10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2004

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 000-31615

DURECT CORPORATION

(Exact name of registrant as specified in its charter)

Delaware	94-3297098
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

10240 Bubb Road

Cupertino, California 95014

(Address of principal executive offices, including zip code)

(408) 777-1417

(Registrant’s telephone number, including area code)

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 an accelerated filer (as defined in Rule 12b-2 of the Act).     YES  x    NO  ¨

As of July 30, 2004, there were 51,555,822 shares of the registrant’s Common Stock outstanding.

INDEX

		Page
	PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements	3
	Condensed Consolidated Statements of Operations For the three and six months ended June 30, 2004 and 2003 (unaudited)	3
	Condensed Consolidated Balance Sheets As of June 30, 2004 (unaudited) and December 31, 2003	4
	Condensed Consolidated Statements of Cash Flows For the six months ended June 30, 2004 and 2003 (unaudited)	5
	Notes to Condensed Consolidated Financial Statements (unaudited)	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	10
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	34
Item 4.	Controls and Procedures	34
	PART II. OTHER INFORMATION
Item 1.	Legal Proceedings	35
Item 2.	Changes in Securities and Use of Proceeds	35
Item 3.	Defaults Upon Senior Securities	35
Item 4.	Submission of Matters to a Vote of Security Holders	35
Item 5.	Other Information	36
Item 6.	Exhibits and Reports on Form 8-K	36
	(a) Exhibits	36
	(b) Reports on Form 8-K	36
Signatures		37

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

DURECT CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)

	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Product revenue, net	$	1,760		$	1,715		$	3,125		$	3,222
Collaborative research and development and other revenue		1,320			1,485			3,340			2,559
Total revenues		3,080			3,200			6,465			5,781
Operating expenses:
Cost of revenues		867			534			1,432			1,129
Research and development		6,040			5,282			11,449			10,854
Selling, general and administrative		2,339			2,219			4,563			4,462
Amortization of intangible assets		308			335			643			670
Stock-based compensation(1)		135			135			170			(19	)
Total operating expenses		9,689			8,505			18,257			17,096
Loss from operations		(6,609	)		(5,305	)		(11,792	)		(11,315	)
Other income (expense):
Interest income		289			368			593			609
Interest expense		(1,113	)		(179	)		(2,224	)		(303	)
Net other income (expense)		(824	)		189			(1,631	)		306
Net loss	$	(7,433	)	$	(5,116	)	$	(13,423	)	$	(11,009	)
Net loss per common share, basic and diluted	$	(0.14	)	$	(0.10	)	$	(0.26	)	$	(0.22	)
Shares used in computing basic and diluted net loss per share		51,396			50,294			51,260			50,209
(1) Stock-based compensation related to the following:
Cost of revenues	$	(2	)	$	3		$	1		$	11
Research and development		126			(23	)		153			(259	)
Selling, general and administrative		11			155			16			229
	$	135		$	135		$	170		$	(19	)

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

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DURECT CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)

	June 30, 2004			December 31, 2003
	(unaudited)			(Note 1)
ASSETS
Current assets:
Cash and cash equivalents	$	7,680		$	21,203
Short-term investments		44,154			39,511
Accounts receivable, net of allowance of $99 and $141, respectively		2,321			1,968
Inventories		1,914			1,902
Prepaid expenses and other current assets		1,340			1,480
Total current assets		57,409			66,064
Property and equipment, net		8,250			9,316
Goodwill		6,399			6,399
Intangible assets, net		2,351			2,994
Long-term investments		19,231			21,334
Restricted investments		2,782			3,119
Other long-term assets		2,929			3,181
Total assets	$	99,351		$	112,407
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	866		$	616
Accrued liabilities		2,207			2,618
Contract research liability		924			987
Accrued liabilities to related party		12			17
Interest payable on convertible notes		167			167
Deferred revenue		392			146
Term loan, current portion		283			283
Bonds payable, current portion		180			180
Total current liabilities		5,031			5,014
Term loan, noncurrent portion		165			307
Bonds payable, noncurrent portion		1,065			1,065
Convertible subordinated notes		60,000			60,000
Other long-term liabilities		916			906
Commitments
Stockholders’ equity:
Common stock, $0.0001 par value: 110,000 shares authorized at June 30, 2004 and December 31, 2003, respectively; 51,556 and 51,163 shares issued and outstanding at June 30, 2004 and December 31, 2003, respectively		5			5
Additional paid-in capital		195,630			194,968
Notes receivable from stockholders		—			(50	)
Deferred compensation		(9	)		(59	)
Deferred royalties and commercial rights		(13,480	)		(13,480	)
Accumulated other comprehensive loss		(295	)		(15	)
Accumulated deficit		(149,677	)		(136,254	)
Total stockholders’ equity		32,174			45,115
Total liabilities and stockholders’ equity	$	99,351		$	112,407

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

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DURECT CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	Six months ended June 30,
	2004			2003
Cash flows from operating activities
Net loss	$	(13,423	)	$	(11,009	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation		1,593			1,774
Amortization		643			722
Non-cash charges related to stock-based compensation		170			(19	)
Changes in assets and liabilities:
Accounts receivable		(353	)		(605	)
Inventories		(12	)		9
Prepaid expenses and other assets		393			184
Accounts payable		250			222
Accrued liabilities and other long-term liabilities		(408	)		485
Contract research liability		(63	)		(124	)
Deferred revenue		246			(492	)
Total adjustments		2,459			2,156
Net cash and cash equivalents used in operating activities		(10,964	)		(8,853	)
Cash flows from investing activities
Purchases of equipment		(527	)		(408	)
Purchases of available for sale securities		(35,744	)		(60,051	)
Proceeds from maturities of available-for-sale securities		33,261			44,300
Net cash and cash equivalents used in investing activities		(3,010	)		(16,159	)
Cash flows from financing activities
Payments on equipment financing obligations		—			(731	)
Payments on term loan		(142	)		—
Net proceeds from term loan		—			850
Net proceeds from issuance of convertible notes		—			47,200
Net proceeds from issuances of common stock through exercise of options and warrants		543			255
Proceeds from notes receivable from stockholders		50			189
Net cash and cash equivalents provided by financing activities		451			47,763
Net increase/(decrease) in cash and cash equivalents		(13,523	)		22,751
Cash and cash equivalents, beginning of the period		21,203			14,089
Cash and cash equivalents, end of the period	$	7,680		$	36,840
Supplemental disclosure of cash flow information
Cash paid during the period for interest	$	1,933		$	197

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

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DURECT CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED

FINANCIAL STATEMENTS

Note 1. Summary of Significant Accounting Policies

Nature of Operations

DURECT Corporation (the Company) was incorporated in the state of Delaware on February 6, 1998. The Company is a pharmaceutical company developing therapies for the treatment of chronic diseases and conditions with its proprietary drug formulations and delivery platform technologies. The Company has several product candidates under development by itself and with third party collaborators in the areas of pain, cardiovascular diseases and central nervous system disorders. The Company also manufactures and sells osmotic pumps used in laboratory research. In addition, the Company conducts research and development of pharmaceutical product candidates with third party pharmaceutical and biotechnology company partners.

Absorbable Polymers International Corporation, formally known as Birmingham Polymers, Inc., a wholly owned subsidiary of the Company, develops and manufactures biodegradable polymers for third party pharmaceutical and biotechnology companies for use in their products.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its subsidiary. All significant intercompany accounts and transactions have been eliminated. These financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission, and therefore, do not include all the information and footnotes necessary for a complete presentation of the Company’s results of operations, financial position and cash flows in conformity with accounting principles generally accepted in the United States. The unaudited financial statements reflect all adjustments (consisting only of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of the financial position at June 30, 2004, the operating results for the three and six months ended June 30, 2004 and 2003, and cash flows for the six months ended June 30, 2004 and 2003. The condensed consolidated balance sheet as of December 31, 2003 has been derived from audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. These financial statements and notes should be read in conjunction with the Company’s audited financial statements and notes thereto, included in the Company’s annual report for the year ended December 31, 2003 on Form 10-K filed with the Securities and Exchange Commission.

The results of operations for the interim periods presented are not necessarily indicative of results that may be expected for any other interim period or for the full fiscal year.

Inventories

Inventories are stated at the lower of cost or market, with cost determined on a first-in, first-out basis.

Inventories consisted of the following (in thousands):

	June 30, 2004		December 31, 2003
	(unaudited)
Raw materials	$	197	$	212
Work in process		502		542
Finished goods		1,215		1,148
Total inventories	$	1,914	$	1,902

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DURECT CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED

FINANCIAL STATEMENTS—(Continued)

Stock-Based Compensation

The Company accounts for stock-based employee compensation arrangements in accordance with the provisions and related interpretations of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and has elected to follow the “disclosure only” alternative prescribed by Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123). Under APB 25, stock-based compensation is based on the difference, if any, on the date of grant, between the fair value of the Company’s stock and the exercise price. Unearned compensation is amortized using the graded vesting method and expensed over the vesting period of the respective options.

At June 30, 2004, the company has five stock-based employee compensation plans. The company accounts for those plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income when all options granted under those plans have an exercise price at least equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation (in thousands, except per share amounts).

	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Net loss—as reported	$	(7,433	)	$	(5,116	)	$	(13,423	)	$	(11,009	)
Add: Stock-based employee compensation expense included in reported net loss		5			128			(15	)		(114	)
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards		(789	)		(787	)		(1,250	)		(1,414	)
Pro forma net loss	$	(8,217	)	$	(5,775	)	$	(14,688	)	$	(12,537	)
Net loss per share:
Basic and diluted—as reported	$	(0.14	)	$	(0.10	)	$	(0.26	)	$	(0.22	)
Basic and diluted—pro forma	$	(0.16	)	$	(0.11	)	$	(0.29	)	$	(0.25	)

The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS 123 and Emerging Issues Task Force 96-18, Accounting for Equity Instruments that are Issued to other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. The fair value of equity instruments granted to non-employees is periodically remeasured as the underlying options vest.

Revenue Recognition

Revenue from the sale of products is recognized at the time the product is shipped and title transfers to customers, provided no continuing obligation exists and the collectibility of the amounts owed is reasonably assured.

Revenue related to collaborative research and development with our corporate partners is recognized as the related research and development services are performed over the related funding periods for each agreement. The payments received under each respective agreement are not refundable and are generally based on reimbursement of qualified expenses, as defined in the agreements. Research and development expenses under the collaborative and development research agreements approximate or exceed the revenue recognized under such agreements over the term of the respective agreements. Upfront payment received upon execution of collaborative agreements are recorded as deferred revenue and recognized as collaborative research and development revenue on a systematic basis (based on a straight-line basis or upon the timing and level of work performed) over the period that the related research and development services are performed as defined in the respective agreements. Milestone and royalties payments, if any, will be recognized as earned in accordance with the terms of the respective agreements. Deferred revenue may result when we do not expend the required level of effort during a specific period in comparison to funds received under the respective agreement.

Revenue on cost-plus-fee contracts, such as under contracts to perform research and development for others, is recognized only to the extent of reimbursable costs incurred plus estimated fees thereon. Revenue on fixed price contracts is recognized on a percentage-of-completion method based on cost incurred in relation to total estimated cost. In all cases, revenue is recognized only after a signed agreement is in place. For contracts that have a ceiling price or contract value, losses on contracts are recognized in the period in which the losses become known and estimable.

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Comprehensive Loss

The Company’s comprehensive losses, which include unrealized gains and losses on the Company’s available-for-sale securities for the three months ended June 30, 2004 and 2003, were $7.8 million and $5.1 million, respectively, compared to its net losses of $7.4 million and $5.1 million, respectively. The Company’s comprehensive losses for the six months ended June 30, 2004 and 2003 were $13.7 million and $11.1 million respectively, compared to its net losses of $13.4 million and $11.0 million, respectively.

Net Loss Per Share

Basic net loss per share is calculated by dividing net loss by the weighted-average number of common shares outstanding, less the weighted average number of common shares subject to repurchase or held in escrow pursuant to an acquisition agreement, during the period. Diluted net loss per share includes the impact of options and warrants to purchase common stock (using the treasury stock method), if dilutive. There is no difference between basic and diluted net loss per share as the Company incurred a net loss in each period presented. The following table presents the calculations of basic and diluted net loss per share (in thousands, except per share amounts):

	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Net loss	$	(7,433	)	$	(5,116	)	$	(13,423	)	$	(11,009	)
Basic and diluted weighted-average shares:
Weighted-average shares of common stock outstanding		51,398			50,497			51,289			50,467
Less: weighted-average shares subject to repurchase		(2	)		(203	)		(29	)		(258	)
Weighted-average shares used in computing basic and diluted net loss per share		51,396			50,294			51,260			50,209
Basic and diluted net loss per share	$	(0.14	)	$	(0.10	)	$	(0.26	)	$	(0.22	)

The computation of diluted net loss per share for the three months ended June 30, 2004 excludes the impact of options to purchase 7.4 million shares of common stock, warrants to purchase 1.0 million shares of common stock, and 19.0 million shares of common stock issuable upon conversion of the subordinated notes, as such impact would be antidilutive. The computation of diluted net loss per share for the six months ended June 30, 2004 excludes the impact of options to purchase 7.0 million shares of common stock, warrants to purchase 1.0 million shares of common stock and 19.0 million shares of common stock issuable upon conversion of the subordinated notes, as such impact would be antidilutive.

The computation of diluted net loss per share for the three months ended June 30, 2003 excludes the impact of options to purchase 6.4 million shares of common stock, warrants to purchase 1.1 million shares of common stock and 2.3 million shares of common stock issuable upon conversion of the subordinated notes, as such impact would be antidilutive. The computation of diluted net loss per share for the six months ended June 30, 2003 excludes the impact of options to purchase 5.9 million shares of common stock, warrants to purchase 1.0 million shares of common stock and 1.1 million shares of common stock issuable upon conversion of the subordinated notes, as such impact would be antidilutive.

Recent Accounting Pronouncements

In November 2003, the EITF reached an interim consensus on Issue 03-01, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments,” to require additional disclosure requirements for securities classified as available-for-sale or held-to-maturity for fiscal years ending after December 15, 2003. In March 2004, the EITF reached a final consensus on this Issue, to provide additional guidance which companies must follow in determining whether investment securities have an impairment which should be considered other-than-temporary. The guidance is applicable for reporting periods after June 15, 2004. The Company does not believe that adoption of the disclosure requirements under the interim consensus would have had a significant impact on the carrying value of its investments at June 30, 2004.

Note 2. Agreement with NeuroSystec Corporation

In May 2004, the Company entered into an exclusive license agreement with NeuroSystec Corporation under which the Company granted to NeuroSystec exclusive worldwide rights to develop and commercialize products designed for the treatment of tinnitus and to

8

improve post-operative recovery and tolerance of surgical implantation of cochlear devices using specified DURECT proprietary drug treatment methods and drug delivery technologies to deliver precise doses of appropriate medications directly to the middle or inner ear. The first product candidate is currently in pre-clinical development. The Company will receive certain milestone payments related to the development and commercialization of products under this agreement, as well as royalties based on product sales. In connection with the agreement, the Company received equity constituting a minority ownership interest in NeuroSystec.

Note 3. Goodwill and Intangible Assets

Intangible assets consist of the following (in thousands):

			June 30, 2004
	Gross Intangibles		Accumulated Amortization			Net Intangibles
Developed technology	$	3,600	$	(2,320	)	$	1,280
Patents		466		(285	)		181
Other intangibles		3,260		(2,370	)		890
Total	$	7,326	$	(4,975	)	$	2,351
			December 31, 2003
	Gross Intangibles		Accumulated Amortization			Net Intangibles
Developed technology	$	3,600	$	(1,991	)	$	1,609
Patents		466		(252	)		214
Other intangibles		3,260		(2,089	)		1,171
Total	$	7,326	$	(4,332	)	$	2,994

Intangible assets subject to amortization at June 30, 2004 totaled $2.4 million, which the Company expects will be amortized as follows: $607,000 in the six months ending December 31, 2004, $1,210,000 in the year of 2005, $424,000 in the year of 2006, $31,000 in each of the years 2007, 2008 and 2009, and $19,000 in the year 2010. Should intangible assets become impaired, the Company will write them down to their estimated fair value.

Goodwill totaled $6.4 million at December 31, 2003. In 2003, goodwill was evaluated and no indicators of impairment were noted. Should goodwill become impaired, the Company may be required to record an impairment charge to write the goodwill down to its estimated fair value.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Management’s Discussion and Analysis of Financial Condition and Results of Operations for the three and six months ended June 30, 2004 and 2003 should be read in conjunction with our annual report on Form 10-K filed with the Securities and Exchange Commission and “Factors that May Affect Future Results” section included elsewhere in this Form 10-Q. This Form 10-Q contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended. When used in this report or elsewhere by management from time to time, the words “believe,” “anticipate,” “intend,” “plan,” “estimate,” “expect,” and similar expressions are forward-looking statements. Such forward-looking statements are based on current expectations. Any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties. Actual events or results may differ materially from those discussed in the forward-looking statements as a result of various factors. For a more detailed discussion of such forward-looking statements and the potential risks and uncertainties that may impact upon their accuracy, see the “Factors that May Affect Future Results” and “Overview” sections of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. These forward-looking statements reflect our view only as of the date of this report. Except as required by law, we undertake no obligations to update any forward looking statements. You should also carefully consider the factors set forth in other reports or documents that we file from time to time with the Securities and Exchange Commission.

Overview

DURECT Corporation is pioneering the treatment of chronic diseases and conditions by developing and commercializing pharmaceutical systems to deliver the right drug to the right site in the right amount at the right time. These capabilities can enable new drug therapies or optimize existing ones based on a broad range of compounds, including small molecule pharmaceuticals as well as biotechnology molecules such as proteins, peptides and genes. We focus on the treatment of chronic diseases including pain, cardiovascular diseases and central nervous system disorders and the development of pharmaceutical products incorporating biotechnology agents. We may also choose to develop product candidates for acute indications, such as our SABER-based post-operative pain product candidate, to the extent it makes strategic sense to do so. We and our collaborative development partners are developing these pharmaceutical system product candidates based on our solid foundation of the following proprietary drug delivery technology platforms: SABER^™, ORADUR^™ (formerly referred to as SABER^™ oral gel cap), DURIN^™, MICRODUR^™ and DUROS^®. The following are our most advanced product candidates in development:

SABER-based Post-Operative Pain Depot

Our post-operative pain relief depot product candidate is a sustained release injectible using our patented SABER^™ delivery system and bupivacaine. SABER is a patented controlled drug delivery technology that can be formulated for systemic or local administration of drugs via the parenteral (i.e., injectible) or oral route. This product candidate is designed to be administered around a surgical site after surgery for post-operative pain relief and is intended to provide local analgesia for up to three days, which we believe coincides with the time period of the greatest need for post surgical pain control in most patients. Bupivacaine, the active agent for the product candidate, is currently FDA-approved for use as a local anesthetic.

In the second and third quarters of 2003, we conducted a Phase I clinical trial for our post-operative pain product candidate. The clinical trial was conducted in Europe and enrolled 12 normal, healthy subjects. The objectives of the clinical study were to determine the safety and tolerability of the SABER delivery system and the SABER-bupivacaine combination and to evaluate the pharmacokinetics of our SABER product candidate versus current treatment methods, which include bupivacaine and ropivacaine. We completed this clinical trial in the third quarter of 2003.

In the first six months of 2004, we formulated our SABER post-operative pain relief depot product candidate with higher drug loadings in preparation for additional clinical trials. We also commenced formulating different compositions for different clinical settings. We anticipate that we will commence a Phase II clinical trial by the end of 2004.

NOTE: SABER^™, DURIN^™, MICRODUR^™, ORADUR^™, CHRONOGESIC^®, IntraEAR^® and ALZET^® are trademarks of DURECT Corporation. LACTEL^® is a trademark of Absorbable Polymers International Corporation (formerly Birmingham Polymers, Inc.), a wholly owned subsidiary of DURECT Corporation. Remoxy^™ is a trademark of Pain Therapeutics, Inc. DUROS^® is a trademark of ALZA Corporation, a Johnson & Johnson company. Other trademarks referred to belong to their respective owners.

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ORADUR-based Oral Oxycodone (Remoxy)

In December 2002, we entered into an agreement with Pain Therapeutics, Inc. under which we granted Pain Therapeutics, Inc. the exclusive right to develop and commercialize selected long-acting oral opioid products using our ORADUR technology. ORADUR is our SABER-based oral gel cap technology. Products based on the ORADUR technology can take the form of an easy to swallow gelatin capsule that provides controlled release of active ingredients for a period of from 12 to 24 hours of drug delivery. Oral dosage forms based on the ORADUR technology may also have the added benefit of being less prone to abuse than other controlled release dosage forms on the market today. Our agreement provides Pain Therapeutics with the exclusive right to commercialize products developed under the agreement on a worldwide basis. In connection with the execution of the agreement, Pain Therapeutics paid us an upfront fee. We will receive payments upon the achievement of certain development and regulatory milestones, payments for research and development expenditures, as well as royalties based on product sales.

The first product candidate being developed under the collaboration is Remoxy, a novel long-acting oral formulation of the opioid oxycodone that utilizes our ORADUR technology and which is targeted to decrease the potential for oxycodone abuse. Pain Therapeutics, Inc. began Phase I clinical testing of the Remoxy product candidate in January 2004 and announced positive Phase I pharmacokinetics and anti-abuse clinical results for Remoxy in July 2004. Pain Therapeutics has announced their plans to initiate Phase III studies for Remoxy by the end of 2004.

DURIN-based Alzheimer’s disease Treatment

In July 2002, we entered into a development and commercialization agreement with Voyager Pharmaceutical Corporation (Voyager). Under the terms of the agreement, we will collaborate with Voyager to develop a product candidate using our DURIN technology to provide a sustained release therapy based on Voyager’s patented method of treatment of Alzheimer’s disease. DURIN is our proprietary biodegradable polymeric implant drug delivery technology which can deliver a wide variety of drugs from several weeks to six months or more. The agreement also provides Voyager with the right to commercialize the product developed under the agreement on a worldwide basis once such product obtains regulatory approval. We will receive payments upon the achievement of certain development and regulatory milestones, payments for research and development expenditures, as well as royalties based on product sales.

In 2004, we continued to make progress with Voyager on the development of a DURIN-based treatment for Alzheimer’s disease. During the first six months of 2004, Voyager completed an interim analysis of a proof of concept clinical study that supported advancing the DURIN-based product candidate further in development. Voyager plans to initiate Phase I clinical studies on the DURIN-based product candidate by the end of the year.

CHRONOGESIC (sufentanil) Pain Therapy System

CHRONOGESIC (sufentanil) Pain Therapy System is an osmotic implant that continuously delivers sufentanil, an opioid medication, for three months. This product candidate is designed to treat chronic pain, and is based on the DUROS implant technology for which we hold an exclusive license from ALZA Corporation, a Johnson & Johnson company, to develop and commercialize products in selected fields. In 2001, we successfully completed a Phase II clinical trial, a pharmacokinetic trial and a pilot Phase III clinical trial for the CHRONOGESIC product candidate. We also completed construction of a pilot aseptic manufacturing facility designed to manufacture the CHRONOGESIC product candidate for our Phase III clinical trials and to meet initial commercial demand for our product if approved by the FDA.

In 2002, we announced positive results of our pilot Phase III clinical trial, validated our aseptic manufacturing facility and used the facility to manufacture clinical supplies for our initial pivotal Phase III clinical trial. We also conducted ongoing animal toxicological studies and other development activities that are necessary to support regulatory approval of the product candidate in the U.S. and abroad. We initiated our first pivotal Phase III clinical trial for the CHRONOGESIC product candidate in June 2002. In August 2002, the FDA requested that we delay enrolling new patients in our Phase III clinical trial initiated in June 2002 until the clinical trial protocol is revised and approved by the FDA to provide for additional patient monitoring and data collection. These requested protocol changes were not in response to any observed patient safety or adverse event. We subsequently discontinued all patients from the clinical trial at our discretion in September 2002. Independently from the FDA’s request for protocol changes, in October 2002, we started to implement manufacturing process changes to the CHRONOGESIC product candidate to permit terminal sterilization of the product candidate and system design enhancements to prevent a premature shutdown in the delivery of drug prior to the end of the intended 3-month delivery period which was observed in a number of units utilizing the previous system design. We have stopped all clinical trials for the CHRONOGESIC product candidate until the system design is completed.

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In November 2002, we entered into a development, commercialization and supply license agreement with Endo Pharmaceuticals Holdings Inc. (Endo) under which the companies will collaborate on the development and commercialization of our CHRONOGESIC product candidate for the U.S. and Canada. In January 2004, we amended the agreement to take into account the delay in the CHRONOGESIC development program due to DURECT’s implementation of necessary design and manufacturing enhancements to the product candidate. In connection with the execution of the agreement, Endo purchased 1,533,742 shares of newly issued common stock of DURECT at an aggregate purchase price of approximately $5.0 million. Under the terms of the agreement, as amended, we will be responsible for the CHRONOGESIC product candidate’s design and development. For the period commencing January 1, 2004 until the earlier of January 1, 2005 or the commencement of a specified clinical trial, Endo will fund 25% of the ongoing development costs for the CHRONOGESIC product candidate in the U.S. and Canada, excluding system redesign costs and pharmacokinetic trials necessitated by any system redesign, up to an aggregate amount of $250,000 for the period. Commencing on January 1, 2005 or, if earlier, the commencement of a specified clinical trial for the CHRONOGESIC product candidate, Endo will fund 50% of the ongoing development costs and will reimburse us for a portion of our prior development costs for the product candidate upon the achievement of certain milestones. Development-based milestone payments made by Endo under this agreement could total up to $52 million. Under the agreement, Endo has licensed exclusive promotional rights to the CHRONOGESIC product candidate in the U.S. and Canada. Endo will be responsible for marketing, sales and distribution, including providing specialty sales representatives dedicated to supplying technical and training support for CHRONOGESIC therapy and will pay for product launch costs. We will be responsible for the manufacture of the CHRONOGESIC product candidate. We will share profits from the commercialization of the product in the U.S. and Canada with Endo based on the financial performance of the CHRONOGESIC product candidate. Based on our projected financial performance of the product in the U.S. and Canada, we anticipate that our share of such profits from commercialization of the product candidate, if approved, will be approximately 50%. Our agreement with Endo provides each party with specified termination rights. In particular, our agreement can be terminated by Endo in January 2005 in the event we have not commenced a specified clinical trial by January 1, 2005. Due to the delay in our program timeline as a result of our continued efforts to redesign the system to eliminate the premature shutdown problem, we will not commence such specified clinical trial by January 1, 2005. See “Factors that May Affect Future Results--Our near-term revenues depend on collaborations agreements with other companies which may be terminated under specified conditions. If we are unable to meet milestones under these agreements or enter into additional collaboration agreements or if our existing collaborations are terminated, our revenues may decrease.”

In 2003, we continued to conduct laboratory and animal studies, implement and evaluate system design and manufacturing process changes and revise clinical trial protocols for the CHRONOGESIC product candidate. In October 2003, we announced that we had received data from a preclinical animal test with our CHRONOGESIC product candidate utilizing a revised system design which indicate that a small number of units continue to experience a premature shutdown of drug delivery prior to the end of the intended 3-month delivery period. In parallel track with the CHRONOGESIC development program using the revised system design, we explored additional enhancements to prevent any premature shutdown, and generated feasibility data relating to these enhancements. We evaluated incorporating these enhancements into our system design and other system design changes to prevent any premature shutdown of the system.

During the first six months of 2004, we conducted feasibility studies to test and measure the performance of a number of alternative prototype systems of our CHRONOGESIC product candidate in animals. We had previously anticipated resuming clinical trials with our CHRONOGESIC product candidate in the second half of 2004. However, on July 21, 2004, we announced that we had learned recently from an animal study that we have not yet solved the pre-mature shutdown problem. Therefore, based on this information, we will not be resuming clinical trials with our CHRONOGESIC product candidate in 2004. We continue to work to address this premature shutdown problem, and we will not resume any clinical trials until the system design is completed.

