UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
________________________________

FORM 10-Q

(MARK ONE)

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

For the quarterly period ended September 30, 2008
 
o TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
 
For the transition period from ___________ to __________

Commission file number: 000-32603


ARBIOS SYSTEMS, INC.
(Exact name of registrant as specified in its charter)

Delaware
91-1955323
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)

200 E. Del Mar Blvd., Suite 320, Pasadena, CA
91105
(Address of principal executive offices)
(Zip Code)

(626) 356-3105
(Registrant's telephone number, including area code) 

1050 Winter Street, #1000
Waltham, MA 02451
(Former name or former address, if changed since last report)
______________________________

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.    
Yes  x    No  ¨

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

Large Accelerated filer o
Accelerated filer o
 

 
Non-accelerated filer o
(do not check if a smaller reporting company)
Smaller reporting company x
 
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

On September 30, 2008, there were 25,792,747 shares of common stock, $.001 par value per share, issued and outstanding.



ARBIOS SYSTEMS, INC.
FORM 10-Q
TABLE OF CONTENTS

     
PAGE NO.
PART I. FINANCIAL INFORMATION
     
         
Item 1.
Financial Statements:
     
         
 
Condensed Balance Sheets as of September 30, 2008 (unaudited) and December 31, 2007 (audited)
 
4
 
         
 
Condensed Statements of Operations for the three and nine months ended September 30, 2008 and 2007 and from August 23, 2000 (inception) through September 30, 2008 (all unaudited)
 
5
 
         
 
Condensed Statements of Cash Flows for the nine months ended September 30, 2008 and 2007 and from August 23, 2000 (inception) through September 30, 2008 (all unaudited)
 
6
 
         
 
Condensed Statement of Stockholders’ Equity (Deficit) from August 23, 2000 (inception) through September 30, 2008 (unaudited)
 
7
 
 
Notes to Condensed Financial Statements
  12  
Item 2.
Management's Discussion and Analysis of Financial Condition and Results Of Operations
 
17
 
         
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
 
21
 
         
Item 4T.
Controls and Procedures
 
21
 
         
PART II. OTHER INFORMATION
     
         
Item 1.
Legal Proceedings
 
22
 
         
Item 1A.
Risk Factors
 
22
 
         
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
23
 
         
Item 3.
Defaults Upon Senior Securities
 
23
 
         
Item 4.
Submission of Matters to a Vote of Security Holders
 
23
 
         
Item 5.
Other Information
 
23
 
         
Item 6.
Exhibits
 
23
 
         
SIGNATURES
 
24
 
 
3


PART I - FINANCIAL INFORMATION

ITEM 1. Condensed Financial Statements
 
ARBIOS SYSTEMS, INC.
(A development stage company)
CONDENSED BALANCE SHEETS

   
September 30, 2008
 
December 31,
 
   
(Unaudited)
 
2007
 
ASSETS 
             
               
Current assets
             
Cash and cash equivalents
 
$
477,756
 
$
2,735,944
 
Prepaid expenses
   
2,087
   
37,546
 
Total current assets
   
479,843
   
2,773,490
 
               
Net property and equipment
   
22,240
   
45,450
 
Assets held for sale
   
116,931
   
132,293
 
Deferred financing costs
   
-
   
16,757
 
Other assets
   
1,550
   
70,236
 
               
Total assets
 
$
620,564
 
$
3,038,226
 
               
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
             
Current liabilities
             
Accounts payable
 
$
320,578
 
$
434,727
 
Accrued expenses
   
386,250
   
483,617
 
Total current liabilities
   
706,828
   
918,344
 
               
Long term contract obligations
   
150,000
   
250,000
 
Total liabilities
   
856,828
   
1,168,344
 
               
Stockholders' equity (deficit)
             
Preferred stock, $.001 par value; 5,000,000 shares authorized:
             
none issued and outstanding
   
-
   
-
 
               
Common stock, $.001 par value; 100,000,000 shares authorized; 25,792,747 and 25,578,461 shares issued and outstanding at September 30, 2008 and December 31, 2007, respectively
   
25,792
   
25,578
 
Additional paid-in capital
   
21,600,117
   
21,159,276
 
Deficit accumulated during the development stage
   
(21,862,173
)
 
