UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

 

 

 

 

Commission File Number: 000-51863

 

 

VANDA PHARMACEUTICALS INC.

(Exact name of registrant as specified in its charter)

 

 

 

 

(240) 599-4500

(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 þ     No o

 

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

 

Large Accelerated Filer o     Accelerated Filer o     Non-Accelerated Filer þ

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

As of August 3, 2007, there were 26,626,604 shares of the Registrant’s Common Stock issued and outstanding.

 

 

Vanda Pharmaceuticals Inc.
(A Development Stage Enterprise)

 

Form 10-Q Index

 

For the Three and Six Months Ended June 30, 2007

 

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

 

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

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

 

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

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

 

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

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

 

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

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

 

Business organization

 

Vanda Pharmaceuticals Inc. (Vanda or the Company) is a biopharmaceutical company focused on the development and commercialization of small molecule therapeutics, with exclusive worldwide commercial rights to three product candidates in clinical development for various central nervous system disorders. Vanda commenced its operations on March 13, 2003. The Company’s lead product candidate, iloperidone, is a compound for the treatment of schizophrenia and bipolar disorder. The Company expects to file a New Drug Application (NDA) for iloperidone in schizophrenia with the United States Food and Drug Administration (FDA) by the end of 2007. The Company’s second product candidate, VEC-162, is a compound for the treatment of sleep and mood disorders, which previously demonstrated positive results from a Phase III clinical trial in transient insomnia. VEC-162 is also ready for Phase II trials for the treatment of depression. The Company expects to initiate dosing for the next Phase III trial of VEC-162 in chronic primary insomnia in the fourth quarter of 2007. The Company’s third product candidate, VSF-173, is a compound for the treatment of excessive sleepiness. The Company expects to complete its first VSF-173 Phase II clinical trial in the fourth quarter of 2007.

 

Initial public and follow-on offerings

 

The Company completed its initial public offering in April 2006. The offering totaled 5,964,188 shares of common stock at a public offering price of $10.00 per share, resulting in net proceeds to the Company of approximately $53.3 million after deducting payments of underwriters’ discounts and commissions and offering expenses.

 

In January 2007 the Company completed its follow-on offering. The offering totaled 4,370,000 shares of common stock at a public offering price of $27.29 per share, resulting in net proceeds to the Company of approximately $111.3 million after deducting underwriting discounts and commissions and offering expenses.

 

Capital resources

 

Since its inception, the Company has devoted substantially all of its efforts to business planning, research and development, recruiting management and technical staff, acquiring operating assets, raising capital and market research. Accordingly, the Company is considered to be in the development stage as defined in Statement of Financial Accounting Standards (SFAS) No. 7, Accounting and Reporting by Development Stage Enterprises.

 

The Company’s activities will necessitate significant uses of working capital throughout 2007 and beyond. Additionally, the Company’s capital requirements will depend on many factors, including the success of the Company’s research and development efforts, payments received under contractual agreements with other parties, if any, and the status of competitive products. The Company plans to continue financing its operations with cash received from financing activities and believes that its current capital resources will be sufficient to meet its current operating needs into mid-2008 and, after that time, the Company will require additional capital. In budgeting for our activities, we have relied on a number of assumptions, including assumptions that we will file an NDA for iloperidone in schizophrenia with the FDA by the end of 2007, that we will continue to expend funds in preparation of a commercial launch of iloperidone, that we will expend funds on the extended-release injectable formulation of iloperidone, that we will initiate dosing for the next Phase III trial of VEC-162 in chronic primary insomnia in the fourth quarter of 2007 and that this trial will be conducted in accordance with our expectations, that we will conduct our VSF-173 Phase II trial for excessive sleepiness in accordance with our expectations, that we will not engage in further in-licensing activities, that we will not receive any proceeds from potential partnerships, that we will not expend funds on the bipolar indication for

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — (Continued)

iloperidone, that we will continue to evaluate pre-clinical compounds for potential development, that we will be able to continue the manufacturing of our product candidates at commercially reasonable prices, that we will be able to retain our key personnel, and that we will not incur any significant contingent liabilities.

 

The Company may need to raise additional funds more quickly if one or more of the above assumptions proves to be incorrect, if the Company chooses to expand its product development efforts more rapidly than presently anticipated or if the Company seeks to acquire additional product candidates. The Company may decide to raise additional funds even before they are needed if the conditions for raising capital are favorable. However, the Company may not be able to raise additional funds on acceptable terms, or at all. If the Company is unable to secure sufficient capital to fund its research and development activities, the Company may not be able to continue operations, or the Company may have to enter into collaboration agreements that could require the Company to share commercial rights to its products to a greater extent or at earlier stages in the drug development process than is currently intended.

 

Basis of presentation

 

The accompanying unaudited condensed consolidated financial statements of Vanda Pharmaceuticals Inc. have been prepared in accordance with accounting principles generally accepted in the United States and the rules and regulations of the Securities and Exchange Commission (SEC), for interim financial information. Accordingly, they do not include all the information and footnotes required by generally accepted accounting principles for complete financial statements and should be read in conjunction with the Company’s consolidated financial statements for the year ended December 31, 2006 included in the Company’s annual report on the Form 10-K. The financial information as of June 30, 2007 and for the periods of the three and six months ended June 30, 2007 and 2006 and for the period from March 13, 2003 (inception) to June 30, 2007, is unaudited, but in the opinion of management all adjustments, consisting only of normal recurring accruals, considered necessary for a fair statement of the results of these interim periods have been included. The condensed balance sheet data as of December 31, 2006 was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States.

 

The results of the Company’s operations for any interim period are not necessarily indicative of the results that may be expected for any other interim period or for a full fiscal year. The financial information included herein should be read in conjunction with the consolidated financial statements and notes in the Company’s annual report incorporated by reference in the Form 10-K for year ended December 31, 2006. The condensed consolidated financial statements include the accounts of the Company and its wholly-owned Singapore subsidiary. All inter-company balances and transactions have been eliminated.

 

 

Cash and cash equivalents

 

For purposes of the condensed consolidated balance sheets and condensed consolidated statements of cash flows, cash equivalents represent highly-liquid investments with a maturity of three months or less at the date of purchase.