Other Product Candidates

In addition to the above mentioned product candidates, we continue to research and develop other product candidates for the treatment of chronic diseases using our platform technologies.

Collaborative Agreements

In order to rapidly identify and fund additional product opportunities, we may enter into agreements with various companies who wish to explore the feasibility of combining their drugs with our drug delivery technologies to develop product candidates. In addition, we may enter into agreements with companies who wish to collaborate on the development and commercialization of our existing product candidates in development. Under these collaborative agreements, we perform research and development activities to develop product candidates utilizing our drug delivery technologies and recognize collaborative research and development revenue on reimbursement payments of expenses and milestone payments from our collaborators. Depending on the agreement, we may also have royalty, distribution, or other rights once product candidates are commercialized under the agreement. To date, we have entered into such arrangements with Pain Therapeutics, Voyager and

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Endo as discussed above. In addition, during the second quarter of 2004, we announced an exclusive license agreement for NeuroSystec Corporation to develop, market and sell product candidates for the treatment of certain inner ear disorders including chronic tinnitus (ringing in the ears) based on our technologies. The first product candidate is currently in pre-clinical development. We will receive certain milestone payments related to the development and commercialization of products, if approved, under this agreement, as well as royalties based on product sales. In connection with the agreement, we received equity constituting a minority ownership interest in NeuroSystec. We intend to enter into additional collaborative arrangements in the future.

Product Revenues

We currently generate product revenue from the sale of two product lines:

• ALZET osmotic pumps for animal research use; and

• LACTEL biodegradable polymers through our wholly owned subsidiary, API, which are used by our customers as raw materials in their pharmaceutical and medical products.

Because we consider our core business to be developing and commercializing pharmaceutical systems, we do not intend to significantly increase our investments in or efforts to sell or market any of our existing product lines. However, we expect that we will continue to make efforts to increase our revenue related to collaborative research and development by entering into additional research and development agreements with third party partners to develop product candidates based on our drug delivery technologies.

Since our inception in 1998, we have had a history of operating losses. At June 30, 2004, we had an accumulated deficit of $149.7 million and our net losses were $13.4 million and $11.0 million for the six months ended June 30, 2004 and 2003, respectively. These losses have resulted primarily from costs incurred to research and develop our product candidates and to a lesser extent, from selling, general and administrative costs associated with our operations and product sales. We expect our research and development expenses to increase modestly in the near future as we expect to continue to expand our animal studies, clinical trials and other research and development activities. We expect our general and administrative expenses to increase modestly in the near future in light of the additional cost of corporate governance requirements. We also expect to incur additional non-cash expenses relating to amortization of intangible assets and stock-based compensation. We do not anticipate revenues from our pharmaceutical systems, should they be approved, for at least several years. Therefore, we expect to incur continuing losses and negative cash flow from operations for the foreseeable future.

Critical Accounting Policies and Estimates

General

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 the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The most significant estimates and assumptions relate to revenue recognition, the recoverability of our long-lived assets, including goodwill and other intangible assets, accrued liabilities and contract research liabilities. Actual amounts could differ significantly from these estimates.

Revenue Recognition

Revenue from the sale of products is recognized at the time the product is shipped and title transfers to customers, provided no continuing obligation exists and the collectibility of the amounts owed is reasonably assured. Incorrect assumptions at the time of sale about our customers’ ability to pay could result in an overstatement of revenue.

Revenue related to collaborative research and development with our collaborators is recognized as the related research and development services are performed over the related funding periods for each agreement. The payments received under each respective agreement are not refundable and are generally based on reimbursement of qualified expenses, as defined in the agreements. Research and development expenses under the collaborative and development research agreements approximate or exceed the revenue recognized under such agreements over the term of the respective agreements. Deferred revenue may result when we do not expend the required level of effort during a specific period in comparison to funds received under the respective agreement. Milestone and royalties payments, if any, will be recognized as earned. Incorrect determination of qualified expenses could result in greater or lesser revenue being recorded.

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Revenue on cost-plus-fee contracts, such as other contract research and development revenue, is recognized only to the extent of reimbursable costs incurred plus estimated fees thereon. Revenue on fixed price contracts is recognized on a percentage-of-completion method based on cost incurred in relation to total estimated cost. In all cases, revenue is recognized only after a signed agreement is in place. For contracts that have a ceiling price or contract value, losses on contracts are recognized in the period in which the losses become known and estimable. Incorrect estimates as to percentage of completion or losses expected to be incurred could result in greater or lesser revenues or losses being recorded.

Intangible Assets and Goodwill

We record intangible assets when we acquire other companies. The cost of an acquisition is allocated to the assets acquired and liabilities assumed, including intangible assets, with the remaining amount being classified as goodwill. Certain intangible assets such as completed or core technology are amortized over time, while acquired in-process research and development is recorded as a one-time charge on the acquisition date. Acquired in-process research and development represents the value of research projects in process at the time of acquisition which have not yet reached technological feasibility, and which have no alternative future use. The determination of the amount of acquired in-process research and development involves several estimates and judgments, including the percentage of completion of the in-process technology and assumptions about future cash flows to be derived from the technology and discount rates. Different assumptions employed in determining the value of in-process research and development could result in a greater or lesser amount being recorded.

As of January 1, 2002, goodwill is not amortized to expense but rather periodically assessed for impairment. The allocation of the cost of an acquisition to intangible assets and goodwill therefore has a significant impact on our future operating results. The allocation process requires the extensive use of estimates and assumptions, including estimates of future cash flows expected to be generated by the acquired assets. We are also required to estimate the useful lives of those intangible assets subject to amortization, which determines the amount of amortization that will be recorded in a given future period and how quickly the total balance will be amortized. We periodically review the estimated remaining useful lives of our intangible assets. A reduction in our estimate of remaining useful lives, if any, could result in increased amortization expense in future periods.

We assess the impairment of identifiable intangible assets, long-lived assets and goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

• significant underperformance relative to expected historical or projected future operating results;

• significant changes in the manner of our use of the acquired assets or the strategy for our overall business;

• significant negative industry or economic trends;

• significant decline in our stock price for a sustained period; and

• our market capitalization relative to net book value.

When we determine that the carrying value of intangibles, long-lived assets and goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. The amount of any impairment charge is significantly impacted by and highly dependent upon assumptions as to future cash flows and the appropriate discount rate. Management believes that the discount rate used in this analysis is reasonable in light of currently available information. The use of different assumptions or discount rates could result in a materially different impairment charge.

In 2002, Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142) became effective. As a result, we ceased amortizing approximately $4.7 million of goodwill and assembled workforce. In lieu of amortization, we perform a review for impairment at least annually. No impairment of goodwill has been recorded through June 30, 2004. However, there can be no assurance that at the time other periodic reviews are completed, a material impairment charge will not be recorded.

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Accrued Liabilities and Contract Research Liabilities

We incur significant costs associated with third party consultants and organizations for clinical trials, engineering, validation, testing, and other research and development-related services. We are required to estimate periodically the cost of services rendered but unbilled based on managements’ estimates of project status. If these good faith estimates are inaccurate, actual expenses incurred could materially differ from our estimates.

The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States, with no need for management’s judgment in their application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result. See our audited consolidated financial statements and notes thereto in Item 8 of our Form 10-K which contain accounting policies and other disclosures required by generally accepted accounting principles.

Results of Operations

Three and six months ended June 30, 2004 and 2003

Revenues. Net revenues were $3.1 million and $6.5 million in the three and six months ended June 30, 2004, respectively, compared to $3.2 million and $5.8 million for the corresponding periods in 2003. The slight decrease in total revenues for the three months ended June 30, 2004 was primarily attributable to lower collaborative research and development revenue recognized from our agreements with Pain Therapeutics, Inc. and Voyager Pharmaceutical Corporation during the quarter. The increase in total revenues for the six months ended June 30, 2004 was primarily attributable to higher collaborative research and development revenue from our strategic partners.

Net product revenues were $1.8 million and $3.1 million in the three and six months ended June 30, 2004, respectively, compared to $1.7 million and $3.2 million for the corresponding periods in 2003. Revenues from our existing product lines in the three months and six months ended June 30, 2004, have been comparable to the corresponding periods in 2003.

We also recognize our revenues from collaborative research and development activities and service contracts. We recorded $1.2 million and $3.0 million of collaborative research and development revenue for the three and six months ended June 30, 2004, respectively, compared to $1.5 million and $2.6 million for the corresponding periods in 2003. Collaborative research and development revenue represents reimbursement of qualified expenses related to the collaborative agreements with various third parties to research, develop and commercialize potential product candidates using our drug delivery technologies. Other revenue from service contracts was $94,000 and $294,000 for the three and six months ended June 30, 2004 and none for the same periods in 2003. The service contract revenues were related to certain polymer related service contracts API signed with various customers. Other license revenue was $68,000 for the three months and six months ended June 30, 2004 compared with none for the same periods in 2003. The license revenue was recognized in connection with our agreement with NeuroSystec Corporation.

In the future, we do not intend to significantly increase our investments in or efforts to sell or market any of our existing product lines. However, we will continue to make efforts to increase our revenue related to collaborative research and development by entering into additional research and development agreements with third party partners to develop product candidates based on our drug delivery technologies.

Cost of revenues. Cost of revenues increased to $867,000 and $1.4 million for the three and six months ended June 30, 2004, respectively, from $534,000 and $1.1 million for the corresponding periods in 2003. Cost of revenues includes cost of product revenue and, to a lesser extent, cost of contracts services provided by us. The increase in the cost of revenues in three and six months ended June 30, 2004 was primarily due to increased manufacturing costs in our commercial product lines.

Cost of revenues associated with product revenue increased to $797,000 and $ 1.2 million for the three and six months ended June 30, 2004, respectively, from $534,000 and $1.1 million for the corresponding periods in 2003, as the result of an increase in manufacturing costs of our ALZET mini pump product line and API biodegradable polymer product line. Cost of service revenues were $69,000 and $258,000 for the three and six months ended June 30, 2004, respectively, compared with none for the same periods of 2003. As of June 30, 2004, we had 20 manufacturing employees compared with 17 as of the corresponding date in 2003.

Research and Development. Research and development expenses increased to $6.0 million and $11.4 million for the three and six months ended June 30, 2004, respectively, from $5.3 million and $10.9 million for the corresponding periods in 2003. The increases were primarily attributable to higher development costs related to CHRONOGESIC, our SABER post-operative pain product candidate and other product candidates in development. As of June 30, 2004, we had 63 research and

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development employees compared with 69 as of the corresponding date in 2003. We expect research and development expenses to increase in the near future once we start our Phase II clinical trial for our SABER post-operative pain depot product candidate.

Selling, General and Administrative. Selling, general and administrative expenses increased to $2.3 million and $4.6 million for the three and six months ended June 30, 2004, respectively, from $2.2 million and $4.5 million for the corresponding periods in 2003. The increase in expenses in the three and six months ended June 30, 2004 resulted from higher external expenses to comply with the Sarbanes-Oxley Act. As of June 30, 2004, we had 33 selling, general and administrative personnel compared with 37 as of the corresponding date in 2003. We expect selling, general and administrative expenses to increase modestly in light of the additional cost of corporate governance requirements in the near future even though we strive to conserve cash and leverage our existing infrastructure to support our current business activities.

Amortization of intangible assets. Amortization of intangible assets was $308,000 and $335,000 for the three months ended June 30, 2004 and 2003, respectively. Amortization of intangible assets was $643,000 and $670,000 for the six months ended June 30, 2004 and 2003, respectively. The amortization of intangible assets decreased as certain intangible assets were fully amortized in the three months ended June 30, 2004. We continue to amortize the rest of the existing intangible assets at a constant rate over their estimated useful lives.

The net amount of other intangible assets at June 30, 2004 was $2.4 million, which will be amortized as follows: $607,000 for the six months ending December 31, 2004, $1,210,000 for the year ending December 31, 2005, $424,000 in the year of 2006, $31,000 in each of the years 2007, 2008 and 2009, and $19,000 in the year 2010. We periodically evaluate acquired intangible assets for impairment or obsolescence. Should the intangible assets become impaired or obsolete, we will write them down to their estimated fair value.

Stock-Based Compensation. For the three and six months ended June 30, 2004, we recorded $5,000 and ($15,000) of stock-based compensation, compared with $128,000 and ($113,000) recorded for the corresponding periods in 2003. Of these amounts, employee stock-based compensation related to the following: cost of revenues of ($2,000) and $1,000 for the three and six months ended June 30, 2004, and $3,000 and $11,000 for the corresponding periods in 2003; research and development expenses of $2,000 and ($26,000) for the three and six months ended June 30, 2004, compared with ($30,000) and ($354,000) for the corresponding periods in 2003; and selling, general and administrative expenses of $5,000 and $10,000 in the three and six months ended June 30, 2004, compared with $155,000 and $229,000 for the corresponding periods in 2003.

Non-employee stock compensation related to research and development expenses was $124,000 and $179,000 for the three and six months ended June 30, 2004, compared with $7,000 and $95,000 for the corresponding periods in 2003. Non-employee stock compensation related to selling, general and administrative expenses was $6,000 and $6,000 for the three and six months ended June 30, 2004, compared with none in the corresponding periods in 2003. Expenses for non-employee stock options are recorded over the vesting period of the options, with the amount determined by the Black-Scholes option valuation method and remeasured over the vesting term.

The remaining employee deferred stock compensation at June 30, 2004 was $9,000, which will be amortized as follows: $5,000 for the six months ending December 31, 2004 and $4,000 for the year ending December 31, 2005. Termination of employment of option holders could cause stock-based compensation in future years to be less than indicated and require reversal of previously recognized stock-based compensation.

Other Income (Expense). Interest income decreased to $289,000 and $593,000 for the three and six months ended June 30, 2004, respectively, from $368,000 and $609,000 for each of the corresponding periods in 2003. The decrease in interest income was primarily attributable to lower average outstanding investment balances and lower yields on debt security investments. Interest expense was $1.1 million and $2.2 million for the three and six months ended June 30, 2004, respectively, and $179,000 and $303,000 for the corresponding periods in 2003. The increase in interest expense for the three and six months ended June 30, 2004 compared to the corresponding periods in 2003 was primarily due to interest expense on the $60.0 million convertible notes we issued in June and July of 2003.

Liquidity and Capital Resources

Since our inception in 1998, we have funded our operations primarily through convertible preferred stock financings of $53.2 million, our initial public offering of $84.0 million and the issuance of $60.0 million principal amount of convertible notes. We had cash, cash equivalents, and investments totaling $73.8 million at June 30, 2004 compared to $85.2 million at December 31, 2003. These numbers include $2.8 million and $3.1 million of interest-bearing marketable securities classified as restricted investments on our balance sheets as of June 30, 2004 and December 31, 2003 respectively. The decrease in cash, cash equivalents and investments during the six months ended June 30, 2004 was primarily the result of ongoing operating expenses, partially offset by payments received from customers and our strategic partners.

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Working capital was $52.4 million and $61.1 million at June 30, 2004 and December 31, 2003, respectively. The decrease was primarily attributable to expenditures related to our research and development efforts and selling, general and administrative expenses.

We used $11.0 million of cash for operations for the six months ended June 30, 2004 compared to $8.9 million for the corresponding period in 2003. The cash used for operations was primarily to fund operations as well as our working capital requirements. The increase in cash used for operations was primarily attributable to a higher operating expenses in the six months ended June 30, 2004 compared to the same period in 2003.

We used $3.0 million of cash in investing activities for the six months ended June 30, 2004 compared to $16.2 million for the corresponding period in 2003. The decrease in cash used by investing activities was primarily due to lower net purchases of investments, offset by an increase in purchases of plant and equipment.

We received $451,000 of cash from financing activities for the six months ended June 30, 2004 compared to a receipt of $47.8 million for the corresponding period in 2003. In the six months ended June 30, 2004, cash received from financing activities was primarily due to proceeds from exercises of stock options and notes receivable from stockholders, offset by payments on the term loan. In the six months ended June 30, 2003, cash received from financing activities was primarily due to net proceeds of approximately $47.2 million aggregate principal amount of convertible notes due 2008, a term loan of $850,000 issued in January 2003 and proceeds from notes receivable from stockholders and exercises of stock options, offset by a final payment on the previous equipment loan.

In conjunction with the acquisition of SBS in April 2001, we assumed Alabama State Industrial Development Bonds (SBS Bonds) with remaining principal payments of $1.7 million and a current interest rate of 6.35% increasing each year up to 7.20% at maturity on November 1, 2009. As part of the acquisition agreement, we were required to guarantee and collateralize these bonds with a letter of credit of approximately $2.4 million that we secured with investments deposited with a financial institution in July 2001. Interest payments are due semi-annually and principal payments are due annually. Principal payments increase in annual increments from $150,000 to $240,000 over the term of the bonds until the principal is fully amortized in 2009. We have an option to call the SBS Bonds at any time, and must pay a call premium if the bonds are called prior to November 2004. The call premium decreases annually from 1 ¹/2% in 2001 to 0% in November 2004. On December 31, 2002, SBS was merged into DURECT, and the SBS bonds were assigned to DURECT with the terms unchanged. At June 30, 2004, the remaining principal payments of the bonds were $1.25 million.

We anticipate that cash used in operating and investing activities will stay at current level or slightly decrease in the near future as we continue to research, develop, and manufacture our product candidates through internal efforts and partnering activities, and service our debt obligations. In aggregate, we are required to make future payments pursuant to our existing contractual obligations as follows (in thousands):

Contractual Obligations	2004		2005		2006		2007		2008		Thereafter		Total
Convertible subordinated notes (1)	$	1,875	$	3,750	$	3,750	$	3,750	$	61,875	$	—	$	75,000
Long-term debt (1)		224		266		263		258		258		258		1,527
Term loan (1)		151		292		24		—		—		—		467
APT acquisition consideration payable (2)		250		250		500		—		—		—		1,000
Operating lease obligations		1,383		2,677		1,749		1,152		1,162		197		8,320
Total contractual cash obligations	$	3,883	$	7,235	$	6,286	$	5,160	$	63,295	$	455	$	86,314

Note (1): Includes principal and interest payments

Note (2): To be paid by our common stock or cash at our election

We also anticipate incurring capital expenditures of at least $1 million over the next 12 months to purchase research and development and other capital equipment. The amount and timing of these capital expenditures will depend on, among other things, the timing of clinical trials for our product candidates and our collaborative research and development activities.

We believe that our existing cash, cash equivalents and investments will be sufficient to finance our planned operations and capital expenditures through at least the next 12 months. We may consume available resources more rapidly than currently anticipated, resulting in the need for additional funding. Additionally, we do not expect to generate revenues from our pharmaceutical systems currently under development for at least the next several years. Accordingly, we may be required to raise additional capital through a variety of sources, including:

• the public equity market;

• private equity financing;

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• collaborative arrangements; and

• public or private debt.

There can be no assurance that additional capital will be available on favorable terms, if at all. If adequate funds are not available, we may be required to significantly reduce or refocus our operations or to obtain funds through arrangements that may require us to relinquish rights to certain of our product candidates, technologies or potential markets, any of which could have a material adverse effect on our business, financial condition and results of operations. To the extent that additional capital is raised through the sale of equity or convertible debt securities, the issuance of such securities would result in ownership dilution to our existing stockholders.

Our cash and investments policy emphasizes liquidity and preservation of principal over other portfolio considerations. We select investments that maximize interest income to the extent possible given these two constraints. We satisfy liquidity requirements by investing excess cash in securities with different maturities to match projected cash needs and limit concentration of credit risk by diversifying our investments among a variety of high credit-quality issuers.

Recent Accounting Pronouncements

In November 2003, the EITF reached an interim consensus on Issue 03-01, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments,” to require additional disclosure requirements for securities classified as available-for-sale or held-to-maturity for fiscal years ending after December 15, 2003. In March 2004, the EITF reached a final consensus on this Issue, to provide additional guidance which companies must follow in determining whether investment securities have an impairment which should be considered other-than-temporary. The guidance is applicable for reporting periods after June 15, 2004. The Company does not believe that adoption of the disclosure requirements under the interim consensus would have had a significant impact on the carrying value of its investments at June 30, 2004.

Factors that May Affect Future Results

In addition to the other information in this Form 10-Q, a number of factors may affect our business and prospects. These factors include but are not limited to the following, which you should consider carefully in evaluating our business and prospects.

We have not completed development of any of our pharmaceutical systems, and we cannot be certain that our pharmaceutical systems will be able to be commercialized

To be profitable, we must successfully research, develop, obtain regulatory approval for, manufacture, introduce, market and distribute our pharmaceutical systems under development. For each pharmaceutical system that we or our third party collaborators intend to commercialize, we must successfully meet a number of critical developmental milestones for each disease or medical condition that we target, including:

• selecting and developing drug delivery platform technology to deliver the proper dose of drug over the desired period of time;

• selecting and developing catheter or other targeting technology, if appropriate, to deliver the drug to a specific location within the body;

• determining the appropriate drug dosage for use in the pharmaceutical system;

• developing drug compound formulations that will be tolerated, safe and effective and that will be compatible with the system;

• demonstrating the drug formulation will be stable for commercially reasonable time periods; and

• demonstrating through clinical trials that the drug and system combination is safe and effective in patients for the intended indication.

The time frame necessary to achieve these developmental milestones for any individual product is long and uncertain, and we may not successfully complete these milestones for any of our product candidates in development. We have not yet selected the drug dosages nor finalized the formulation or the system design of any pharmaceutical systems, including our

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SABER-based post-operative pain depot, Remoxy, our DURIN-based Alzheimer’s disease product candidate and our CHRONOGESIC product candidate, and DURECT has limited experience in developing such products. We may not be able to finalize the design or formulation of any of our product candidates. In addition, we may select components, solvents, excipients or other ingredients to include in our pharmaceutical systems that have not been previously approved for use in pharmaceutical products, which may require us to perform additional studies and may delay clinical testing and regulatory approval of our pharmaceutical systems. Even after we complete the design of the product candidate, the product candidate must still complete required clinical trials and additional safety testing in animals before approval for commercialization. See “We must conduct and satisfactorily complete required laboratory performance and safety testing, animal studies and clinical trials for our pharmaceutical systems before we can sell them.” We are continuing testing and development of our product candidates and may explore possible design or formulation changes to address issues of safety, manufacturing efficiency and performance. We may not be able to complete development of any product candidates that will be safe and effective and that will have a commercially reasonable treatment and storage period. If we are unable to complete development of our SABER-based post-operative pain depot product candidate, Remoxy, our DURIN-based Alzheimer’s disease product candidate, CHRONOGESIC or other product candidates, we will not be able to earn revenue from them, which would materially harm our business.

We must conduct and satisfactorily complete required laboratory performance and safety testing, animal studies and clinical trials for our pharmaceutical systems before we can sell them

Before we can obtain government approval to sell any of our pharmaceutical systems, we must demonstrate through laboratory performance studies and safety testing, preclinical (animal) studies and clinical (human) trials that each system is safe and effective for human use for each targeted disease. As of June 30, 2004, we have completed a Phase I clinical trial for our SABER-based post-operative pain depot product candidate, and Pain Therapeutics has completed a Phase I clinical trial for Remoxy, an oral oxycodone product candidate based on our ORADUR technology. With respect to our CHRONOGESIC product candidate, as of June 30, 2004, we have completed an initial Phase I clinical trial using an external pump to test the safety of continuous chronic infusion of sufentanil, a Phase II clinical trial, a pilot Phase III clinical trial and a pharmacokinetic trial. We had previously anticipated resuming clinical trials with our CHRONOGESIC product candidate in the second half of 2004. However, on July 21, 2004, we announced that we had learned recently from an animal study that we have not yet solved the pre-mature shutdown problem associated with the system. Therefore, based on this information, we will not be resuming clinical trials with our CHRONOGESIC product candidate in 2004. We continue to work to address this premature shutdown problem, and we will not resume any clinical trials until the system design is completed. See “Management’s Discussion and Analysis of Financial Condition and Results of Operation—Overview—CHRONOGESIC (sufentanil) Pain Therapy System.”

We are currently in the preclinical or research stages with respect to all our other product candidates under development. We plan to continue extensive and costly tests, clinical trials and safety studies in animals to assess the safety and effectiveness of our product candidates. These studies include laboratory performance studies and safety testing, pivotal Phase III and other clinical trials and animal toxicological studies necessary to support regulatory approval of the product candidate in the United States and other countries of the world. These studies are costly, complex and last for long durations, and may not yield the data required for regulatory approval. In addition, we plan to conduct extensive and costly clinical trials and animal studies for our other potential product candidates including our post-operative pain depot product candidate. We may not be permitted to begin or continue our planned clinical trials for our potential product candidates. If our trials are permitted, our potential product candidates may not prove to be safe or produce their intended effects. In addition, we may be required by regulatory agencies to conduct additional animal or human studies regarding the safety and efficacy of our product candidates which we have not planned or anticipated that could delay commercialization of such product candidates and harm our business and financial conditions.

The length of our clinical trials will depend upon, among other factors, the rate of trial site and patient enrollment and the number of patients required to be enrolled in such studies. We may fail to obtain adequate levels of patient enrollment in our clinical trials. Delays in planned patient enrollment may result in increased costs, delays or termination of clinical trials, which could have a material adverse effect on us. In addition, even if we enroll the number of patients we expect in the time frame we expect, our clinical trials may not provide the data necessary to support regulatory approval for the product candidates for which they were conducted. Additionally, we may fail to effectively oversee and monitor these clinical trials, which would result in increased costs or delays of our clinical trials. Even if these clinical trials are completed, we may fail to complete and submit a new drug application as scheduled. Even if we are able to submit a new drug application as scheduled, the Food and Drug Administration may not clear our application in a timely manner or may deny the application entirely.

Data already obtained from preclinical studies and clinical trials of our pharmaceutical systems do not necessarily predict the results that will be obtained from later preclinical studies and clinical trials. Moreover, preclinical and clinical data such as ours is susceptible to varying interpretations, which could delay, limit or prevent regulatory approval. A number of companies in the pharmaceutical industry have suffered significant setbacks in advanced clinical trials, even after promising results in earlier trials. The failure to adequately demonstrate the safety and effectiveness of a product candidate under development could delay or prevent regulatory clearance of the potential product candidate, resulting in delays to the commercialization of

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our product candidates, and could materially harm our business. Our clinical trials may not demonstrate the sufficient levels of safety and efficacy necessary to obtain the requisite regulatory approvals for our product candidates, and thus our product candidates may not be approved for marketing.

We may not be able to manufacture sufficient quantities of our products and components to support the clinical and commercial requirements of our partners and ourselves at an acceptable cost, and we have limited manufacturing experience

We must manufacture our product candidates and components in clinical and commercial quantities, either directly or through third parties, in compliance with regulatory requirements and at an acceptable cost. The manufacture processes associated with our pharmaceutical systems are complex. We have not yet completed development of the manufacturing process for any product candidates or components including our SABER-based post-operative pain depot, Remoxy, our DURIN-based Alzheimer’s disease product candidate and our CHRONOGESIC product candidate. If we fail to timely complete the development of the manufacturing process for our product candidates, we will not be able to timely produce product candidate for our clinical trials and commercialization. In the future, we will continue to consider ways to optimize our manufacturing process and to explore possible changes to improve product performance and quality, increase efficiencies and lower costs. We have also committed to manufacture and supply product candidates or components under a number of our collaborative agreements with third party companies. If we fail to develop manufacturing processes to permit us to manufacture a product candidate or component at an acceptable cost, then we and our third party partners may not be able to commercialize that product candidate or we may be in breach of our supply obligations to our third party partners.

We completed construction of a manufacturing facility initially intended for our DUROS-based pharmaceutical systems in May 2001, and we expect that this facility will be capable of manufacturing supplies for our Phase III and other clinical trials required for regulatory approval and commercial launch of our CHRONOGESIC product candidate and for our other DUROS-based product candidates on a pilot scale. We anticipate that we will also utilize this facility to manufacture some of our other pharmaceutical systems and components. In the future, we may need to build or acquire other space or facilities for manufacture of product candidates and components for our third party partners and ourselves. We have limited experience building and validating manufacturing facilities, and we may not be able to timely accomplish these tasks.

