of exchangeable preferred stock, net		73,605			—
Issuance of common stock, net		218			75
Debt issuance cost		(100	)		—
Payments on notes payable and capital lease obligations		(2,097	)		(468	)
Net cash provided by financing activities		91,626			389
Increase/(decrease) in cash and cash equivalents		33,371			(28,200	)
Cash and cash equivalents, beginning of period		50,190			65,018
Cash and cash equivalents, end of period	$	83,561		$	36,818

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 the commercial success of its products and 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 sales of AzaSite and its co-promotion of Restasis® (cyclosporine ophthalmic emulsion) 0.05% and Elestat® (epinastine HCl ophthalmic solution) 0.05%. The Company will continue to incur operating losses until product and co-promotion revenues reach a level sufficient to support ongoing operations. AzaSite is a trademark owned by InSite Vision Incorporated (“InSite Vision”). Restasis and Elestat are trademarks owned by Allergan, Inc. (“Allergan”).

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, restricted stock units that are paid in shares of the Company’s stock upon conversion, and shares of exchangeable preferred stock on an if-converted basis. The calculation of diluted earnings per share for the three months ended September 30, 2007 and 2006 does not include 11,545 and 495, respectively, and for the nine months ended September 30, 2007 and 2006 does not include 4,220 and 468, 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, 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 6 to the accompanying Condensed Financial Statements for a further discussion on stock-based compensation.

Intangible Assets

Costs associated with obtaining 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 September 30, 2007, the Company had $664 in accumulated amortization.

Revenue Recognition

The Company records all of its revenue from (1) sales of AzaSite; (2) product co-promotion activities; and (3) collaborative research agreements in accordance with Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements,” (“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

The Company recognizes 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 transactions whereby product stocking incentives were offered approximately one month prior to the product’s August

7

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

13, 2007 launch. In the United States, we sell AzaSite to wholesalers and distributors, who, in turn, sell to pharmacies and Federal, State and commercial healthcare organizations. Accruals, or reserves, for estimated rebates, discounts, chargebacks and other sales incentives (collectively “sales incentives”) are recorded in the same period that the related sales are recorded and are recognized as a reduction in sales of AzaSite. These sales incentive reserves are recorded in accordance with Emerging Issues Task Force (“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, are based on reasonable estimates of the amounts earned or claimed on the sales of AzaSite. These estimates 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 are adjusted for actual results and when trends or significant events indicate that an adjustment is appropriate.

In addition to SAB No. 104, the Company’s ability to recognize revenue for sales of AzaSite is subject to the requirements of SFAS No. 48, “Revenue Recognition When Right of Return Exists” (“SFAS No. 48”), as issued by the Financial Accounting Standards Board (“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 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 the Company’s return goods policy. Consistent with industry standards, the Company’s return goods policy allows for returns of AzaSite within an eighteen-month period, from six months prior to the expiration date and up to twelve months after the expiration date. In accordance with SFAS No. 48, the Company is required to estimate the level of sales that will ultimately be returned pursuant to its return policy and to record a related reserve at the time of sale. These amounts are deducted from the Company’s gross sales of AzaSite in determining its net sales. Since AzaSite is a new product, the Company is 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 its initial return estimates, including its own experience with Restasis and Elestat 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 the Company’s own historical experience with AzaSite. The Company also considers 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, the Company offered wholesalers stocking incentives that allowed for extended payment terms, product discounts, and guaranteed sale provisions (collectively, “special terms”). These special terms were only offered during a specified time period of approximately one month prior to the August 13, 2007 launch of AzaSite. Any sales of AzaSite made under these special term provisions were accounted for using a consignment model since substantially all the risks and rewards of ownership did not transfer upon shipment. Under the consignment model, the Company did not recognize revenue upon shipment of AzaSite purchased with the special terms, but recorded deferred revenue at gross invoice sales price, less all appropriate discounts and rebates, and accounted for AzaSite inventory held by the wholesalers as consignment inventory. The Company recognized the revenue from these sales with special terms at the earlier of when the inventory of AzaSite held by the wholesalers was sold through to the wholesalers’ customers or when such inventory of AzaSite was no longer subject to these special terms. All sales subsequent to this specified “launch” time period include return rights and pricing that are customary in the industry. For these sales, the Company is recording revenue on the date of shipment, as discussed above.

8

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

The Company utilizes data from external sources to help it estimate its 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 includes among others, information obtained from certain wholesalers with respect to their inventory levels and sell-through to customers as well as data from IMS Health, a supplier of market research data to the pharmaceutical industry. The Company also utilizes this data to help estimate and identify prescription trends and patient demand.

Product Co-promotion Revenues

The Company recognizes co-promotion revenue based on net sales for Restasis and Elestat, as defined in the co-promotion agreements, and as reported to Inspire by Allergan. The Company actively promotes both Restasis and Elestat 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 Restasis and Elestat, 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 Restasis and Elestat. 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 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

9

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

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 $8 of unrealized gains and $152 of unrealized losses on its investments that are classified as accumulated other comprehensive income/(loss) at September 30, 2007 and December 31, 2006, respectively. Comprehensive loss consists of the following components:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2007			2006			2007			2006
Net loss	$	(13,694	)	$	(7,175	)	$	(45,686	)	$	(26,579	)
Adjustment for realized losses in net loss		—			—			26			29
Change in unrealized gain on investments		102			169			134			91
Total comprehensive loss	$	(13,592	)	$	(7,006	)	$	(45,526	)	$	(26,459	)

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 Restasis and Elestat 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. The Company is responsible for the remaining manufacture of AzaSite to refine the active pharmaceutical ingredient into a finished product, for which it relies on 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 Restasis and Elestat.

10

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

Significant Customers and Risk

The Company relies primarily on three pharmaceutical wholesalers to purchase and supply the majority of AzaSite at the retail level. The loss of one or more of these wholesalers as a customer could negatively impact the commercialization of AzaSite. All co-promotion revenues recognized and recorded for each of the nine months ended September 30, 2007 and 2006, were from one collaborative partner. The Company is entitled to receive co-promotion revenue from net sales of Restasis and Elestat under the terms of its collaborative agreements with Allergan, and accordingly, all trade receivables for these two products are concentrated with Allergan. Due to the nature of these agreements, Allergan has significant influence over the commercial success of Restasis and Elestat.

3. 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 September 30, 2007, the Company’s inventories consisted of the following:

Consignment inventory at wholesalers	$	43
Finished Goods		178
Raw Materials		368
Work-in-Process		321
Total Inventories	$	910

4. Recent 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” (“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.