(19,314,972
)
Total stockholders' equity (deficit)
   
(236,264
)
 
1,869,882
 
               
Total liabilities and stockholders' equity (deficit)
 
$
620,564
 
$
3,038,226
 

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

4


ARBIOS SYSTEMS, INC.
(A development stage company)
CONDENSED STATEMENTS OF OPERATIONS
(Unaudited)

   
For the three months ended September 30,
 
For the nine months ended September 30,
 
August 23, 2000 (inception) 
 
   
2008
 
2007
 
2008
 
2007
 
through September 30, 2008
 
                       
Revenues
 
$
-
 
$
-
 
$
-
 
$
-
 
$
320,966
 
                                 
Operating expenses:
                               
General and administrative
   
147,103
   
1,025,108
   
1,358,718
   
2,651,264
   
13,100,855
 
Research and development
   
164,350
   
422,743
   
1,220,747
   
1,982,747
   
9,333,555
 
Total operating expenses
   
311,453
   
1,447,851
   
2,579,465
   
4,634,011
   
22,434,410
 
                                 
Loss before other income (expense)
   
(311,453
)
 
(1,447,851
)
 
(2,579,465
)
 
(4,634,011
)
 
(22,113,444
)
                                 
Other income (expense):
                               
Interest income
   
3,786
   
53,445
   
32,264
   
128,064
   
495,409
 
Interest expense
   
-
   
-
   
-
   
-
   
(244,138
)
Total other income (expense)
   
3,786
   
53,445
   
32,264
   
128,064
   
251,271
 
                                 
                                 
Net loss
 
$
(307,667
)
$
(1,394,406
)
$
(2,547,201
)
$
(4,505,947
)
$
(21,862,173
)
                                 
Net loss per share:
                               
Basic and diluted
 
$
(0.01
)
$
(0.05
)
$
(0.10
)
$
(0.20
)
     
                                 
Weighted-average shares:
                               
Basic and diluted
   
25,792,747
   
25,446,803
   
25,712,950
   
22,021,676
       

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

5


ARBIOS SYSTEMS, INC.
(A Development Stage Company)
CONDENSED STATEMENTS OF CASH FLOWS
(Unaudited)

   
For the nine months ended September 30,
 
August 23, 2000 (inception)
 
   
2008
 
2007
 
through September 30, 2008
 
Cash flows from operating activities:
                   
Net loss
 
$
(2,547,201
)
$
(4,505,947
)
$
(21,862,173
)
                     
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
                   
Amortization of debt discount
   
-
   
-
   
244,795
 
Depreciation and amortization
   
32,190
   
37,506
   
334,454
 
Patent rights impairment
   
-
   
-
   
91,694
 
Issuance of common stock, options and warrants for compensation
   
441,055
   
585,376
   
4,054,502
 
Issuance of warrants for patent acquistion
   
-
   
74,570
   
74,570
 
Settlement of accrued expense
   
-
   
-
   
54,401
 
Deferred compensation costs
   
-
   
-
   
319,553
 
Loss on disposition of fixed assets
   
2,207
   
2,766
   
4,973
 
Changes in operating assets and liabilities:
                   
Prepaid expenses
   
35,459
   
96,388
   
(2,089
)
Deferred financing costs
   
16,757
   
-
   
-
 
Other assets
   
68,686
   
(13,187
)
 
(1,550
)
Accounts payable
   
(114,149
)
 
75,102
   
320,578
 
Accrued expenses
   
(97,367
)
 
549,141
   
292,748
 
Other liabilities
   
-
   
-
   
64,695
 
Contractual obligation
   
(100,000
)
 
250,000
   
150,000
 
Net cash used in operating activities
   
(2,262,363
)
 
(2,848,285
)
 
(15,858,849
)
                     
Cash flows from investing activities:
                   
Dispositions (Additions) of property and equipment
   
4,175
   
(2,500
)
 
(145,292
)
Purchase of short term investments
   
-
   
-
   
(21,866,787
)
Maturities of short term investments
   
-
   
-
   
21,866,787
 
Net cash provided by (used in) investing activities
   
4,175
   
(2,500
)
 
(145,292
)
                     
Cash flows from financing activities:
                   