In order to manufacture clinical and commercial supplies of our pharmaceutical systems or components for our third party partners or ourselves, we must attain and maintain compliance with applicable federal, state and foreign regulatory standards relating to manufacture of pharmaceutical products which are rigorous, complex and subject to varying interpretations. Furthermore, our facilities will be subject to government audits to determine compliance with good manufacturing practices regulations, and we may be unable to pass inspection with the applicable regulatory agencies or may be asked to undertake corrective measures which may be costly and cause delay.

If we are unable to manufacture product or components in a timely manner or at an acceptable cost, quality or performance level, and attain and maintain compliance with applicable regulations, the clinical trials and the commercial sale of our pharmaceutical systems and those of our third party partners could be delayed. Additionally, we may need to alter our facility design or manufacturing processes, install additional equipment or do additional construction or testing in order to meet regulatory requirements, optimize the production process, increase efficiencies or production capacity or for other reasons, which may result in additional cost to us or delay production of product candidate needed for the clinical trials and commercial launch of our product candidates and those of our third party collaborators. We may also need or choose to subcontract with third party contractors to perform manufacturing steps of our pharmaceutical systems or components in which case we will be subject to the schedule, expertise and performance of third parties as well as incur significant additional costs. See “We rely heavily on third parties to support development, clinical testing and manufacturing of our products.” Under our development and commercialization agreement with ALZA, we cannot subcontract the manufacture of subassemblies of the DUROS system components of our DUROS-based pharmaceutical system product candidates to third parties which have not been approved by ALZA. If we cannot manufacture product candidate or components in time to meet the clinical or commercial requirements of our partners or ourselves or at an acceptable cost, our operating results will be harmed.

In April 2000, we acquired the ALZET product and related assets from ALZA. We manufacture subassemblies of the ALZET product at our Vacaville facility. We currently rely on a third party, to perform the coating process for the manufacture of the ALZET product under a contract that expires in January 2008.

Failure to obtain product approvals or comply with ongoing governmental regulations could delay or limit introduction of our new products and result in failure to achieve anticipated revenues

The manufacture and marketing of our product candidates and our research and development activities are subject to extensive regulation for safety, efficacy and quality by numerous government authorities in the United States and abroad. We must obtain clearance or approval from applicable regulatory authorities before we can market or sell our product candidates in

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the U.S. or abroad. Before receiving approval or clearance to market a product in the U.S. or in any other country, we will have to demonstrate to the satisfaction of applicable regulatory agencies that the product candidate is safe and effective on the patient population and for the diseases that will be treated. Clinical trials, manufacturing and marketing of products are subject to the rigorous testing and approval process of the FDA and equivalent foreign regulatory authorities.

The Federal Food, Drug and Cosmetic Act and other federal, state and foreign statutes and regulations govern and influence the testing, manufacture, labeling, advertising, distribution and promotion of drugs and medical devices. These laws and regulations are complex and subject to change. Furthermore, these laws and regulations may be subject to varying interpretations, and we may not be able to predict how an applicable regulatory body or agency may choose to interpret or apply any law or regulation. As a result, clinical trials and regulatory approval can take a number of years to accomplish and require the expenditure of substantial resources. We may encounter delays or rejections based upon administrative action or interpretations of current rules and regulations. We may not be able to timely reach agreement with the FDA on our clinical trial protocols or on the required data we must collect to continue with our clinical trials or eventually commercialize our product candidates.

We may also encounter delays or rejections based upon additional government regulation from future legislation, administrative action or changes in FDA policy during the period of product development, clinical trials and FDA regulatory review. We may encounter similar delays in foreign countries. Sales of our product candidates outside the U.S. are subject to foreign regulatory standards that vary from country to country. The time required to obtain approvals from foreign countries may be shorter or longer than that required for FDA approval, and requirements for foreign licensing may differ from FDA requirements. We may be unable to obtain requisite approvals from the FDA and foreign regulatory authorities, and even if obtained, such approvals may not be on a timely basis, or they may not cover the clinical uses that we specify. If we fail to obtain timely clearance or approval for our product candidates, we will not be able to market and sell our product candidates, which will limit our ability to generate revenue.

Marketing or promoting a drug is subject to very strict controls. Furthermore, clearance or approval may entail ongoing requirements for post-marketing studies. The manufacture and marketing of drugs are subject to continuing FDA and foreign regulatory review and requirements that we update our regulatory filings. Later discovery of previously unknown problems with a product, manufacturer or facility, or our failure to update regulatory files, may result in restrictions, including withdrawal of the product from the market. Any of the following events, if they were to occur, could delay or preclude us from further developing, marketing or realizing full commercial use of our product candidates, which in turn would materially harm our business, financial condition and results of operations:

• failure to obtain or maintain requisite governmental approvals;

• failure to obtain approvals for clinically intended uses of our product candidates under development; or

• identification of serious and unanticipated adverse side effects in our product candidates under development.

Manufacturers of drugs also must comply with the applicable FDA good manufacturing practice regulations, which include production design controls, testing, quality control and quality assurance requirements as well as the corresponding maintenance of records and documentation. Compliance with current good manufacturing practices regulations is difficult and costly. Manufacturing facilities are subject to ongoing periodic inspection by the FDA and corresponding state agencies, including unannounced inspections, and must be licensed before they can be used for the commercial manufacture of our product candidates. We and/or our present or future suppliers and distributors may be unable to comply with the applicable good manufacturing practice regulations and other FDA regulatory requirements. We have not been subject to a good manufacturing regulation inspection by the FDA relating to our pharmaceutical systems. If we do not achieve compliance for the product candidates we manufacture, the FDA may refuse or withdraw marketing clearance or require product recall, which may cause interruptions or delays in the manufacture and sale of our product candidates.

Our near-term revenues depend on collaborations agreements with other companies which may be terminated under specified conditions. If we are unable to meet milestones under these agreements or enter into additional collaboration agreements or if our existing collaborations are terminated, our revenues may decrease.

Our near-term revenues are based to a significant extent on collaborative arrangements with third parties, pursuant to which we receive payments based on our performance of research and development activities and the attainment of milestones set forth in the agreements. We may not be able to attain milestones set forth in any specific agreement, which could cause our revenues to fluctuate or be less than anticipated. In general, our collaboration agreements, including our agreements with Endo Pharmaceuticals, Inc., Pain Therapeutics, Inc., Voyager Pharmaceutical Corporation and NeuroSystec Corporation, may be terminated by the other party at will or upon specified conditions including, for example, if we fail to satisfy specified performance milestones or if we breach the terms of the agreement.

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Our agreement with Endo for the development and commercialization of our CHRONOGESIC product candidate in the U.S. and Canada can be terminated by Endo in January 2005 in the event we have not commenced a specified clinical trial for the CHRONOGESIC product candidate by January 1, 2005. Due to the delay in our CHRONOGESIC program timeline as a result of our continued efforts to redesign the system to eliminate the premature shutdown problem, we will not commence such specified clinical trial by January 1, 2005, and Endo may elect to terminate the agreement.

If the agreements are terminated, our revenues will be reduced and our product candidates related to those agreements may not be commercialized. We have limited or no control over the resources that any collaborator may devote to our product candidates. Any of our present or future collaborators may not perform their obligations as expected. These collaborators may breach or terminate their agreement with us or otherwise fail to conduct their collaborative activities successfully and in a timely manner. Further, our collaborators may elect not to develop or commercialize products arising out of our collaborative arrangements or not devote sufficient resources to the development, manufacture, marketing or sale of these products. If any of these events occur, we may not be able to develop our technologies or commercialize our product candidates based on such collaborations.

We may not have sufficient funds to redeem our outstanding convertible subordinated notes if required to do so, and the redemption rights in our outstanding convertible subordinated notes could discourage a potential acquirer

If we engage in any transaction or event in connection with which all or substantially all of our common stock is exchanged for, converted into, acquired for or constitutes solely the right to receive consideration which is not all or substantially all common stock listed on a United States national securities exchange or approved for quotation on the NASDAQ National Market or any similar United States system of automated dissemination of quotations of securities prices, or, if for any reason, our common stock is no longer listed for trading on a United States national securities exchange nor approved for trading on the NASDAQ National Market (a “fundamental change”), we may be required to redeem all or part of the $60 million in outstanding principal, plus any accrued but unpaid interest on our outstanding convertible promissory notes. We may not have enough funds to pay the redemption price for all tendered notes. In addition, any credit agreement or other agreements relating to our indebtedness may contain provisions prohibiting redemption of the notes under certain circumstances, or expressly prohibit our redemption of the notes upon a designated event or may provide that a designated event constitutes an event of default under that agreement. Our failure to redeem tendered notes would constitute an event of default under the indenture, which might also constitute a default under the terms of our other indebtedness.

A fundamental change could also discourage a potential acquirer. However, this redemption feature is not the result of management’s knowledge of any specific effort to obtain control of us by means of a merger, tender offer or solicitation, or part of a plan by management to adopt a series of anti-takeover provisions. The term “fundamental change” is limited to specified transactions and may not include other events that might adversely affect our financial condition or business operations.

We have a history of operating losses, expect to continue to have losses in the future and may never achieve or maintain profitability

We have incurred significant operating losses since our inception in 1998 and, as of June 30, 2004, had an accumulated deficit of approximately $149.7 million. We expect to continue to incur significant operating losses over the next several years as we continue to incur costs for research and development, clinical trials and manufacturing. Our ability to achieve profitability depends upon our ability, alone or with others, to successfully complete the development of our proposed product candidates, obtain the required regulatory clearances and manufacture and market our proposed product candidates. Development of pharmaceutical systems is costly and requires significant investment. In addition, we may choose to license either additional drug delivery platform technology or rights to particular drugs or other appropriate technology for use in our pharmaceutical systems. The license fees for these technologies or rights would increase the costs of our pharmaceutical systems.

To date, we have not generated significant revenue from the commercial sale of our products and do not expect to receive significant revenue in the near future. Our current product revenues are from the sale of the ALZET product we acquired in April 2000 from ALZA and the sale of biodegradable polymers through our wholly owned subsidiary, API. We do not expect the product revenues to increase significantly in future periods. We do not anticipate commercialization and marketing of our product candidates in development in the near future, and therefore do not expect to generate sufficient revenues to cover expenses or achieve profitability in the near future.

We may have difficulty raising needed capital in the future

Our business currently does not generate sufficient revenues to meet our capital requirements and we do not expect that it will do so in the near future. We have expended and will continue to expend substantial funds to complete the research, development and clinical testing of our product candidates. We will require additional funds for these purposes, to establish

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additional clinical- and commercial-scale manufacturing arrangements and facilities and to provide for the marketing and distribution of our product candidates. Additional funds may not be available on acceptable terms, if at all. If adequate funds are unavailable from operations or additional sources of financing, we may have to delay, reduce the scope of or eliminate one or more of our research or development programs which would materially harm our business, financial condition and results of operations.

We believe that our cash, cash equivalents and investments, will be adequate to satisfy our capital needs for at least the next 12 months. However, our actual capital requirements will depend on many factors, including:

• continued progress and cost of our research and development programs;

• success in entering into collaboration agreements and meeting milestones under such agreements;

• progress with preclinical studies and clinical trials;

• the time and costs involved in obtaining regulatory clearance;

• costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims;

• costs of developing sales, marketing and distribution channels and our ability to sell our product candidates;

• costs involved in establishing manufacturing capabilities for clinical and commercial quantities of our product candidates;

• competing technological and market developments;

• market acceptance of our product candidates; and

• costs for recruiting and retaining employees and consultants.

We may consume available resources more rapidly than currently anticipated, resulting in the need for additional funding. We may seek to raise any necessary additional funds through equity or debt financings, convertible debt financings, collaborative arrangements with corporate partners or other sources, which may be dilutive to existing stockholders and may cause the price of our common stock to decline. In addition, in the event that additional funds are obtained through arrangements with collaborators or other sources, we may have to relinquish rights to some of our technologies, product candidates or products that we would otherwise seek to develop or commercialize ourselves. If adequate funds are not available, we may be required to significantly reduce or refocus our product development efforts, resulting in loss of sales, increased costs, and reduced revenues.

Investors may experience substantial dilution of their investment

In the past, we have issued and have assumed, pursuant to the SBS acquisition, options and warrants to acquire common stock. To the extent these outstanding options are ultimately exercised, there will be dilution to investors. In addition, conversion of some or all of the $60.0 million aggregate principal amount of convertible subordinated notes that we issued in June and July 2003 will dilute the ownership interests of investors. Investors may experience further dilution of their investment if we raise capital through the sale of additional equity securities or convertible debt securities. See “Liquidity and Capital Resources”. Any sales in the public market of the common stock issuable upon such conversion could adversely affect prevailing market prices for our common stock.

If we do not generate sufficient cash flow through increased revenues or raising additional capital, then we may not be able to meet our substantial debt obligations.

As of June 30, 2004, we had approximately $60.0 million in long-term convertible subordinated notes which mature in June 2008, $165,000 in non-current term loan obligations, $1.1 million in non-current bonds payable and $916,000 in other long-term liabilities. Our substantial indebtedness, which totals $62.1 million, has and will continue to impact us by:

• making it more difficult to obtain additional financing; and

• constraining our ability to react quickly in an unfavorable economic climate.

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Currently we are not generating positive cash flow. Delay in the approval of CHRONOGESIC, or other adverse occurrences related to our product development efforts will adversely impact our ability to meet our obligations to repay the principal amounts on our convertible subordinated notes when due. In addition, if the market price of our common stock on the due date of our notes is below the equity conversion price of the notes, it will be highly unlikely that the holders of a large percentage of our outstanding convertible subordinated notes will convert such securities to equity in accordance with their existing terms. If we are unable to satisfy our debt service requirements, substantial liquidity problems could result. As of June 30, 2004 we had cash and investments valued at approximately $73.8 million. We expect to use substantially all of these assets to fund our on-going operations over the next few years. We may not generate sufficient cash from operations to repay our convertible subordinated notes or satisfy any other of these obligations when they become due and may have to raise additional financing from the sale of equity or debt securities or otherwise restructure our obligations in order to do so. There can be no assurance that any such financing or restructuring will be available to us on commercially acceptable terms, if at all.

Our stock price may fluctuate, and your investment in our stock could decline in value

The average daily trading volume of our common stock for the three months ending June 30, 2004, was 216,942 shares. The limited trading volume of our stock may contribute to its volatility, and an active trading market in our stock might not develop or continue. In accordance with our Common Stock Purchase Agreement with Endo, we filed a registration statement on Form S-3 with the SEC on August 29, 2003 to register 1,533,742 shares of our common stock issued to Endo and 485,122 shares issued to former APT shareholders for resale. The registration statement was declared effective by the SEC on September 26, 2003. Pursuant to a Purchase Agreement with Morgan Stanley & Co., Incorporated, we filed a registration statement with the SEC on Form S-3 to register an aggregate of $60.0 million in convertible subordinated notes for resale on August 29, 2003. The registration statement was declared effective by the SEC on November 3, 2003. The convertible subordinated notes are convertible into shares of our common stock at a conversion rate of 317.4603 shares per $1,000 principal amount of notes, subject to adjustment and will bear interest at a rate of 6.25% per annum. So long as these registration statements are effective, shares covered thereunder are tradeable without limitation. If substantial amounts of our common stock were to be sold in the public market, the market price of our common stock could fall. In addition, the existence of our convertible subordinated notes may encourage short selling by market participants. The market price of our common stock may fluctuate significantly in response to factors which are beyond our control. The stock market in general has recently experienced extreme price and volume fluctuations. In addition, the market prices of securities of technology and pharmaceutical companies have also been extremely volatile, and have experienced fluctuations that often have been unrelated or disproportionate to the operating performance of these companies. These broad market fluctuations could result in extreme fluctuations in the price of our common stock, which could cause a decline in the value of our investors’ stock.

We could be exposed to significant product liability claims which could be time consuming and costly to defend, divert management attention and adversely impact our ability to obtain and maintain insurance coverage

The testing, manufacture, marketing and sale of our product candidates involve an inherent risk that product liability claims will be asserted against us. Although we are insured against such risks up to an annual aggregate limit in connection with clinical trials and commercial sales of our product candidates, our present product liability insurance may be inadequate and may not fully cover the costs of any claim or any ultimate damages we might be required to pay. Product liability claims or other claims related to our product candidates, regardless of their outcome, could require us to spend significant time and money in litigation or to pay significant damages. Any successful product liability claim may prevent us from obtaining adequate product liability insurance in the future on commercially desirable or reasonable terms. In addition, product liability coverage may cease to be available in sufficient amounts or at an acceptable cost. An inability to obtain sufficient insurance coverage at an acceptable cost or otherwise to protect against potential product liability claims could prevent or inhibit the commercialization of our pharmaceutical systems. A product liability claim could also significantly harm our reputation and delay market acceptance of our product candidates.

We may be required to obtain rights to certain drugs

Some of the pharmaceutical systems that we are currently developing require the use of proprietary drugs to which we do not have commercial rights. For example, our research collaboration with the University of Maastricht has demonstrated that the use of a proprietary angiogenic factor in a pharmaceutical system can lead to elevated local concentration of the angiogenic factor in the pericardial sac of the heart, resulting in physical changes, including the growth of new blood vessels. We do not currently have a license to develop or commercialize a product containing such proprietary angiogenic factor.

To complete the development and commercialization of pharmaceutical systems containing drugs to which we do not have commercial rights, we will be required to obtain rights to those drugs. We may not be able to do this at an acceptable cost,

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if at all. If we are not able to obtain required rights to commercialize certain drugs, we may not be able to complete the development of pharmaceutical systems which require use of those drugs. This could result in the cessation of certain development projects and the potential write-off of certain assets.

Technologies and businesses which we have acquired may be difficult to integrate, disrupt our business, dilute stockholder value or divert management attention. We may also acquire additional businesses or technologies in the future, which could have these same effects

We may acquire technologies, products or businesses to broaden the scope of our existing and planned product lines and technologies. For example, in October 1999, we acquired substantially all of the assets of IntraEAR, Inc., in April 2000 we acquired the ALZET product and related assets from ALZA, in April 2001, we completed the acquisition of SBS and in August 2003, we acquired Absorbable Polymers Technologies, Inc (APT). These and our future acquisitions expose us to:

• increased costs associated with the acquisition and operation of the new businesses or technologies and the management of geographically dispersed operations;

• the risks associated with the assimilation of new technologies, operations, sites and personnel;

• the diversion of resources from our existing business and technologies;

• the inability to generate revenues to offset associated acquisition costs;

• the requirement to maintain uniform standards, controls, and procedures; and

• the impairment of relationships with employees and customers as a result of any integration of new management personnel.

Acquisitions may also result in the issuance of dilutive equity securities, the incurrence or assumption of debt or additional expenses associated with the amortization of acquired intangible assets or potential businesses. Past acquisitions, such as our acquisitions of IntraEAR, ALZET, SBS and APT, as well future acquisitions, may not generate any additional revenue or provide any benefit to our business.

Our limited operating history makes evaluating our stock difficult

Investors can only evaluate our business based on a limited operating history. We were incorporated in February 1998 and have engaged primarily in research and development, licensing technology, raising capital and recruiting scientific and management personnel. This short history may not be adequate to enable investors to fully assess our ability to successfully develop our product candidates, achieve market acceptance of our product candidates and respond to competition. Furthermore, we anticipate that our quarterly and annual results of operations will fluctuate for the foreseeable future. We believe that period-to-period comparisons of our operating results should not be relied upon as predictive of future performance. Our prospects must be considered in light of the risks, expenses and difficulties encountered by companies at an early stage of development, particularly companies in new and rapidly evolving markets such as pharmaceuticals, drug delivery, and biotechnology. To address these risks, we must, among other things, obtain regulatory approval for and commercialize our product candidates, which may not occur. We may not be successful in addressing these risks and difficulties. We may require additional funds to complete the development of our product candidates and to fund operating losses to be incurred in the next several years.

Acceptance of our products in the marketplace is uncertain, and failure to achieve market acceptance will delay our ability to generate or grow revenues

Our future financial performance will depend upon the successful introduction and customer acceptance of our future products, including our CHRONOGESIC product candidate and our SABER-based post-operative pain product candidate. Even if approved for marketing, our products may not achieve market acceptance. The degree of market acceptance will depend upon a number of factors, including:

• the receipt of regulatory clearance of marketing claims for the uses that we are developing;

• the establishment and demonstration in the medical community of the safety and clinical efficacy of our products and their potential advantages over existing therapeutic products, including oral medication, transdermal drug delivery products such as drug patches, or external or implantable drug delivery products; and

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• pricing and reimbursement policies of government and third-party payors such as insurance companies, health maintenance organizations and other health plan administrators.

Physicians, patients, payors or the medical community in general may be unwilling to accept, utilize or recommend any of our products. If we are unable to obtain regulatory approval, commercialize and market our future products when planned and achieve market acceptance, we will not achieve anticipated revenues.

If users of our products are unable to obtain adequate reimbursement from third-party payors, or if new restrictive legislation is adopted, market acceptance of our products may be limited and we may not achieve anticipated revenues

The continuing efforts of government and insurance companies, health maintenance organizations and other payors of healthcare costs to contain or reduce costs of health care may affect our future revenues and profitability, and the future revenues and profitability of our potential customers, suppliers and collaborative partners and the availability of capital. For example, in certain foreign markets, pricing or profitability of prescription pharmaceuticals is subject to government control. In the United States, recent federal and state government initiatives have been directed at lowering the total cost of health care, and the U.S. Congress and state legislatures will likely continue to focus on health care reform, the cost of prescription pharmaceuticals and on the reform of the Medicare and Medicaid systems. While we cannot predict whether any such legislative or regulatory proposals will be adopted, the announcement or adoption of such proposals could materially harm our business, financial condition and results of operations.

Our ability to commercialize our products successfully will depend in part on the extent to which appropriate reimbursement levels for the cost of our products and related treatment are obtained by governmental authorities, private health insurers and other organizations, such as HMOs. Third-party payors are increasingly limiting payments or reimbursement for medical products and services. Also, the trend toward managed health care in the United States and the concurrent growth of organizations such as HMOs, which could control or significantly influence the purchase of health care services and products, as well as legislative proposals to reform health care or reduce government insurance programs, may limit reimbursement or payment for our products. The cost containment measures that health care payors and providers are instituting and the effect of any health care reform could materially harm our ability to operate profitably.

We may be sued by third parties which claim that our products infringe on their intellectual property rights, particularly because there is substantial uncertainty about the validity and breadth of medical patents

We may be exposed to future litigation by third parties based on claims that our products or activities infringe the intellectual property rights of others or that we have misappropriated the trade secrets of others. This risk is exacerbated by the fact that the validity and breadth of claims covered in medical technology patents and the breadth and scope of trade secret protection involve complex legal and factual questions for which important legal principles are unresolved. Any litigation or claims against us, whether or not valid, could result in substantial costs, could place a significant strain on our financial resources and could harm our reputation. In addition, intellectual property litigation or claims could force us to do one or more of the following, any of which could harm our business or financial results:

• cease selling, incorporating or using any of our products that incorporate the challenged intellectual property, which would adversely affect our revenue;

• obtain a license from the holder of the infringed intellectual property right, which license may be costly or may not be available on reasonable terms, if at all; or

• redesign our products, which would be costly and time-consuming.

If we are unable to adequately protect or enforce our intellectual property rights or secure rights to third-party patents, we may lose valuable assets, experience reduced market share or incur costly litigation to protect our rights

Our success will depend in part on our ability to obtain patents, maintain trade secret protection and operate without infringing the proprietary rights of others. As of June 30, 2004, we held 21 issued U.S. patents and 11 issued foreign patents. In addition, we have 39 pending U.S. patent applications and have filed 47 patent applications under the Patent Cooperation Treaty, from which 90 national phase applications are currently pending in Europe, Australia, Japan, Canada, Mexico, New Zealand, Brazil, Israel and China. Our patents expire at various dates starting in the year 2012. Under our agreement with ALZA, we must assign to ALZA any intellectual property rights relating to the DUROS system and its manufacture and any combination of the DUROS system with other components, active agents, features or processes. In addition, ALZA retains the right to enforce and defend against infringement actions relating to the DUROS system, and if ALZA exercises these rights, it will be entitled to the proceeds of these infringement actions.

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The patent positions of pharmaceutical companies, including ours, are uncertain and involve complex legal and factual questions. In addition, the coverage claimed in a patent application can be significantly reduced before the patent is issued. Consequently, our patent applications or those of ALZA that are licensed to us may not issue into patents, and any issued patents may not provide protection against competitive technologies or may be held invalid if challenged or circumvented. Our competitors may also independently develop products similar to ours or design around or otherwise circumvent patents issued to us or licensed by us. In addition, the laws of some foreign countries may not protect our proprietary rights to the same extent as U.S. law.

We also rely upon trade secrets, technical know-how and continuing technological innovation to develop and maintain our competitive position. We require our employees, consultants, advisors and collaborators to execute appropriate confidentiality and assignment-of-inventions agreements with us. These agreements typically provide that all materials and confidential information developed or made known to the individual during the course of the individual’s relationship with us is to be kept confidential and not disclosed to third parties except in specific circumstances, and that all inventions arising out of the individual’s relationship with us shall be our exclusive property. These agreements may be breached, and in some instances, we may not have an appropriate remedy available for breach of the agreements. Furthermore, our competitors may independently develop substantially equivalent proprietary information and techniques, reverse engineer our information and techniques, or otherwise gain access to our proprietary technology.

We may be unable to meaningfully protect our rights in trade secrets, technical know-how and other non-patented technology. We may have to resort to litigation to protect our intellectual property rights, or to determine their scope, validity or enforceability. Enforcing or defending our proprietary rights is expensive, could cause diversion of our resources and may not prove successful. Any failure to enforce or protect our rights could cause us to lose the ability to exclude others from using our technology to develop or sell competing products.

We rely heavily on third parties to support development, clinical testing and manufacturing of our product candidates

We rely on third party contract research organizations, service providers and suppliers to provide critical services to support development, clinical testing, and manufacturing of our pharmaceutical systems. For example, we currently depend on third party vendors to perform blood plasma assays in connection with our clinical trials and quality control services related to components of our DUROS-based pharmaceutical systems, and to supply us with molded rubber components of our DUROS-based pharmaceutical systems. In the past, we relied on a third party contract manufacturer to perform the final manufacturing steps of our CHRONOGESIC product candidate, and we may need or choose to rely on a third party manufacturer again. See “We may not be able to manufacture sufficient quantities of our product candidates to support our clinical and commercial requirements at an acceptable cost, and we have limited manufacturing experience.” We anticipate that we will continue to rely on these and other third party contractors to support development, clinical testing, and manufacturing of our pharmaceutical systems. Failure of these contractors to provide the required services in a timely manner or on reasonable commercial terms could materially delay the development and approval of our product candidates, increase our expenses and materially harm our business, financial condition and results of operations.

Key components of our pharmaceutical systems are provided by limited numbers of suppliers, and supply shortages or loss of these suppliers could result in interruptions in supply or increased costs

Certain components and drug substances used in our pharmaceutical systems are currently purchased from a single or a limited number of outside sources. The reliance on a sole or limited number of suppliers could result in:

• delays associated with redesigning a product candidate due to a failure to obtain a single source component;

• an inability to obtain an adequate supply of required components; and

• reduced control over pricing, quality and time delivery.

We have a supply agreement with Mallinckrodt, Inc. for our sufentanil requirements for our CHRONOGESIC product candidate, the original term of which expires in September 2004 but will be renewed for successive one year renewal terms unless terminated by either party upon one year’s prior written notice. Other than this agreement, we do not have long-term agreements with any of our suppliers, and therefore the supply of a particular component could be terminated at any time without penalty to the supplier. Any interruption in the supply of single source components could cause us to seek alternative sources of supply or manufacture these components internally. If the supply of any components for our pharmaceutical systems is interrupted, components from alternative suppliers may not be available in sufficient volumes or at acceptable quality levels within required timeframes, if at all, to meet our needs. This could delay our ability to complete clinical trials and obtain approval for commercialization and marketing of our product candidates, causing us to lose sales, incur additional costs and delay new product introductions and could harm our reputation.