11

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

5. 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.

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, but for which no advances under the supplemental term loan will be considered in the liquidity calculation.

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 final 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 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 September 30, 2007, the Company had net borrowings of $38,841 under the loan and security agreement that bears interest at a weighted average rate of 7.69%. The carrying amount of total debt of $38,841 approximates its fair value based on prevailing interest rates as of the balance sheet date.

6. Stock-Based Compensation

For the three months ended September 30, 2007 and 2006, the Company recognized total compensation expense of $901 and $417, respectively, and for the nine months ended September 30, 2007 and 2006, the Company recognized total compensation expense of $1,989 and $1,120, respectively, related to its two equity compensation plans.

12

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

Total stock-based compensation was allocated as follows:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006
Research and development	$	228	$	166	$	542	$	454
Selling and marketing		278		77		575		187
General and administrative		395		174		872		479
Total stock-based compensation expense	$	901	$	417	$	1,989	$	1,120

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.

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.

At September 30, 2007, there were 64 and 4,617 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

13

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

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 September 30,						Nine Months Ended September 30,
	2007			2006			2007			2006
Risk-free interest rate		4.40	%		4.78	%		4.62	%		4.61	%
Dividend yield		0	%		0	%		0	%		0	%
Expected volatility		64	%		80	%		67	%		80	%
Expected life of options (years)		3.9			3.8			4.0			4.4
Weighted average fair value of grants	$	2.93		$	2.96		$	3.27		$	3.16

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	1,861			6.10
Exercised	(175	)		1.58
Forfeited/cancelled/expired	(350	)		12.03
Outstanding at September 30, 2007	7,942		$	9.10	5.1	$	2,576
Vested and exercisable at September 30, 2007	5,229		$	10.79	5.0	$	2,319

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INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

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 third 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 September 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 nine months ended September 30, 2007 was $843. Cash received from stock option exercises for the nine months ended September 30, 2007 was $278. Due to the Company’s net loss position, no windfall tax benefits have been realized during the nine months ended September 30, 2007.

As of September 30, 2007, approximately $7,832 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 September 30 2007, there were 195 restricted stock units outstanding, of which 39 were vested. Additionally, approximately $534 of unrecognized share-based compensation expense related to unvested restricted stock units is expected to be recognized over the next 3.8 years.

7. 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 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 full valuation allowance.

8. 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

15

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

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. 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. On August 24, 2007, the plaintiffs filed an appeal to the United States Court of Appeals for the Fourth Circuit. The Company will continue 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.

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 then 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 nine months ended September 30, 2007, approximately $1,266 has been recorded as reimbursement from the Company’s insurance provider of certain legal expenses incurred as a result of defending against the stockholder litigation and SEC investigation.

16

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

9. Subsequent Events

Warburg Pincus Private Equity IX, L.P

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 Company incurred issuance costs of approximately $1,395 in connection with the sale of the Exchangeable Preferred Stock. The Exchangeable Preferred Stock was exchangeable for shares of common stock at a ratio of 1:100.

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.

On October 31, 2007, the Company held a special meeting of stockholders in which the proposed exchange of all outstanding Exchangeable Preferred Stock for shares of the Company’s common stock was approved by the Company’s stockholders. The total number of shares of common stock issued in the exchange was 14,018, which as of October 31, 2007, represented approximately 25% of the Company’s 56,439 shares of common stock outstanding after giving effect to the exchange. Additionally, due to the exchange for common stock, there is no dividend obligation associated with the preferred stock. These newly issued shares of common stock will be classified on the Company’s balance sheet as a component of stockholders’ equity in future periods. The Company has agreed to use its best efforts to file a registration statement to register the shares of common stock into which the holders’ shares of Exchangeable Preferred Stock were exchanged no later than 30 days after the exchange of the Exchangeable Preferred Stock into common stock. As of September 30, 2007, the Exchangeable Preferred Stock has been classified outside of the stockholders’ equity section, as temporary equity, based on the redemption rights that Warburg has been granted with regards to the Exchangeable Preferred Stock prior to the exchange on October 31, 2007.

The exchange of the Exchangeable Preferred Stock was subject to stockholder approval by the holders of the Company’s common stock and the expiration or termination of any waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, both of which have now occurred.

The Exchangeable Preferred Stock was accounted for in accordance with EITF 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,” and EITF 00-27, “Application of Issue 98-5 to Certain Convertible Instruments.” The difference between the effective conversion price per share of underlying common stock in the exchange provision and the market value per share of common stock as of the closing date of the Exchangeable Preferred Stock transaction resulted in the calculation of an embedded contingent beneficial conversion feature, which is required to be treated as a deemed non-cash dividend to preferred stockholders. The calculated intrinsic value of the beneficial conversion feature is approximately $8,300 and will be recorded to accumulated deficit with the offsetting credit to additional paid-in-capital in the quarter ended December 31, 2007. The Company will reflect the beneficial conversion feature on its statement of operations to adjust its reported net loss available to common shareholders. This accounting treatment does not represent any obligation, cash or otherwise, to the Exchangeable Preferred Stockholders.

Ophthalmic Research Associates

On October 15, 2007, the Company and Ophthalmic Research Associates (“ORA”) entered into a clinical services agreement (the “Services Agreement”) pursuant to which ORA will provide clinical research services to the Company relating to Prolacria. Pursuant to the terms of the Services Agreement, the parties shall develop a research program in which ORA’s proprietary dry eye model shall be used by independent clinical investigators to evaluate the effects of Prolacria on patients with dry eye. The parties are required to develop a statement of work and allocate responsibilities in relation to the individual studies for support of the development of Prolacria.

The Company is responsible for paying all costs associated with each study, including payments to ORA for all services rendered under the applicable statements of work. In addition, the Company is required to make payments in the event certain milestones are reached under the Services Agreement. Specifically, the Services Agreement provides that in the event a pivotal clinical trial is conducted under an FDA approved Special Protocol Assessment, the Company will be obligated to pay ORA $2,000 at such time as the first patient is dosed in such pivotal trial. In addition, if Prolacria receives FDA approval, the Company will be obligated to pay ORA either $10,500 or $22,500, based upon the clinical program pursued. If the Company’s applicable development costs exceed $7,000, including

17

INSPIRE PHARMACEUTICALS, INC.