 

Marketable securities

 

The Company classifies all of its marketable securities as available-for-sale. Available-for-sale securities are carried at fair value, with the unrealized gains and losses reported as a component of stockholders’ equity in accumulated other comprehensive loss. Interest income, amortization of premiums and accretion of discounts on marketable securities, and realized gains and losses on securities are included in interest income

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — (Continued)

in the statements of operations. Marketable securities with a maturity of more than one year at the end of the period are classified as long-term securities.

 

Restricted cash

 

During 2005, in conjunction with the lease of the office and laboratory space in Rockville, MD, the Company provided the landlord with a letter of credit, which was collateralized with a deposit in the amount of $430,230. The deposit is recorded as non-current restricted cash at June 30, 2007 since the letter of credit is required until the lease expires in 2016.

 

Concentrations of credit risk

 

Financial instruments which potentially subject the Company to significant concentrations of credit risk consist primarily of cash and cash equivalents and marketable securities. The Company places its cash and cash equivalents and marketable securities with highly-rated financial institutions. At June 30, 2007, the Company maintained all of its cash and cash equivalents in three financial institutions. Deposits held with these institutions may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand, and the Company believes there is minimal risk of losses on such balances.

 

Stock-based compensation

 

The Company accounts for the stock-based compensation expenses in accordance with the Financial Accounting Standards Board (FASB) revised SFAS No. 123, Share-Based Payment (SFAS 123(R)). Accordingly, compensation costs for all stock-based awards to employees and directors are measured based on the grant date fair value of those awards and recognized over the period during which the employee is required to perform service in exchange for the award. The Company generally recognizes the expense over the award’s vesting period.

 

For stock awards granted in 2006 and 2007, expenses are amortized under the accelerated attribution method. For stock awards granted prior to January 1, 2006, expenses are amortized under the accelerated attribution method for options that were modified after the original grant date and under the straight-line attribution method for all other options. As stock-based compensation expense recognized in the condensed consolidated statements of operations for the three and six months ended June 30, 2006 and 2007 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Pre-vesting forfeitures on the options granted during 2006 and 2007 were estimated to be approximately 2% based on the Company’s historical experience.

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — (Continued)

Total employee stock-based compensation expense recognized during the three and six months ended June 30, 2007 and 2006 comprised of the following:

 

 

As of June 30, 2007, approximately $35.0 million of total unrecognized compensation costs related to non-vested awards is expected to be recognized over a weighted average period of 3.0 years.

 

As of June 30, 2007, the Company had two equity incentive plans, the Second Amended and Restated Management Equity Plan (the 2004 Plan) and the 2006 Equity Incentive Plan (the 2006 Plan) that were adopted in December 2004 and April 2006, respectively. An aggregate of 1,233,756 shares were subject to outstanding options granted under the 2004 Plan as of June 30, 2007, and no additional options will be granted under this plan. As of June 30, 2007 there are 2,385,141 shares of the Company’s common stock reserved under the 2006 Plan of which 1,606,928 shares were subject to outstanding options to employees and non-employees.

 

Options are subject to terms and conditions established by the compensation committee of the board of directors. None of the stock-based awards are classified as a liability as of June 30, 2007. Option awards have 10-year contractual terms and all options granted prior to December 31, 2006 and options granted to new employees vest and become exercisable on the first anniversary of the grant date with respect to the 25% of the option awards and the remaining 75% of the option awards vest and become exercisable monthly in equal installments thereafter over three years. Option awards granted to existing employees after December 31, 2006 vest and become exercisable monthly in equal installments over four years. The initial stock options granted to directors upon their election vest and become exercisable in equal monthly installments over a period of four years, while the subsequent annual stock option grants to directors vest and become exercisable in equal monthly installments over a period of one year. Certain option awards provide for accelerated vesting if there is a change in control of the Company.

 

The fair value of each option award is estimated on the date of grant using the Black-Scholes option pricing model (Black-Scholes model) that uses the assumptions noted in the following table. Expected volatility rates are based on historical volatility of the common stock of comparable entities and other factors due to the lack of historic information of the Company’s publicly traded common stock. The expected term of options granted is based on the transition approach provided by Staff Accounting Bulletin (“SAB”) No. 107 as the options meet the “plain vanilla” criteria required by this method. The risk-free interest rates are based on the U.S. Treasury yield for a period consistent with the expected term of the option in effect at the time of the grant. The Company has not paid dividends to its stockholders since its inception and does not plan to pay dividends in the foreseeable future.

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — (Continued)

Assumptions used in the Black-Scholes model for employee and director stock options granted during the six months ended June 30, 2007 and 2006 were as follows:

 

 

A summary of option activity for the 2004 Plan is presented below:

 

 

A summary of option activity for the 2006 Plan is presented below:

 

 

The weighted average grant-date fair value of options granted during the six months ended June 30, 2007 was $20.38 per share. For the six months ended June 30, 2007 and 2006 the Company received a total of $79,587 and $294, respectively, in cash from options exercised under the stock-based arrangements.

 

Equity instruments issued to non-employees

 

The equity instruments issued to non-employees in exchange for services are recorded at the fair value of the equity instruments on the measurement date. The measurement of expense is subject to periodic adjustment as the underlying equity instruments vest and the performance by the third party is complete. The Company recognizes the fair value of non-employee equity instruments in the same periods and in the same manner as if the Company had paid cash for the services.

 

As of June 30, 2007 an aggregate of 35,625 shares were subject to outstanding options granted to non-employees under the 2004 Plan and 2006 Plan of which 29,837 options are subject to vesting. Total non-

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — (Continued)

employee equity-based compensation expense, recognized during the three and six months ended June 30, 2007 and 2006 was comprised of the following:

 

 

Accrued expenses

 

Management is required to estimate accrued expenses as part of the process of preparing financial statements. The estimation of accrued expenses involves identifying services that have been performed on the Company’s behalf, and then estimating the level of service performed and the associated cost incurred for such services as of each balance sheet date in the financial statements. Examples of estimated accrued expenses include professional service fees, such as lawyers and accountants, contract service fees, such as amounts paid to clinical monitors, data management organizations and investigators in conjunction with clinical trials, fees paid to contract manufacturers in conjunction with the production of clinical materials, and fees paid for marketing and other commercialization activities. Pursuant to management’s assessment of the services that have been performed on clinical trials and other contracts, the Company recognizes these expenses as the services are provided. Such management assessments include, but are not limited to: (1) an evaluation by the project manager of the work that has been completed during the period, (2) measurement of progress prepared internally and/or provided by the third-party service provider, (3) analyses of data that justify the progress, and (4) management’s judgment.