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We will not control sales and distribution for our pharmaceutical systems

In November 2002, we entered into an agreement with Endo Pharmaceuticals, Inc. related to the promotion and distribution of our CHRONOGESIC product candidate in the U.S. and Canada once it is approved for commercialization. In addition, we have entered into agreements with Pain Therapeutics, Inc., Voyager Pharmaceutical Corporation and NeuroSystec Corporation under which we will collaborate with these companies to develop select pharmaceutical system product candidates and such third parties will have the right to promote and distribute the resulting developed products subject to payments to us in the form of product royalties and other payments. See “Management’s Discussion and Analysis or Financial Condition and Results of Operations—Overview.” These agreements make us dependent on third parties to sell and distribute our pharmaceutical systems. These third parties may have similar or more established relationships with our competitors, which may reduce their interest in selling our products. In addition, these third parties may terminate these agreements under specified conditions provided in these agreements. Other than these agreements with third party companies, we have yet to establish marketing, sales or distribution capabilities for our pharmaceutical system product candidates.

We compete with many other companies that currently have extensive and well-funded marketing and sales operations. Our marketing and sales efforts and those of our third party collaborations may be unable to compete successfully against these other companies. We may be unable to establish a sufficient sales and marketing organization on a timely basis, if at all. We may be unable to engage qualified distributors. Even if engaged, these distributors may:

• fail to satisfy financial or contractual obligations to us;

• fail to adequately market our products;

• cease operations with little or no notice to us;

• offer, design, manufacture or promote competing product lines;

• fail to maintain adequate inventory and thereby restrict use of our products; or

• build up inventory in excess of demand thereby limiting future purchases or our products resulting in significant quarter-to-quarter variability in our sales.

The failure of our third parties to effectively sell and market our products will hurt our business and financial results.

If we are unable to train physicians to use our pharmaceutical systems to treat patients’ diseases or medical conditions, we may incur delays in market acceptance of our products

Broad use of our pharmaceutical systems will require extensive training of numerous physicians on the proper and safe use of our products. The time required to begin and complete training of physicians could delay introduction of our products and adversely affect market acceptance of our products. We or third parties selling our products may be unable to rapidly train physicians in numbers sufficient to generate adequate demand for our pharmaceutical systems. Any delay in training would materially delay the demand for our systems and harm our business and financial results. In addition, we may expend significant funds towards such training before any orders are placed for our products, which would increase our expenses and harm our financial results.

Some of our product candidates contain controlled substances, the making, use, sale, importation and distribution of which are subject to regulation by state, federal and foreign law enforcement and other regulatory agencies

Some of our product candidates currently under development contain, and our products in the future may contain, controlled substances which are subject to state, federal and foreign laws and regulations regarding their manufacture, use, sale, importation and distribution. CHRONOGESIC, Remoxy and other product candidates we have under development contain opioids which are classified as Schedule II controlled substances under the regulations of the U.S. Drug Enforcement Agency. For our products containing controlled substances, we and our suppliers, manufacturers, contractors, customers and distributors are required to obtain and maintain applicable registrations from state, federal and foreign law enforcement and regulatory agencies and comply with state, federal and foreign laws and regulations regarding the manufacture, use, sale, importation and distribution of controlled substances. These regulations are extensive and include regulations governing manufacturing, labeling, packaging, testing, dispensing, production and procurement quotas, record keeping, reporting, handling, shipment and disposal. Failure to obtain and maintain required registrations or comply with any applicable regulations could delay or preclude us from developing and commercializing our product candidates containing controlled substances and subject us to enforcement action. In addition, because of their restrictive nature, these regulations could limit our commercialization of our products containing controlled substances.

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Write-offs related to the impairment of long-lived assets and other non-cash charges, as well as future deferred compensation expenses may adversely impact or delay our profitability

We may incur significant non-cash charges related to impairment write-downs of our long-lived assets, including goodwill and other intangible assets. In 2002, Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142) became effective and as a result, we ceased to amortize approximately $4.7 million of goodwill and assembled workforce on January 1, 2002.

However, we will continue to incur non-cash charges related to amortization of other intangible assets. We are required to perform periodic impairment reviews of our goodwill at least annually. To the extent these reviews conclude that the expected future cash flows generated from our business activities are not sufficient to recover the cost of our long-lived assets, we will be required to measure and record an impairment charge to write down these assets to their realizable values. We completed our initial review during the second quarter of 2002. We concluded that our goodwill was fairly stated as of January 1, 2002 and no accounting change adjustment was required. We performed the annual assessment in the fourth quarter of 2002 and 2003 and determined that goodwill was not impaired as of December 31, 2002 and 2003. However, there can be no assurance that upon completion of subsequent reviews a material impairment charge will not be recorded. If future periodic reviews determine that our assets are impaired and a write down is required, it will adversely impact or delay our profitability.

To date, we have recorded deferred compensation expenses related to stock options grants, including stock options assumed in our acquisition of SBS, which will be amortized through 2006. In addition, deferred compensation expense related to option awards to non-employees will be calculated during the vesting period of the option based on the then-current price of our common stock, which could result in significant charges that adversely impact or delay our profitability. Furthermore, we have issued to ALZA common stock and a warrant to purchase common stock with an aggregate value of approximately $13.5 million, which will be amortized over time based on sales of our products and which will also adversely impact or delay our profitability.

We depend upon key personnel who may terminate their employment with us at any time, and we need to hire additional qualified personnel

Our success will depend to a significant degree upon the continued services of key management, technical, and scientific personnel, including Felix Theeuwes, our Chairman and Chief Scientific Officer, James E. Brown, our President and Chief Executive Officer and Thomas A. Schreck, our Chief Financial Officer. Although we have obtained key man life insurance policies for each of Messrs. Theeuwes, Brown and Schreck in the amount of $1.0 million, this insurance may not adequately compensate us for the loss of their services. In addition, our success will depend on our ability to attract and retain other highly skilled personnel. Competition for qualified personnel is intense, and the process of hiring and integrating such qualified personnel is often lengthy. We may be unable to recruit such personnel on a timely basis, if at all. Our management and other employees may voluntarily terminate their employment with us at any time. The loss of the services of key personnel, or the inability to attract and retain additional qualified personnel, could result in delays to product development or approval, loss of sales and diversion of management resources.

We may not successfully manage our growth

Our success will depend on the timely expansion of our operations and the effective management of growth, which will place a significant strain on our management and on our administrative, operational and financial resources. To manage such growth, we must expand our facilities, augment our operational, financial and management systems and hire, train and supervise additional qualified personnel. If we were unable to manage growth effectively our business would be harmed.

The market for our product candidates is new, rapidly changing and competitive, and new products or technologies developed by others could impair our ability to grow our business and remain competitive

The pharmaceutical industry is subject to rapid and substantial technological change. Developments by others may render our product candidates under development or technologies noncompetitive or obsolete, or we may be unable to keep pace with technological developments or other market factors. Technological competition in the industry from pharmaceutical and biotechnology companies, universities, governmental entities and others diversifying into the field is intense and is expected to increase. Many of these entities have significantly greater research and development capabilities than we do, as well as substantially more marketing, manufacturing, financial and managerial resources. These entities represent significant competition for us. Acquisitions of, or investments in, competing pharmaceutical or biotechnology companies by large corporations could increase such competitors’ financial, marketing, manufacturing and other resources.

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We are a new enterprise and are engaged in the development of novel therapeutic technologies. As a result, our resources are limited and we may experience technical challenges inherent in such novel technologies. Competitors have developed or are in the process of developing technologies that are, or in the future may be, the basis for competitive products. Some of these products may have an entirely different approach or means of accomplishing similar therapeutic effects than our product candidates. Our competitors may develop products that are safer, more effective or less costly than our product candidates and, therefore, present a serious competitive threat to our product offerings.

The widespread acceptance of therapies that are alternatives to ours may limit market acceptance of our product candidates even if commercialized. Chronic pain can also be treated by oral medication, transdermal drug delivery systems, such as drug patches, or with other implantable drug delivery devices. These treatments are widely accepted in the medical community and have a long history of use. The established use of these competitive products may limit the potential for our product candidates to receive widespread acceptance if commercialized.

Our business involves environmental risks and risks related to handling regulated substances

In connection with our research and development activities and our manufacture of materials and product candidates, we are subject to federal, state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, air emission, effluent discharge, handling and disposal of certain materials, biological specimens and wastes. Although we believe that we have complied with the applicable laws, regulations and policies in all material respects and have not been required to correct any material noncompliance, we may be required to incur significant costs to comply with environmental and health and safety regulations in the future. Our research and development involves the use, generation and disposal of hazardous materials, including but not limited to certain hazardous chemicals, solvents, agents and biohazardous materials. The extent of our use, generation and disposal of such substances has increased substantially since we started manufacturing and selling biodegradable polymers through our subsidiary Absorbable Polymers International Corporation (API). Although we believe that our safety procedures for storing, handling and disposing of such materials comply with the standards prescribed by state and federal regulations, we cannot completely eliminate the risk of accidental contamination or injury from these materials. We currently contract with third parties to dispose of these substances generated by us, and we rely on these third parties to properly dispose of these substances in compliance with applicable laws and regulations. If these third parties do not properly dispose of these substances in compliance with applicable laws and regulations, we may be subject to legal action by governmental agencies or private parties for improper disposal of these substances. The costs of defending such actions and the potential liability resulting from such actions are often very large. In the event we are subject to such legal action or we otherwise fail to comply with applicable laws and regulations governing the use, generation and disposal of hazardous materials and chemicals, we could be held liable for any damages that result, and any such liability could exceed our resources.

Our agreement with ALZA limits our fields of operation for our DUROS-based pharmaceutical systems and gives ALZA a first right to negotiate to distribute selected products for us

In April 1998, we entered into a development and commercialization agreement with ALZA Corporation, which was amended and restated in April 1999, April 2000 and October 2002. ALZA was acquired by Johnson & Johnson in June 2001 and has since operated as a wholly owned subsidiary. Our agreement with ALZA gives us exclusive rights to develop, commercialize and manufacture products using ALZA’s DUROS technology to deliver by catheter:

• drugs to the central nervous system to treat select nervous system disorders;

• drugs to the middle and inner ear;

• drugs to the pericardial sac of the heart; and

• select drugs into vascular grafts.

We also have the right to use the DUROS technology to deliver systemically and by catheter:

• sufentanil to treat chronic pain; and

• select cancer antigens.

We may not develop, manufacture or commercialize DUROS-based pharmaceutical systems outside of these specific fields without ALZA’s prior approval. In addition, if we develop or commercialize any drug delivery technology for use in a manner similar to the DUROS technology in a field covered in our license agreement with ALZA, then we may lose our exclusive rights to use the DUROS technology in such field as well as the right to develop new product candidates using

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DUROS technology in such field. In order to maintain commercialization rights for our products on a worldwide basis, we must diligently develop our product candidates, procure required regulatory approvals and commercialize the product candidates in selected major market countries. If we fail to meet commercialization diligence requirements, we may lose rights for products in some or all countries, including the U.S. These rights would revert to ALZA, which could then develop DUROS-based pharmaceutical products in such countries itself or license others to do so. In addition, in the event that our rights terminate with respect to any product or country, or this agreement terminates or expires in its entirety (except for termination by us due to a breach by ALZA), ALZA will have the exclusive right to use all of our data, rights and information relating to the products developed under the agreement as necessary for ALZA to commercialize these products, subject to the payment of a royalty to us based on the net sales of the products by ALZA.

Our agreement with ALZA gives us the right to perform development work and manufacture the DUROS pump component of our DUROS-based pharmaceutical systems. In the event of a change in our corporate control, including an acquisition of us, our right to manufacture and perform development work on the DUROS pump would terminate and ALZA would have the right to manufacture and develop DUROS systems for us so long as ALZA can meet our specification and supply requirements following such change in control.

Under the ALZA agreement, we must pay ALZA royalties on sales of DUROS-based pharmaceutical systems we commercialize and a percentage of any up-front license fees, milestone or special fees, payments or other consideration we receive, excluding research and development funding. In addition, commencing upon the commercial sale of a product developed under the agreement, we are obligated to make minimum product payments to ALZA on a quarterly basis based on our good faith projections of our net product sales of the product. These minimum payments will be fully credited against the product royalty payments we must pay to ALZA.

ALZA may obtain from us, for its own behalf or on behalf of one of its affiliates, the exclusive right to develop and commercialize a product in a field of use exclusively licensed to us, provided that such product does not incorporate a drug in the same drug class and is not intended for the same therapeutic indication as a product which is then being developed or commercialized by us or for which we have made commitments to a third party. In the event that ALZA or an affiliate commercializes such a product, ALZA or its affiliate will pay us a royalty on sales of such product at a specified rate.

ALZA also has an exclusive option to distribute any DUROS-based pharmaceutical system we develop to deliver non-proprietary cancer antigens worldwide. The terms of any distribution arrangement have not been set and are to be negotiated in good faith between ALZA and us. ALZA’s option to acquire distribution rights limits our ability to negotiate with other distributors for these products and may result in lower payments to us than if these rights were subject to competitive negotiations. We must allow ALZA an opportunity to negotiate in good faith for commercialization rights to our products developed under the agreement prior to granting these rights to a third party. These rights do not apply to products that are subject to ALZA’s option or products for which we have obtained funding or access to a proprietary drug from a third party to whom we have granted commercialization rights prior to the commencement of human clinical trials.

ALZA has the right to terminate the agreement in the event that we breach a material obligation under the agreement and do not cure the breach in a timely manner. In addition, ALZA has the right to terminate the agreement if at any time prior to July 2006, we solicit for employment or hire, without ALZA’s consent, a person who is or within the previous 180 days has been an employee of ALZA in the DUROS technology group.

We do not control ALZA’s ability to develop and commercialize DUROS technology outside of fields licensed to us, and problems encountered by ALZA could result in negative publicity, loss of sales and delays in market acceptance of our DUROS-based pharmaceutical systems

ALZA retains complete rights to the DUROS technology for fields outside the specific fields licensed to us. Accordingly, ALZA may develop and commercialize DUROS-based products or license others to do so, so long as there is no conflict with the rights granted to us. ALZA received FDA approval to market its first DUROS-based product, VIADUR (leuprolide acetate implants) for the palliative treatment of advanced prostate cancer in March 2000. If ALZA or its commercialization partner, Bayer, fails to commercialize this product successfully, or encounters problems associated with this product, negative publicity could be created about all DUROS-based products, which could result in harm to our reputation and cause reduced sales of our product candidates. In addition, if any third-party that may be licensed by ALZA fails to develop and commercialize DUROS-based products successfully, the success of all DUROS-based systems could be impeded, including ours, resulting in delay or loss of revenue or damage to our reputation, any one of which could harm our business.

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We do not own the trademark “DUROS” and any competitive advantage we derive from the name may be impaired by third-party use

ALZA owns the trademark “DUROS.” Because ALZA is also developing and marketing DUROS-based systems, and may license third parties to do so, there may be confusion in the market between ALZA, its potential licensees and us, and this confusion could impair the competitive advantage, if any, we derive from use of the DUROS name. In addition, any actions taken by ALZA or its potential licensees that negatively impact the trademark “DUROS” could negatively impact our reputation and result in reduced sales of our DUROS-based pharmaceutical systems.

Our corporate headquarters, manufacturing facilities and personnel are located in a geographical area that is seismically active

Our corporate headquarters, manufacturing facilities and personnel are located in a geographical area that is known to be seismically active and prone to earthquakes. Should such a natural disaster occur, our ability to conduct our business could be severely restricted, and our business and assets, including the results of our research and development efforts, could be destroyed.

We have broad discretion over the use of our cash and investments, and their investment may not yield a favorable return

Our management has broad discretion over how our cash and investments are used and may invest in ways with which our stockholders may not agree and that do not yield favorable returns.

Executive officers, directors and entities affiliated with them have substantial control over us, which could delay or prevent a change in our corporate control favored by our other stockholders

Our directors, executive officers and principal stockholders, together with their affiliates have substantial control over us. The interests of these stockholders may differ from the interests of other stockholders. As a result, these stockholders, if acting together, would have the ability to exercise control over all corporate actions requiring stockholder approval irrespective of how our other stockholders may vote, including:

• the election of directors;

• the amendment of charter documents;

• the approval of certain mergers and other significant corporate transactions, including a sale of substantially all of our assets; or

• the defeat of any non-negotiated takeover attempt that might otherwise benefit the public stockholders.

Our certificate of incorporation, our bylaws, Delaware law and our stockholder rights plan contain provisions that could discourage another company from acquiring us

Provisions of Delaware law, our certificate of incorporation, bylaws and stockholder rights plan may discourage, delay or prevent a merger or acquisition that stockholders may consider favorable, including transactions in which you might otherwise receive a premium for your shares. These provisions include:

• authorizing the issuance of “blank check” preferred stock without any need for action by stockholders;

• providing for a dividend on our common stock, commonly referred to as a “poison pill”, which can be triggered after a person or group acquires 17.5% or more of common stock;

• providing for a classified board of directors with staggered terms;

• requiring supermajority stockholder voting to effect certain amendments to our certificate of incorporation and by-laws;

• eliminating the ability of stockholders to call special meetings of stockholders;

• prohibiting stockholder action by written consent; and

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• establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted on by stockholders at stockholder meetings.

Legislative actions, potential new accounting pronouncements and higher insurance costs are likely to impact our future financial position or results of operations.

Future changes in financial accounting standards, including proposed changes in accounting for employee stock-based awards, may cause adverse, unexpected fluctuations in the timing of the recognition of revenues or expenses and may affect our financial position or results of operations. New pronouncements and varying interpretations of pronouncements have occurred with frequency and may occur in the future and we may make changes in our accounting policies in the future. Compliance with changing regulation of corporate governance and public disclosure may result in additional expenses. Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations, PCAOB pronouncements and Nasdaq National Market rules, are creating uncertainty for companies such as ours and insurance, accounting and auditing costs are increasing as a result of this uncertainty and other factors. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, we intend to invest all reasonably necessary resources to comply with evolving standards, and this investment may result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities.

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ITEM 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Sensitivity

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio and long-term debt obligations. Fixed rate securities and borrowings may have their fair market value adversely impacted due to fluctuations in interest rates, while floating rate securities may produce less income than expected if interest rates fall and floating rate borrowings may lead to additional interest expense if interest rates increase. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if forced to sell securities which have declined in market value due to changes in interest rates.

Our primary investment objective is to preserve principal while at the same time maximizing yields without significantly increasing risk. Our portfolio includes money markets funds, commercial paper, medium-term notes, corporate notes, government securities, auction rate securities, corporate bonds and market auction preferreds. The diversity of our portfolio helps us to achieve our investment objective. As of June 30, 2004, approximately 62% of our investment portfolio is composed of investments with original maturities of one year or less and approximately 9% of our investment portfolio matures less than 90 days from the date of purchase.

The following table presents the amounts of our cash equivalents and investments that may be subject to interest rate risk and the average interest rates as of June 30, 2004 by year of maturity (dollars in thousands):

	2004			2005			2006			Total
Cash equivalents:
Fixed rate	$	6,396		$	—		$	—		$	6,396
Average fixed rate		0.72	%		—			—			0.72	%
Variable rate	$	964			—			—		$	964
Average variable rate		0.8	%		—			—			0.8	%
Short-term investments:
Fixed rate	$	14,211		$	7,593			—		$	21,804
Average fixed rate		2.83	%		2.66	%		—			2.76	%
Variable rate	$	22,350			—			—		$	22,350
Average variable rate		1.39	%		—			—			1.39	%
Long-term investments:
Fixed rate	$	—		$	6,081		$	13,150		$	19,231
Average fixed rate		—			3.49	%		2.53	%		2.85	%
Restricted investments:
Fixed rate	$	2,782			—			—		$	2,782
Average fixed rate		0.88	%		—			—			0.88	%
Total investment securities	$	46,703		$	13,674		$	13,150		$	73,527
Average rate		1.63	%		3.02	%		2.53	%		2.09	%

ITEM 4. Controls and Procedures

Within 90 days prior to the date of this Quarterly Report on Form 10-Q, we evaluated our “disclosure controls and procedures” and our “internal controls and procedures for financial reporting.” This evaluation was done under the supervision and with the participation of management, including our chief executive officer and our chief financial officer.

(a) Evaluation of disclosure controls and procedures. Disclosure controls are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 (the “Exchange Act”), such as this Quarterly Report on Form 10-Q, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s (“SEC”) rules and forms. Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.

Based on their evaluation, the chief executive officer and the chief financial officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.

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(b) Changes in internal controls. Internal Controls are procedures which are designed with the objective of providing reasonable assurance that (1) our transactions are properly authorized; (2) our assets are safeguarded against unauthorized or improper use; and (3) our transactions are properly recorded and reported, all to permit the preparation of our financial statements in conformity with accounting principles generally accepted in the United States. Among other matters, we evaluated our internal controls to determine whether there were any “significant deficiencies” or “material weaknesses,” and sought to determine whether the Company had identified any acts of fraud involving personnel who have a significant role in the Company’s internal controls. In the professional auditing literature, “significant deficiencies” are referred to as “reportable conditions”; these are control issues that could have a significant adverse effect on the ability to record, process, summarize and report financial data in the financial statements. A “material weakness” is defined in the auditing literature as a particularly serious reportable condition where the internal control does not reduce to a relatively low level the risk that misstatements caused by error or fraud may occur in amounts that would be material in relation to the financial statements and would not be detected within a timely period by employees in the normal course of performing their assigned functions.

In accordance with the requirements of the SEC, since the date of the evaluation of our disclosure controls and our internal controls to the date of this Quaterly Report, our chief executive officer and chief financial officer concluded that there were no significant deficiencies or material weaknesses in our internal controls. In addition, there were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Limitations on the Effectiveness of Controls. Our management, including our chief executive and chief financial officer, does not expect that our disclosure controls or our internal controls will prevent all error and all fraud. A control system can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, control systems may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

PART II—OTHER INFORMATION

ITEM 1. Legal Proceedings

We are not a party to any material legal proceedings.

ITEM 2. Changes in Securities and Use of Proceeds

None

ITEM 3. Defaults Upon Senior Securities

None

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

On June 3, 2004, the Annual Meeting of Stockholders of DURECT Corporation was held at our offices in Cupertino, California.

An election of Class I directors was held with the following individuals being elected to our Board of Directors to serve until our annual meeting of stockholders for the year ending December 31, 2007:

Felix Theeuwes	(43,528,016 votes for, 323,503 votes withheld)
Albert L. Zesiger	(39,349,413 votes for, 4,502,106 votes withheld)

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Other matters voted upon and approved at the meeting and the number of affirmations, negative votes cast and abstentions with respect to each such matter were as follows:

• Ratification of the appointment of Ernst & Young LLP as our independent auditors for the fiscal year ending December 31, 2004 (43,655,652 votes in favor, 147,607 votes opposed, 21,260 votes abstaining).

ITEM 5. Other Information

None

ITEM 6. Exhibits and Reports on Form 8-K

(a) Exhibits:

10.38	Indenture of Lease between the Company and the Board of Trustees of the University of Alabama dated as of May 1, 2004.
10.39*	License and Commercial Agreement between the Company and NeuroSystec Corporation dated as of May 13, 2004.
31.1	Rule 13a-14(a) Section 302 Certification.
31.2	Rule 13a-14(a) Section 302 Certification.
32.1	Certificate pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certificate pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

*Confidential treatment requested with respect to portions of this Exhibit

(b) Durect Corporation filed a report on Form 8-K on April 22, 2004 announcing the Company’s financial results for the three months period ended March 31, 2004.

DURECT Corporation filed a report on Form 8-K on June 21, 2004 announcing an exclusive agreement with NeuroSystec Corporation to develop treatments for certain inner ear disorders including Tinnitus.

DURECT Corporation filed a report on Form 8-K on July 6, 2004 announcing positive clinical results with the Company’s ORADUR^™ sustained release oral gel-cap technology.

Durect Corporation filed a report on Form 8-K on July 21, 2004 announcing the Company’s financial results for the three months period ended June 30, 2004 and an update on its development programs.

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SIGNATURES

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

DURECT CORPORATION
By:	/s/    THOMAS A. SCHRECK
	Thomas A. Schreck
	Chief Financial Officer (Principal Financial Officer)

Date: August 4, 2004

By:	/s/    JIAN LI
	Jian Li
	Vice President, Finance and Corporate Controller

Date: August 4, 2004

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EX-10.38

Exhibit 10.38

LEASE AGREEMENT

THIS INDENTURE OF LEASE (hereinafter referred to as the “Lease”), made and entered into this     1^st     day of May, 2004, is by and between THE BOARD OF TRUSTEES OF THE UNIVERSITY OF ALABAMA, a body corporate for its division the University of Alabama at Birmingham (hereinafter referred to as “LANDLORD” ) and _Durect Corporation (hereafter referred to as “TENANT”).

WHEREAS, the LANDLORD is participating in a program of The Office for the Advancement of Developing Industries sponsored by the University of Alabama at Birmingham whereby financial assistance is provided to developing industries in advanced technology; and

WHEREAS, as part of the Program, LANDLORD is leasing commercial rental property to such developing industries at below market rates and is providing such developing industries with administrative services and management support; and

WHEREAS, developing industries participating in the Program will become candidates for “graduation” from the Program upon their achievement of any of one of the benchmarks for graduation set forth herein; and

WHEREAS, as a participant in the above described program, the LANDLORD desires to lease to TENANT certain space in a 66,840 square foot facility located at 2800 Milan Court, Birmingham, Alabama and known as the “OADI Technology Center”; and

WHEREAS, the TENANT desires to lease certain space in the above described building on the terms and conditions set forth herein;

NOW THEREFORE, for the consideration hereinafter set forth, the parties do hereby agree as follows:

PREMISES

1. The LANDLORD hereby leases unto TENANT the following described premises (hereinafter called “Premises”), identified as Suite(s) 131 and 259 located on the 1st and 2rd floor of the OADI Technology Center (hereinafter called “Building”). Attached hereto as a part hereof is a building floor plan of the Premises marked “Exhibit A,” which has been approved by LANDLORD and TENANT. LANDLORD agrees to provide for TENANT the space, arrangement, and facilities shown and specified in “Exhibit A,” but LANDLORD reserves the right at any time to make alterations or additions to, and to build additional stories on the Building and to build adjoining the same.

RENT

2. TENANT shall pay monthly rent to LANDLORD in accordance with the following rent schedule:

LEASE YEAR	SUITE		TOTAL RENT MONTH/ANNUAL
1st	131*		$	950.00 /$ 11,400.00
	259 **		$	1,400.00 /$ 16,800.00
		TOTAL	$	2,350.00 /$ 28,200.00

*  = Office Space

**  = Laboratory Space

(A) Rent due hereunder shall be payable in advance on or before the fifth (5th) day of each month during the term hereof to the following address:

The OADI Technology Center

UAB Research Park at Oxmoor

2800 Milan Court # 100

Birmingham, Alabama 35211

or at such other place as LANDLORD may in writing designate from time to time, without any prior demand therefore, and without any deduction or setoff whatsoever. All rent checks shall be made payable to The OADI Technology Center. TENANT agrees that a service and bookkeeping charge equal to eight percent (8%) of the monthly rental payment shall become due and payable each and every month that the rent has not been received in the office of the LANDLORD by the TENTH (10th) day of the month.

(B) If the term commences other than on the first day of a calendar month, then TENANT shall pay pro-rata rent, in advance, for the period from such commencement date to the first day of the next following calendar month. Rent for such period shall be determined by multiplying the monthly rent under the preceding paragraph by a fraction, the numerator of which shall be the number of days in such period, the denominator of which shall be the number of days in such calendar month. TENANT shall also pay the rent as otherwise provided in this Lease.

(C) If this Lease is executed before the Premises herein become ready for occupancy and LANDLORD cannot acquire and/or deliver possession of the herein Leased Premises by the time the Term of this Lease is fixed herein to begin, TENANT waives the payment of any rental until LANDLORD delivers possession to TENANT.