Notes to Condensed Financial Statements

(Unaudited)

(in thousands, except per share amounts)

those development costs paid to ORA and those incurred by the Company in relation to statistics and data management for all of the studies relating to the research program, the Company will be entitled to offset the above described milestone payments with a credit equal to 50% of the excess costs. Furthermore, the amount of such milestones will be reduced in the event certain enrollment targets with respect to an applicable study are not met.

If Prolacria receives FDA approval, the Company will also be obligated to pay (1) a $5,000 milestone payment upon timely completion of certain additional work by ORA, which is expected to be completed in the event of FDA approval, (2) a $5,000 milestone payment in the event of the approval of a line extension involving ORA, and (3) sales milestones, which include one-time sales achievement milestones and recurring annual sales milestones.

In the event that the development program contemplated by the parties does not lead to approval of Prolacria, the approval and post approval milestones payments shall not be paid. The term of the Services Agreement is three years or until the earlier completion of the services, unless earlier terminated.

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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 numerous factors. We launched AzaSite in August 2007 and began recording product revenue 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; competitor response to the launch of AzaSite; discounts, pricing and coverage on governmental and commercial formularies; are all factors, among others, that will impact the level of revenue recorded for AzaSite in 2007 and subsequent periods. 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 Medicaid programs, and the marketing and sales activities of competitors, among others. 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. Cost of sales as they relate to AzaSite contain variable and fixed cost components and the variable components will increase or decrease depending on the volume of AzaSite sold. In addition, certain of these variable costs included in cost of sales are subject to annual increases which are somewhat out of our control. 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

19

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. Once again, management may in some cases be able to control the timing and magnitude of these expenses. We have incurred and expect to continue to incur significant costs related to the commercialization 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
AzaSite™	Bacterial conjunctivitis	InSite Vision	Promoting
Elestat®	Allergic conjunctivitis	Allergan	Co-promoting
Restasis®	Dry eye disease	Allergan	Co-promoting
Product Candidates in Clinical Development
ProlacriaTM (diquafosol tetrasodium)	Dry eye disease	Allergan and Santen Pharmaceutical	Phase 3; Approvable (2)
Denufosol tetrasodium	Cystic fibrosis	None	Phase 3
Epinastine nasal spray	Allergic rhinitis	Boehringer Ingelheim	Entering Phase 3
Bilastine	Seasonal allergic rhinitis	FAES Farma (3)	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 agreements with these collaborative partners. See also footnote 3 below.

(2) 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).

(3) In June 2007, we amended our license agreement with FAES Farma. See Product Candidates in Clinical Development - Bilastine for seasonal allergic rhinitis discussion below.

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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, Restasis and Prolacria 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

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 U.S. Food and Drug Administration, or FDA, for the treatment of bacterial conjunctivitis in adults and pediatric patients one year old or older. In August 2007, we launched AzaSite in the United States and are promoting it to select eye care professionals, pediatricians and primary care providers.

Market Opportunity. The current single-entity ocular antibiotic market, in which AzaSite is directly competing, is approximately $379 million in annual sales in the United States based on data compiled by IMS Health as of June 30, 2007. Total prescriptions in the single-entity ocular antibiotic market were approximately 15 million for the twelve months ended June 30, 2007, up 5% 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 products 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 the United States, 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 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.

In September 2007, we entered into a long term manufacturing services agreement with Catalent Pharma Solutions for the manufacture of the finished product AzaSite.

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 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.

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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. We are promoting it to ophthalmologists, optometrists and allergists, and in association with the commercialization of AzaSite, we are also promoting 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. Our ability to gain additional intellectual property protection related to Elestat has been challenging. We cannot provide any 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 essentially cease.

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.

For the three and nine months ended September 30, 2007, Allergan recognized approximately $88 million and $244 million, respectively, of revenue from net sales of Restasis. In November 2007, Allergan revised guidance for 2007 net sales of Restasis to be in the range of $330-$340 million.

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.

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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 conducted meetings with the FDA relating to Prolacria and dry eye disease. We were working to identify a clinical trial design that the FDA and Inspire agreed was appropriate and reasonable to continue our clinical development of Prolacria. Based upon analysis of our historical clinical trial data, input from experts in the dry eye field, and discussions with the FDA, we have evaluated our options and intend to focus our future development on evaluating the effects of Prolacria on the central region of the cornea, as measured by fluorescein staining scores. Based upon the progress we have achieved thus far, we now believe additional development work is warranted. In October 2007, we entered into a clinical services agreement with Ophthalmic Research Associates Inc., or ORA, to gain access to its proprietary dry eye model (i.e., the controlled adverse environment or dry eye chamber). The agreement contemplates conducting various studies in a step-wise approach to facilitate optimal clinical trial design for possible future clinical development of Prolacria, leveraging ORA’s extensive knowledge in conducting ophthalmic clinical trials. See Note 9 to our Notes to Condensed Financial Statements for a detailed description of the agreement.

We have initiated preliminary clinical work with ORA to confirm the appropriate clinical trial design to be used for a pivotal Phase 3 clinical trial. We will be working closely with ORA and an independent network of clinical dry eye investigators to study Prolacria using ORA’s proprietary dry eye model, which includes using ORA’s stationary and mobile dry eye chambers. While this process will take some time, we believe it is a prudent approach to investing in the program. Based upon our current plans, we would expect to update our progress on our stepwise approach by the third quarter of 2008.

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 $10 million to $15 million, depending on our approach to achieving NDA approval of the product candidate. This range includes costs for conducting various studies under our ORA agreement, regulatory and consulting activities, completing one additional Phase 3 clinical trial, salaries for development personnel, and other unallocated development costs, but excludes any milestone payments upon NDA approval or otherwise under our ORA agreement, as well as the cost of pre-launch

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inventory which is Allergan’s responsibility. 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.

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.

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. Additionally, 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.

Development Status. We have recently completed patient enrollment in TIGER-1, the first of two planned pivotal Phase 3 clinical trials with denufosol tetrasodium inhalation solution for the treatment of cystic fibrosis. The TIGER-1 clinical trial, initiated in July 2006, is a double-blind, placebo-controlled, randomized clinical trial comparing 60 mg of denufosol to placebo, administered three-times daily by jet nebulizer, in approximately 350 patients with mild cystic fibrosis lung disease at clinical centers across North America. The approximate mean age of patients enrolled in TIGER-1 is 14 years. The clinical trial includes a 24-week efficacy and safety portion, followed by a 24-week open-label denufosol safety extension. Patients are continuing to roll into the open-label safety extension phase. As TIGER-1 proceeds, the safety data will continue to 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 mid-year 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)

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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. 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, our second Phase 3 clinical trial which is required for regulatory approval, will include approximately 350 patients and be 24 weeks in duration. For the remainder of 2007, we expect to work with select cystic fibrosis treatment centers in the United States and Canada to prepare for patient enrollment. We intend to have a staged enrollment process for TIGER-2, with the first stage to begin in U.S. and Canadian sites in early 2008. Subsequently, we intend to commence additional international site enrollment in the second half of 2008 as countries become eligible to be included from a regulatory perspective.