 

Research and development expenses

 

The Company’s research and development expenses consist primarily of fees paid to third parties in connection with the services they provide for our clinical trials, costs of contract manufacturing services, license fees, costs of materials used in clinical trials and research and development, depreciation of capital resources used to develop our products, all related facilities costs, and salaries, other related costs and stock-based compensation related to our research and development personnel. We expense research and development costs as they are incurred, including payments made to date under our license agreements. Manufacturing-related costs are also included in research and development expenses as we do not yet have FDA approval for any of our product candidates. Costs related to our acquisitions of intellectual property have been expensed as incurred since the underlying technology associated with these acquisitions were made in connection with the Company’s research and development efforts and have no alternative future use.

 

General and administrative expenses

 

General and administrative costs consist primarily of salaries, other related costs and stock-based compensation for personnel serving executive, finance, accounting, information technology and human resource functions, facility costs not otherwise included in research and development expenses, insurance costs and professional fees for legal, accounting and other professional services. General and administrative costs also include third party expenses incurred to support business development, marketing and other business activities related to our product candidate iloperidone, in anticipation of its commercial launch.

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — (Continued)

Income taxes

 

The Company accounts for income taxes under the liability method in accordance with provisions of SFAS No. 109, Accounting for Income Taxes, (SFAS 109) which requires companies to account for deferred income taxes using the asset and liability method. Under the asset and liability method, current income tax expense or benefit is the amount of income taxes expected to be payable or refundable for the current year. A deferred income tax asset or liability is recognized for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and tax credits and loss carryforwards. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Tax rate changes are reflected in income during the period such changes are enacted. Changes in ownership may limit the amount of net operating loss carryforwards that can be utilized in the future to offset taxable income.

 

Segment information

 

Management has determined that the Company operates in one business segment which is the development and commercialization of pharmaceutical products.

 

Use of estimates

 

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

 

Deferred grant revenue

 

Vanda Singapore entered into an agreement with the Economic Development Board of Singapore (EDB) to provide a grant for a development project. During 2005, the Company received its first reimbursement under the agreement. Given that the Company has not met all of the conditions attached to the grant expected to be met to date and therefore under certain conditions EDB may reclaim funds paid to date, the payment has been recorded as deferred grant revenue at June 30, 2007.

 

Recent accounting pronouncements

 

In September 2006, the FASB issued FASB Statement No. 157, Fair Value Measurements (SFAS 157), which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under generally accepted accounting principles. SFAS 157 outlines a common definition of fair value and the new standard intends to make the measurement of fair value more consistent and comparable and improve disclosures about those measures. The Company will need to adopt SFAS 157 for financial statements issued for fiscal years beginning after November 15, 2007. While the Company continues to evaluate the impact of SFAS 157, this pronouncement is not expected to have significant impact on its results of operations and financial condition.

 

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115 (SFAS 159). According to this standard the entities will now be permitted to measure many financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis (the fair value option). SFAS 159 is effective for fiscal years beginning after November 15, 2007. While the Company continues to evaluate the impact of

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — (Continued)

SFAS 159, this pronouncement is not expected to have significant impact on its results of operations and financial condition.

 

 

Net loss attributable to common stockholders per share is calculated in accordance with SFAS No. 128, Earnings per Share and SAB No. 98. Basic earnings per share (“EPS”) is calculated by dividing the net income or loss attributable to common stockholders by the weighted average number of shares of common stock outstanding, reduced by the weighted average unvested shares of common stock subject to repurchase.

 

Diluted EPS is computed by dividing the net income or loss attributable to common stockholders by the weighted average number of other potential common stock outstanding for the period. Other potential common stock includes the Company’s Series A Preferred Stock and Series B Preferred Stock outstanding prior to the consummation of the Company’s initial public offering, stock options and warrants to purchase common stock, but only to the extent that their inclusion is dilutive. The Company incurred a net loss in all periods presented, causing inclusion of any potentially dilutive securities to have an anti-dilutive affect, resulting in dilutive loss per share attributable to common stockholders and basic loss per share attributable to common stockholders being equivalent.

 

 

Upon consummation of the initial public offering on April 12, 2006, all shares of the Company’s Series A Preferred Stock and Series B Preferred Stock were converted into an aggregate of 15,794,632 shares of common stock. Additionally, the holders of the warrants to purchase 50,335 shares of common stock exercised their warrants upon the Company’s initial public offering.

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — (Continued)

 

The following is a summary of the Company’s available-for-sale marketable securities as of June 30, 2007:

 

 

The following is a summary of the Company’s available-for-sale marketable securities as of December 31, 2006:

 

 

5.  Prepaid expenses, deposits and other current assets

 

The following is a summary of the Company’s prepaid expenses, deposits and other current assets:

 

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — (Continued)

 

Property and equipment — at cost:

 

 

Depreciation and amortization expense for the six months ended June 30, 2007 was $293,660, for the six months ended June 30, 2006 was $247,860 and for the period from March 13, 2003 (inception) to June 30, 2007 was $1,725,686.

 

 

Accrued expenses consist of the following:

 

 

 

Singapore research facility

 

In May 2007, the Company initiated a plan to move all of its operations out of Singapore and consolidate all of its discovery research activities in its Rockville, Maryland research facility by the end of 2007. As the timing and the amount of the restructuring expenses were not known as of June 30, 2007, the Company did not record any restructuring charge during the six-month period ended June 30, 2007. The restructuring expenses will likely include employee severance and relocation expenses, certain minimal lease termination expenses and other related costs, the total of which is not expected to have significant impact on the financial results of the Company.