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(D) In addition to the above monthly rent, TENANT shall pay to LANDLORD the sums set forth in the TENANT MANUAL for any receptionist, telephone, photocopy, mail, etc., services, if any, used by TENANT in the operation of its business at the Premises. With the exception of the minimum plan for receptionist charges, no such charge shall be due unless TENANT elects to use the services offered by LANDLORD as listed in the TENANT MANUAL. Failure by TENANT to pay for any services used by TENANT shall constitute an Event of Default hereunder, and shall entitle LANDLORD to exercise all rights and remedies provided to it hereunder.

TERM

3. The term of this Lease shall be for a period commencing on May 1, 2004 with respect to Suite 259 and July 1, 2004 with respect to Suite 131 (the “Commencement Date”), and ending on April 30, 2005 (the “Termination Date”);

Provided that (i) TENANT is not then in default under this Lease, and (ii) TENANT has not given LANDLORD ninety (90) days prior written notice of its election to terminate this Lease. Any extensions beyond these periods will be negotiated at the discretion of the LANDLORD. TENANT may terminate this Lease at its discretion upon ninety (90) days prior written notice to the LANDLORD.

4. [INTENTIONALLY OMITTED]

TENANT PROGRESS MEETINGS

5. As a public company, TENANT files quarterly (Form 10-Q) and annual (Form 10-K) filings with the Securities and Exchange Commission. On a quarterly basis, TENANT will send to LANDLORD by e-mail TENANT’s press release summarizing TENANT’s financial results of operations for each calendar quarter and fiscal year promptly after such results are publicly available. If after review of these, LANDLORD has additional questions or concerns, LANDLORD shall notify TENANT and the parties shall discuss in good faith LANDLORD’s questions and concerns.

SERVICES

6. (A) Between the hours of 7:00 A.M. and 6:00 P.M., Monday through Sunday (exclusive of holidays), LANDLORD agrees to furnish to the Premises hot and cold water at points of supply provided for general use, heated and refrigerated air conditioning in season at reasonable temperatures and in reasonable amounts, and electrical, and elevator services in the manner and to the extent deemed standard by LANDLORD. LANDLORD reserves the right to furnish all such facilities and services, at its option, on such holidays as LANDLORD chooses. LANDLORD agrees to provide janitorial service Monday through Friday (exclusive of legal holidays).

(B) If TENANT desires to have installed in the Premises any special facilities or equipment requiring other than normal electric service for ordinary lighting and minor electric appliances such as

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typewriters, small business and accounting machines, and other than the normal and regular service mentioned in Paragraph (A) LANDLORD will, if reasonably possible, furnish such additional special facilities or equipment provided that TENANT will pay LANDLORD in advance for the cost of providing and installing any additional wiring, equipment, meters and safety devices, and the cost of any repairs, alternations, additions to, and refinishing of the Premises or Building so necessitated, and provided TENANT shall pay all additional utility charges incurred by use of said special facilities or equipment.

(C) LANDLORD shall not be liable to TENANT in damages or otherwise for failure to perform any of the covenants on its part under this paragraph 6, nor shall temporary stoppages, temporary failures or interruptions of any of the services to be supplied by LANDLORD unto TENANT under this paragraph be construed as an eviction of TENANT, work an abatement of rent, or relieve TENANT from any covenant or agreement, but LANDLORD agrees diligently to restore any services obliged to be provided by it hereunder when temporary failures, stoppages, or interruptions occur.

SECURITY

7. LANDLORD agrees to provide such security as LANDLORD deems necessary or desirable, but LANDLORD shall in no event be liable for any theft or other loss of property occurring in or about the Premises or Building.

ADDITIONAL EXPENDITURES

8. TENANT agrees to pay to LANDLORD as additional rent all sums provided for in this Lease at the times and in the manner provided. If LANDLORD shall make any expenditure for which TENANT is responsible or which TENANT should make, then, at LANDLORD’S election, the amount thereof may be added to the installment of rent next falling due or constitute any item of account payable on demand.

GOOD ORDER AND REPAIR

9. TENANT agrees to take good care, as determined by the LANDLORD, of the Premises and not to allow or commit any waste with respect to the Premises or Building. Upon termination of this Lease, by lapse of time or otherwise, TENANT will surrender the Premises to LANDLORD in as good condition as at the date of initial possession hereunder by TENANT, ordinary wear and tear and damage by unavoidable casualty excepted. Any damage to the Premises or Building resulting from acts or neglect of TENANT or TENANT’S agents, employees, patrons, or invitees, shall be repaired or replaced at TENANT’S expense. The Premises shall not be altered, changed, nor any additions or improvements made, without the prior written consent of LANDLORD and unless otherwise provided in writing, all work shall be done by or under the direction of LANDLORD at TENANT’S expense, and any alterations, physical additions or improvements, except movable office furniture, shall at once become the property of LANDLORD upon termination of this Lease.

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ASSIGNMENT

10. TENANT shall not, without the express prior written consent of LANDLORD, assign, mortgage, or otherwise encumber or transfer this Lease, or sublease, or permit any other person to use or occupy, all or any part of the Premises. The parties expressly agree that: (a) LANDLORD’S consent may be withheld for any reason whatsoever and regardless of whether such withholding is contrary to any prevailing commercial standards; and (b) LANDLORD’S decision regarding such consent shall be binding on the parties, regardless of the reason or basis of the decision. If the TENANT desires to assign or encumber this Lease or sublet the Premises or any part thereof, the TENANT will give the LANDLORD written notice of such desire specifying the name of the proposed assignee, mortgagee, or sublessee and all of the terms of the proposed assignment, mortgage, or sublease at least sixty (60) days prior to the date such assignment, encumbrance, or sublease is proposed to be effective. The LANDLORD will have the option for a period of thirty (30) days after receipt of such notice to: (a) terminate this Lease as of the date specified by the TENANT as to the portion of the Premises affected; or (b) permit the TENANT to assign, encumber, or sublet such portion of the Premises; or (c) refuse to consent to the proposed assignment, encumbrance, or subletting and continue this Lease in effect as to the entire Premises. The failure by the LANDLORD to exercise any of the foregoing options within the time provided will be deemed an exercise of option (c) above. Notwithstanding any consent granted by the LANDLORD, the TENANT, and each assignee, mortgagee, and sublessee will at all times remain fully liable for the payment of Rent and for the performance of the TENANT’S obligations hereunder. No consent granted by the LANDLORD will constitute a waiver of the provisions of this Lease except as to the specific instance covered thereby. In the event LANDLORD consents to such assignment, sublease, or other transfer of all or any portion of this Lease, TENANT shall remit to LANDLORD that portion of any payment TENANT receives from its sub-lessee, assignees, etc., which exceeds the rent due and payable as is set forth in Paragraph 3 herein or any amendments hereto.

COMPLIANCE

11. TENANT agrees to maintain the Premises in a clean, orderly, healthful condition and to comply with all laws, ordinances, rules, and regulations of all governmental agencies having jurisdiction over the Premises. TENANT will not use, occupy, or permit the use or occupancy of the Premises for any unlawful, disreputable, or hazardous purpose, maintain or permit the maintenance of any public or private nuisance, or do or permit any act or thing that may disturb the quiet enjoyment of any other tenant of the Building, or permit anything to be done that would increase the fire insurance rate on Building or its contents.

RIGHT OF ENTRY

12. TENANT agrees that LANDLORD’S representatives shall have the right to enter all parts of the Premises at all reasonable hours to inspect, test, clean, make repairs, alterations, and additions to the Building or the Premises that it may deem necessary or desirable or to provide

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any service which it is obligated to furnish tenants of the Building; provided, however, that this paragraph shall be inoperative in the event that any federal or state law or regulation prohibits public access to the Premises without security clearance from such federal or state agencies.

SURRENDER OF PREMISES

13. At the expiration of the tenancy hereby created, TENANT shall surrender the Premises in the same condition as the Premises were in upon delivery of possession thereto under this Lease, reasonable wear and tear excepted and damage by unavoidable casualty excepted, and shall surrender all keys for the Premises to LANDLORD at the place then fixed for the payment of rent and shall inform LANDLORD of all combinations on locks, safes, and vaults, if any, in the Premises. TENANT shall remove all its trade fixtures and any alterations or improvements which LANDLORD requests to be removed before surrendering the Premises as aforesaid and shall repair any damage to the Premises caused thereby. TENANT’S obligation to observe or perform this covenant shall survive the expiration or other termination of the term of this Lease.

INDEMNITY OF LANDLORD

14. By taking possession of the Premises, the TENANT will be deemed to have accepted the Premises as suitable for the purposes for which the same are leased, to have accepted the Building, and, except for any matters specified in writing to the LANDLORD, TENANT agrees to indemnify and hold LANDLORD harmless from and against any and all liability, claims, demands, loss, or damage for injury to, or death of, any person or persons or damage to property in any way arising from or in connection with the occupancy or use by tenant of the Premises or any part thereof or occasioned wholly or in part by any act of omission of TENANT, its agents, employees, or invitees. TENANT further agrees to indemnify and hold LANDLORD harmless from all fines, suits, claims, demands, and actions resulting from any breach, violation, or nonperformance of any covenant or condition hereof by TENANT or TENANT’S agents, employees, or invitees.

TAKING BY EMINENT DOMAIN

15. (A) Entire Premises

If the whole of the Premises hereby leased shall be taken by any authority under the power of eminent domain, then this Lease shall terminate as of the day possession shall be taken by such authority, and all rent shall be paid up to that date, with a proportionate refund by LANDLORD of such rent as may have been paid in advance.

(B) Partial Taking of Premises

If less than 20 percent of the floor area of the Premises be so taken by eminent domain, then this Lease shall terminate only as to the part so taken from the day possession shall be taken by such authority, and all rent shall be paid up to that day and thereafter the rent due hereunder shall be adjusted accordingly.

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(C) Substantial Taking of Premises

If more than 20 percent, but not all, of the floor area of the Premises be so taken, then this Lease shall terminate only as to the part so taken from the day possession shall be taken by such authority, and all rent shall be paid up to that day; provided, however, that TENANT and LANDLORD shall each have the right to terminate this Lease by giving written notice thereof within ten (10) days from the date such possession is taken by said authority. In the event TENANT elects to remain in possession, and LANDLORD does not so terminate, all of the terms herein provided shall continue in effect except that the fixed minimum rent shall be adjusted proportionately.

(D) Substantial Taking of Building

If more than 50 percent of the floor area of the Building be taken under the power of eminent domain, whether or not the Premises or any part thereof be taken, LANDLORD may, by notice in writing to TENANT delivered within thirty (30) days after the day of surrendering possession to the authority, terminate this Lease, and rent shall be paid or refunded, as of the date of termination.

(E) Damages

All damages awarded for such taking under the power of eminent domain, whether for the whole or a part of the Premises, shall be the property of LANDLORD, including but not limited to such damages as shall be awarded as compensation for diminution in value of the leasehold and to the fee of the Premises; provided, however, that LANDLORD shall not be entitled to any award made to TENANT for loss of business, depreciation to and cost of removal of stock and fixtures. The term “eminent domain” shall include the exercise of any similar governmental power and any purchase or other disposition in lieu of, or under threat of, condemnation.

PROPERTY DAMAGE

16. LANDLORD shall not be liable to TENANT for any loss or damage to any person or property, including the person and property of TENANT occasioned by theft, the acts of any co-tenant, casualty, rain, water, condensation, fire, acts of God, public enemy, injunction, riot, strike, picketing, mob action, bombing, explosion, war, court order, latent defects, requisition or order of governmental authority, the construction, repair, maintenance or alteration of any part of the Premises or Building as a whole; all personal and business property in the Leased Premises shall be and remain at TENANT’s personal risk, and LANDLORD shall not be liable for any damages to nor loss of such personal or business property arising from acts of negligence of any other persons; not from the leaking of the roof, nor from the bursting, leaking, or overflowing of water, sewer, or steam pipes, nor from the heating or plumbing fixtures; nor from electric wires for fixtures; nor from any other cause whatsoever.

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PERFORMANCE

17. Anything in this Lease to the contrary notwithstanding, LANDLORD shall not be deemed in default with respect to the performance of any of the terms, covenants, and conditions of this Lease to be performed by it. If any failure of its performance shall be due to any strike, lockout, civil commotion, war, war-like operation, invasion, rebellion, hostilities, military or usurped power, sabotage, governmental regulations or controls, inability to obtain any material or service, act of God, or any other cause whatever (including failure of TENANT to supply necessary data or instructions) beyond the reasonable control of LANDLORD, or inability of LANDLORD to obtain financing satisfactory to LANDLORD, the time for performance by LANDLORD shall be extended by the period of delay resulting from or due to any of said causes.

OCCUPANCY OF PREMISES

18. (A) Premises Rendered Wholly Unfit for Occupancy

In the event the Premises shall be destroyed or so damaged by fire, explosion, earthquake, or any other cause so as to become wholly unfit for occupancy, then the LANDLORD may, if it so elects, rebuild and put the Premises in good condition and fit for occupancy within a reasonable time after such Premises have become wholly unfit for occupancy, or it may give notice in writing to TENANT terminating this Lease. If LANDLORD elects to repair or rebuild the Premises, it shall give the TENANT notice thereof within thirty (30) days after such injury or damage of its intention to repair or rebuild, and then LANDLORD shall proceed with reasonable speed to repair or rebuild the Premises. TENANT shall not be obligated to pay any rent from the time that such Premises were rendered wholly unfit for occupancy until such Premises are again fit and ready for occupancy.

(B) Premises Rendered Partially Unfit for Occupancy

In the event the Premises shall be destroyed or so damaged by fire, explosion, earthquake, or any other cause so as to become partially unfit for occupancy, LANDLORD shall forthwith cause the same to be repaired as soon as is reasonably possible and, only while such damage is being repaired, TENANT shall be entitled to a proportionate abatement of the monthly rent.

(C) Building Rendered Totally or Partially Unfit for Occupancy

In the event that the Building in which the Premises are situated is destroyed or damaged from any cause to the extent (in LANDLORD’S sole judgment) of one-third or more of the replacement cost of such Building, LANDLORD shall have an option to terminate this Lease, whether the Premises be damaged or not; such option to be exercised within thirty (30) days after such occurrence so damaging the Building. Anything in this Lease to the contrary notwithstanding, a total or substantially total destruction of the Building shall terminate this Lease.

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(D) General

LANDLORD shall not be liable or responsible to TENANT for any inconvenience or loss due to making repairs or reconstruction as aforesaid nor for any delays in repairing or rebuilding due to strikes, acts of God, governmental regulations, or any other causes beyond its control. Nothing herein shall be deemed to waive or relieve TENANT from any liability for any loss or damage to LANDLORD, or LANDLORD’S property due to negligence or willful acts of TENANT, its agents, servants, employees, or invitees; provided, however, if LANDLORD’S fire and extended coverage insurance policy permits, without penalty, the release of others from liability for loss from insured casualties, such release from liability is hereby granted to the extent that LANDLORD actually recovers for loss under such policy.

HOLDING OVER

19. If the TENANT continues to occupy the Leased Premises after the expiration or other termination of the Lease Term, such holding over will, unless otherwise agreed by the LANDLORD in writing, constitute a tenancy at will at a daily rental equal to one-thirtieth (1/30th) of an amount of equal to twice the amount of the rent payable during the last month prior to the termination of this Lease subject to all of the other provisions set forth herein.

DEFAULT PROVISIONS

20. (A) The happenings of any one or more of the following events shall constitute a default hereunder: (i) TENANT’S failure to pay any one or more said installments of rent hereunder as and when the same becomes due; (ii) at LANDLORD’S option, TENANT’S failure to pay the rent due hereunder within ten (10) days of the due date therefore for two consecutive months; (iii) TENANT’S filing of a petition in bankruptcy or a petition under the Bankruptcy Act, or any amendment thereto by or against TENANT, or TENANT being adjudged a bankrupt; (iv) TENANT’S making an assignment for the benefit of creditors; (v) the appointment of a receiver of TENANT’S property; (vi) TENANT’S vacation of the Premises or abandonment of the possession thereof, or use of the same for purposes other than that for which the same are hereby let, or failure to use the Premises for the purposes herein specified; or (vii) TENANT’S violation of any of the other terms, conditions or covenants on the part of TENANT herein contained.

(B) Upon the happening of any of the above defaults, LANDLORD may, as LANDLORD deems appropriate: (i) annul and terminate this Lease, and thereupon re-enter and take possession of the Premises; or (ii) re-enter and re-let the Premises from time to time as agents of TENANT, and such re-entry and/or re-letting shall not discharge TENANT from any liability or obligations hereunder, except that net rents (that is, gross rents less the expense of collecting and handling, and less commissions) collected as a result of such re-letting shall be a credit on TENANT’S liability for rents under the terms of this Lease; (iii) perform or cause to be performed the obligations of the TENANT under this Lease and enter the Premises to accomplish such purpose without being liable for prosecution therefor...or (iv) terminate this Lease and demand that tenant vacate the premises occupied. In the event LANDLORD opts to perform the obligations of the TENANT, TENANT hereby agrees to reimburse the LANDLORD

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on demand for any expense which the LANDLORD might incur in effecting compliance with this Lease on behalf of the TENANT, and the TENANT further agrees the LANDLORD will not be liable for any damage resulting to the TENANT from such action, whether caused by the negligence of the LANDLORD or otherwise. Nothing herein, however, shall be construed to require LANDLORD to re-enter, re-let, or perform the TENANT’S obligations. Nor shall anything herein be construed to postpone the right of LANDLORD to sue for rents, whether matured by acceleration or otherwise, but on the contrary, LANDLORD is hereby given the right to demand, collect, and/or sue therefor at any time after default.

(C) Upon default, or upon the termination of this Lease or re-entry upon the Premises for any one or more of the causes set forth above, or upon any termination of this Lease or re-entry upon the Premises, the rents hereunder for the remainder of the entire rental period, and all other indebtedness, if any, payable under the provisions hereof, shall be and become immediately due and payable at the option of LANDLORD and without regard for whether or not possession of the Premises shall have been surrendered to or taken by LANDLORD; provided, however, no default on account of payment for rent shall occur until such rent is ten (10) days in arrears, and no default for other cause shall occur until the expiration of a period of thirty (30) days after written notice to TENANT of any breach of any other covenant hereof without correction of such breach.

(D) In the event of employment of an attorney by LANDLORD for collection of any amount due hereunder or for the institution of any suit for possession of the Premises, or for advice or services incident to the breach of any other covenant of this Lease by TENANT or on account of bankruptcy proceedings by or against TENANT or on account of bankruptcy proceedings by or against TENANT, or the leasehold interest of TENANT, TENANT agrees to pay and shall be taxed with a reasonable attorney’s fee which shall be a part of the debt evidenced and secured by this Lease. In order further to secure the prompt payment of said rents when the same mature, and the faithful performance by TENANT of all and singular the terms, conditions, and covenants on the part of TENANT herein contained and all damages and costs that LANDLORD may sustain by reason of the violation of said terms, conditions, and covenants, or any of them, TENANT does hereby waive any and all right to claim personal property as exempt from levy and sale under the Constitution and Laws of the State of Alabama or any other State.

SECURITY DEPOSIT

21. LANDLORD and TENANT agree that TENANT will deposit with LANDLORD the sum of $ 4,800.00(an amount equal to two months rent plus $100 telephone deposit) on the Commencement Date, to be held, without interest, as security for the payment of rent and any and all other sums of money for which TENANT shall or may become liable to LANDLORD under this Lease, and for the faithful performance by TENANT of all other covenants and agreements under this Lease. The foregoing deposit shall be returned to TENANT after the termination of this Lease and any renewal hereof, provided TENANT shall have made all such payments and performed all such covenants and agreements. Nothing in this paragraph shall be deemed to limit the amount of any claim, demand, or cause of action of LANDLORD against TENANT under the provisions of this Lease.

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REMEDIES

22. TENANT agrees that all remedies herein given LANDLORD, including all those not set forth but provided by law shall be cumulative, and the exercise of one or more of any such remedies by LANDLORD shall not exclude the exercise of any other lawful remedy nor shall any waiver by LANDLORD, express or implied, of any breach of any term, covenant, or condition hereof be deemed a waiver of any subsequent breach of the same or any other term, covenant, or condition hereof. Acceptance of rental by LANDLORD from TENANT or any assignee, sub-tenant, or other successor in interest to TENANT, with or without notice shall never be construed as a waiver of any breach of any term, condition, or covenant of this Lease. Failure of LANDLORD to declare any default upon occurrence thereof, or delay in taking action with respect thereto, shall not waive such default, but LANDLORD shall have the right to declare such default at any time and take such action as may be authorized hereunder, in law or equity, or otherwise. TENANT agrees to pay all costs and expenses that may be incurred in connection with the enforcement of any of the provisions of this Lease.

SIGNS

23. TENANT agrees not to install or paint any signs, name plates, symbols, pictures, or any other paintings or hangings within or outside the Premises or the Building without the prior written consent of the LANDLORD.

PARKING PROVISIONS

24. (A) All parking facilities provided by LANDLORD shall be under the control of LANDLORD, and TENANT agrees that TENANT, its agents, employees, and invitees shall conform to such written parking regulations, conditions, and provisions as may be from time to time prescribed by LANDLORD.

(B) Parking area is not to be used by TENANT at any time as a storage area for any merchandise, goods, equipment, or any other item.

(C) TENANT shall not make any use of the Premises which will in any manner overburden the parking which is available to the Building in which the Premises are located.

(D) LANDLORD reserves the right to decrease or otherwise alter, in any manner which LANDLORD deems appropriate, the parking areas at any time without notice to TENANT.

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TRANSFER OF OWNERSHIP

25. LANDLORD shall have the right to sell, assign, or transfer, in whole or in part, all of its rights and/or obligations hereunder or in the Building and/or Premises. Such sale, assignment, or transfer may be made to a corporation, trust, trust company, individual, or group of individuals, and howsoever made shall be binding on TENANT in all respects and recognized by TENANT. In the event LANDLORD transfers LANDLORD’S interest in the Building and/or Premises, LANDLORD will thereby be released from any further obligation of any kind whatsoever hereunder and the TENANT agrees to attorn to and look solely to the transferee for the performance of such obligations. TENANT agrees to execute and deliver to the designee of the LANDLORD from time to time within ten (10) days after written request therefor all instruments that might be required by the LANDLORD to confirm such attornment.

NOTICE

26. Notices provided for in this Lease shall be sufficiently given if sent by registered mail, return receipt requested, postage prepaid, and addressed to such address as the parties may designate to each other in writing from time to time.

SUBORDINATION

27. At the option of LANDLORD, this Lease may be subordinated to the lien of any mortgage or mortgages, or the lien resulting from any other method of financing or refinancing, now or hereafter in force against the land and/or Building of which the Premises are a part and to all advances heretofore made or hereafter to be made upon the security thereof. The TENANT agrees to execute and deliver to the LANDLORD from time to time within ten (10) days after written request by the LANDLORD, all instruments that might be required by the LANDLORD to confirm such subordination.

PURPOSE

28. TENANT’S operation in this location is for the purpose of pharmaceutical research and development and TENANT shall use said Premises therefore and for no other purpose.

TITLES

29. The titles and headings in this Lease are used only to facilitate reference, and in no way to define or limit the scope or intent of any of the provisions of this Lease.

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ENTIRE CONTRACT

30. This Lease constitutes the entire contract between the parties hereto with respect to the Premises and this Lease covers, merges, and includes all agreements, oral or written, between the parties hereto and made in connection herewith, whether the same be made prior to, or contemporaneously with the execution hereof. This Lease cannot be modified or changed by any verbal statement, promise, or agreement by whomsoever made, and no modification, change, or amendment shall be binding on the parties unless it shall have been agreed to in writing. No surrender of the Demised Premises or of the remainder of the Term under this Lease shall be valid unless accepted by LANDLORD in writing.

LEGAL EFFECT

31. In the event any provision of this Lease is found by a court of competent jurisdiction to be contrary to law or void as against public policy or otherwise, such provision shall be either modified to conform to law or considered severable, with the remaining provisions hereof continuing in full force and effect.

BINDING EFFECT

32. This Agreement and all covenants, obligations, and conditions hereof shall inure to the benefit of and shall be binding upon LANDLORD, and LANDLORD’s successors and assigns. This Agreement and all its covenants, obligations, and conditions hereof also shall inure to the benefit of and be binding upon TENANT and TENANT’s heirs, executors, administrators, successors, and assigns, except that TENANT shall have no right to assign or sublet the Leased Premises or any part thereof without the prior written consent of LANDLORD.

IMPROVEMENTS

33. Upon TENANT’S reasonable request, the LANDLORD will install in the Premises, at TENANT’S cost and expense, additional divisional partitioning with wall, ceiling, and floor surface treatments and finishes, electrical and telephone outlets and other facilities, or will remove or replace existing walls or petitions. Any and all other alterations, changes, additions, and improvements, if consented to by LANDLORD, including, but not limited to

(1) All partitioning or shelving required by TENANT, other than LANDLORD’S standard partitioning and shelving,

(2) Any special decorative millwork treatment,

(3) Any special floor coverings,

(4) Any special decorative paint or other wall or surface treatments,

(5) Any private laboratory, private shower or private plumbing and fixtures,

(6) Any abnormal quantity of electrical or telephone outlets

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shall be made by the LANDLORD at TENANT’S cost and expense and the same shall immediately be and become part of the realty without any payment therefor by LANDLORD. Upon completion of such work, TENANT shall immediately pay the LANDLORD the full amount of such charges.

CERTIFICATE

34. TENANT agrees to deliver a certificate to any proposed mortgagee or purchaser or the LANDLORD certifying (if such be the case) that this Lease is in full force and effect, that there are no defenses or offsets hereto, or stating those claimed by TENANT, and also stating any other pertinent information required by the LANDLORD or the LANDLORD’S lender.

POWER OF SALE

35. TENANT shall, in the event any proceedings are brought for the foreclosure of, or in the event of exercise of the power of sale under any mortgage made by the LANDLORD covering the Premises, attorn to the purchaser upon any such foreclosure or sale and recognize such purchaser as the LANDLORD under this Lease.

QUIET ENJOYMENT

36. Upon payment by TENANT of the rents provided, and upon the observance and performance of all the covenants, terms, and conditions on TENANT’S part to be observed and performed, TENANT shall peaceably and quietly hold and enjoy the Premises for the term hereby demised without hindrance or interruption by LANDLORD or any other person or persons lawfully or equitably claiming by, through, or under LANDLORD; subject, nevertheless, to the terms and conditions of this Lease.

FULL PAYMENT

37. No payment by TENANT or receipt by LANDLORD of a lesser amount than the monthly rent herein stipulated shall be deemed to be other than on account of the earliest stipulated rent, nor shall any endorsement or statement on any check or any letter accompanying any check or payment as rent be deemed an accord and satisfaction, and LANDLORD may accept such check or payment without prejudice to LANDLORD’S right to recover the balance of such rent or pursue any other remedy provided in this Lease.

MUTUAL AGREEMENT

38. It is expressly understood and agreed that this Lease and the covenants contained herein are for the sole benefit of LANDLORD and TENANT, their successors and assigns, and that all rights of action for any breach or any covenant herein contained are reserved to such parties. It is further expressly understood and agreed that such parties may by mutual agreement alter, amend, modify, or revoke or rescind this Lease or any covenant herein contained in writing and at any time.

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EXPIRATION OF LEASE

39. During the period of six (6) months prior to the expiration of this Lease or any renewal thereof, LANDLORD shall have the right to display on the exterior of the Premises, but not in any window or doorway thereof, the customary sign “For Rent,” and during such period LANDLORD may show the Premises and all parts thereof to prospective lessees between the hours of 10:00 a.m. and 5:00 p.m. on any day.

RECORDATION

40. TENANT shall not record this Lease without the written consent of LANDLORD; however, upon the request of either party hereto, the other party shall join in the execution of a “short form” of this Lease for the purposes of recordation. The short form of this Lease shall describe the parties, the Premises and the term of this Lease and shall incorporate this Lease by reference. TENANT shall record this Lease or said short form at the request of LANDLORD, and shall pay the cost of recording same.