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.

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 completing TIGER-1, conducting TIGER-2, conducting required toxicology and carcinogenicity studies, any additional Phase 2 clinical trials, manufacturing denufosol for clinical trials, producing qualification lots consistent with current Good Manufacturing Practices, 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 and any product approval 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 ongoing or 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.

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. 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.

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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 Investigational New Drug Application, or IND, 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, or SAR. 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.

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 SAR clinical trials and one long-term safety trial in patients with perennial allergic rhinitis, or PAR. We expect to initiate the first Phase 3 clinical trial in the fourth quarter of 2007 during the mountain cedar pollen season, with results anticipated in the second quarter of 2008. In August 2007, we initiated the required 6-month intranasal toxicology study of epinastine in a single animal species and expect to have results by mid-year 2008. These results are necessary to begin a subsequent 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 one-year safety clinical trial in 2008, dependent upon the results of the first Phase 3 SAR clinical trial, the outcome of the 6-month toxicology study and other factors.

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 primarily includes conducting three planned Phase 3 pivotal 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.

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Bilastine for seasonal allergic rhinitis

Overview. Bilastine is a non-sedating oral H1-antihistamine compound being developed for the treatment of allergic rhinitis.

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. In addition, the future development and ultimate commercial availability of bilastine in the United States is largely dependent on FAES’ completion of these development activities and the related data generated from these activities. 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, Inspire 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. Also commencing on December 1, 2007, FAES may terminate such development activities prior to their completion by giving us 30 days notice.

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. Based on a meeting with the Pulmonary Division of the FDA, 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.

Prior to the completion of the additional clinical work by FAES, we expect to have minimal costs related to the oral bilastine program. Based upon the limited data available and the uncertainty of the future of the bilastine 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.

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.

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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 ongoing and we expect top line results from this clinical trial in 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.

RESULTS OF OPERATIONS

Three Months Ended September 30, 2007 and 2006

Revenues

Product Sales, net

Product sales of AzaSite, net of rebates and discounts, for the three months ended September 30, 2007 were approximately $1.1 million. Beginning in July 2007, we started receiving and processing orders for AzaSite as we loaded the supply chain in preparation of the August 2007 launch. These initial orders were offered with special terms as stocking incentives for wholesalers. The special terms were only offered for a specified period of time of approximately one month prior to the August 13, 2007 launch of AzaSite. Sales with these special terms are being 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. As of September 30, 2007, we had deferred AzaSite revenue, net of estimated rebates and discounts, of approximately $1.1 million. Sales made subsequent to this specified “launch” time period include return rights that are customary in the industry. For these orders, we are recording revenue at the date of shipment, when title and substantially all the risks and rewards of ownership has transferred to the customer.

We expect that AzaSite will exhibit a slight seasonal trend similar to other products in the bacterial conjunctivitis market, with a slight decline in sales during the Summer months when children are typically out of school.

Product Co-Promotion

Co-promotion revenues for the three months ended September 30, 2007 were approximately $11.1 million, as compared to approximately $9.7 million for the same period in 2006. Co-promotion revenue from net sales of Restasis for the three months ended September 30, 2007 was approximately $6.5 million, as compared to approximately $4.3 million for the same period in 2006. The increase in 2007 co-promotion revenue for Restasis of approximately $2.2 million, or 52%, was primarily due to increased patient usage of Restasis, based on the increase of prescriptions year-over-year; the normal annual price increase that became effective during the first quarter of 2007; and the final scheduled increase on 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. Co-promotion revenue from net sales of Elestat for the three months ended September 30, 2007 was approximately $4.6 million, as compared to approximately $5.4 million for the same period in 2006. The 15% decrease in 2007 co-promotion revenue for Elestat was primarily due to a decline in market share for Elestat due to an increasingly competitive market environment and an overall decline in the allergic conjunctivitis market in terms of prescriptions. The reduction in market share is partially offset by a reduction in rebates and discounts related to the loss of coverage under certain governmental formularies and a price increase for Elestat that became effective during the first quarter of 2007.

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 544,000

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for the three months ended September 30, 2007, a 14% 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 September 30, 2007, Allergan recorded approximately $88 million of revenue from net sales of Restasis, as compared to approximately $69 million for the three months ended September 30, 2006.

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 September 30, 2007, Elestat represented approximately 9% of the total U.S. allergic conjunctivitis market, as compared to approximately 10% for the same period in 2006.

Cost of Sales

Cost of sales related to the sales of AzaSite, which was launched in August 2007, were approximately $603,000 for the three months ended September 30, 2007. Cost of sales consist of variable and fixed cost components. Variable cost components include the cost of AzaSite inventory sold, distribution, shipping and logistic service charges from our third-party logistics provider, and royalties on net sales of AzaSite that we are obligated to pay under our licensing agreement with InSite Vision. Fixed cost components are primarily the amortization of the $19 million approval milestone that we paid InSite Vision as part of our licensing agreement. Royalties owed to InSite Vision related to the deferred portion of sales of AzaSite have also been deferred and will be recognized as cost of sales as the revenue related to such sales is able to be recognized.

Research and Development Expenses

Research and development expenses were approximately $8.1 million for the three months ended September 30, 2007, as compared to approximately $8.2 million for the same period in 2006. The slight decrease in research and development expenses of approximately $138,000, or 2%, for the three months ended September 30, 2007, as compared to the same period in 2006, was primarily due to a reallocation of spending on our later stage development programs.

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. Year over year spending on active development programs can vary due to the differing levels and stages of development activity, the timing of certain expenses and other factors.

Selling and Marketing Expenses

Selling and marketing expenses were approximately $14.3 million for the three months ended September 30, 2007, as compared to approximately $6.2 million for the same period in 2006. The increase in selling and marketing expenses of approximately $8.1 million, or 131%, for the three months ended September 30, 2007, as compared to the same period in 2006, resulted primarily from an increase in various expenses associated with the AzaSite launch, including the expansion of our commercial sales force as well as 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.