 

Operating leases

 

The Company has commitments totaling approximately $4.4 million under operating real estate leases for its current and former headquarters located in Rockville, Maryland, expiring in 2016 and 2008, respectively. In

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — (Continued)

connection with the consolidation of the Company’s research activities, the Company terminated its Singapore lease and expects to vacate its Singapore premises no later than by the end of 2007. Additionally, during the second quarter of 2007, the Company also exercised an option to lease additional space in its current Rockville, Maryland headquarters and is currently negotiating the terms of the lease.

 

Guarantees and indemnifications

 

The Company has entered into a number of standard intellectual property indemnification agreements in the ordinary course of its business. Pursuant to these agreements, the Company indemnifies, holds harmless, and agrees to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally the Company’s business partners or customers, in connection with any U.S. patent or any copyright or other intellectual property infringement claim by any third party with respect to the Company’s products. The term of these indemnification agreements is generally perpetual from the date of execution of the agreement. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited. Since inception, the Company has not incurred costs to defend lawsuits or settle claims related to these indemnification agreements. The Company also indemnifies its officers and directors for certain events or occurrences, subject to certain limits. The Company believes that the fair value of the indemnification agreements is minimal, and accordingly the Company has not recognized any liabilities relating to these agreements as of June 30, 2007.

 

Licensing agreements

 

The Company’s rights to develop and commercialize the clinical-stage product candidates are subject to the terms and conditions of licenses granted to the Company by other pharmaceutical companies.

 

Iloperidone.  The Company acquired exclusive worldwide rights to patents for iloperidone through a sublicense agreement with Novartis. A predecessor company of sanofi-aventis, Hoechst Marion Roussel, Inc. (HMRI), discovered iloperidone and completed early clinical work on the compound. In 1996, following a review of its product portfolio, HMRI licensed its rights to the iloperidone patents to Titan Pharmaceuticals, Inc. on an exclusive basis. In 1997, soon after it had acquired its rights, Titan sublicensed its rights to iloperidone on an exclusive basis to Novartis. In June 2004, the Company acquired exclusive worldwide rights to these patents to develop and commercialize iloperidone through a sublicense agreement with Novartis. In partial consideration for this sublicense, the Company paid Novartis an initial license fee of $500,000 and is obligated to make future milestone payments to Novartis of less than $100 million in the aggregate (the majority of which are tied to sales milestones), as well as royalty payments to Novartis at a rate which, as a percentage of net sales, is in the mid-twenties. The Company expects to meet a milestone in 2007 under this license agreement, for which the Company would be obligated to make a license payment of $5 million.

 

The rights with respect to the patents to develop and commercialize iloperidone may terminate, in whole or in part, if the Company fails to meet certain development or commercialization milestones relating to the time it takes for the Company to launch iloperidone commercially following regulatory approval, and the time it takes for the Company to receive regulatory approval following the submission of an NDA or equivalent foreign filing. Additionally, the Company’s rights may terminate in whole or in part if the Company does not meet certain other obligations under the sublicense agreement to make royalty and milestone payments, if the Company fails to comply with requirements in the sublicense agreement regarding its financial condition, or if the Company does not abide by certain restrictions in the sublicense agreement regarding other development activities.

 

VEC-162.  In February 2004, the Company entered into a license agreement with Bristol-Myers Squibb (BMS) under which the Company received an exclusive worldwide license under certain patents and patent applications, and other licenses to intellectual property, to develop and commercialize VEC-162. In partial

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — (Continued)

consideration for the license, the Company paid BMS an initial license fee of $500,000 and is obligated to make future milestone payments to BMS of less than $40 million in the aggregate (the majority of which are tied to sales milestones) as well as royalty payments based on the net sales of VEC-162 at a rate which, as a percentage of net sales, is in the low teens. The Company is also obligated under this agreement to pay BMS a percentage of any sublicense fees, upfront payments and milestone and other payments (excluding royalties) that the Company receives from a third party in connection with any sublicensing arrangement, at a rate which is in the mid-twenties. The Company has agreed with BMS in the license agreement for VEC-162 to use commercially reasonable efforts to develop and commercialize VEC-162 and to meet certain milestones in initiating and completing certain clinical work. During March 2006, the Company met its first milestone relating to the initiation of the Phase III clinical trial for VEC-162 and recorded a license fee expense of $1,000,000.

 

BMS holds certain rights with respect to VEC-162 in the license agreement. If the Company has not agreed to one or more partnering arrangements to develop and commercialize VEC-162 in certain significant markets with one or more third parties after the completion of the Phase III program, BMS has the option to exclusively develop and commercialize VEC-162 on its own on pre-determined financial terms, including milestone and royalty payments. If the Company seeks a co-promotion agreement for VEC-162, BMS has a right of first negotiation to enter into such an agreement with the Company.

 

Either party may terminate the VEC-162 license agreement under certain circumstances, including a material breach of the agreement by the other. In the event that BMS has not exercised its option to reacquire the rights to VEC-162 and the Company terminates the license, or if BMS terminates the license due to the Company’s breach, all rights licensed and developed by the Company under this agreement will revert or otherwise be licensed back to BMS on an exclusive basis.

 

VSF-173.  In June 2004, the Company entered into a license agreement with Novartis under which the Company received an exclusive worldwide license to develop and commercialize VSF-173. In consideration for the license, the Company paid Novartis an initial license fee of $500,000. The Company is also obligated to make future milestone payments to Novartis of less than $50 million in the aggregate (the majority of which are tied to sales milestones) and royalty payments at rates which, as a percentage of net sales, range from the low-to-mid teens. In March 2007, the Company met its first milestone under this license agreement relating to the initiation of the Phase II clinical trial for VSF-173, and recorded a license fee expense of $1,000,000.

 

Novartis has the right to co-develop and exclusively commercialize VSF-173 on its own after the completion of Phase II and Phase III programs in exchange for certain milestones and royalty payments. In the event that Novartis chooses not to exercise either of these options and the Company decides to enter into a partnering arrangement to commercialize VSF-173, Novartis has a right of first refusal to negotiate such an agreement with the Company, as well as a right to submit a last matching counteroffer regarding such an agreement. In addition, the rights with respect to VSF-173 may terminate, in whole or in part, if the Company fails to meet certain development and commercialization milestones described in the license agreement relating to the time it takes the Company to complete the development work on VSF-173. These rights may also terminate in whole or in part if the Company fails to make royalty or milestone payments or if the Company does not comply with requirements in the license agreement regarding its financial condition. In the event of an early termination of the license agreement, all rights licensed and developed by the Company under this agreement may revert back to Novartis.