INSURANCE

41. TENANT will maintain at the TENANT’S expense throughout the Lease Term a policy or policies of insurance insuring the TENANT and the LANDLORD against: (a) loss or damage by fire, explosion, or other casualty covering the TENANT’S property located in the Leased Premises for the full insurable value thereof; and (b) all liability for injury to or death of any person occasioned by or arising out of or in connection with the occupancy of the Leased Premises. The limits of such policy or policies shall be in an amount not less than $1,000,000 per occurrence and $2,000,000 annual aggregate. The TENANT will furnish evidence satisfactory to the LANDLORD of the maintenance of such insurance and will obtain a written obligation on the part of each insurance company to notify the LANDLORD at least ten (10) days prior to cancellation of such insurance. The TENANT hereby waives any cause of action that the TENANT might now or hereafter have against the LANDLORD on account of any loss or damage that is insured against under any insurance policy that names the TENANT as an additional insured.

LIABILITY FOR LOSSES

42. Neither LANDLORD nor TENANT shall be liable to the other for any loss or damage from risks ordinarily insured against under fire insurance policies with extended-coverage endorsements, irrespective of whether such loss or damage results from their negligence or that of any of their agents, servants, employees, licensees, or contractors to the extent that such losses are covered by valid and collectable insurance on the property at the time of loss.

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COMPLIANCE WITH AUTHORITIES

43. TENANT shall promptly comply with all statutes, ordinances, rules, orders, regulations, and requirements of the federal, state, county, and city governments, and of any and all their departments and bureaus, applicable to said Premises and shall also promptly comply with all rules, orders, and regulations of the Fire Underwriters’ Association for the Prevention of Fires at TENANT’s own cost and expense. TENANT agrees to pay any increase in the amount of insurance premiums over and above the rate now in force that may be caused by TENANT’s use or occupancy of the Premises. Said payments shall be in addition to any amounts due LANDLORD.

TENANT understands that LANDLORD and LANDLORD’S property is subject to the Americans with Disabilities Act (ADA). TENANT specifically agrees to comply with, and to pay all costs of compliance with, laws, regulations and any ordinances that may apply to TENANT’S business or locations, including, but not limited to, the ADA requirements as it may relate to the Premises. The TENANT will hold harmless and protect the LANDLORD in the event the TENANT is found to be in violation of its obligation to comply with the ADA.

ATTORNEY’S FEES

44. TENANT agrees to pay all attorneys’ fees, court costs, and expenses that LANDLORD incurs in enforcing any of the obligations of the TENANT under this Lease, or in any litigation or negotiation in which the LANDLORD shall become involved through or on account of the Lease.

HOLD HARMLESS

45. TENANT shall be liable for and shall hold LANDLORD harmless in respect of damage or injury to the Leased Premises, or the person or property of the TENANT, or the person or property of LANDLORD’s other tenants, or anyone else, if due to the act or neglect of TENANT or anyone in his control or employ. TENANT shall at once report in writing to LANDLORD any defective condition known to him which LANDLORD is required to repair and failure to so report shall make TENANT responsible for damages resulting from such defective conditions. All personal property upon the Premises shall be at the risk of the TENANT only, and LANDLORD shall not be liable for any damage thereto or theft thereof.

RULES AND REGULATIONS

46. The present rules and regulations in regard to the Building are attached hereto and made a part hereof as though fully set out herein. LANDLORD reserves the right to change these rules and regulations. Notice of changes in the rules and regulations shall be given to the Tenant in written form. The TENANT shall faithfully observe and perform such rules and regulations, as modified or supplemented from time to time by the LANDLORD, and the TENANT shall further be responsible for the compliance with such rules and regulations by the TENANT’s employees, its invitees, agents, servants, or visitors.

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TIME

47. With respect to all obligations of TENANT as set forth in this Lease, time is of the essence.

STORAGE OF RADIOACTIVE MATERIAL

48. Tenant will carefully designate specific locations for the storage of Radioactive Material. These designated areas must be positioned away from the more traveled areas of the laboratory. These areas must be approved by the UAB Radiation Safety Division prior to the storage of Radioactive Material. When the storage area is located inside a laboratory or office suite, it must have adequate shielding to ensure that the radiation exposure rate at one foot from the surface of the storage area does not exceed 0.5 mR/hour. No Radioactive Material may be stored in common or public areas of the building.

Storage areas must be kept locked at all times, except for when in use. Radioactive Material that is volatile or powdery or that might be emitted into the air must be kept in a fume hood. All storage areas must be labeled with the conventional radiation symbol and must bear the words “Caution Radioactive Material” or “Danger Radioactive Material.” All storage containers must be labeled with a standard radiation symbol and the identity, quantity, and assay date of the radioisotope must be on the container.

No Radioactive Material will be allowed to be stored in any hallway, not even temporarily awaiting decontaminated radioactive waste removal. Decontaminating radioactive waste must be properly stored in the laboratory or other designated site location away from the more heavily traveled areas. Proper shielding must be maintained for decontaminating radioactive waste. An inventory must be taken quarterly by the Tenant for all sealed sources that are in storage and are either being used or have not been used in six months.

All of Tenant’s employees must be provided with and wear Radiation I.D. Badges. The badges must be worn at all times while on the premises.

Tenant agrees to freely submit to inspections conducted by the UAB Department of Occupational Health and Safety. Tenant further agrees to abide by all State, Federal, and UAB Radiation Safety Committee guidelines regarding the handling and storage of Radioactive Material. The terms and conditions of Paragraph 48 are subject to the approval and changes as designated by the UAB Department of Occupational Health and Safety.

STORAGE OF HAZARDOUS MATERIAL

49. No prolonged storage of Hazardous Material is allowed in the building at any time. Tenant may accumulate no more than twenty (20) gallons of liquid Hazardous Material at any given time. The allowable limit of twenty (20) gallons must be kept in four (4) separate five gallon containers. All Hazardous Material must be kept in a fireproof storage container at all times. This storage container

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must remain locked at all times except for when in use. Upon reaching the allowable limit of twenty (20) gallons, Tenant agrees to have a licensed hazardous waste carrier promptly remove the waste from the building. All related documents, certificates of insurance, and shipment forms must be submitted in advance to the Genesis Center director. The terms and conditions of Paragraph 49 are subject to the approval and changes as designated by the UAB Department of Occupational Health and Safety. Tenant agrees to abide by all State, Federal, and UAB guidelines regarding the handling and storage of Hazardous Material.

SMOKING POLICY

50. Smoking is strictly prohibited in all areas within the OADI Technology Center.

TENANT MANUAL

51. TENANT has read OADI TENANT MANUAL and agrees to abide by all rules and regulations of the OADI program.

This Lease shall be governed, construed and enforced in accordance with the laws of the State of Alabama.

IN WITNESS WHEREOF, the TENANT and the LANDLORD have hereunto set their hands and seals in duplicate, as set forth below, on the day and year first above written.

LANDLORD:
THE BOARD OF TRUSTEES OF THE
UNIVERSITY OF ALABAMA FOR THE
UNIVERSITY OF ALABAMA AT BIRMINGHAM
By	/s/
Its	Acting Provost
TENANT:
DURECT Corporation
By:	/s/
Its:	CFO

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LANDLORD’S ACKNOWLEDGMENT:

STATE OF ALABAMA )

COUNTY OF JEFFERSON)

I, the undersigned authority, a Notary Public in and for said County in said State, hereby certify that                                                                          ,whose name as                                                                          , of the Board of Trustees of the University of Alabama is signed to the foregoing conveyance and who is known to me, acknowledged before me on this day that, being informed of the contents of the conveyance, he, in his capacity as such                                                          , executed the same voluntarily and with full authority as for the act of the Board of Trustees of the University of Alabama on the day the same bears date.

Given under my hand this the     day of                                 , 20     .

NOTARY PUBLIC

My commission expires:

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TENANT’S ACKNOWLEDGMENT (CORPORATE) :

STATE OF CALIFORNIA )

COUNTY OF SANTA CLARA)

I, the undersigned authority, a Notary Public in and for said County in said State, hereby certify that,                                                                          , whose name as                                                                          , of                                                                                  is signed to the foregoing conveyance and who is known to me, acknowledged before me on this day that, being informed of the contents of the conveyance, he, in his capacity as such                                 , executed the same voluntarily and with full authority as and for

the act of                                                                                                   , on the day the same bears date.

Given under my hand this the     day of                                 , 20     .

NOTARY PUBLIC

My commission expires:

20

INSERT MAP AS EXHIBIT A

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RULES AND REGULATIONS:

1. Sidewalks, entries, passages, courts, corridors, stairways, etc., shall not be obstructed by TENANT or its clerks or used by them for other purposes than ingress and egress.

2. All heavy articles or machinery shall be carried up or into the Premises only at such times and in such manner as shall be prescribed by LANDLORD, and LANDLORD shall in all cases have the right to specify the proper weight and position of any heavy machinery or articles. Any damage done to the Building by installing or removing such machinery or from overloading any floor in any way shall be paid by the TENANT. Any repairs or restoration caused by defacing or injuring in any way part of the Building by TENANT, its agent(s) or servant(s) shall by paid by TENANT.

3. No sign advertisement, or notices may be inscribed, painted, or affixed on any part of the inside or outside of said Building unless of such color, size, and style and in such place in or upon said Building as shall be designated under prior approval therefor by LANDLORD, but there shall be no obligation or duty on LANDLORD to allow any sign, advertisement, or notice to be inscribed, painted, or affixed on any part of the inside or outside of said Building. Signs on doors shall be subject to the approval of LANDLORD, and the cost of such signs shall be paid by the TENANT. Directory in a conspicuous place with the names of the TENANT will be provided by the LANDLORD. Any necessary revision of same shall be made by LANDLORD within a reasonable time after written notice from the TENANT of the error or change making the revision necessary. No showcase or any other fixture or object whatsoever shall be placed in front of the Building or in the court, corridor, or parking area of the Building without prior written consent of the LANDLORD.

4. No TENANT shall do or permit anything to be done in the said Premises or bring or keep anything therein which will in any way increase the rate of fire insurance on said Building or on property kept therein or obstruct or interfere with the rights of other TENANTS or in any way injure or annoy them or conflict with the laws relating to fire or with any regulation of the Fire Department or with any insurance policy upon said Building or any part thereof.

5. No TENANT shall employ any person or persons other than the janitor of the LANDLORD (who will be provided with pass keys to all offices) for the purpose of cleaning or taking charge of the Premises Leased without the written consent of the LANDLORD, it being understood and agreed that the LANDLORD shall in no way be responsible to any TENANT for any loss of property from the Leased Premises, however occurring, or for any damage done to the furniture by the janitor or any of his employees, or by any other person or persons whomsoever. Any person or persons employed by the TENANT with the written consent of the LANDLORD must be subject to and under control and direction of the LANDLORD of the Building and all things in the Building and outside of said Premises.

6. No additional locks, hooks, or attachments shall be placed on any door or window of the Building. TENANT will not permit any duplicate keys to be made, but if more than two keys for any locks are desired, the additional number must be procured from the LANDLORD and paid for by the TENANT.

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7. No animal or birds, bicycles, or other vehicles shall be allowed in halls, corridors, elevators, or elsewhere in the Building.

8. The water closets, wash basins, sinks, and other apparatus shall not be used for any purpose than those for which they are constructed, and no sweepings, rubbish, or other substance shall be thrown therein nor shall anything be thrown by the TENANTS or their agents, or employees out of the windows, doors, or other openings.

9. The floors, skylights, and windows that reflect or admit light into the corridors or passageways or to any place in said Building shall not be covered or obstructed by any of the TENANTS.

10. All TENANTS and occupants must not open their windows. In the case of emergency, an OADI employee is to be called and they will open the window with a special unlocking device.

11. If any TENANT desires telegraphic, telephonic, fiber optic or other electronic connections, the LANDLORD or its agents will direct the electricians as to where and how the wires may be introduced and without such directions, no boring or cutting for wires will be permitted. TENANT will be held responsible for all costs associated with the installation and service of such electronic connections.

12. No shade or awning shall be put up, no painting done, or any alterations made in any part of the Building by putting up or changing any partitions, doors, or windows, nor shall there be any nailing, boring, screwing into woodwork or walls or plastering, nor shall there be upon the Premises any engine, boiler, or other machinery without the prior written consent of the LANDLORD in each and every instance.

13. TENANT, its employees, clerks, or servants shall not use the Demised Premises for the purpose of lodging rooms or for any immoral or unlawful purpose.

14. No room or rooms shall be occupied or used for sleeping or lodging apartments or for any other purpose than the purpose for which same is leased at any time.

15. No TENANT shall permit gambling or unlawful practice or practices of any kind in the Leased Premises.

16. The LANDLORD or any agents or watchman shall have the right, with a passkey or otherwise, to enter any Premises in the Building at any time to examine the same or to make such alterations, repairs, or additions as it shall deem necessary for the safety, preservation, cleanliness, or improvement of the Building.

17. TENANT shall not install or operate vending machines of any kind in the Leased Premises without the written consent of LANDLORD.

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18. All glass, locks, and trimmings, in or about the doors and windows, and all electric globes and shades, belonging to the Building, shall be kept whole, and whenever broken by any TENANT, shall be immediately replaced or repaired and put in order by such TENANT under the direction and to the satisfaction of the LANDLORD, and on removal, shall be left whole and in good repair.

19. LANDLORD reserves the right to make and enforce such other reasonable rules and regulations as, in its judgment, may be deemed necessary or advisable from time to time to promote the safety, care, and cleanliness of the Premises and for the preservation of good order therein.

20. Smoking is strictly prohibited in all areas within the OADI Technology Center.

21. Any TENANT occupying laboratory space shall provide a list of the chemicals and other substances to be used in said laboratory, and the maximum quantity of each expected to be on site. The list shall be provided prior to signing of the LEASE. A new list shall be provided when there has been a significant change in the types and quantity of chemicals on site.

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EX-10.39

Exhibit 10.39

LICENSE AND COMMERCIALIZATION AGREEMENT

THIS LICENSE AND COMMERCIALIZATION AGREEMENT including the exhibits referred to herein and attached hereto which are hereby incorporated by reference (the “Agreement”), entered into as of May 13, 2004, by and between NeuroSystec Corporation, a Delaware corporation having a principal place of business located at Mann Biomedical Park, 25134 Rye Canyon Loop, Suite 370, Valencia, CA 91355 (“NeuroSystec”) and DURECT Corporation, a Delaware corporation having a principal place of business located at 10240 Bubb Road, Cupertino, California 95104 (“DURECT”).

RECITALS

A. WHEREAS, DURECT owns or has rights to certain information and data relating to the development of [***], including rights in the Field (as defined below) and has conducted certain pre-clinical investigations regarding same.

B. WHEREAS, DURECT has licensed certain rights to Active Agents as locally delivered therapeutics in the Field with rights to sublicense to NeuroSystec pursuant to [***].

C. WHEREAS, DURECT owns or has rights to certain proprietary technology for site-specific and time-released delivery of drugs, defined below as the DURECT Drug Delivery Platforms.

D. WHEREAS, NeuroSystec desires to research, develop and commercialize one or more Active Agents in the Field, possibly in connection with a DURECT Drug Delivery Platform.

E. WHEREAS, DURECT desires to grant certain rights and licenses to NeuroSystec for the development and commercialization of Active Agents in the Field, including rights under the DURECT Drug Delivery Platforms.

F. WHEREAS, DURECT desires to assist NeuroSystec in the development of Active Agents in the Field in accordance with the terms and conditions herein set forth.

G. WHEREAS, NeuroSystec desires to purchase from DURECT supplies of the DURECT Drug Delivery Platforms, in each case to the extent desired by NeuroSystec in the commercialization of Active Agents in the Field.

NOW, THEREFORE, in consideration of the mutual covenants and obligations set forth herein, and for other good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged, NeuroSystec and DURECT hereby agree as follows:

1. DEFINITIONS

As used in this Agreement, the following terms shall have the meanings indicated herein:

1.1. “Active Agent” shall mean the compounds disclosed in the Joint Patent Rights for use in the Field.

1.2. “Affiliate” shall mean, with respect to any Person, any other Person that, directly or indirectly, through one or more intermediates, is controlled by, controls, or is under common control with such Person, as of or after the Effective Date. For purposes of this definition only, the term “control” means the possession of the power to direct or cause the direction of the management and policies of an entity, whether by ownership of voting stock or partnership interest, by contract or otherwise, including, without limitation, direct or indirect ownership of fifty percent (50%) or more of the voting interest in the entity in question.

1.3. “Approval” shall mean the approval, including pharmacological, toxicological, and clinical approvals, which need to be granted by the relevant governmental authorities of a territory, for importation, promotion, distribution, sale, and administration thereof to patients of a Licensed Product in such territory (including, without limitation, an NDA or PMA granted by the FDA, including variations, extensions, and renewals thereof).

1.4. “Combination Product” shall mean a Licensed Product sold in combination with one or more commercially available products, which are sold separate from the Licensed Product by NeuroSystec or a third party in the ordinary course of business (such one or more commercially available product or products shall hereinafter be referred to collectively as the “Combination Component”). By way of example and without limitation, the following would be a Combination Product: [***].

1.5. “Commercially Reasonable Efforts” shall mean a level of effort that would ordinarily be applied by a company of similar size and assets in developing, registering and marketing pharmaceutical or medical device products of a similar market potential, profit potential, strategic value and of similar scientific and regulatory risks.

1.6. “Confidential Information” shall have the meaning set forth in Section 11.1 below.

1.7. “Control” or “Controlled” shall mean owned or in-licensed from a Third Party, with the ability to grant access to or a license or sublicense to NeuroSystec in accordance with this Agreement without violating the terms of any agreement or other arrangement with any Third Party.

1.8. “Deductible Expenses” shall mean to the extent actually incurred or allowed with respect to any sale of a Licensed Product: [***]

1.9. “DURECT Data” shall mean all data and information owned or Controlled by DURECT as of or after the Effective Date related to the development, manufacturing, administration and use of Active Agent, the Joint Patent Rights, and any DURECT Drug Delivery Platforms, in each case in the Field, including but not limited to pre-clinical and clinical

Page 2 of 30

***Material has been omitted pursuant to a request for confidential treatment and such material has been filed separately with the SEC.

investigation protocols, data, and other results (including safety and efficacy data), information typically found in a Chemistry, Manufacturing and Controls (CMC) section of an FDA filing, all FDA, EMEA and other regulatory submissions and correspondence, and information for investigations, including but not limited to investigator brochures.

1.10. [***]

1.11. “DURECT Drug Delivery Platforms” shall mean the following drug delivery technology or methods owned or Controlled by DURECT: [***].

1.12. “DURECT Know-How” shall mean all proprietary data, information and materials owned or Controlled by DURECT relating to the development and manufacturing of DURECT Drug Delivery Platforms, any Active Agent and the Joint Patent Rights including, without limitation, know-how, test results, knowledge, techniques, discoveries, inventions, specifications, designs, regulatory filings, reports and all other documents, and specifically includes, but is not limited to, the DURECT Data.

1.13. “DURECT Patent Rights” shall mean any existing and future Patent Rights anywhere in the world owned or Controlled by DURECT specific to the DURECT Drug Delivery Platforms, the Active Agent and the Joint Patent Rights, including without limitation, “DURECT Core Inventions,” as defined in Section 7.2 below.

1.14. “DURECT Intellectual Property” shall mean DURECT Know-How and DURECT Patent Rights.

1.15. “Effective Date” shall mean the date on which [***].

1.16. “EMEA” shall mean the European Medicines Evaluation Agency or any successor thereto.

1.17. “Equity Agreement” shall mean the Stockholders Agreement of NeuroSystec dated May 13, 2004.

1.18. “FDA” shall mean the United States Food and Drug Administration, or any successor thereto.

1.19. “Field” shall mean local delivery of therapeutic agent(s) to the middle or inner ear for the following indications: (a) treatment of tinnitus; and (b) to improve post-operative recovery and tolerance of surgical implantation of devices such as cochlear implants in the inner ear.

1.20. “GAAP” shall mean United States generally accepted accounting principles, consistently applied or, if applicable, corresponding accounting principles in effect in relevant jurisdictions outside the United States, consistently applied.

1.21. [***]

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***Material has been omitted pursuant to a request for confidential treatment and such material has been filed separately with the SEC.

1.22. “Joint Patent Rights” shall mean the intellectual property disclosed in the patent application filed as [***], as well as any Patent Rights covering Inventions as that term is defined in the [***].

1.23. “Licensed Product” shall mean: (i) any pharmaceutical formulation containing an Active Agent or, (ii) a product incorporating an active ingredient and a DURECT Drug Delivery Platform pursuant to NeuroSystec opting to develop such Licensed Product under Section 2.7, in any case for use in the Field, either of which may be alone or in association or combination with one or several other active or inactive ingredients, as a stand-alone product, or in combination with appropriate devices or bioerodable compounds which provide for site-directed delivery and/or extended release of such pharmaceutical formulation, including, without limitation, DURECT Drug Delivery Platforms which is developed and commercialized by NeuroSystec under this Agreement.

1.24. “Marketing Approval Application” shall mean generally a marketing authorization application filed with the FDA, EMEA or other applicable health/regulatory authority, for approval to market and distribute Licensed Products in the applicable jurisdiction, including, without limitation, an NDA or PMA filed with the FDA.

1.25. “NeuroSystec Data” shall mean all data and information developed by or for NeuroSystec, its Affiliates and/or its Sublicensee(s) in connection with the development, manufacturing, administration and use of any Active Agent and generally of any Licensed Product in the Field during the Term, including but not limited to pre-clinical and clinical investigation protocols, data, and other results (including safety and efficacy data), information typically found in a Chemistry, Manufacturing and Controls (CMC) section of an FDA filing, all FDA, EMEA and other regulatory submissions and correspondence, and information for investigators including investigator brochures.

1.26. “NDA” shall mean a new drug application filed with or granted by the FDA with respect to a Licensed Product seeking approval to commercially market said new drug.

1.27. “Net Sales” shall mean with respect to a Licensed Product on a country-by-country basis (subject to the Combination Product adjustment below), [***].

1.28. “Patent Rights” shall mean any patent applications, continuations, continuations-in-parts, divisionals, or other patent applications (including, without limitation, provisional applications and PCT patent applications) and patents issuing from any of the foregoing including, but not limited to, any extension, renewal, reexamination, substitution, or reissue of such patents and all foreign equivalents of any of the foregoing.

1.29. “Party” shall mean either NeuroSystec or DURECT, as appropriate, and collectively NeuroSystec and DURECT are referred to herein as the “Parties”.

1.30. “Party Data” shall mean either NeuroSystec Data or DURECT Data, as appropriate, each to the extent developed under this Agreement after the Effective Date.

1.31. “Person” shall mean an individual, corporation, partnership, limited liability company (“LLC”), trust, business trust, association, joint stock company, joint venture, sole proprietorship, unincorporated organization, governmental authority or any other form of entity not specifically listed herein.

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***Material has been omitted pursuant to a request for confidential treatment and such material has been filed separately with the SEC.

1.32. “PMA” shall mean a pre-marketing application filed with or granted by the FDA with respect to a Licensed Product seeking approval to commercially market said new device.

1.33. “Sublicensee(s)” shall mean any Third Party to whom NeuroSystec has sublicensed any or all of the rights in, to and under the DURECT Patent Rights and/or DURECT Know-How licensed to NeuroSystec hereunder.

1.34. “Term” shall have the meaning set forth in Section 10.1 of this Agreement.

1.35. “Territory” shall mean the world.

1.36. “Third Party” shall mean any Person or entity other than a Party.

1.37. “Valid Claim” shall mean any claim of an issued and unexpired patent within the DURECT Patent Rights, which has not been held unenforceable or invalid by a court or other governmental agency of competent jurisdiction in an unappealed and unappealable decision, and which has not been disclaimed or admitted to be invalid or unenforceable through reissue or otherwise.

1.38. “Work Plan” shall mean the detailed written plan, budget and timeline for the development of each Licensed Product, the first of which shall be drafted and approved by NeuroSystec within sixty (60) days after the Effective Date, as may be amended from time to time thereafter at the direction of NeuroSystec.

For purposes of this Agreement, except as otherwise expressly provided herein or unless the context otherwise requires: (a) the use herein of the plural shall include the single and vice versa and the use of the masculine shall include the feminine; (b) unless otherwise set forth herein, the use of the term “including” means “including but not limited to”; and (c) the words “herein,” “hereof,” “hereunder” and other words of similar import refer to this Agreement as a whole and not to any particular provision. Additional terms may be defined throughout this Agreement.

2. LICENSES

2.1. License Grant. DURECT hereby grants to NeuroSystec an exclusive, royalty-bearing license, including the right to grant sublicenses, under the DURECT Intellectual Property, to research and develop, make, have made, use, sell, offer for sale, import, export, and otherwise commercialize any Licensed Product within the Field in the Territory.

2.2. Exclusivity. The license granted to NeuroSystec in section 2.1 is exclusive even with respect to DURECT, and DURECT shall not retain any rights under the DURECT Intellectual Property to research and develop, make, have made, use, sell, offer for sale or otherwise commercialize, import, and export any Licensed Product within the Field in the Territory except as expressly provided herein. NeuroSystec hereby grants to DURECT a non-exclusive, royalty-free license with no right to sublicense, under its rights in the DURECT

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Intellectual Property solely to perform the work assigned to it under the Work Plan. During the Term, DURECT shall not, directly or indirectly, perform any development or commercialization activities in the Field except as expressly set forth in the Work Plan and DURECT shall not, directly or indirectly, license any Third Party any rights to develop or commercialize any product in the Field.

2.3. Sublicensing. NeuroSystec may, under the rights granted to it hereunder, freely grant sublicenses to any Third Party, including the right to grant further sublicenses.

2.4. Termination of Exclusivity by DURECT. In the event that NeuroSystec has failed to use Commercially Reasonable Efforts to develop and commercialize a Licensed Product in the Field, DURECT shall notify NeuroSystec in writing. NeuroSystec shall have the greater of [***] days from the date of such notice or, if [***] days is not commercially reasonable, such longer period as is commercially reasonable, to remedy such failure (the “Cure Period”). By way of example without limitation, it is hereby agreed that cessation by NeuroSystec of all activities related to the research, development, registration or marketing of all Licensed Products for a period of [***] consecutive months would constitute a failure to use Commercially Reasonable Efforts where such cessation was not otherwise due to a Force Majeure event pursuant to Section 12.6. If NeuroSystec has failed to remedy such failure within the Cure Period, then DURECT may elect, in its sole discretion, by written notice to NeuroSystec to (i) terminate this Agreement, such termination to take effect in due course so as to permit an orderly wind down of operations pertaining to this agreement; or (ii) convert the license granted in Section 2.1 to DURECT Intellectual Property into a non-exclusive license. However, if NeuroSystec disputes such lack of diligence in writing within the Cure Period, DURECT shall not have the right to terminate this Agreement or convert the license in Section 2.1 to non-exclusive unless and until an arbitration tribunal has determined pursuant to Section 12.3 that NeuroSystec has not used Commercially Reasonable Efforts to develop and commercialize a Licensed Product, and NeuroSystec has failed to cure such lack of diligence within a reasonable period of time to be set by such arbitration tribunal. DURECT acknowledges and agrees that as a part of its development activities and diligence obligations hereunder NeuroSystec may conduct feasibility studies for the application of Licensed Product(s) to specific indications in the Field before undertaking further development.

2.5. Limitation on Commercialization. DURECT shall not market or sell any product for any use outside of the Field to the extent that the formulation of such product would not require a separate FDA Approval from the Approval already in place for the formulation of the Licensed Product developed, marketed or sold by NeuroSystec, its Affiliates or Sublicensees if the formulation of such product were to be sold for the same indication as the Licensed Product; however, the foregoing shall not apply in the event DURECT has commenced development of such product outside the Field prior to NeuroSystec’s commencement of development of the Licensed Product. For the avoidance of doubt, DURECT will not be restricted from marketing or selling a different formulation for use outside of the Field if such formulation would require a different FDA Approval from the one in place for the Licensed Product in question.

2.6. [***]

2.6.1. [***]

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2.6.2. [***]

2.7. Other Active Ingredients. DURECT acknowledges that NeuroSystec shall have the right to develop products hereunder that do not include an Active Agent. In the event NeuroSystec develops, makes, uses, imports, sells or offers for sale a product not incorporating an Active Agent but incorporating a DURECT Drug Delivery Platform, then that product shall be deemed a Licensed Product and the license granted pursuant to Section 2.1 hereunder shall include such product and such product shall be subject to the royalty set forth in Sections 4.1.5 (iii) and (iv) and 4.2, to the extent applicable.

3. DISCLOSURE OF DURECT KNOW-HOW.

3.1. Disclosure of DURECT Know-How. Subject to the last two sentences of this Section 3.1, DURECT shall on NeuroSystec’s reasonable request upon reasonable notice transfer to or make available to NeuroSystec the then most current version of all relevant DURECT Know-How and related expertise useful for NeuroSystec with the goal of enabling NeuroSystec to undertake the research, development and commercialization of the Active Agent and generally any Licensed Product so long as such Licensed Product is under active development. DURECT shall update DURECT Know-How and expertise related to any Active Agent and Licensed Products previously transferred to NeuroSystec regularly at Development Committee meetings. NeuroSystec shall have access to DURECT personnel for the purpose of transferring and/or updating DURECT Know-How which shall be at no cost to NeuroSystec, but is limited to a total of [***] person hours within the first [***] months after the Effective Date. Any request by NeuroSystec under this Section 3.1 for such transfer of DURECT Know-How requiring an expenditure of time by DURECT personnel in excess of the [***] person hours will be deemed to be an assignment of work to DURECT under the Work Plan as specified in Section 6.2 below.

4. ROYALTIES, PAYMENTS AND RELATED OBLIGATIONS

4.1. Payments by NeuroSystec to DURECT. As a partial reimbursement to DURECT for research and development and other expenses incurred by DURECT in connection with its efforts researching and developing Active Agents and DURECT Drug Delivery Platforms, NeuroSystec shall pay to DURECT the amounts set forth in Sections 4.1.1 through 4.1.4 below:

4.1.1. Up-Front Fees. [***]

4.1.2. Equity. [***]

4.1.3. Milestones. Upon the first occurrence of the following milestones by NeuroSystec, its Affiliates or any Sublicensee, each a one-time, non-refundable fee, due and payable within sixty (60) days after such event:

[***]

Each of the above milestones shall be payable once only and only for the first occurrence of each such milestone.

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4.1.4. Sublicense Fees. [***] of all upfront, milestone, or any special fees, payments or other consideration realized by NeuroSystec in exchange for granting a sublicense of any rights granted in Section 2.1 to a Third Party (excluding Affiliates of NeuroSystec, for clarification examples of which include [***], and affiliates of [***] that are also Affiliates of NeuroSystec, so long as such entities are Affiliates of NeuroSystec at the relevant time).

4.1.5. Royalties. In addition to the foregoing, earned running royalties for each tier of sales by NeuroSystec, its Affiliates and Sublicensees in each country in the Territory where a Valid Claim within the DURECT Patent Rights exists:

(i) a royalty of [***] of Net Sales of all Licensed Products (excluding any Licensed Product which does not include an Active Agent) covered by a Valid Claim, on that portion of annual Net Sales in a calendar year which does not exceed [***]; and

(ii) a royalty of [***] of Net Sales of all Licensed Products (excluding any Licensed Product which does not include an Active Agent) covered by a Valid Claim, on that portion of annual Net Sales in a calendar year in excess of [***];

and if a Licensed Product includes a DURECT Drug Delivery Platform:

(iii) a royalty of [***] of Net Sales of all such Licensed Products covered by a Valid Claim, that include a DURECT Drug Delivery Platform, on that portion of annual Net Sales in a calendar year which does not exceed [***]; and

(iv) a royalty of [***] of Net Sales of all such Licensed Products covered by a Valid Claim, that include a DURECT Drug Delivery Platform, on that portion of annual Net Sales in a calendar year in excess of [***].

For the avoidance of doubt, no royalty shall be payable under Sections 4.1.5 (i) and (ii) for a Licensed Product that does not include an Active Agent. Further, royalties payable under Section 4.1.5 (iii) and (iv), if in fact payable, shall be in addition to and not in substitution for those payable under Section 4.1.5 (i) and (ii).

4.2. Payments by NeuroSystec for the [***]. In addition to the royalties of Section 4.1.5 above, NeuroSystec shall pay to DURECT royalties for net sales of Licensed Products by NeuroSystec, its Affiliates and Sublicensees that include [***].

4.3. Payments by NeuroSystec to [***]. In addition to the royalties of Section 4.1.5 and 4.2 above, NeuroSystec shall pay to [***], earned running royalties for net sales of Licensed Products by NeuroSystec, its Affiliates and Sublicensees where such products are covered by a Valid Claim under the Joint Patent Rights. Such royalty shall be [***] of net sales of such products. For the purposes of this Section 4.3, net sales shall be calculated as [***]. Such payments will be calculated at the end of each calendar year and paid to [***] within sixty (60) days of the end of each calendar year. All calculations of fees payable to [***] will be based on United Stated Dollars. Net sales in currency other than United Stated Dollars will be converted to United States Dollars using the currency exchange rate quoted in the Wall St. Journal (or comparable publication if not quoted in the Wall St. Journal) on the last day of the calendar year for which net sales are calculated. Along with payment, NeuroSystec will provide a statement showing the calculation used to calculate net sales and the royalty payment.

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4.4. Royalty Term. NeuroSystec’s obligation to pay royalties under Sections 4.1.4, 4.1.5 and 4.3 shall continue on a Licensed Product-by-Licensed Product and on a country-by-country basis in the Territory until expiration or determination of invalidity of the last Valid Claim within the DURECT Patent Rights in such country. NeuroSystec’s obligation to pay royalties under Sections 4.2 shall continue for so long as DURECT is obligated to make payments to [***] under the [***], but only to the extent that DURECT’s obligations to pay [***] are due to NeuroSystec’s activities hereunder.

4.5. Royalty Reports. NeuroSystec shall deliver to DURECT, within forty-five (45) days after the end of each calendar year in which a Licensed Product is sold, transferred or otherwise disposed of by NeuroSystec, its Affiliates or Sublicensees, a written report setting forth in reasonable detail (a) the number and types of Licensed Product(s) sold in each country, (b) the gross proceeds from such sales, (c) the calculation of the royalties payable to DURECT for such calendar year under Section 4.1, including the amount of Net Sales and Deductible Expenses (broken down by category) and (d) the calculation of royalties payable to [***] and [***], respectively. Notwithstanding the foregoing, NeuroSystec shall have no obligation under this Section 4.5 for so long as no royalties are payable under this Article 4.

4.6. Payment Terms.

4.6.1. NeuroSystec shall pay all royalties due and payable on Net Sales by it, its Affiliates and Sublicensees pursuant to Sections 4.1.5 on a per calendar year basis within forty-five (45) days after the last day of each calendar year in which the applicable Licensed Product is sold, transferred or otherwise disposed of by NeuroSystec, its Affiliates and Sublicensees.

4.6.2. Unless expressly stated otherwise, all payments made under this Agreement shall be made in United States Dollars and by wire transfer (net of bank charges which shall be borne by the paying party) to one or more bank accounts to be designated in writing by each Party or by [***] as the case may be. In the event that a Licensed Product is sold by NeuroSystec, its Affiliates or Sublicensees in currencies other than United States Dollars, Net Sales shall be calculated by conversion of foreign currency to U.S. Dollars at the conversion rate equal to the average of the conversion rates existing in the United States (referencing the “U.S. dollar noon buying rates”, or its equivalent, published in the Wall Street Journal) on the last working day of each month of the period during which royalties are being calculated.

4.6.3. Except as specifically provided in Section 4.1.5, no multiple royalties shall be due or payable for any Licensed Product notwithstanding that the manufacture, use, offer for sale, sale or import of any Licensed Product by or for NeuroSystec, its Affiliates or Sublicensees is or shall be covered by more than one Valid Claim within DURECT Patent Rights. For the avoidance of doubt, royalties due under Sections 4.2 and 4.3 shall not be deemed multiple royalties.

4.7. Taxes. Each Party shall be responsible for and pay all taxes, duties and levies directly imposed by all foreign, federal, state, local or other taxing authorities (including, without limitation, export, sales, use, excise, and value-added taxes) based on such Party’s transactions or payments under this Agreement, other than taxes imposed or based on net income. If withholding under the applicable laws of any country is required with respect to any payment to be made by

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either Party under this Agreement, the paying Party shall withhold the required amount and pay such amount to the appropriate governmental authority and all amounts due hereunder shall be reduced by the amount required to be withheld. In such a case, the withholding Party shall, upon the other Party’s request, promptly provide the other Party with original receipts or other evidence sufficient to allow the other Party to obtain the benefits of any such tax withholding. The Parties shall use reasonable efforts, if applicable and appropriate, to cooperate in reducing any tax withholding on payments made hereunder.

4.8. Inspection of Books and Records. Each Party shall maintain, and require its Affiliates and Sublicensees to maintain in accordance with GAAP, complete and accurate books and records which enable the calculation of royalties and other payments payable hereunder to be verified. Each Party, its Affiliates and its Sublicensees shall retain such books and records for each annual period for [***] after the submission of the corresponding report under Section 4.5 or invoice under Section 6.2. Upon [***] prior written notice to the other Party, independent accountants reasonably acceptable to such other Party may have access to such books and records to conduct a review or audit no more than once per calendar year, for the sole purpose of verifying the accuracy of the other Party’s reports and payments under this Agreement. Such access shall be permitted during the audited Party’s normal business hours [***]. In the event of any underpayment or overcharge, the audited Party shall promptly pay to the auditing Party the difference between the amount actually paid or charged by the audited Party and the amount determined to be owed under this Section 4.8. Any such inspection or audit shall be at the auditing Party’s expense, unless the inspection or audit results in a determination that the audited Party’s payment obligations to the auditing Party have been understated, that audited Party’s payments have been underpaid, or that the audited Party has overcharged the auditing Party, each by more than [***] of the amount actually paid by the audited Party or owed by the auditing Party for the period examined, in which case the audited Party shall pay all reasonable costs and expenses incurred by the auditing Party in the course of making such determination, including the reasonable fees and expenses of such accountant.

4.9. Royalty Anti-stacking. If NeuroSystec must pay to a Third Party license fees or royalties to obtain patent rights from such Third Party without which NeuroSystec could not practice under the DURECT Patent Rights and thereby sell Licensed Product (because the sale of Licensed Product in the absence of such license would infringe such Third Party’s patent rights), then the royalties described in Sections 4.1.5 shall be [***]

5. MANUFACTURE AND SUPPLY

5.1. Supply of DURECT Drug Delivery Platforms. DURECT shall have the exclusive right to manufacture and supply DURECT Drug Delivery Platforms including [***] for use in NeuroSystec’s development efforts as set forth in the Work Plan at DURECT’s fully burdened cost determined in accordance with GAAP.

5.2. Commercial Manufacture and/or Assembly of Licensed Products. DURECT shall have the exclusive right to manufacture and supply Licensed Products pursuant to a Supply Agreement to be negotiated as set forth in Section 5.3 as follows:

5.2.1. If, and to the extent that, NeuroSystec determines in its sole discretion to commercialize Licensed Products utilizing [***], DURECT shall manufacture and supply the final, fully assembled product including such [***].

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5.2.2. If, and to the extent that, NeuroSystec determines in its sole discretion to commercialize Licensed Products utilizing a [***], DURECT shall manufacture and supply, at a minimum, such [***].

5.2.3. If, and to the extent that, NeuroSystec determines in its sole discretion to commercialize Licensed Products utilizing a [***], DURECT shall manufacture and supply any raw polymer substances required by such [***].

5.2.4. If, and to the extent that, NeuroSystec determines in its sole discretion to commercialize Licensed Products utilizing a [***], DURECT shall manufacture and supply any raw polymer substances required by such [***].

5.3. Supply Pricing. DURECT shall provide any Licensed Products or components thereof designated in Section 5.2 (“DURECT Manufactured Products”) pursuant to a Supply Agreement. The parties will negotiate a Supply Agreement defining the products to be supplied by DURECT and the terms and conditions of such supply. Such Supply Agreement shall include, without limitation: [***]

6. DEVELOPMENT, REGISTRATION, COMMERCIALIZATION AND ADVERSE EVENTS

6.1. Development Committee. NeuroSystec and DURECT will form a development committee (the “Development Committee”), consisting of an equal number of representatives of each of NeuroSystec and DURECT (initially being two representatives each, unless and until the parties mutually agree to another number of equal representatives for each Party). For each Licensed Product, the Development Committee shall develop a work plan (a “Product Work Plan”), subject to approval by NeuroSystec, which outlines the pre-clinical program required to establish the feasibility of such Licensed Product for use in humans in the Field, which may include: [***]. Each such Product Work Plan once approved by NeuroSystec shall be deemed a part of the Work Plan. The Development Committee shall be chaired by a NeuroSystec-appointed member thereof designated from time to time by NeuroSystec. Meetings of the Development Committee shall be at least biannual and at such times and places or in such form (e.g., in person, telephonic or video conference) as the members of the Development Committee shall determine. The Development Committee shall keep minutes of its discussions. All records of the Development Committee shall at all times be available to both Parties. The Development Committee may from time-to-time and as determined appropriate by NeuroSystec participate in (a) amendment of the Work Plan, as directed by NeuroSystec, (b) facilitation and coordination of the flow of information between NeuroSystec and DURECT and the activities of the parties under this Agreement and (c) discussion of the parties’ research and development activities with respect to each Licensed Product under this Agreement and sharing of information with respect thereto. The preparation, amendment, and implementation of the Work Plan by the Development Committee shall be subject to review by, and require the written approval of, NeuroSystec.

6.2. Development Services Provided by DURECT. The Development Committee may assign responsibility for development activities to DURECT by amendment of the Work Plan at the direction of NeuroSystec; provided, however, that DURECT accepts to perform the work assigned. DURECT shall be solely responsible for all initial and subsequent Formulation Development with respect to the Licensed Product during the Term of the Agreement in

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accordance with specifications as are set forth in the Work Plan, and NeuroSystec shall reimburse to DURECT all DURECT FTE Development Costs as calculated in accordance with Exhibit C associated with such Formulation Development activities in accordance with the procedures set forth in Sections 6.2.1 and 6.2.2 below with respect to DURECT’s Formulation Development activities; provided, however, if DURECT is unable to perform or fails to carry out any such Formulation Development, then NeuroSystec (itself or through Third Parties) shall have the right to perform such formulation development. “Formulation Development” means [***]. DURECT’s attendance at Development Committee meetings and related travel and expenses shall be deemed development activities assigned to DURECT under the Work Plan, reimbursable at DURECT’s actual costs and standard personnel FTE rates. DURECT shall use commercially reasonable efforts to render the services assigned to and accepted by DURECT as set forth in the Work Plan in a timely and professional manner consistent with industry standards and in accordance with this Agreement and any terms set forth in the Work Plan and agreed to by DURECT, including, without limitation, timely delivery of all deliverables.

6.2.1. In consideration for DURECT performing the Formulation Development, NeuroSystec shall reimburse to DURECT all DURECT FTE Development Costs incurred by DURECT in connection with the Formulation Development; provided that with respect to the Formulation Development, NeuroSystec shall not be obligated to pay for any portion of the DURECT FTE Development Costs that exceeds the budget in the then-current Work Plan, and DURECT shall not be obligated to perform activities which would result in DURECT FTE Development Costs in excess of the budget in the then-current Work Plan therefor without the prior written agreement of the Parties to amend such budget.

6.2.2. DURECT shall submit an invoice to NeuroSystec for DURECT FTE Development Costs under the Work Plan on a monthly basis in arrears, and NeuroSystec shall render payment to DURECT within thirty (30) days of NeuroSystec’s receipt of such invoice. DURECT shall retain copies of any receipts, bills, invoices, expense account information and any other supporting data for DURECT’s FTE Development Costs, which NeuroSystec shall have the right to audit in accordance with Section 4.8. NeuroSystec shall be responsible for all expenses relating to the Work Plan.

6.3. No Authority or Decision Making. Although development of Licensed Products will be discussed by the Development Committee, and the Development Committee shall strive to act unanimously, the Development Committee shall operate solely as a forum for discussing scientific, technical, clinical, and regulatory matters relating to the development of the Licensed Products. Accordingly, the Development Committee shall have no authority to make decisions binding upon either Party. NeuroSystec shall retain all rights and authority to make development and commercialization decisions within the Field regarding the Licensed Products.

6.4. Information Transfer and Reference Rights.

6.4.1. During the term of this Agreement, the parties will share with each other relevant data and information relating to the development of Licensed Products (excluding internal business and financial information, except as otherwise expressly provided for herein) primarily through Development Committee meetings and teleconferences or as otherwise

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reasonably necessary for such sharing to occur. All Party Data and other information disclosed by a Party pursuant to this Section 6.4 shall be treated as the disclosing Party’s Confidential Information in accordance with Article 11.

6.4.2. [***]

6.4.3. [***]

6.5. Adverse Event Reporting. Each Party shall itself comply, and cause any of its personnel, employees, agents, consultants, contractors and subcontractors to comply with all applicable local, state and national laws, rules and regulations regarding adverse event reporting and shall promptly notify the other Party in writing upon receipt of any information concerning any potentially serious or unexpected side effect, injury, toxicity or sensitivity reaction or any unexpected incidents or other adverse experience and the severity thereof associated with the development, clinical uses, studies, investigations, tests, marketing and commercialization of any product containing an Active Agent or any Licensed Product, whether or not determined to be attributable to the Active Agent or the Licensed Products. Prior to the first clinical use of the first Licensed Product, the parties shall mutually agree upon the details of reasonable policies and procedures to govern and effectuate the foregoing adverse event reporting obligations. Prior to commercialization by either Party of a pharmaceutical containing an Active Agent, the Parties shall develop and exchange pharmacovigilance standard operating procedures (“SOPs”). Based upon such SOPs, the Parties shall agree upon a detailed procedure regarding handling of adverse events from the commercialization activities conducted by any of the Parties. NeuroSystec agrees and acknowledges that DURECT may provide information it obtains under this Section 6.5 to DURECT’s other clients developing and/or marketing products incorporating a DURECT Drug Delivery Platform or Active Agent outside of the Field.

6.6. Regulatory Reporting. Subject to Section 6.6.1 below, the Parties understand and agree that NeuroSystec, itself or through its agents, shall have the sole right to correspond with appropriate regulatory agencies and submit INDs and Marketing Approval Applications for Licensed Products as NeuroSystec deems useful or necessary to fulfill its obligations hereunder. Accordingly, except as otherwise required by law, DURECT shall not correspond directly with the FDA or any other regulatory authority relating to the process of obtaining Approvals for Licensed Products, without NeuroSystec’s prior permission. Notwithstanding the foregoing, DURECT agrees to provide such reasonable assistance, as requested by NeuroSystec and at NeuroSystec’s expense, in preparing, submitting and maintaining such INDs and Marketing Approval Applications

6.6.1. [***]

6.6.2. [***]

6.7. Development and Commercialization Responsibilities. Subject to this Section 6.7, NeuroSystec shall pay for all costs related to and shall bear all responsibility for the development, manufacturing, registration and sale of the Licensed Product(s). Subject to this Section 6.7, NeuroSystec shall pay for all costs related to and shall bear all responsibility for all marketing and promotional activities related to Licensed Product(s) in the Territory and shall decide on the strategy regarding such activities. NeuroSystec shall use Commercially Reasonable Efforts to develop, obtain Approvals for, promote and sell Licensed Product(s) being granted Approval in the Territory.

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7. PATENT MAINTENANCE AND ENFORCEMENT

7.1. Sole Inventions. Subject to Sections 7.2, 7.3, and 7.4, any and all inventions and Patent Rights thereto developed or conceived by or on the behalf of a Party or its Affiliates alone or jointly with any Third Party shall be solely owned by such Party or its Affiliates with regard to the other Party. The other Party shall have no rights to participate in or obligation to share costs related to the filing, prosecution, maintenance, enforcement, and defense of Patent Rights directed to such inventions, if any.

7.2. DURECT Core Inventions. Without regard to inventorship, all inventions (together with all intellectual property rights therein) that comprise: [***] (individually and collectively, the “DURECT Core Inventions”) shall be solely owned by DURECT with regard to NeuroSystec and its Affiliates or Sublicensees. DURECT’s rights and interests in and to DURECT Core Inventions shall be deemed part of DURECT Patent Rights hereunder and are licensed to NeuroSystec in accordance with the licenses granted herein. DURECT acknowledges and agrees that it shall use commercially reasonable efforts to gain Control of DURECT Core Inventions to the extent that such inventions are developed by or with any third party pursuant to an agreement between DURECT and such Third Party.

7.3. NeuroSystec Funded Inventions. Without regard to inventorship, all inventions in the Field (together with all intellectual property rights therein) [***] (“NeuroSystec Funded Inventions”) and Patent Rights thereto shall be solely owned by NeuroSystec with regard to DURECT and its Affiliates. NeuroSystec hereby grants DURECT a non-exclusive, royalty free, perpetual license to any NeuroSystec Funded Inventions that relate to an Active Agent, for use outside the Field and subject to all other terms of this Agreement. DURECT shall have no rights to participate in or obligation to share costs related to the filing, prosecution, maintenance, enforcement, and defense of Patent Rights directed to NeuroSystec Funded Inventions, if any.

7.4. Patent Enforcement. If either Party becomes aware that any patents within the DURECT Patent Rights are being or have been infringed by any Third Party in the Field, such Party shall promptly notify the other Party in writing describing the facts relating thereto in reasonable detail. DURECT shall have the initial right, but not the obligation, to institute, prosecute and control any action, suit or proceeding (an “Action”) with respect to such infringement including any declaratory judgment action, at its expense, using counsel of its choice. NeuroSystec shall cooperate reasonably with DURECT, including being named in such Action if necessary, at DURECT’s written request and expense, in connection with any such Action. Any amounts recovered in such Action shall be used first to reimburse costs and expenses incurred by DURECT and then NeuroSystec, to the extent such costs and expenses have been reasonably incurred in connection with such Action (including attorneys and expert fees) and any remainder attributable to compensatory damages shall be retained by NeuroSystec and shall be treated as Net Sales hereunder except to the extent that DURECT has already received royalty payments pursuant to Section 4.1.5 for such amounts; provided, however, that any remainder that is attributable to an increase by the court pursuant to 35 USC Section 284 or equivalent foreign law provision shall be retained by DURECT. For the avoidance of doubt, in the event that the court awards increased damages pursuant to 35 USC Section 284 or equivalent foreign law provision, the reimbursement of costs and expenses shall be subtracted first from such increased damages.

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7.5. Step-In Enforcement. In the event DURECT fails to initiate any Action involving any commercially significant infringement of the DURECT Patent Rights within the Field within [***] of receiving notice thereof or a shorter period of time if NeuroSystec’s rights in the DURECT Patent Rights are reasonably likely to be prejudiced by such a delay, NeuroSystec shall have the right, but not the obligation, to initiate and/or maintain such Action in its own name, or in DURECT’s name if necessary, and at its own expense, and DURECT shall cooperate reasonably with NeuroSystec, at NeuroSystec’s written request and expense, in connection with any such Action. Any amounts recovered in such Action shall be used first to reimburse costs and expenses incurred by NeuroSystec and then DURECT, to the extent such costs and expenses have been reasonably incurred in connection with such Action (including attorneys and expert fees) and any remainder attributable to compensatory damages shall be retained by NeuroSystec and shall be treated as Net Sales hereunder except to the extent that DURECT has already received royalty payments pursuant to Section 4.1.5 for such amounts; provided, further, that any remainder that is attributable to an increase by the court pursuant to 35 USC Section 284 or equivalent foreign law provision shall be retained by NeuroSystec. For the avoidance of doubt, in the event that the court awards increased damages pursuant to 35 USC Section 284 or equivalent foreign law provision, the reimbursement of costs and expenses shall be subtracted first from such increased damages.

7.6. Cooperation. In any Action, the parties shall provide each other with reasonable cooperation and assistance, including agreeing to be named as a party to such Action, causing other necessary parties and parties with an interest to join and be named as necessary, and, upon the written request and at the expense of the Party bringing such Action, the other Party shall make available, at reasonable times and under appropriate conditions, all relevant personnel, records, papers, information, samples, specimens, and the like in its possession. Notwithstanding any other provision of this Article 7, neither Party shall make any settlements of any suit, proceeding or action relating to an infringement of any DURECT Patent Rights in the Field that would materially and adversely affect the other Party or the rights and licenses granted hereunder without first obtaining such other Party’s prior written consent, such consent not to be unreasonably withheld or delayed or conditioned upon receipt of consideration.

7.7. DURECT Rights. Notwithstanding anything set forth in this Agreement, DURECT shall have sole discretion with regard to whether and where to file for patent protection for any DURECT Intellectual Property. In the event DURECT desires to abandon prosecution or maintenance of any patent application or patent within the DURECT Intellectual Property directly relevant to the Field in any country or region, it shall, within sufficient time, offer to permit NeuroSystec to assume the prosecution of such patent application or the maintenance of such patent. If NeuroSystec elects to assume the same, it shall have the right to offset the full cost of such maintenance and prosecution against the royalty otherwise owed to DURECT from Net Sales in such country or region.

7.8. [***] Inventions. The provisions of this Article 7 notwithstanding, and without regard to inventorship, the Parties acknowledge that [***] shall own certain inventions related to the [***] pursuant to the terms of the [***].

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8. REPRESENTATIONS, WARRANTIES AND COVENANTS

8.1. Representations, Warranties and Covenants of NeuroSystec. NeuroSystec represents and warrants that, as of the Effective Date:

8.1.1. NeuroSystec is a corporation, duly organized, validly existing and in good standing under the laws of Delaware.

8.1.2. The execution, delivery and performance of this Agreement has been duly authorized by all necessary corporate action on the part of NeuroSystec.

8.1.3. There is no pending, or to its knowledge, threatened Third Party lawsuit, claim, action or demand against NeuroSystec.

8.1.4. The execution, delivery and performance of this Agreement will not conflict with (a) the Equity Agreement of NeuroSystec or (b) any other agreement to which NeuroSystec is a party or by which it is bound.

8.2. Representations, Warranties and Covenants of DURECT. DURECT represents, warrants and covenants that, as of the Effective Date:

8.2.1. DURECT is a corporation, duly organized validly existing and in good standing under the laws of Delaware;

8.2.2. The execution, delivery and performance of this Agreement has been duly authorized by all necessary corporate action on the part of DURECT;

8.2.3. DURECT has the right and authority to grant the rights and licenses granted to NeuroSystec under this Agreement;

8.2.4. DURECT has not granted any right, license or interest in, to or under the DURECT Patent Rights or DURECT Data inconsistent with the rights, license and interests granted to NeuroSystec in this Agreement, and DURECT shall not grant during the term of this Agreement any right, license or interest in, to or under the DURECT Intellectual Property that is inconsistent with the rights, licenses and interests granted to NeuroSystec hereunder;

8.2.5. DURECT has provided to NeuroSystec a true copy (including any amendments thereto) of each agreement with a Third Party referring or relating substantially to the manufacture, use or sale of any Active Agent. Exhibit A contains a complete list of all such Third Party agreements.

8.2.6. There is no pending or, to DURECT’s knowledge, threatened Third Party lawsuit, claim, action or demand against DURECT which relates to the use of any Active Agent or the DURECT Intellectual Property.

8.2.7. To DURECT’s knowledge, the exercise of the rights (including intellectual property rights existing as of the Effective Date) to the DURECT Know How, the DURECT Drug Delivery Platforms and the Active Agent granted hereunder would not infringe or

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give rise to a claim of misappropriation of the intellectual property of any Third Party in the Territory, it being understood that DURECT has undertaken no investigation or analysis with respect to the Active Agent.

8.2.8. Other than the patents and patent applications DURECT has licensed from [***] and those listed on Exhibit B, DURECT represents and warrants that it is not the assignee, co-assignee, or licensee, of any patents, or patent applications, that would preclude NeuroSystec from exercising any of the rights granted hereunder.

8.2.9. To its knowledge, DURECT does not own or control any investigational new drug application, drug master file or comparable regulatory filing for any Active Agent not included in this Agreement.

8.3. Disclaimer. EXCEPT AS EXPRESSLY PROVIDED FOR IN THIS AGREEMENT, NEITHER PARTY MAKES, AND EACH PARTY HEREBY DISCLAIMS, ANY AND ALL REPRESENTATIONS AND WARRANTIES OF ANY KIND, EXPRESS OR IMPLIED, WITH RESPECT TO THE SUBJECT MATTER OF THIS AGREEMENT, INCLUDING WITHOUT LIMITATION, WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NON-INFRINGEMENT AND ANY WARRANTY ARISING OUT OF PRIOR COURSE OF DEALING AND USAGE OF TRADE.

9. INDEMNIFICATION AND INSURANCE

9.1. Indemnification by NeuroSystec. NeuroSystec shall indemnify and hold harmless DURECT, its Affiliates and their respective officers, directors, employees and agents (each a “DURECT Indemnitee”) from and against claims, demands, liabilities, damages, losses and expenses, including reasonable attorney’s fees and costs, actually incurred by the indemnified party arising out of or in connection with any lawsuit, claim, action or demand (“Claims”) based upon (i) the negligence, intentional misconduct of NeuroSystec or its Affiliates; (ii) breach by NeuroSystec or its Affiliates of the terms of, or the covenants, representations and warranties made by it in this Agreement; (iii) use by or on behalf of NeuroSystec of any Active Agents or Licensed Products for clinical trials, (iv) the use, manufacture, marketing, promotion, sale, advertising, transportation, handling, storage, or distribution of Licensed Products, (v) any defect or alleged defect in the labeling of the Licensed Products, and (vi) any defect or alleged defect in the design or formulation of the Licensed Products; except in each case for (x) Claims arising due to the negligence, intentional misconduct, or breach of this Agreement by DURECT or its Affiliates, and (y) Claims for which DURECT is obligated to indemnify NeuroSystec Indemnitees pursuant to Section 9.2.

9.2. Indemnification by DURECT. DURECT shall indemnify and hold harmless NeuroSystec, its Affiliates and their respective officers, directors, employees and agents (each a “NeuroSystec Indemnitee”) from and against claims, demands, liabilities, damages, losses and expenses, including reasonable attorney’s fees and costs, actually incurred by the indemnified party arising out of or in connection with any Claims based upon (i) the negligence, intentional misconduct of DURECT or its Affiliates; (ii) breach by DURECT or its Affiliates of the terms of, or the covenants, representations and warranties made by it in this Agreement; (iii) manufacturing defects of any DURECT Drug Delivery Platform, only if manufactured by or for DURECT and provided to NeuroSystec hereunder; and (iv) any defect or alleged defect in the design of the

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underlying DURECT Drug Delivery Platform (for the avoidance of doubt, this clause is not intended to apply to design defects or alleged defects introduced in a Licensed Product as a result of work performed by DURECT under the Work Plan at the direction of NeuroSystec unless such alleged defects are a result of the negligence or intentional misconduct of DURECT); except in each case for (x) Claims arising due to the negligence, intentional misconduct omissions of, or breach of this Agreement by NeuroSystec or its Affiliates and (y) Claims for which NeuroSystec is obligated to indemnify DURECT Indemnitees pursuant to Section 9.1.

9.3. Procedure. The foregoing indemnifications are subject to the following procedural requirements: the NeuroSystec Indemnitee or DURECT Indemnitee shall give prompt written notice to the indemnifying party of any claims, suits or proceedings by Third Parties which may give rise to any claim for which indemnification may be required under this Article 9, and the NeuroSystec Indemnitee or DURECT Indemnitee shall reasonably cooperate with the indemnifying party and its counsel in the course of the defense of any such suit, claim or demand, such cooperation to include without limitation using reasonable efforts to provide or make available documents, information and witnesses at the expense of the indemnifying party. The indemnifying party shall be entitled to assume the defense and control of any such claim at its own cost and expense; provided, however, that the NeuroSystec Indemnitee or DURECT Indemnitee shall have the right to be represented by its own counsel at its own cost in such matters. Neither the indemnifying party nor the indemnified party shall settle or dispose of any such matter in any manner which would materially and adversely affect the rights or interests of the other party (including the obligation to indemnify hereunder) without the prior written consent of the other party, which shall not be unreasonably withheld or delayed or conditioned on further consideration.

9.4. NeuroSystec Insurance. Prior to dosing the first human with the Licensed Product in the first clinical trial, NeuroSystec shall, at its sole cost and expense, procure and maintain comprehensive general liability insurance and clinical trial insurance policies from a qualified insurance company which has a superior rating from a recognized rating service, with minimum limits of [***] for combined bodily injury and property damage. Additionally, prior to launch of any Licensed Product hereunder, NeuroSystec shall, at its sole cost and expense, procure and maintain products liability insurance policies from a qualified insurance company which has a superior rating from a recognized rating service, with coverage terms and limits standard and customary for commercialization of products similar to the Licensed Products in the pharmaceutical industry, but no less than [***] for combined bodily injury and property damage. All such insurance policies shall include DURECT as an additional named insured.

NeuroSystec will furnish to DURECT certificates of all such insurance policies:

- at least 30 days prior to the scheduled commencement of a clinical trial for a Licensed Product (and within 30 days of the date of each anniversary of the related insurance certificate date), evidence of coverage in accordance with this Section 9.4; and

- at least 60 days prior to the first commercial sale by NeuroSystec in the Territory (and within 30 days of the date of each anniversary of the related insurance certificate date), evidence of insurance coverage in accordance with this Section 9.4.

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If NeuroSystec is unable to secure or maintain all such insurance policies and coverage as provided for herein, the parties will negotiate in good faith reasonable accommodations regarding risk exposure of the parties.

10. TERM AND TERMINATION

10.1. Term. This Agreement shall commence on the Effective Date and continue in full force and effect until the expiration of all of NeuroSystec’s royalty payment obligations as specified under Section 4.4, unless terminated earlier pursuant to Sections 2.4, 10.2, 10.3, 10.4 or 12.6 (the “Term”). [***]

10.2. NeuroSystec Termination. NeuroSystec may terminate this Agreement:

10.2.1. upon [***] days prior written notice if NeuroSystec decides to halt development of Licensed Products.

10.2.2. upon [***] days prior written notice if the Effective Date does not occur within [***] days of the execution of this Agreement, provided such written notice is sent by NeuroSystec within [***] days of the execution of the Agreement.

10.3. Termination by Either Party. Either Party may terminate this Agreement upon written notice to the other Party if the other Party (i) makes a general assignment for the benefit of creditors; (ii) files an insolvency petition in bankruptcy; (iii) petitions for or acquiesces in the appointment of any receiver, trustee or similar officer to liquidate or conserve its business or any substantial part of its assets; (iv) commences under the laws of any jurisdiction any proceeding for relief under the Bankruptcy Code of 1986, as amended (“Code”) or similar bankruptcy laws in applicable jurisdictions, involving its insolvency, reorganization, adjustment of debt, dissolution, liquidation or any other similar proceeding for the release of financially distressed debtors; or (v) becomes a party to any proceeding or action of the type described above in (iii) or (iv), and such proceeding or action remains undismissed or unstayed for a period of more than sixty (60) days.

10.4. DURECT Termination. DURECT may terminate this agreement upon written notice if (i) NeuroSystec has not paid DURECT the amounts set forth in Section 4.1.1 in the time period set forth therein and has not cured such breach within [***] days following receipt of notice of such breach, (ii) NeuroSystec has not issued to DURECT the stock set forth in the Equity Agreement within the agreed upon timeframe and has not cured such breach within seven (7) days following receipt of notice of such breach or (iii) NeuroSystec is in material breach of any other provision hereunder and has not cured such breach within [***] days following the receipt of a first notice which specifies in reasonable detail the nature of the breach sent to it by DURECT; provided, however, that in each case under this clause iii), if NeuroSystec disputes such breach in writing within the Cure Period, DURECT shall not have the right to terminate this Agreement unless and until an arbitration tribunal has determined pursuant to Section 12.3 that NeuroSystec is in material breach of any other provision hereunder as set forth in (iii), and NeuroSystec has failed to cure such breach within a reasonable period of time to be set by such arbitration tribunal.

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10.5. Effect of Termination.

10.5.1. Upon termination of this Agreement in its entirety pursuant to Section 2.4, 10.2, or 10.4, the licenses granted by DURECT to NeuroSystec hereunder shall terminate and NeuroSystec shall provide all data and information requested by DURECT that is reasonably deemed necessary by DURECT to continue research, development and commercialization of Licensed Products that had been conducted by NeuroSystec and [***] Termination of this Agreement by any Party shall not require resort to any court or compliance with any other formality and shall not prejudice the right of either party to recover any damages for breach of this Agreement.

10.5.2. Upon termination of this Agreement in its entirety pursuant to Section 12.6, the licenses granted by DURECT to NeuroSystec hereunder shall terminate.

10.6. Survival. Articles 4 (solely with respect to amounts owed prior to expiration or termination), 1, 9, 10, 11 and 12 and Sections 7.1, 7.2, 7.3, and 8.3 shall survive expiration or termination of this Agreement.

11. CONFIDENTIAL INFORMATION AND PUBLICATION

11.1. Confidentiality. In connection with the Non-Disclosure Agreement, as defined below, and with this Agreement, the parties have disclosed and will disclose or make available to each other information, data and materials of a confidential or proprietary nature (“Confidential Information”), including but not limited to each Party’s proprietary know-how, invention disclosures, materials and/or technologies, economic information, business or research strategies, clinical trial data and information, trade secrets and material embodiments thereof.

11.2. Confidentiality and Non-Use. The recipient of a disclosing Party’s Confidential Information shall maintain such Confidential Information in confidence, and shall disclose such Confidential Information only to those of its employees, agents, consultants, Sublicensees, attorneys, accountants, advisors, existing and potential investors, and potential development and commercialization partners who have a reasonable need to know such Confidential Information for purposes contemplated by this Agreement and who are bound by obligations of confidentiality and non-use no less restrictive then those set forth herein. The recipient of the disclosing Party’s Confidential Information shall use such Confidential Information solely to exercise its rights and perform its obligations under this Agreement (including, without limitation, the right to use and disclose such Confidential Information, to the extent required, in regulatory applications and filings), unless otherwise mutually agreed in writing. The recipient of the disclosing Party’s Confidential Information shall take the same degree of care that it uses to protect its own confidential and proprietary information of a similar nature and importance (but in any event no less than reasonable care).

11.3. Exclusions. Confidential Information of a disclosing Party shall not include information that: (a) was in the recipient’s possession prior to receipt from the disclosing Party as demonstrated by contemporaneous documentation; (b) was or becomes, through no fault of the recipient, publicly known; (c) was furnished to the recipient by a Third Party without breach of a duty or obligation of confidentiality to the disclosing Party; (d) was independently developed by the recipient without use of, application of or reference to the disclosing Party’s Confidential Information as demonstrated by contemporaneous documentation.

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11.4. Legal Disclosures. It shall not be a violation of this Article 11 for the recipient to disclose the disclosing Party’s Confidential Information when such information is required to be disclosed under applicable law, but such disclosure shall be for the sole purpose of and solely to the extent required by such law, and provided that the recipient, to the extent possible, shall give the disclosing Party prior written notice of the proposed disclosure and cooperate fully with the disclosing Party to minimize the scope of any such required disclosure, to the extent possible and in accordance with applicable law and will use all reasonable efforts to secure confidential treatment of such Confidential Information required to be disclosed.

11.5. Termination. All obligations of confidentiality and non-use imposed under this Article 11 shall expire [***] years after the date of expiration or termination of this Agreement.

11.6. Non-Disclosure Agreement. The nondisclosure agreement between DURECT and Stephen McCormack (acting as an agent for NeuroSystec) dated August 15, 2003 (“Non-Disclosure Agreement”) is expressly superseded with respect to the Confidential Information disclosed under the Non-Disclosure Agreement that are also disclosed under this Agreement and therefore subject to the confidentiality restrictions of this Article 11. [***]

11.7. Publications and Press Releases. Neither Party shall issue any press release, publication, or any other public announcement relating to this Agreement, without obtaining the other Party’s prior written approval, provided, however, that the parties may issue a mutually agreed upon joint press release regarding this Agreement at a time to be mutually agreed upon. In the event a Party desires to publish in a scientific or academic journal or similar publication or to make a public presentation in the form of a seminar or lecture or the like, Confidential Information developed by such Party relating to a Licensed Product, in addition to any necessary internal reviews or approvals by such Party, such Party shall submit a copy of the proposed publication or presentation to the other Party [***] days prior to any disclosure or submission to any Third Party. The parties agree to review and evaluate the submission to determine the effect, if any, that such publication or presentation would have on the commercialization of Licensed Products, whereupon the parties may either approve, require modifications to, or disapprove the proposed publication or presentation. Neither Party shall have the right to publish or present Confidential Information of the other and shall remove the Confidential Information of the other Party from any proposed publication or presentation at the request of the other Party. Once such press releases, publications, or other public announcements have been approved for disclosure by the parties, such approval will not be required again before a Party may subsequently repeat disclosure of information contained therein. Notwithstanding the foregoing, each Party shall have the right to make such disclosures as may be required by applicable laws, including applicable securities laws. Independent investigators that have been engaged by one or both parties shall be allowed to release information regarding studies performed by such investigators in a manner consistent with academic standards so long as each Party is given a reasonable opportunity to review such release of information to ensure that intellectual property being disclosed has been appropriately handled in accordance with Article 7, such review not to exceed [***] days.

12. MISCELLANEOUS

12.1. Trademarks. NeuroSystec will have sole responsibility for, and ownership of, any and all trademarks for the Licensed Product used in the Territory.

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12.2. Marking Requirement. Each Party agrees to mark the appropriate patent number or numbers as reasonably requested by the other Party on such Licensed Products made or sold in accordance with all applicable governmental laws, rules and regulations to the extent reasonably possible, and to require its Affiliates and Sublicensees to do the same. Each Party acknowledges and agrees that by agreeing to mark Licensed Products, the other Party is not agreeing or otherwise admitting that any such marked product is covered by the claims of the DURECT Patent Rights or any other patent. In the event that [***] requests that DURECT cause a Licensed Product and its packaging to display prominently, in a manner reasonably acceptable to [***], an [***] name and logo, and to identify [***] as a developer of such Licensed Product, NeuroSystec shall identify [***] as the developer of the [***] and include the [***] name and logo on such Licensed Product and packaging for Licensed Products incorporating the [***] to the extent permitted by applicable law, regulation, or the FDA or foreign counterpart thereof having jurisdiction. Unless otherwise instructed by DURECT, NeuroSystec shall identify, in a manner reasonably acceptable to DURECT, DURECT as the developer of the DURECT Drug Delivery Platforms on the packaging of Licensed Products incorporating DURECT Drug Delivery Platforms to the extent permitted by applicable law, regulation, or the FDA or foreign counterpart thereof having jurisdiction. All uses of the DURECT name and marks or [***] name and marks shall be subject to prior review and approval by DURECT and/or [***] as the case may be, such approval not to be unreasonabley withheld or conditioned on further consideration.

12.3. Governing Law; Dispute Resolution.

12.3.1. This Agreement shall be governed by, and construed and interpreted, in accordance with the internal laws of the State of California without giving effect to any choice of law rule that would cause the application of the laws of any jurisdiction other than the internal laws of the State of California to the rights and duties of the parties.

12.3.2. In the event of any controversy, claim or dispute arising out of or related to this Agreement or to the breach or interpretation thereof (a “Dispute”), the parties shall first refer such Dispute to the Chief Executive Officer, or his or her duly appointed representative (each a “Responsible Executive”) of each Party for attempted resolution by good faith executive negotiations within thirty (30) days after such referral is made. In the event such officers are unable to resolve such Dispute within such thirty (30) day period, either Party may assert its rights in a manner in accordance with the provisions of Section 12.3.3-12.3.6.

12.3.3. Subject to Section 12.3.5, any Dispute that is not resolved under Section 12.3.2 shall be solely and exclusively settled by final and binding arbitration in accordance with the then current commercial arbitration rules of the American Arbitration Association, subject to the terms and conditions of this Section 12.3. Either Party may initiate the arbitration of a Dispute by sending written notice of such election to the other Party clearly marked “Arbitration Demand” (the “Arbitration Demand”). The Dispute shall be adjudicated by three (3) neutral and impartial arbitrators. Each Party shall nominate one arbitrator within thirty (30) days after the other Party’s receipt of the Arbitration Demand, and the two arbitrators so named will then jointly appoint the third arbitrator as chairman of the arbitration tribunal. The decision of the arbitration tribunal shall be final and binding upon the parties hereto, and may be entered in any competent court for judicial acceptance of such an award and order of enforcement.

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12.3.4. All costs of the arbitration shall be shared equally by the parties, and each Party shall be responsible for its own legal and other costs. The arbitrators shall not have the right or authority to award punitive damages to either Party.

12.3.5. Notwithstanding anything to the contrary in this Section 12.3, each Party may, and expressly reserves the right to, seek judicial relief from any court of competent jurisdiction in order to obtain an injunction or other equitable relief or to enforce a breach of the confidentiality provisions in Article 11 or to otherwise obtain temporary relief pending the outcome of the arbitration.

12.3.6. Arbitration will take place in Cupertino, California if requested by NeuroSystec and in Los Angeles, California if requested by DURECT. The proceedings shall be conducted and all documentation shall be presented in English. The parties agree that the arbitration proceedings and its contents shall be kept confidential, except as may otherwise be required by applicable law.

12.4. Export Regulations. The parties agree that this Agreement is subject in all respects to the laws and regulations of the United States of America, including the Export Administration Act of 1979, as amended, and any regulations thereunder.

12.5. Limitation of Liability. IN NO EVENT SHALL EITHER PARTY BE LIABLE FOR INCIDENTAL, CONSEQUENTIAL, INDIRECT, PUNITIVE OR SPECIAL DAMAGES OF THE OTHER PARTY ARISING OUT OF OR RELATED TO THIS AGREEMENT, HOWEVER CAUSED, UNDER ANY THEORY OF LIABILITY, EVEN IF ADVISED OF THE POSSIBILITY OF SUCH DAMAGES.

12.6. Force Majeure. Neither Party shall be held responsible for any delay or failure in performance hereunder to the extent caused by strikes, embargoes, unexpected government requirements, civil or military authorities, acts of God, earthquake, or by war, insurrection, terrorism or other causes beyond such Party’s control and without such Party’s fault or negligence; provided that the affected Party notifies the unaffected Party as soon as reasonably possible, and resumes performance hereunder as soon as reasonably possible following cessation of such force majeure event. Each Party agrees to give the other Party prompt written notice of the occurrence of any such condition set forth herein, the nature thereof, and the extent to which the affected Party will be unable fully to perform its obligations hereunder. Each Party further agrees to use all reasonable efforts to correct the condition as quickly as possible, and to give the other prompt written notice when it is again fully able to perform such obligations. If, as a result of conditions set forth herein, either Party is unable to substantially perform any of its material obligations hereunder for any consecutive period of three hundred and sixty-five (365) days, the other Party shall have the right to terminate this Agreement upon written notice.

12.7. Independent Contractors. The relationship of NeuroSystec and DURECT established by this Agreement is that of independent contractors. Nothing in this Agreement shall be construed to create any other relationship between NeuroSystec and DURECT. Neither Party shall have any right, power or authority to bind the other or assume, create or incur any expense, liability or obligation, express or implied, on behalf of the other.

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12.8. Assignment. NeuroSystec and DURECT may assign this Agreement to an Affiliate or in connection with the merger, acquisition or sale by NeuroSystec or DURECT, as the case may be, of all or substantially all of its assets relating to this Agreement upon prior written notice to DURECT or NeuroSystec, as the case may be, and without the need for DURECT’s or NeuroSystec’s consent, as applicable, provided however that (a) any such assignee shall assume all obligations of NeuroSystec or DURECT, as the case may be, under this Agreement and (b) no assignment shall relieve NeuroSystec or DURECT of responsibility for the performance of any accrued obligations which NeuroSystec or DURECT then has hereunder. Aside from the foregoing, no rights or obligations under this Agreement may be transferred or assigned by a Party to a Third Party without the prior written consent of the other Party. Any assignment not in conformance with this Section 12.8 shall be null, void and of no legal effect.

12.9. Notices. All notices required or permitted to be given hereunder shall be (a) delivered in person or (b) sent by express courier (via a reliable courier company such as FedEx or DHL), or (c) sent by registered airmail, with postage prepaid, and return receipt requested or (d) sent by facsimile (with a confirmation letter thereof sent by express courier or registered airmail) to the address specified below or to such changed address as may have been previously specified in writing by the addressed Party from time to time during the term of this Agreement. If notice is given in person, by courier or by fax, it shall be effective upon receipt; if notice is given by overnight delivery service, it shall be effective two (2) business days after deposit with the delivery service; and if notice is given by mail, it shall be effective five (5) business days after deposit in the mail. Notices shall be sent as follows:

If to DURECT:

Attn: General Counsel

DURECT Corporation

10240 Bubb Road

Cupertino, CA 95014

Main: (408) 777-1827

Facsimile: (408) 777-3577

If to NeuroSystec:

NEUROSYSTEC

Attn: Stephen McCormack

Mann Biomedical Park

25134 Rye Canyon Loop

Suite 370

Valencia, CA 91355

Main: (661) 702-6880

Facsimile: (661) 702-6715

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With copy to:

Alfred E. Mann

c/o Advanced Bionics Corporation

25129 Rye Canyon Road

Valencia, CA 91355

12.10. Modification; Waiver. This Agreement may not be altered, amended or modified in any way except by a writing signed by authorized representatives of both of the parties. The failure of a Party to enforce any rights or provisions of the Agreement shall not be construed to be a waiver of such rights or provisions, or a waiver by such Party to thereafter enforce such rights or provision or any other rights or provisions hereunder. No waiver shall be effective unless made in writing and signed by the waiving Party.

12.11. Severability. If any provision of this Agreement shall be found by a court of competent jurisdiction or the arbitration panel described in Section 12.3 to be void, invalid or unenforceable, the same shall be reformed to comply with applicable law or stricken if not so conformable, so as not to affect the validity or enforceability of the remainder of this Agreement. In the event that any provision of this Agreement becomes or is declared by a court of competent jurisdiction or the arbitration panel described in Section 12.3 to be void, invalid or unenforceable, and reformation or striking of such provision materially changes the economic benefit of this Agreement to either NeuroSystec or DURECT, NeuroSystec and DURECT shall modify such provision in accordance with this Section 12.13 to obtain a legal, valid and enforceable provision and provide an economic benefit to NeuroSystec and DURECT that most nearly effects NeuroSystec’s and DURECT’s intent on entering into this Agreement.

12.12. Bankruptcy Treatment of Licenses. The parties agree that the rights granted to NeuroSystec hereunder, including, without limitation, those rights granted in Section 2, are rights in “intellectual property” within the scope of Section 101 (or its successors) of the United States Bankruptcy Code (the “Code”). Licensee shall have the rights set forth herein with respect to the Licensed Products when and as developed or created. In addition, NeuroSystec, as a licensee of intellectual property rights hereunder, shall have and may fully exercise all rights available to a licensee under the Code, including, without limitation, under Section 365(n) or its successors. In the event of a case under the Code involving DURECT, NeuroSystec shall have the right to obtain (and DURECT or any trustee for DURECT or its assets shall, at NeuroSystec’s written request, deliver to NeuroSystec) a copy of all embodiments (including, without limitation, any work in progress) of any intellectual property rights granted hereunder, including, without limitation, embodiments of any Licensed Products, and any DURECT Drug Delivery Platforms or any other intellectual property necessary or desirable for NeuroSystec to use or exploit any Licensed Products or to exercise its rights hereunder. In addition, DURECT shall take all steps reasonably requested by NeuroSystec to perfect, exercise and enforce its rights hereunder, including, without limitation, filings in the U.S. Copyright Office and U.S. Patent and Trademark Office, and under the Uniform Commercial Code.

12.13. Entire Agreement. The parties hereto acknowledge that this Agreement, together with the exhibits attached hereto, sets forth the entire agreement and understanding of the parties as to the subject matter hereto, and supersedes all prior and contemporaneous discussions, agreements and writings in respect hereto. This Agreement supersedes the Non-Disclosure Agreement to the extent indicated in Section 11.6 hereunder.

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***Material has been omitted pursuant to a request for confidential treatment and such material has been filed separately with the SEC.

12.14. Headings. The article, section and paragraph headings contained herein are for the purposes of convenience only and are not intended to define or limit the contents of the articles, sections or paragraphs to which such headings apply.

12.15. Counterparts. This Agreement may be executed in two or more counterparts (including faxed counterparts), each of which shall be deemed an original and all of which together shall constitute one instrument.

12.16. No Third-Party Beneficiaries. Nothing in this Agreement, express or implied, is intended to confer, nor shall anything herein confer on, any person other than the parties and the respective successors or permitted assigns of the parties, any rights, remedies, obligations or liabilities. For the avoidance of doubt, any payment made to [***] pursuant to Section 4.3 represents payments owed by NeuroSystec to DURECT, which DURECT would otherwise remit to [***] pursuant to DURECT’s payment obligations, and are paid by NeuroSystec to [***] directly on behalf of DURECT solely for the convenience of DURECT and NeuroSystec. Such payments do not relieve DURECT of its obligations to pay [***] and do not create an independent right on the part of [***] under this Agreement.

12.17. [***]

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***Material has been omitted pursuant to a request for confidential treatment and such material has been filed separately with the SEC.

IN WITNESS WHEREOF, NeuroSystec and DURECT have executed this Agreement by their respective duly authorized representatives.

NEUROSYSTEC CORPORATION		DURECT CORPORATION
By:	/s/	By:	/s/
Name:	Alfred E. Mann	Name:	James E. Brown
Title:	Chairman	Title:	CEO

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***Material has been omitted pursuant to a request for confidential treatment and such material has been filed separately with the SEC.

EXHIBIT A

DURECT THIRD PARTY LICENSES

[***]

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***Material has been omitted pursuant to a request for confidential treatment and such material has been filed separately with the SEC.

EXHIBIT B

DURECT PATENT RIGHTS

[***]

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***Material has been omitted pursuant to a request for confidential treatment and such material has been filed separately with the SEC.

EXHIBIT C

FTE COST CALCULATION

FTE Development Costs are equal to [***]

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***Material has been omitted pursuant to a request for confidential treatment and such material has been filed separately with the SEC.

EX-31.1

Exhibit 31.1

Rule 13a-14(a) Section 302 Certification

CERTIFICATIONS

I, James E. Brown, certify that:

1. I have reviewed this report on Form 10-Q of DURECT Corporation;

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

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

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

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

(b) [Paragraph reserved pursuant to SEC Release 33-8238]

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

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

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

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

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

August 4, 2004

/s/     JAMES E. BROWN    

James E. Brown

Chief Executive Officer

EX-31.2

Exhibit 31.2

Rule 13a-14(a) Section 302 Certification

CERTIFICATIONS

I, Thomas A. Schreck, certify that:

1. I have reviewed this report on Form 10-Q of DURECT Corporation;

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

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

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

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

(b) [Paragraph reserved pursuant to SEC Release 33-8238]

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

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

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

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

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

August 4, 2004

/s/    THOMAS A. SCHRECK    

Thomas A. Schreck

Chief Financial Officer

EX-32.1

Exhibit 32.1

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of DURECT Corporation (the “Company”) on Form 10-Q for the period ending June 30, 2004 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, James E. Brown, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that:

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

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

August 4, 2004

/s/    JAMES E. BROWN        

James E. Brown

Chief Executive Officer

EX-32.2

Exhibit 32.2

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of DURECT Corporation (the “Company”) on Form 10-Q for the period ending June 30, 2004 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Thomas A. Schreck, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that:

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

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

August 4, 2004

/s/    THOMAS A. SCHRECK          

Thomas A. Schreck

Chief Financial Officer