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Our commercial organization currently focuses its promotional efforts on approximately 12,000 select pediatricians, primary care physicians, eye care professionals and allergists for AzaSite, Restasis and Elestat. 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 $3.6 million for both the three months ended September 30, 2007 and 2006. Decreases in legal expenses associated with our stockholder litigation and SEC investigation due to less legal activity associated with these issues and reimbursement from our insurance provider of approximately $371,000 of legal costs covered under our Directors’ and Officers’ insurance policy, were offset by increases in administration and personnel costs.

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 $694,000 for the three months ended September 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 $481,000, or 41%, for the three months ended September 30, 2007, as compared to the same period in 2006, was primarily due to an increase in interest expense of approximately $861,000, primarily associated with borrowing $20.0 million of debt in December 2006 and additional borrowings of $20.0 million in the first half of 2007, partially offset by an increase in interest income as a result of higher average cash and investment balances following the sale of $75 million of exchangeable preferred stock in July 2007.

Nine Months Ended September 30, 2007 and 2006

Revenues

Total revenues were approximately $34.8 million for the nine months ended September 30, 2007, as compared to approximately $28.6 million for the same period in 2006. The increase in 2007 revenue of approximately $6.2 million, or 22%, was primarily due to increased co-promotion revenue from net sales of Restasis and Elestat in 2007, as compared to 2006, as well as initial product revenue from sales of AzaSite, which we launched in August 2007. 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.

Product sales of AzaSite, net of rebates and discounts, for the nine months ended September 30, 2007 were approximately $1.1 million, as compared to none for the same period in 2006. Co-promotion revenue from net sales of Restasis and Elestat for the nine months ended September 30, 2007 was approximately $17.0 million and $16.7 million, respectively, as compared to approximately $11.2 million and approximately $16.1 million, respectively, for the same period in 2006. For the nine months ended September 30, 2007, Allergan recorded approximately $244 million of revenue from net sales of Restasis, as compared to approximately $201 million for the nine months ended September 30, 2006. Based upon national prescription data from IMS Health, for the nine months ended September 30, 2007 and 2006, Elestat represented approximately 8% and 9% of the total U.S. allergic conjunctivitis market, respectively.

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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. Our revenue from net sales of Elestat in 2007 is expected to approximate our revenue from net sales of Elestat in 2006.

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 have been 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. To date, the increasing competitive environment and price discounting has resulted in Elestat losing coverage under state Medicaid plans; however, the loss to our co-promotion revenue has been minimal due to the large price concessions associated with these particular plans. 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, at which time competitors will be able to submit to the FDA an 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. Our ability to gain additional intellectual property protection related to Elestat has been challenging. We cannot provide any 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 essentially cease. Loss of our co-promotion revenue from Elestat will materially impact our results of operations and cash flows.

Our future revenue will depend on various factors including: the effectiveness of our commercialization of AzaSite; continued commercial success of Restasis and Elestat; pricing, rebates, discounts and returns for all 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 Restasis and Elestat. If Allergan significantly under-estimates or over-estimates rebate amounts, there could be a material effect on our revenue. In addition to the continuing sales of AzaSite, Restasis and Elestat, our future revenue will also depend on 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.

Cost of Sales

Cost of sales related to the product sales of AzaSite, which was launched in August 2007, were approximately $603,000 for the nine months ended September 30, 2007. Cost of sales consist of variable cost components that will increase or decrease depending on the volume of AzaSite sold and fixed cost components, primarily related to the amortization of the $19.0 million approval milestone paid to InSite Vision. Certain costs included in cost of sales are subject to annual increases which are out of our control. We expect that cost of sales will increase in relation to, but not proportionately to, the expected increases in revenue from sales of AzaSite.

Research and Development Expenses

Research and development expenses were approximately $38.8 million for the nine months ended September 30, 2007, as compared to approximately $26.5 million for the same period in 2006. The increase in research and development expenses of approximately $12.3 million, or 47%, for the nine months ended September 30, 2007, as compared to the same period in 2006, was primarily due to approximately $14.2 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

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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 nine months ended September 30, 2007 were approximately $24.6 million and were primarily associated with our denufosol for cystic fibrosis and our epinastine nasal spray for allergic rhinitis programs.

Our research and development expenses for the nine months ended September 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)
	Nine Months Ended September 30,						Cumulative from Inception to September 30, 2007
	2007		%	2006		%			%
AzaSite (1)	$	14,191	36	$	—	—	$	14,191	6
Denufosol tetrasodium for cystic fibrosis		9,196	24		8,001	30		41,744	17
Epinastine nasal spray for allergic rhinitis (2)		4,986	13		5,295	20		13,461	5
INS115644 for glaucoma		2,234	6		2,059	8		5,877	2
Bilastine for seasonal allergic rhinitis		1,384	4		—	—		8,523	3
Prolacria (diquafosol tetrasodium) for dry eye disease		1,148	3		984	4		40,286	16
INS50589 for use in acute cardiac care (3)		95	—		3,405	13		13,064	5
Denufosol tetrasodium for retinal disease (3)		83	—		1,178	4		9,188	4
Other research, preclinical and development costs (4)		5,494	14		5,569	21		107,290	42
Total	$	38,811	100	$	26,491	100	$	253,624	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 September 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. Year over year spending on active development programs can vary due to the differing levels and stages of development activity, the timing of certain expenses and other factors. 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 $32.2 million for the nine months ended September 30, 2007, as compared to approximately $19.8 million for the same period in 2006. The increase in selling and marketing expenses of approximately $12.4 million, or 63%, for the nine months ended September 30, 2007, as compared to the same period in 2006, resulted from an overall increase in various expenses associated with the launch activities related to AzaSite, including the expansion of our sales force as well as marketing and promotional activities, particularly relating to our AzaSite product. 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.

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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 following our August 2007 launch of AzaSite.

General and Administrative Expenses

General and administrative expenses were approximately $10.4 million for the nine months ended September 30, 2007, as compared to approximately $12.4 million for the same period in 2006. The decrease in general and administrative expenses of approximately $2.0 million, or 16%, for the nine months ended September 30, 2007, as compared to the same period in 2006, was primarily due to lower legal and administrative expenses associated with our stockholder litigation and SEC investigation. For the nine months ended September 30, 2007, we have recorded reimbursement from our insurance provider of approximately $1.3 million related to legal fees incurred as a result of defending against the stockholder litigation and SEC investigation, which activities were covered under our Directors’ and Officers’ insurance policy. Legal fees, excluding amounts reimbursed, were approximately $1.8 million for the nine months ended September 30, 2007, as compared to approximately $3.2 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 $1.5 million for the nine months ended September 30, 2007, as compared to approximately $3.5 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 $2.0 million, or 57%, for the nine months ended September 30, 2007, as compared to the same period in 2006, was primarily due to an increase in interest expense of approximately $1.8 million, primarily associated with borrowing $20.0 million of debt in December 2006 and additional borrowings of $20.0 million in the first half of 2007. 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. We also currently receive revenue from net sales of Restasis and Elestat, and began receiving revenue from net sales of AzaSite in the third quarter of 2007. We do not expect our revenue to exceed our 2007 operating expenses.