 

Future license payments.  No amounts were recorded as liabilities nor were any other contractual obligations relating to the license agreements included in the condensed consolidated financial statements as of June 30, 2007, since the amounts, timing and likelihood of these future payments are unknown and will

 

VANDA PHARMACEUTICALS INC.
(A Development Stage Enterprise)

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — (Continued)

depend on the successful outcome of future clinical trials, regulatory filings, favorable FDA regulatory approvals, growth in product sales and other factors.

 

Research and development and marketing agreements

 

The Company entered into agreements with several organizations to provide services relating to clinical development, clinical manufacturing activities and marketing services under fee service arrangements. The Company’s current agreements for these services may be terminated on no more than 60 days notice without incurring additional charges, other than charges for work completed but not paid for through the effective date of termination and other costs incurred by the Company’s contractors in closing out work in progress as of the effective date of termination.

 

 

On January 1, 2007, the Company adopted the provisions of Financial Standards Accounting Board Interpretation (“FIN”) No. 48, Accounting for Uncertainty in Income Taxes. The adoption of FIN No. 48 did not have a material effect on our financial position or results of operations. In addition, there are no uncertain tax positions whose resolution in the next 12 months is expected to materially affect operating results. The Company accounts for income taxes using the asset and liability method. Deferred income taxes are recognized by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The measurement of deferred tax assets is reduced, if necessary, by a valuation allowance for any tax benefits for which future realization is uncertain.

 

The Company has not recorded any tax provision or benefit for the six months ended June 30, 2007 or 2006, except for an estimated tax expense resulting from the research and development agreement with the Company’s subsidiary in Singapore. The Company has provided a valuation allowance for the full amount of its net deferred tax assets since realization of any future benefit from deductible temporary differences and net operating loss cannot be sufficiently assured at June 30, 2007 and December 31, 2006. Under the Tax Reform Act of 1986, the amounts of and benefits from the operating loss carryforwards may be impaired in certain circumstances. Events which cause limitations in the amount of net operating losses that the Company may utilize in any one year include, but are not limited to, a cumulative ownership change of more than 50%, as defined, over a three year period.

 

Forward Looking Statements

 

Various statements in this report are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. Words such as, but not limited to, “believe,” “expect,” “anticipate,” “estimate,” “intend,” “plan,” “targets,” “likely,” “will,” “would,” and “could,” and similar expressions or words, identify forward-looking statements. Such forward-looking statements are based upon current expectations that involve risks, changes in circumstances, assumptions and uncertainties. Vanda is at an early stage of development and may not ever have any products that generate significant revenue. Important factors that could cause actual results to differ materially from those reflected in Vanda’s forward-looking statements include, among others:

 

 

The information in this report is provided only as of the date of this report, and Vanda undertakes no obligation to update any forward-looking statements contained in this report on account of new information, future events, or otherwise, except as required by law.

 

Forward-looking statements, therefore, should be considered in light of all of the information included or referred to in this report, including the “Risk Factors” section set forth as Item 1A of Part II of this report. You should also read the following discussion and analysis of financial condition and results of operations together with our condensed consolidated financial statements and related notes included elsewhere in this report.

 

Our Business

 

We are a biopharmaceutical company focused on the development and commercialization of clinical-stage product candidates for central nervous system disorders, with exclusive worldwide commercial rights to three product candidates in clinical development. Our lead product candidate, iloperidone, is a compound for the treatment of schizophrenia and bipolar disorder and in December 2006 we announced positive results from our Phase III trial of iloperidone for schizophrenia. Our second product candidate, VEC-162, is a compound for the treatment of sleep and mood disorders, which previously demonstrated positive results in a Phase III clinical trial for transient insomnia. VEC-162 is also ready for Phase II trials for the treatment of depression. Our third product candidate, VSF-173, is a compound for the treatment of excessive sleepiness and we expect to complete our first VSF-173 Phase II clinical trial in the fourth quarter of 2007.

We expect to file a New Drug Application (NDA) for iloperidone in schizophrenia with the United States Food and Drug Administration (FDA) by the end of 2007. We will have to conduct additional trials for VEC-162 prior to our filing of an NDA for VEC-162, and we expect to begin dosing for the next Phase III trial of VEC-162 in chronic primary insomnia in the fourth quarter of 2007. Assuming successful outcomes of our clinical trials and approval by the FDA, we may commercialize iloperidone and VSF-173 with our own sales force in the U.S., and expect to commercialize VEC-162 through a partnership with a global pharmaceutical company, although we have not yet identified such a global partner.

 

We are a development stage enterprise and have accumulated net losses of approximately $131.2 million since the inception of our operations through June 30, 2007. We have no product revenues to date and have no approved products for sale. Since inception we have devoted substantially all of our efforts to business planning, research and development, recruiting management and technical staff, acquiring operating assets, raising capital and conducting market research. Our future operating results will depend largely on our ability to successfully develop and commercialize our lead product candidates, iloperidone and VEC-162, and on the progress of other product candidates currently in our research and development pipeline. The results of our operations will vary significantly from year-to-year and quarter-to-quarter and depend on a number of factors, including risks related to our business, risks related to our industry, and other risks which are detailed in the “Risk factors” section of this quarterly report on Form 10-Q.

 

We completed our initial public offering in April 2006. The offering totaled 5,964,188 shares of common stock at a public offering price of $10.00 per share, resulting in net proceeds to the Company of approximately $53.3 million, after deducting underwriters’ discounts and commissions as well as offering expenses.

 

In January 2007 we completed our follow-on offering. The offering totaled 4,370,000 shares of common stock at the public offering price of $27.29 per share, resulting in net proceeds to the Company of approximately $111.3 million after deducting underwriting discounts and commissions and offering expenses.