Proceeds from issuance of convertible debt
   
-
   
-
   
400,000
 
Proceeds from common stock option/warrant exercise
   
-
   
2,700
   
67,900
 
Net proceeds from issuance of common stock and warrants
   
-
   
4,483,831
   
15,797,080
 
Net proceeds from issuance of preferred stock
   
-
   
-
   
238,732
 
Payments on capital lease obligation, net
   
-
   
-
   
(21,815
)
Net cash provided by financing activities
   
-
   
4,486,531
   
16,481,897
 
Net increase (decrease) in cash
   
(2,258,188
)
 
1,635,746
   
477,756
 
                     
Cash at beginning of period
 
$
2,735,944
 
$
2,054,280
 
$
-
 
                     
Cash at end of period
 
$
477,756
 
$
3,690,026
 
$
477,756
 
                     
Supplemental disclosures of non-cash financing activity
                   
Issuance of securities for obligation related to finder's fees
 
$
-
 
$
-
 
$
47,500
 

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

6

 
ARBIOS SYSTEMS, INC.
(A Development Stage Company)
CONDENSED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
PERIOD FROM AUGUST 23, 2000 (INCEPTION) THROUGH SEPTEMBER 30, 2008

                           
Deficit
     
                           
Accumulated
     
                   
Additional
     
During the
     
   
Preferred Stock
 
Common Stock
 
Paid-In
 
Deferred
 
Development
     
   
Shares
 
Amount
 
Shares
 
Amount
 
Capital
 
Costs
 
Stage
 
Total
 
                                   
                                   
Balance, August 23, 2000 (inception) restated for effect of reverse merger with Historical Autographs U.S.A. Inc.
   
-
 
$
-
   
-
 
$
-
 
$
-
 
$
-
 
$
-
 
$
-
 
                                                   
Stock issuance in exchange for cash
               
5,000,000
   
50
   
4,950
               
5,000
 
                                                   
Net loss
   
 
   
 
   
 
   
 
   
 
   
 
   
(9,454
)
 
(9,454
)
                                                   
Balance, December 31, 2000, as restated
   
-
   
-
   
5,000,000
   
50
   
4,950
   
-
   
(9,454
)
 
(4,454
)
                                                   
Issuance of junior preferred stock for cash of $250,000 and in exchange for $400,000 in patent rights, research and development costs, and employee loanout costs less issuance expenses of $11,268, June 29, 2001
   
681,818
   
7
               
958,278
   
(343,553
)
       
614,732
 
                                                   
Issuance of common stock in exchange for patent rights and deferred research and development costs
               
362,669
   
4
   
547,284
               
547,288
 
                                                   
Services receivable
                                 
(550,000
)
       
(550,000
)
                                                   
Deferred employee loan-out costs receivable earned
                                 
82,888
         
82,888
 
 
                                                 
Net loss
   
 
   
 
   
 
   
 
   
 
   
 
   
(237,574
)
 
(237,574
)
                                                   
Balance, December 31, 2001
   
681,818
   
7
   
5,362,669
   
54
   
1,510,512
   
(810,665
)
 
(247,028
)
 
452,880
 

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

7

 
ARBIOS SYSTEMS, INC.
(A Development Stage Company)
CONDENSED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
PERIOD FROM AUGUST 23, 2000 (INCEPTION) THROUGH SEPTEMBER 30, 2008

                           
Deficit
     
                           
Accumulated
     
                   
Additional
     
During the
     
   
Preferred Stock
 
Common Stock
 
Paid-In
 
Deferred
 
Development
     
   
Shares
 
Amount
 
Shares
 
Amount
 
Capital
 
Costs
 
Stage
 
Total
 
                                   
Amendment of December 31, 2001 agreement for the issuance of common stock agreement in exchange for research and development services
                           
(495,599
)
 
550,000
         
54,401
 
                                                   
Deferred employee loan out costs receivable earned
                                 
171,776
         
171,776
 
                                                   
Issuance of common stock for compensation
               
70,000
   
1
   
10,499
               
10,500
 
                                                   
Issuance of common stock for cash
               
999,111
   
9
   
149,857
               
149,866
 
                                                   
Net loss
   
 
   
 
   
 
   
 
   
 
   
 
   
(494,780
)
 
(494,780
)
                                                   