At September 30, 2007, we had net working capital of approximately $109.3 million, an increase of approximately $19.6 million from approximately $89.7 million at December 31, 2006. The increase in working capital was principally due to $75 million from the sale of preferred stock to Warburg Pincus Private Equity IX, L.P., or Warburg, in July 2007 as well as the additional $20.0 million draw down from our loan facility, both of which are discussed below. These increases were offset by $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 September 30, 2007 were approximately $83.6 million in cash and cash equivalents and approximately $47.0 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.

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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. The commitment period during which we can draw upon the new $20.0 million supplemental term loan facility ends on December 31, 2007. All loan advances made under the agreement have a final maturity date in March 2011.

On July 20, 2007, we completed a sale of preferred stock with Warburg pursuant to which we 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. The Exchangeable Preferred Stock was exchangeable for shares of common stock at a ratio of 1:100. We incurred approximately $1.4 million in issuance costs in connection with the sale of the Exchangeable Preferred Stock. The Exchangeable Preferred Stock was accounted for in accordance with EITF 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,” and EITF 00-27, “Application of Issue 98-5 to Certain Convertible Instruments.” The difference between the effective conversion price per share of underlying common stock in the exchange provision and the market value per share of common stock as of the closing date of the Exchangeable Preferred Stock transaction resulted in the calculation of an embedded contingent beneficial conversion feature, which is required to be treated as a deemed non-cash dividend to preferred stockholders. The calculated intrinsic value of the beneficial conversion feature is approximately $8.3 million and will be recorded to accumulated deficit with the offsetting credit to additional paid-in-capital in the quarter ended December 31, 2007. We will reflect the beneficial conversion feature on our statement of operations to adjust our reported net loss available to common shareholders. This accounting treatment does not represent any obligation, cash or otherwise, to the Exchangeable Preferred stockholders.

On October 31, 2007, we held a special meeting of stockholders in which the proposed exchange of all outstanding Exchangeable Preferred Stock for shares of our common stock was approved by our stockholders. The total number of shares of common stock issued in the exchange was 14,018,600, which as of October 31, 2007, represented approximately 25% of our 56,439,001 shares of common stock outstanding after giving effect to the exchange. Additionally, due to the exchange for common stock, there is no dividend obligation associated with the preferred stock. These newly issued shares of common stock will be classified on our balance sheet as a component of stockholders’ equity in future periods. In addition, we have agreed to use our best efforts to file a registration statement to register the shares of common stock into which the holders’ shares of Exchangeable Preferred Stock were exchanged no later than 30 days after the exchange of the Exchangeable Preferred Stock into common 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 conjunctivitis. 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 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 commercial potential of our products; 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 product candidates; unreimbursed 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 Restasis and Elestat trends and our 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 nine 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.

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Research and development expenses are estimated to be in the range of $55-$65 million. The expected cash usage for the remaining three months of 2007 is expected to be in the range of $10-$20 million, excluding any additional borrowings under our debt facility.

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 September 30, 2007, our current stock price, and an anticipated level of share-based payments granted during the remainder of 2007. For the nine months ended September 30, 2007, we recognized non-cash stock-based compensation expense of approximately $2 million.

Our 2007 forecasted results will be largely dependent on the effectiveness of our commercialization of AzaSite and key development and regulatory events. 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. Our liquidity needs will largely be determined by the commercial success of our products and 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 through December 31, 2007, 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 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

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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. On August 24, 2007, the plaintiffs filed an appeal to the United States Court of Appeals for the Fourth Circuit. We will continue 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 then 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 (1) sales of AzaSite; (2) product co-promotion activities; and (3) collaborative research agreements 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 recognize 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 transactions whereby product stocking incentives were offered approximately one month prior to the product’s August 13, 2007 launch. In the United States, we sell AzaSite 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, chargebacks and other sales incentives (collectively “sales incentives”) are recorded in the same period that the related sales are recorded and are recognized as a reduction in sales of AzaSite. These sales incentive reserves are 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, are based on reasonable estimates of the amounts earned or claimed on the sales of AzaSite. These estimates 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 are 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 seller, (5) the seller does not have significant obligations for future performance to directly bring about resale of the

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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. Consistent with industry standards, our return goods policy allows for returns of AzaSite within an eighteen-month period, from six months prior to the expiration date and 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 are 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 Restasis and Elestat 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 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 offered wholesalers stocking incentives that allowed for extended payment terms, product discounts, and guaranteed sale provisions (collectively, “special terms”). These special terms were only offered during a specified time period of approximately one month prior to the August 13, 2007 launch of AzaSite. Any sales of AzaSite made under these special term provisions were accounted for using a consignment model since substantially all the risks and rewards of ownership did not transfer upon shipment. Under the consignment model, we did not recognize revenue upon shipment of AzaSite purchased with the special terms, but recorded deferred revenue at gross invoice sales price, less all appropriate discounts and rebates, and accounted for AzaSite inventory held by the wholesalers as consignment inventory. We recognized the revenue from these sales with special terms at the earlier of when the inventory of AzaSite held by the wholesalers was sold through to the wholesalers’ customers or when such inventory of AzaSite was no longer subject to these special terms. All sales subsequent to this specified “launch” time period include return rights and pricing that are customary in the industry. For these sales, we record revenue on the date of shipment, as discussed above.

We utilize 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 includes among others, information obtained from certain wholesalers with respect to their inventory levels and sell-through to customers as well as data from IMS Health, a supplier of market research data to the pharmaceutical industry. We also utilize this data to help estimate and identify prescription trends and patient demand.

Product Co-promotion Revenues

We recognize co-promotion revenue based on net sales for Restasis and Elestat, as defined in the co-promotion agreements, and as reported to us by Allergan. We actively promote both Restasis and Elestat 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 Restasis and Elestat, 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 Restasis and Elestat. We make no adjustments to the amounts reported to us by Allergan other than reductions in net sales to reflect the incentive programs managed 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.