 

Based on our current operating plans, we believe that our existing cash, cash equivalents and marketable securities, will be sufficient to meet our anticipated operating needs through mid-2008, and after that time we will require additional capital. In budgeting for our activities, we have relied on a number of assumptions, including assumptions that we will file an NDA for iloperidone in schizophrenia with the FDA by the end of 2007, that we will continue to expend funds in preparation of a commercial launch of iloperidone, that we will expend funds on the extended-release injectable formulation of iloperidone, that we will initiate dosing for the next VEC-162 trial in chronic primary insomnia in the fourth quarter of 2007 and that this trial will be conducted in accordance with our expectations, that we will conduct our VSF-173 Phase II trial for excessive sleepiness in accordance with our expectations, that we will not engage in further in-licensing activities, that we will not receive any proceeds from potential partnerships, that we will not expend funds on the bipolar indication for iloperidone, that we will continue to evaluate pre-clinical compounds for potential development, that we will be able to continue the manufacturing of our product candidates at commercially reasonable prices, that we will be able to retain our key personnel, and that we will not incur any significant contingent liabilities.

 

We may need to raise additional funds more quickly if one of the above assumptions proves to be incorrect, if we choose to expand our product development efforts more rapidly than presently anticipated or seek to acquire additional product candidates, and we may also decide to raise additional funds even before they are needed if the conditions for raising capital are favorable. We may seek to sell additional equity or debt securities or to obtain a bank credit facility. The sale of additional equity or debt securities, if convertible, could result in dilution to our stockholders. The incurrence of indebtedness would result in increased fixed obligations and could also result in covenants that would restrict our operations.

 

Iloperidone

 

Iloperidone is our product candidate under development to treat schizophrenia and bipolar disorder. Iloperidone has successfully completed its Phase III trial in schizophrenia. We are also developing a 4-week injectable formulation of iloperidone, for which we already have early Phase II data from a study previously conducted by Novartis. We are planning to conduct additional clinical work on this formulation in 2008.

From inception to June 30, 2007, we incurred approximately $55.8 million in research and development costs directly attributable to our development of iloperidone. We remain on track to file our NDA for iloperidone in schizophrenia by the end of this year.

 

We expect to increase our pre-launch commercial activities relating to iloperidone, and we expect to start marketing iloperidone commercially in early 2009. However, the time it takes to receive cash inflows from the sale of iloperidone is highly dependent on facts and circumstances that we may not be able to control and are subject to a number of risks. For example, delays in the approval process and subsequent commercial launch of iloperidone following our filing may occur if the FDA fails to attend to our filing in a timely manner or requires further data to approve iloperidone. Please see the “Risk factors” section of this quarterly report on Form 10-Q for a more detailed discussion of these and other risks.

 

We also continue to progress with the development of our 4-week injectable formulation of iloperidone, for which we already have early Phase II data from a study previously conducted by Novartis. We are planning to conduct additional clinical work in 2008.

 

VEC-162

 

VEC-162 is our product candidate under development to treat insomnia and depression. VEC-162 is a melatonin receptor agonist that works by adjusting the human “body clock” of circadian rhythm. VEC-162 has successfully completed a Phase III trial in transient insomnia.

 

From inception to June 30, 2007, we incurred approximately $27.0 million in direct research and development costs of VEC-162. We believe that we will have to conduct additional trials to receive FDA approval of VEC-162. We expect to initiate dosing in the fourth quarter of 2007 of our next Phase III clinical trial of VEC-162, to evaluate the safety and efficacy of VEC-162 in chronic primary insomnia. The trial is expected to be a randomized, double-blind, and placebo-controlled study, and will enroll approximately 400 patients. The trial will measure time to fall asleep and sleep maintenance, as well as next-day performance and mood.

 

VSF-173

 

In April 2007, we initiated the Phase II clinical trial for our product candidate VSF-173 in excessive sleepiness. The trial is a randomized, double-blind, placebo-controlled study to investigate the efficacy and safety of three oral doses of VSF-173 for the treatment of induced excessive sleepiness in approximately 60 healthy male and female volunteers. The primary endpoint of the study is the difference from placebo on the Maintenance of Wakefulness Test (MWT), a standard measure of sleepiness. As trial enrollment is ahead of schedule, we expect to announce the results in the fourth quarter of 2007.

 

Excessive sleepiness is a common symptom that can significantly impair a person’s ability to function. The effects of excessive sleepiness range from mild sleepiness to unrecognized episodes of “microsleeps” and uncontrollable sleep attacks. Excessive sleepiness is a symptom of many disorders, including obstructive sleep apnea, narcolepsy, shift worker sleep disorder, Parkinson’s disease and Alzheimer’s disease.

 

From inception to June 30, 2007, we incurred approximately $4.9 million in direct research and development costs related to VSF-173, including a milestone license fee of $1.0 million paid upon the initiation of our first Phase II clinical trial.

 

Research and development expenses

 

The Company’s research and development expenses consist primarily of fees paid to third parties in connection with the services they provide for our clinical trials, costs of contract manufacturing services, license fees, costs of materials used in clinical trials and research and development, depreciation of capital resources used to develop our products, all related facilities costs, and salaries, benefits and stock-based compensation expenses related to our research and development personnel. We expense research and development costs as they are incurred, including payments made to date under our license agreements. We believe that significant investment in product development is a competitive necessity and plan to continue

these investments in order to realize the potential of our product candidates and pharmacogenetics and pharmacogenomics expertise. From inception through June 30, 2007, we incurred research and development expenses in the aggregate of approximately $99.2 million, including stock-based compensation expenses of approximately $3.7 million. We expect our research and development expenses to increase as we continue to develop our product candidates. We also expect to incur substantial licensing costs in the future, as we continue our efforts to develop our product candidates and to evaluate potential in-license product candidates.

 

The following table summarizes our product development initiatives for the three and six months ended June 30, 2007 and 2006 and the period from March 13, 2003 (inception) to June 30, 2007. Included in this table are the research and development expenses recognized in connection with our product candidates in clinical development. Included in “Other product candidates” are the costs directly related to research initiatives for all other product candidates.