Balance, December 31, 2002
   
681,818
   
7
   
6,431,780
   
64
   
1,175,269
   
(88,889
)
 
(741,808
)
 
344,643
 
                                                   
Issuance of common stock for cash less issuance expense of $2,956
               
417,000
   
417
   
246,827
               
247,244
 
                                                   
Issuance of common stock in private placement for cash less issuance expense of $519,230
               
4,000,000
   
4,000
   
3,476,770
               
3,480,770
 
                                                   
Issuance of common stock for convertible debenture less issuance expense of $49,500
               
400,000
   
400
   
350,100
               
350,500
 
                                                   
Shares issued in connection with acquisition of Historical Autographs U.S.A., Inc. on October 30, 2003
               
1,220,000
   
8,263
   
(8,263
)
             
-
 

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

8


ARBIOS SYSTEMS, INC.
(A Development Stage Company)
CONDENSED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
PERIOD FROM AUGUST 23, 2000 (INCEPTION) THROUGH SEPTEMBER 30, 2008

                           
Deficit
     
                           
Accumulated
     
                   
Additional
     
During the
     
   
Preferred Stock
 
Common Stock
 
Paid-In
 
Deferred
 
Development
     
   
Shares
 
Amount
 
Shares
 
Amount
 
Capital
 
Costs
 
Stage
 
Total
 
                                   
Value of warrants and beneficial conversion feature of bridge loan
                           
244,795
               
244,795
 
                                                   
Deferred employee loan-out costs receivable earned
                                 
88,889
         
88,889
 
                                                   
Preferred Stock converted to Common Stock
   
(681,818
)
 
(7
)
 
681,818
   
7
                         
                                                   
Net loss
   
 
   
 
   
 
   
 
   
 
   
 
   
(885,693
)
 
(885,693
)
                                                   
Balance, December 31, 2003
   
-
   
-
   
13,150,598
   
13,151
   
5,485,498
   
-
   
(1,627,501
)
 
3,871,148
 
                                                   
Issuance of common stock options and warrants for compensation
               
         
972,430
               
972,430
 
                 
                               
Exercise of common stock options
               
18,000
   
18
   
2,682
               
2,700
 
                                                   
Issuance of securities for payable
               
47,499
   
47
   
47,451
               
47,498
 
                                                   
Net loss
                                       
(3,327,827
)
 
(3,327,827
)
 
   
   
   
   
   
   
   
   
 
Balance, December 31, 2004
   
-
   
-
   
13,216,097
   
13,216
   
6,508,061
   
-
   
(4,955,328
)
 
1,565,949
 
 
                                                 
Issuance of common stock in private placement for cash less issuance expense of $384,312
               
2,991,812
   
2,992
   
6,224,601
               
6,227,593
 
                                                   
Issuance of common stock options and warrants for compensation
               
         
557,080
               
557,080
 
                 
                               
Exercise of common stock options
               
25,000
   
25
   
62,475
               
62,500
 

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

9


ARBIOS SYSTEMS, INC.
(A Development Stage Company)
CONDENSED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
PERIOD FROM AUGUST 23, 2000 (INCEPTION) THROUGH SEPTEMBER 30, 2008

                           
Accumulated During
     
   
Preferred Stock
 
Common Stock
 
Additional Paid-In
 
Deferred
 
the Development
     
   
Shares
 
Amount
 
Shares
 
Amount
 
             Capital           
 
Costs
 
Development Stage
 
Total
 
Net loss
                                       
(3,823,903
)
 
(3,823,903
)
     
   
   
   
   
   
   
   
 
Balance, December 31, 2005
   
-
   
-
   
16,232,909
   
16,233
   
13,352,217
   
-
   
(8,779,231
)
 
4,589,219
 
                                                   
Issuance of common stock in private placement for cash less issuance expense of $95,013
               
1,227,272
   
1,227
   
1,253,760
               
1,254,987
 
                                                   
Issuance of common stock options and warrants for compensation
               
         
703,839
               
703,839
 
                 
                               
Stock warrant term extension
               
-
   
   
482,964
               
482,964
 
 
                                                 
Warrant liability
                           
(1,284,841
)
             
(1,284,841
)
                                                   
Net loss
                                       
(4,461,904
)
 
(4,461,904
)
     
   
   
   
   
   
   