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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 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 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 selected the Black-Scholes option-pricing model as the most appropriate fair-value method for our awards and 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 nine months ended September 30, 2007 and 2006 was allocated as follows (in thousands):

	Three Months Ended September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006
Research and development	$	228	$	166	$	542	$	454
Selling and marketing		278		77		575		187
General and administrative		395		174		872		479
Total stock-based compensation expense	$	901	$	417	$	1,989	$	1,120

As of September 30, 2007, approximately $7.8 million and $534,000 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 3.8 years, respectively. We currently estimate total stock-based compensation expense will be approximately $3 million in 2007. This estimate is based on the unvested portion of stock options and restricted

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stock units outstanding as of September 30, 2007, our current stock price, and an anticipated level of share-based payments granted during 2007. Should our stock price change significantly from its current level, and/or if our anticipated headcount changes, 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 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 September 30, 2007, our portfolio of available-for-sale investments consisted of approximately $37.1 million of investments maturing within one year and approximately $9.9 million of investments maturing after one year but within 36 months. In addition, we have $615,000 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 September 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 September 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.

Foreign Currency Exchange Risk

The majority of our transactions occur in U.S. dollars and we do not have subsidiaries or investments in foreign countries. Therefore, we are not subject to significant foreign currency exchange risk. We do, however, have foreign currency exposure with regard to the purchase of active pharmaceutical ingredients as they relate to AzaSite, which is manufactured by a foreign-based company. We have established policies and procedures for market risk assessment, including a foreign currency-hedging program. The goal of our hedging program is to establish fixed exchange rates on firm foreign currency cash outflows and to minimize the impact of foreign currency fluctuations.

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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. 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. On August 24, 2007, the plaintiffs filed an appeal to the United States Court of Appeals for the Fourth Circuit. We will continue 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 then 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.

We launched AzaSite in August 2007. The effectiveness of the launch and commercial success of AzaSite will largely depend on a number of factors, including:

• 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;

• Market penetration;

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

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

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

Establishment and completion of appropriate steps related to a product launch 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. As part of the launch, we have introduced a significant number of trade-size samples into the market place in order to allow customers to rapidly gain experience with AzaSite. If we are not able have a reduced-fill sample validated and manufactured, we may need to continue to use trade-size samples in our marketing efforts. This may result in a reduction in the number of prescriptions written for AzaSite and therefore, our revenues may be negatively impacted. 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, Restasis and Elestat, as well as other potential products we in-license or develop. 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.

We are promoting AzaSite to select eye care professionals, pediatricians and primary care providers. 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 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

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pediatricians and primary care physicians. Furthermore, if additional products are approved, we will consider 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 currently exceeds, and may continue to exceed, our product revenues.

In addition, prior to the in-licensing and launch of AzaSite, we have had limited 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. The determination of formularies upon which AzaSite is listed, the discounts and pricing under such formularies, as well as the amount of time it takes for us to obtain favorable formulary status under various plans will impact our commercialization efforts. Additionally, inclusion on certain formularies will require significant price concessions through rebate programs that impact the level of revenue that we receive. The need to give price concessions can be particularly acute where competing products are listed on the same formulary, such as the area of bacterial conjunctivitis.

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 Restasis and Elestat 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 Restasis and Elestat are listed and making the appropriate regulatory and other filings.

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 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. Our ability to gain additional intellectual property protection related to Elestat has been challenging. We cannot provide any 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 essentially 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.

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

• Satisfaction with existing alternative therapies;

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• 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 Restasis and Elestat;

• 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 products or 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 have contracted 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 our product candidates 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;

• 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;

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• 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 Restasis, Elestat, 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 Restasis and Elestat. 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 is currently manufactured by a single party. There can be no assurance that such manufacturer will be able to continue 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.

In addition, if Allergan 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.

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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:

Ophthalmic: Alacrity Biosciences, Inc.; Allergan Inc.; 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.; and Vistakon Pharmaceuticals, LLC

Cystic Fibrosis: Gilead Sciences, Inc.; Genentech, Inc.; Novartis; Pharmaxis Ltd.; Predix Pharmaceuticals Holdings, Inc.; and Vertex Pharmaceuticals Inc.

Allergic Rhinitis: AstraZeneca PLC; GlaxoSmithKline plc; ISTA Pharmaceuticals, Inc.; MedPointe Pharmaceuticals; Pfizer; Sanofi-Aventis; and Schering-Plough Corporation

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 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 market and commercialize AzaSite and to co-promote Restasis and Elestat. We are dependent on (i) third parties to perform or assist us in the marketing, distribution or sale of AzaSite and Elestat; and (ii) Allergan to perform or assist us in the marketing, distribution or sale of Restasis. We 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 maintains and provides 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 are based. If third parties do not successfully carry out their contractual duties, meet

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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 third parties or Allergan 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 depend on three pharmaceutical wholesalers for the vast majority of our AzaSite sales 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 be economically or administratively 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, effective and convenient 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 dosing and 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 dosing and 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 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. If our other product candidates are not successfully commercialized following approval, our revenues may be limited.

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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. 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. 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.

A substantial amount of work will be required to advance our 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;

• 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,

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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.

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;

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• 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.

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

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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.

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.

Pharmaceutical companies are subject to significant regulation by a number of national, state and local agencies, including the FDA. Such regulations and their authroizing statutes are amended from time to time. 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. Additional authority to take post-approval actions was given to the FDA under the FDA Amendments Act of 2007, which went into effect on October 1, 2007. 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;

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• 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 labeling changes to help ensure the safe use of products;

• Requiring development and implementation of a Risk Evaluation and Mitigation Strategies plan if the FDA determines that it is necessary to help ensure that the drug’s benefits continue to outweigh the risks of a serious adverse drug experience;

• 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.

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 Restasis and Elestat 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.

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Each participating drug plan is permitted by regulation to develop and establish its own unique drug formulary that may exclude certain drugs from coverage, impose prior authorization and other coverage restrictions, 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.

We are subject to various state and federal laws pertaining to health care fraud and abuse. These include but are not limited to anti-kickback provisions, false claims provisions, the federal Health Insurance Portability and Accountability Act of 1996, and others. 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 federal and state 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.

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, exclusion from government programs, 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.

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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. On August 24, 2007, the plaintiffs filed an appeal to the United States Court of Appeals for the Fourth Circuit. We will continue to defend the litigation vigorously. No assurance can be made that we will 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

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received a Wells Notice letter from the staff of the SEC, issued in connection with this investigation. Our Chief Executive Officer and our then 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.

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 Restasis and Elestat 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 Restasis and Elestat as reported to us by Allergan. Management has concluded that our internal control over financial reporting was effective as of September 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.

Our revenues may fluctuate from period to period due in part to:

• Fluctuations in future sales of AzaSite, Restasis and Elestat 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 commercialization of AzaSite;

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

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• 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.

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.

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 and commercial activities. Our operating expenses were approximately $82.0 million for the nine months ended September 30, 2007 as compared to approximately $83.7 million for the year ended December 31, 2006. Our cash, cash equivalents and investments totaled approximately $131.4 million on September 30, 2007, which includes net borrowings that we received under our debt facilities of $38.8 million and $75 million from the sale of the exchangeable preferred stock to Warburg in July 2007.

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 Restasis and Elestat;

• 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.

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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;

• 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.

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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 $45.7 million for the nine months ended September 30, 2007, and approximately $42.1 million for the year ended December 31, 2006. As of September 30, 2007, our accumulated deficit was approximately $290.8 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 AzaSite, Restasis and Elestat; 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.

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.

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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 disagreements 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.

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.

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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.

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.

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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 AzaSite, Restasis and Elestat;

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

• 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.

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 October 31, 2007, after giving effect to the exchange of the Exchangeable Preferred Stock for 14,018,600 shares of our common stock that was approved by our stockholders, our current 5% stockholders and their affiliates beneficially owned approximately 47% 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

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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, 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).

On October 31, 2007, we held a special meeting of stockholders in which the proposed exchange of all outstanding Exchangeable Preferred Stock for shares of our common stock was approved by our stockholders. The total number of shares of common stock with full voting privileges issued to Warburg in the exchange was 14,018,600 which as of October 31, 2007, represented approximately 25% of our outstanding common stock after giving effect to the exchange. We have agreed to use our best efforts to file a registration statement to register the shares of common stock into which the holders’ shares of Exchangeable Preferred Stock were exchanged no later than 30 days after the exchange of the Exchangeable Preferred Stock into common 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, 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.

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 October 31, 2007, there were 56,439,001 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 were 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 October 31, 2007, after giving effect to the exchange of the Exchangeable Preferred Stock for shares of our common stock, our 4 largest stockholders (which includes Warburg) and their affiliates beneficially owned approximately 47% 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 $6.24 on October 31, 2007, there were outstanding options, which were exercisable and in-the-money, to purchase 1,343,862 shares of our common stock. This amount combined with the total common stock outstanding at October 31, 2007 is 57,782,863 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

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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 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.

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 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).
4.1	Registration Rights Agreement, dated July 20, 2007, by and between Inspire Pharmaceuticals, Inc. and Warburg Pincus Private Equity IX, L.P. (Incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed on July 23, 2007).
4.2	First Amendment to Rights Agreement, dated July 17, 2007, by and between Inspire Pharmaceuticals, Inc. and Computershare Trust Company. (Incorporated by reference to Exhibit 4.2 to the Company’s Current Report on Form 8-K filed on July 23, 2007).
4.3	Certificate of Designations, Number, Voting Powers, Preferences and Rights of Series A Exchangeable Preferred Stock of Inspire Pharmaceuticals, Inc. (Incorporated by reference to Exhibit 4.3 to the Company’s Current Report on Form 8-K filed on July 23, 2007).
4.4	Certificate of Amendment to Certificate of Designations of Series H Preferred Stock of Inspire Pharmaceuticals, Inc. (Incorporated by reference to Exhibit 4.4 to the Company’s Current Report on Form 8-K filed on July 23, 2007).
10.1	Securities Purchase Agreement, dated July 17, 2007, by and between Inspire Pharmaceuticals, Inc. and Warburg Pincus Private Equity IX, L.P. (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on July 23, 2007).
10.2	Standstill Agreement, dated July 20, 2007, among Inspire Pharmaceuticals, Inc., Warburg Pincus Private Equity IX, L.P., Warburg Pincus IX, LLC, Warburg Pincus Partners, LLC and Warburg Pincus & Co. (Incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed on July 23, 2007).
10.3**	Manufacturing Services Agreement, dated September 11, 2007, by and between Inspire Pharmaceuticals, Inc. and Catalent Pharma Solutions, LLC.
10.4	Amendment of Agreement, dated September 11, 2007, by and between Inspire Pharmaceuticals, Inc. and R. Kim Brazzell.
10.5	Termination of Agreement, dated September 11, 2007, by and between Inspire Pharmaceuticals, Inc. and Joseph M. Spagnardi.
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.

68

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

69

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).
4.1	Registration Rights Agreement, dated July 20, 2007, by and between Inspire Pharmaceuticals, Inc. and Warburg Pincus Private Equity IX, L.P. (Incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed on July 23, 2007).
4.2	First Amendment to Rights Agreement, dated July 17, 2007, by and between Inspire Pharmaceuticals, Inc. and Computershare Trust Company. (Incorporated by reference to Exhibit 4.2 to the Company’s Current Report on Form 8-K filed on July 23, 2007).
4.3	Certificate of Designations, Number, Voting Powers, Preferences and Rights of Series A Exchangeable Preferred Stock of Inspire Pharmaceuticals, Inc. (Incorporated by reference to Exhibit 4.3 to the Company’s Current Report on Form 8-K filed on July 23, 2007).
4.4	Certificate of Amendment to Certificate of Designations of Series H Preferred Stock of Inspire Pharmaceuticals, Inc. (Incorporated by reference to Exhibit 4.4 to the Company’s Current Report on Form 8-K filed on July 23, 2007).
10.1	Securities Purchase Agreement, dated July 17, 2007, by and between Inspire Pharmaceuticals, Inc. and Warburg Pincus Private Equity IX, L.P. (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on July 23, 2007).
10.2	Standstill Agreement, dated July 20, 2007, among Inspire Pharmaceuticals, Inc., Warburg Pincus Private Equity IX, L.P., Warburg Pincus IX, LLC, Warburg Pincus Partners, LLC and Warburg Pincus & Co. (Incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed on July 23, 2007).
10.3**	Manufacturing Services Agreement, dated September 11, 2007, by and between Inspire Pharmaceuticals, Inc. and Catalent Pharma Solutions, LLC.
10.4	Amendment of Agreement, dated September 11, 2007, by and between Inspire Pharmaceuticals, Inc. and R. Kim Brazzell.
10.5	Termination of Agreement, dated September 11, 2007, by and between Inspire Pharmaceuticals, Inc. and Joseph M. Spagnardi.
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.