 

 

 

 

General and administrative expenses

 

General and administrative expenses consist primarily of salaries, other related costs and stock-based compensation expenses for personnel serving executive, finance, accounting, information technology and human resource functions, facility costs not otherwise included in research and development expenses, insurance costs and professional fees for legal, accounting and other professional services. General and administrative costs also include third party expenses incurred to support business development, marketing and other business activities related to our product candidate iloperidone in anticipation of its commercial launch. We expect that our general and administrative expenses will increase as we continue to prepare the commercial launch of our lead product candidates, add personnel and fulfill our reporting obligations applicable to public companies. From inception through June 30, 2007, we incurred general and administrative expenses in the aggregate of approximately $37.9 million, including stock-based compensation expenses of approximately $16.7 million.

Critical Accounting Policies

 

The preparation of our condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of our financial statements as well as the reported revenues and expenses during the reported periods. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

Our significant accounting policies are described in the notes to our audited consolidated financial statements for the year ended December 31, 2006 included in our annual report on the Form 10-K. However, we believe that the following critical accounting policies relating to accrued expenses and stock-based compensation expense are important to understanding and evaluating our reported financial results, and we have accordingly included them in this report.

 

Accrued expenses

 

As part of the process of preparing financial statements we are required to estimate accrued expenses. This process involves identifying services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for such service as of each balance sheet date in our financial statements. Examples of estimated accrued expenses include professional service fees, such as lawyers and accountants, contract service fees such as amounts paid to clinical monitors, data management organizations and investigators in conjunction with clinical trials, fees paid to contract manufacturers in conjunction with the production of clinical materials and fees paid for marketing and other commercialization activities. Pursuant to our assessment of the services that have been performed on clinical trials and other contracts, we recognize the expenses as the services are provided. Such assessments include, but are not limited to: (1) an evaluation by the project manager of the work that has been completed during the period, (2) measurement of progress prepared internally and/or provided by the third-party service provider, (3) analyses of data that justify the progress, and (4) management’s judgment. In the event that we do not identify certain costs that have begun to be incurred or we under- or over-estimate the level of services performed or the costs of such services, our reported expenses for such period would be too low or too high.

 

Stock-based compensation

 

We adopted SFAS 123(R) — Share Based Payment, on January 1, 2006 using the modified prospective transition method of implementation. Accordingly, compensation costs for all stock-based awards to employees and directors are measured based on the grant date fair value of those awards and recognized over the service period. The Company generally recognizes the expense over the award’s vesting period, as to date the Company granted no awards with market or performance conditions. For stock awards granted in 2006 and 2007, expenses are amortized under the accelerated attribution method. For stock awards granted prior to January 1, 2006, expenses are amortized under the accelerated attribution method for options that were modified after the original grant date and under the straight line attribution method for all other options.

 

Factors which affect charges or credits to operations related to stock-based compensation expense are the fair value of the common stock underlying stock options for which stock-based compensation is recorded, the volatility of such fair value, risk-free rate and expected dividend yield used in the calculation of the fair value of the stock option. If our estimates of the fair value of these equity instruments are too high or too low, it would have the effect of overstating or understating expenses. The stock-based compensation expense for a period is based on awards ultimately expected to vest and it is reduced for estimated forfeitures. If our estimated forfeiture rate is too high or too low, it would have the effect of overstating or understating expenses for the period.

Total employee stock-based compensation expense recognized during the three and six months ending June 30, 2007 and 2006 was comprised of the following:

 

 

Recent accounting pronouncements

 

In September 2006, the FASB issued FASB Statement No. 157, Fair Value Measurements (SFAS 157), which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under generally accepted accounting principles. SFAS 157 outlines a common definition of fair value and the new standard intends to make the measurement of fair value more consistent and comparable and improve disclosures about those measures. We will need to adopt SFAS 157 for financial statements issued for fiscal years beginning after November 15, 2007. While we continue to evaluate the impact of SFAS 157, this pronouncement is not expected to have significant impact on our results of operations and financial condition.

 

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115 (SFAS 159). According to this standard the entities will now be permitted to measure many financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis (the fair value option). SFAS 159 is effective for fiscal years beginning after November 15, 2007. While we continue to evaluate the impact of SFAS 159, this pronouncement is not expected to have significant impact on our results of operations and financial condition.

 

Results of Operations

 

We have a limited history of operations. We anticipate that our quarterly results of operations will fluctuate for the foreseeable future due to several factors, including any possible payments made or received pursuant to licensing or collaboration agreements, progress of our research and development efforts, and the timing and outcome of clinical trials and related possible regulatory approvals. Our limited operating history makes predictions of future operations difficult or impossible. Since our inception, we have incurred significant losses. As of June 30, 2007, we had a deficit accumulated during the development stage of approximately $131.2 million. We anticipate incurring additional losses, which may increase, for the foreseeable future.

 

Three months ended June 30, 2007 compared to three months ended June 30, 2006

 

Research and development expenses.  Research and development expenses decreased by approximately $8.9 million, or 47%, to approximately $10.2 million for the three months ended June 30, 2007 compared to approximately $19.1 million for the three months ended June 30, 2006.

The following table discloses the components of research and development expenses reflecting all of our project expenses:

 

 

Direct costs decreased approximately $9.0 million for the three months ended June 30, 2007 compared to the three months ended June 30, 2006 as a result of lower clinical trial expenses for the Company’s iloperidone and VEC-162 Phase III trials that were primarily completed in 2006, offset by continuing clinical manufacturing activities for both iloperidone and VEC-162, and iloperidone NDA related expenses. Clinical trials expense decreased approximately $13.6 million for the three months ended June 30, 2007 compared to the three months ended June 30, 2006 primarily due to the cost incurred during the three months ended June 30, 2006 in our Phase III iloperidone and VEC-162 clinical trials. Contract research and development, consulting, materials and other direct costs increased approximately $3.3 million for the three months ended June 30, 2007 relative to the three months ended June 30, 2006, primarily as a result of increased iloperidone NDA related expenses and manufacturing-related development costs incurred in connection with the manufacturing of clinical supply materials for the iloperidone and the VEC-162 programs. Prior to FDA approval of our products, manufacturing-related costs are included in research and development expense. Salaries, benefits and related costs increased approximately $253,000 for the three months ended June 30, 2007 relative to the three months ended June 30, 2006 due to an increase in personnel to support the development and clinical trial activities for iloperidone, VEC-162 and VSF-173. Stock-based compensation expense increased by approximately $1.0 million compared to the three months ended June 30, 2006 as a result of options granted in 2007 and the higher fair value of options granted during 2007 compared to options granted in prior periods.