   
 
Balance, December 31, 2006
   
-
   
-
   
17,460,181
   
17,460
   
14,507,939
   
-
   
(13,241,135
)
 
1,284,264
 
                                                   
Cumulative effect of change in accounting principle: Adjust retained earnings at January 1, 2007 for change in accounting principle
                                       
(521,187
)
 
(521,187
)
Reclassification of warrants
                           
1,284,841
               
1,284,841
 
                                                   
Issuance of common stock and warrants in private placement for cash less issuance expense of $377,169
               
7,478,462
   
7,479
   
4,476,352
               
4,483,831
 
                                                   
Exercise of common stock warrants
               
18,000
   
18
   
2,682
               
2,700
 
                                                   
Stock option based compensation expense
               
         
438,263
               
438,263
 
                 
                               
Stock warrant term extension
               
-
   
   
59,025
               
59,025
 
                                                   
Restricted stock based compensation expense
               
621,818
   
621
   
315,604
               
316,225
 
                                                   
Issuance of warrants for patent acquistion
                           
74,570
               
74,570
 
                                                   
Net loss
                                       
(5,552,650
)
 
(5,552,650
)
     
   
   
   
   
   
   
   
 
Balance, December 31, 2007
   
-
   
-
   
25,578,461
   
25,578
   
21,159,276
   
-
   
(19,314,972
)
 
1,869,882
 

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

10


ARBIOS SYSTEMS, INC.
(A Development Stage Company)
CONDENSED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
PERIOD FROM AUGUST 23, 2000 (INCEPTION) THROUGH SEPTEMBER 30, 2008
(Unaudited)

                           
Accumulated
     
                   
Additional
     
During the
     
   
Preferred Stock
 
Common Stock
 
Paid-In
 
Deferred
 
Development
     
   
Shares
 
Amount
 
Shares
 
Amount
 
Capital
 
Costs
 
Stage
 
Total
 
                                   
                                   
Issuance of common stock for compensation
               
214,286
   
214
   
59,786
               
60,000
 
                                                   
Stock option based compensation expense
               
         
97,866
               
97,866
 
                                                   
Stock warrant term extension
               
-
   
   
175,256
               
175,256
 
                                                   
Restricted stock based compensation expense
               
-
   
-
   
107,933
               
107,933
 
                                                   
Net loss
                                       
(2,547,201
)
 
(2,547,201
)
     
   
   
   
   
   
   
   
 
Balance, September 30, 2008 (unaudited)
   
-
   
-
   
25,792,747
 
$
25,792
 
$
21,600,117
   
-
 
$
(21,862,173
)
$
(236,264
)

The accompanying notes are an integral part of these unaudited condensed financial statements.
 
11


Arbios Systems, Inc.
(A Development Stage Company)
Notes to Condensed Financial Statements (Unaudited)
Nine Months Ended September 30, 2008
 
(1) Basis of Presentation

Arbios Systems, Inc., a Delaware corporation (the “Company”), seeks to develop, manufacture and market liver assist devices to meet the urgent need for therapy of liver failure.
 
On October 30, 2003, Historical Autographs U.S.A., Inc. and Arbios Technologies, Inc. (“ATI”) consummated a reverse merger, in which ATI became the wholly owned subsidiary of Historical Autographs U.S.A., Inc. Concurrently with the merger, Historical Autographs U.S.A., Inc. changed its name to Arbios Systems, Inc. and is herein referred to as “Arbios Systems”. The stockholders of ATI transferred ownership of one hundred percent of all the issued and outstanding shares of their capital stock of ATI in exchange for 11,930,598 newly issued shares, or approximately 91%, of the common stock, $.001 par value, of Arbios Systems. At that time, the former management of Arbios Systems resigned and was replaced by the same persons who served as officers and directors of ATI. Inasmuch as the former owners of ATI controlled the combined entity after the merger, the combination was accounted for as a purchase by ATI as acquirer, for accounting purposes in accordance with Statement of Financial Accounting Standards, (“SFAS”) No. 141: “Business Combinations” using reverse merger accounting, and no adjustments to the carrying values of the assets or liabilities of the acquired entity were required. Proforma operating results, as if the acquisition had taken place at the beginning of the period, have not been presented as the operations of the acquiree were negligible. The financial position and results of operations of Arbios Systems is included in the statements of the Company from the date of acquisition.

On July 25, 2005, Arbios Systems completed its reincorporation as a Delaware corporation by merging with and into Arbios Systems, Inc., a Delaware corporation (“Arbios”). The foregoing merger was approved by the Company’s stockholders at the annual meeting of stockholders held on July 7, 2005. In order to consolidate the functions and operations of Arbios and ATI, on July 26, 2005, ATI merged into Arbios. As a result, Arbios now owns all of the assets of ATI and all of the operations of the two companies have been consolidated into Arbios. Unless the context indicates otherwise, references herein to the “Company” during periods prior to July 26, 2005 include Arbios Systems, a Nevada corporation, and ATI.

The unaudited condensed financial statements and notes are presented as permitted by Form 10-Q. These unaudited condensed financial statements have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the "SEC"). Certain information and footnote disclosures, normally included in financial statements prepared in accordance with generally accepted accounting principles, have been omitted pursuant to such SEC rules and regulations. In the opinion of the management of the Company, the accompanying unaudited condensed financial statements include all adjustments, including those that are normal and recurring considered necessary to present fairly the financial position of the Company as of September 30, 2008, and the results of operations for the periods presented. These unaudited condensed financial statements should be read in conjunction with the Company's audited financial statements and the accompanying notes included in the Company's Annual Report on Form 10-KSB for the year ended December 31, 2007 as filed with the SEC. The Company expects that its operating results will fluctuate for the foreseeable future. Therefore, period-to-period comparisons should not be relied upon as predictive of the results in future periods. The results of operations for the nine months ended September 30, 2008 are not necessarily indicative of the results to be expected for any subsequent periods or for the entire 2008 fiscal year.

12


(2) Going Concern
 
The Company’s financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America, which contemplate continuation of the Company on a going concern basis, and which contemplate the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has incurred a net operating loss of $2,547,201 for the nine months ended September 30, 2008 and an accumulated deficit of $21,862,173 at September 30, 2008. In October 2008 we sold our HepatAssist bioartificial liver device to HepaLife Technologies, Inc. As part of the sale, we received $250,000 in cash, which provides us with additional working capital to continue to seek licensing, merger, or financing opportunities for our remaining SEPET technology into the first quarter of 2009. However, the Company’s lack of adequate cash reserves to fund such activities to the end of the first quarter of 2009 and beyond raises substantial doubt about the Company’s ability to continue as a going concern.

The Company reduced its staffing levels by 2 employees and 1 consultant in the first quarter of 2008 to reduce its administrative expenses. On August 5, 2008, the Company announced that it was suspending its operations to focus its efforts on obtaining financing or consummating a strategic transaction. In connection with the suspension of its operations, the Company on July 31, 2008 terminated the employment of Shawn Cain, Interim President and Chief Executive Officer, Scott Hayashi, Interim Chief Financial Officer, Jacek Rozga, MD, Ph.D., Chief Scientific Officer, and Susan Papalia, Vice President of Clinical Affairs (Mr. Cain and Mr. Hayashi continue to provide services to the Company as part-time consultants.) Upon the termination of their employment, each of the foregoing officers executed the Company’s standard severance/termination agreement, and each of these officers received a severance payment in the following amount: Shawn Cain ($46,250, representing three month’s salary), Scott Hayashi ($20,833, representing two month’s salary), Jacek Rozga ($33,333, representing two month’s salary), and Susan Papalia ($28,333, representing two month’s salary).

If the Company is unsuccessful in its efforts to raise additional funds through the sale of additional equity securities or a strategic transaction, the Company will not have the ability to continue as a going concern into the first quarter of 2009. If the Company is unable to obtain financing, it will wind down operations and actively seek the sale of the assets, licensing of its SEPETTM technology, or exploring a potential merger with another company. While the Company hopes to pursue development of its product candidate, any significant continued development is contingent upon significant additional funding or a strategic partnership. The amount and timing of future capital requirements will depend on numerous factors, including the number and characteristics of product candidates that the Company pursues, the conduct of clinical studies, the status and timelines of regulatory submissions, the costs associated with protecting patents and other proprietary rights, the ability to complete strategic collaborations and the availability of third-party funding, if any. The Company may also seek additional funding through corporate collaborations and other financing vehicles. If funds are obtained through arrangements with collaborative partners or others, the Company may be required to relinquish rights to its technologies or product candidates.

No assurance can be given that the Company will be successful in raising additional capital or will complete a strategic transaction. Furthermore, there can be no assurance, assuming the Company successfully raises additional equity or closes a strategic transaction, that the Company will achieve profitability or positive cash flow. If the Company is unable to raise additional capital or close a strategic transaction for the Company by the first quarter of 2009, the Company will not be able to meet its obligations and will have to cease all operations. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

(3) Recent Accounting Pronouncements
 
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” or SFAS 157. SFAS 157 establishes a single authoritative definition of fair value, sets out a framework for measuring fair value, and requires additional disclosures about fair-value measurements. SFAS 157 applies only to fair value measurements that are already required or permitted by other accounting standards (except for measurements of share-based payments) and is expected to increase the consistency of those measurements. Accordingly, SFAS 157 does not require any new fair value measurements. However, for some entities, the application of SFAS 157 will change current practice. SFAS 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The adoption of FAS 157 did not have a material impact on the financial position or results of operations.

13


In February 2007, the FASB issued FASB Statement No.159: “The Fair Value Option for Financial Assets and Financial Liabilities – including an amendment of FASB Statement No. 115” (“FAS 159”). This statement permits entities to choose to measure many financial instruments and certain other items at fair value and is expected to expand the use of fair value measurement. FASB 159 is effective for fiscal years beginning after November 15, 2007. The Company has adopted FAS 159 and the adoption did not have a material impact on the financial position or results of operations.

On June 27, 2007, the FASB reached a final consensus on EITF Issue No. 07-03: “Accounting for Advance Payments for Goods or Services to Be Used in Future Research and Development Activities” (“EITF 07-03”). Currently, under FASB Statement No. 2: “Accounting for Research and Development Costs,” nonrefundable advance payments for future research and development activities for materials, equipment, facilities and purchased intangible assets that have no alternative future use are expensed as incurred. EITF 07-03 addresses whether such non-refundable advance payments for goods or services that have no alternative future use and that will be used or rendered for research and development activities should be expensed when the advance payments are made or when the research and development activities have been performed. The consensus reached by the FASB requires companies involved in research and development activities to capitalize such non-refundable advance payments for goods and services pursuant to an executory contractual arrangement because the right to receive those services in the future represents a probable future economic benefit. Those advance payments will be capitalized until the goods have been delivered or the related services have been performed. Entities will be required to evaluate whether they expect the goods or services to be rendered. If an entity does not expect the goods to be delivered or services to be rendered, the capitalized advance payment will be charged to expense. The consensus on EITF 07-03 is effective for financial statements issued for fiscal years beginning after December 15, 2007, and interim periods within those fiscal years. Earlier application is not permitted. Entities are required to recognize the effects of applying the guidance in EITF 07-03 prospectively for new contracts entered into after the effective date. In accordance with EITF 07-03, the Company does evaluate its research and development contracts and payments within the guidance of EITF 07-03 and either expenses or capitalizes such payments based upon the contract terms.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable users of the financial statements to better understand the effects on an entity’s financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. The Company is evaluating the impact of adopting SFAS 161 on our financial statements.

(4) Stock-Based Compensation:

On January 1, 2008, in accordance with the established Board of Director’s compensation program, the Company granted 90,000 options to purchase common stock to Board members with an exercise price of $0.69 per share, the closing market price of the Company’s common stock on the date of grant, valued at approximately $47,229, which vest on a monthly pro-rata basis over one year. The fair value of the options was determined using the Black Scholes option pricing model utilizing the following assumptions: risk free interest rate 2.98%, stock price volatility 0.84, expected life 7 years, dividend yield 0%.

On January 28, 2008, the Company granted 70,000 options to purchase common stock to employees with an exercise price of $0.60 per share, the closing market price of the Company’s common stock on the date of grant, valued at approximately $32,000, which vest upon the achievement of a performance milestone by December 31, 2008. The fair value of the options was determined using the Black Scholes option pricing model utilizing the following assumptions: risk free interest rate 2.98%, stock price volatility 0.84, expected life 7 years, dividend yield 0%. As of June 30, 2008, and through the current reporting period, the Company has determined that it is not probable that the performance objective will be met, and in accordance with SFAS 123R, the incremental vesting charges incurred through March 31, 2008 of approximately $5,800 was reversed during the second quarter of 2008.

14


On January 28, 2008, the Company issued 25,000 shares of restricted stock with restrictions that are removed upon achievement of a performance milestone by December 31, 2008, to an advisor and current member of the Board of Directors as compensation for services at a price of $0.01 per share. The approximate $15,000 value of these restricted shares, based on the closing price of the Company’s common stock on the date of issuance, was expensed with a corresponding increase in additional paid in capital. The Company estimated that as of June 30, 2008, and through the current reporting period, it is not probable that the performance objective will be met, and in accordance with SFAS 123R, the incremental vesting charges incurred through March 31, 2008 of $15,000 was reversed during the second quarter of 2008.

On March 25, 2008, the Company issued 250,000 options to purchase common stock with an exercise price of $0.30 per share, the closing market price of the Company’s common stock on the date of grant, to employees as a retention incentive and to compensate employees for a salary deferral that began on April 1, 2008, which options were valued at approximately $57,000 and vested as long as the employee remained with the Company until a financing was achieved. These options are considered performance based options. The Company estimated that as of June 30, 2008 it was not probable that the performance objective would be met, and in accordance with SFAS 123R, the incremental vesting charges incurred through March 31, 2008 of approximately $4,000 were reversed during the second quarter of 2008. The fair value of the options was determined using the Black Scholes option pricing model utilizing the following assumptions: risk free interest rate 2.48%, stock price volatility 0.84, expected life 7 years, dividend yield 0%.

On April 29, 2008, the Company entered into an agreement with a fund raising firm and issued 214,286 shares of common stock at a price of $0.28 per share as compensation plus other agreed upon terms. The value of the shares, based on the closing price of the Company’s common stock on the date of grant, was recorded as a deferred financing expense of $60,000 with a corresponding increase in additional paid in capital. An additional $30,000 cash retainer was also recorded as a deferred financing cost for legal and other expenses. These costs were subsequently expensed as of June 30, 2008 due to the termination of the agreement.

On July 18, 2008, the Company issued 50,000 options to purchase common stock with an exercise price of $0.05 per share, the closing market price of the Company’s common stock on the date of grant, to a consultant per the provisions of a previously negotiated scientific consulting agreement as compensation. The value of the option grant is $2,087. The stock option vested 100% immediately on the date of grant and the termination clause was extended from 90 days to 180 days to compensate for ongoing consulting services from the consultant.

During the three months ended September 30, 2008 and 2007, the Company recognized equity based compensation expense for stock options of $22,000 and $156,000, respectively, which was recognized in the Statement of Operations. During the nine months ended September 30, 2008 and 2007, the Company recognized equity based compensation expense for stock options of $98,000 and $346,000, respectively, which was recognized in the Statement of Operations. As of September 30, 2008, the total compensation costs related to non-vested awards not yet recognized is $11,000 which will be recognized over the next three months. As of September 30, 2008, there were 2,906,677 options to purchase common stock outstanding under the Company’s 2005 Stock Option Plan.

(5) Warrant Extension

On February 15, 2008, the Company amended outstanding warrants to purchase an aggregate of 900,000 shares of common stock of the Company, which have an exercise price of $1.00 per share (the “Warrants”). The Warrants were originally issued in 2003 in connection with certain financing transactions and were scheduled to expire on February 15, 2008. The amendment extends the expiration date of the Warrants until February 15, 2010. The value of the extension of the warrants was calculated using the Black Scholes pricing model and resulted in a charge of approximately $176,000, which was recorded in the statement of operations during the first quarter of 2008.

15

 
In addition, the Warrants contain a call provision whereby the Company can require the holders of the Warrants to exercise them if the Company’s common stock trades at a level of at least $3.25 per share for 20 consecutive trading days (the “Call Provision”). In addition to amending the expiration date of the Warrants as described in the preceding paragraph, the Company amended the Call Provision by lowering the trading price at which the Call Provision may be triggered from $3.25 per share to $2.25 per share.

(6) Subsequent Event
 
October 3, 2008, the Compa