 

We expect to continue to incur substantial research and development expenses due to our ongoing research and development efforts as our existing and future product candidates advance through clinical trials.

 

General and administrative expenses.  General and administrative expenses increased approximately $4.5 million, or 150%, to approximately $7.4 million for the three months ended June 30, 2007 from approximately $3.0 million for the three months ended June 30, 2006.

 

The following table discloses the components of our general and administrative expenses:

 

Salaries, benefits and related costs increased approximately $239,000 for the three months ended June 30, 2007 compared to the three months ended June 30, 2006 due to an increase in personnel as we continued to develop the administrative structure to support the development and clinical trial activities of our lead product candidates and to build our marketing capabilities in anticipation of the commercial launch of iloperidone. Stock-based compensation expense increased by approximately $2.6 million as a result of options granted in 2007 and the higher fair value of options granted during 2007 compared to options granted in prior periods. Marketing and related consulting services expenses increased by approximately $850,000 due to increased business and marketing activity related to our anticipated commercial launch of iloperidone. These increased expenses included market research, branding, medical community cultivation and publication planning costs. Legal, accounting and other professional costs increased by approximately $571,000 for the three months ended June 30, 2007 compared to the three months ended June 30, 2006 due primarily to a higher level of consulting activity in 2007 in support of business development and higher costs associated with our reporting and other regulatory obligations applicable to public companies.

 

In 2007 and thereafter we expect our general and administrative expenses to increase substantially. These increased expenses are expected to be necessary to support primarily our commercial development activities.

 

Interest income, net.  Net interest income in the three months ended June 30, 2007 was approximately $1.7 million compared to net interest income of approximately $707,000 in the three months ended June 30, 2006. Interest income was higher in 2007 due to higher average cash balances for the quarter, primarily resulting from the proceeds from our public offerings and higher short-term interest rates which generated substantially higher interest income than in 2006.

 

Our interest income and expense for the three months ended June 30, 2007 and 2006 are disclosed on the following table:

 

 

Six months ended June 30, 2007 compared to six months ended June 30, 2006

 

Research and development expenses.  Research and development expenses decreased by approximately $13.8 million, or 40%, to approximately $20.8 million for the six months ended June 30, 2007 compared to approximately $34.6 million for the six months ended June 30, 2006.

The following table discloses the components of research and development expenses reflecting all of our project expenses:

 

 

Direct costs decreased approximately $14.0 million for the six months ended June 30, 2007 compared to the six months ended June 30, 2006 as a result of lower clinical trial expenses for the Company’s iloperidone and VEC-162 Phase III trials that were primarily completed in 2006, offset by continuing clinical manufacturing activities for both iloperidone and VEC-162, and iloperidone NDA related expenses. Clinical trials expense decreased approximately $22.4 million for the six months ended June 30, 2007 compared to the six months ended June 30, 2006 primarily due to the cost incurred during the six months ended June 30, 2006 in our Phase III iloperidone and VEC-162 clinical trials. Contract research and development, consulting, materials and other direct costs increased approximately $5.9 million for the six months ended June 30, 2007 relative to the six months ended June 30, 2006 primarily as a result of increased expenses related to the preparation of our NDA for iloperidone and the increased manufacturing of clinical supply materials for the iloperidone and the VEC-162 programs. Prior to FDA approval of our products, manufacturing-related costs are included in research and development expenses. During the six months ended June 30, 2007 we met the requirement for a $1.0 million milestone payment to Novartis under our license agreement for VSF-173, and during the six months ended June 30, 2006 we met the requirements for a $1.0 million milestone payment to BMS under our license agreement for VEC-162. Salaries, benefits and related costs increased approximately $569,000 for the six months ended June 30, 2007 relative to the six months ended June 30, 2006 due to an increase in personnel to support the development and clinical trial activities for iloperidone, VEC-162 and VSF-173. Stock-based compensation expense increased by approximately $1.9 million compared to the six months ended June 30, 2006 as a result of options granted in 2007 and the higher fair value of options granted during 2007 compared to options granted in prior periods.

 

We expect to continue to incur substantial research and development expenses due to our ongoing research and development efforts and as our existing and future product candidates advance through clinical trials.

 

General and administrative expenses.  General and administrative expenses increased approximately $7.8 million, or 132%, to approximately $13.7 million for the six months ended June 30, 2007 from approximately $5.9 million for the six months ended June 30, 2006.

The following table discloses the components of our general and administrative expenses:

 

 

Salaries, benefits and related costs increased approximately $435,000 for the six months ended June 30, 2007 compared to the six months ended June 30, 2006 due to an increase in personnel as we continued to develop the administrative structure to support the development and clinical trial activities of our lead product candidates and to build our marketing capabilities in anticipation of the commercial launch of iloperidone. Stock-based compensation expense increased by approximately $4.3 million as a result of options granted in 2007 and the higher fair value of options granted during 2007 compared options granted in prior periods. Marketing and related consulting services expenses increased by approximately $1.8 million due to increased business and marketing activity related to our anticipated commercial launch of iloperidone. These increased expenses included market research, branding, medical community cultivation and publication planning costs. Legal, accounting and other professional costs increased approximately $1.0 million for the six months ended June 30, 2007 compared to the six months ended June 30, 2006 due primarily to a higher level of consulting activity in 2007 in support of business development and higher costs associated with our reporting and other regulatory obligations applicable to public companies.

 

In 2007 and thereafter we expect our general and administrative expenses to increase substantially. These increased expenses are expected to be necessary to support our commercial development activities.

 

Interest income, net.  Net interest income in the six months ended June 30, 2007 was approximately $3.1 million compared to net interest income of approximately $1.0 million in the six months ended June 30, 2006. Interest income was higher in 2007 due to higher average cash balances for the period, primarily resulting from the proceeds from our public offerings and higher short-term interest rates which generated substantially higher interest income than in 2006.

 

Our interest income and expense for the six months ended June 30, 2007 and the six months ended June 30, 2006 are disclosed on the following table: