This Management’s Discussion and Analysis of Financial Condition and Results of Operations for the three and nine months ended September 30, 2008 and 2007 should be read in conjunction with our annual report on Form 10-K filed with the Securities and Exchange Commission and “Risk Factors” section included elsewhere in this Form 10-Q. This Form 10-Q contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended. Such forward-looking statements are based on current expectations and beliefs. Any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties. Actual events or results may differ materially from those discussed in the forward-looking statements as a result of various factors.

Forward looking statements in this Form 10-Q may be identified by words such as “believe,” “anticipate,” “intend,” “plan,” “estimate,” “expect,” and similar expressions and include, without limitation:

For a more detailed discussion of such forward-looking statements and the potential risks and uncertainties that may impact upon their accuracy, see the “Overview” sections of this Management’s Discussion and Analysis of Financial Condition and Results of Operations and the “Risk Factors” included elsewhere in this Form 10-Q. These forward-looking statements reflect our view only as of the date of this report. Except as required by law, we undertake no obligations to update any forward-looking statements. You should also carefully consider the factors set forth in other reports or documents that we file from time to time with the Securities and Exchange Commission. ¹

Overview

We are an emerging specialty pharmaceutical company focused on the development of pharmaceutical systems based on proprietary drug delivery technology platforms. We are developing and intend to commercialize pharmaceutical systems that will deliver the right drug to the right place in the right amount at the right time to treat chronic or episodic diseases and conditions. By integrating chemistry and engineering advancements, we seek to achieve what drugs or devices alone cannot. Our pharmaceutical systems enable optimized therapy for a given disease or patient population by controlling the rate and duration of drug administration and providing sustained drug delivery.

In addition to developing our own proprietary products, we enter into strategic collaborations with pharmaceutical companies to develop and commercialize proprietary and enhanced pharmaceutical products based on our technologies. We have five disclosed on-going product candidates in development of which four are in collaboration with third-party pharmaceutical companies. The following are our publicly announced product candidates in development:

POSIDUR™ (SABER™-Bupivacaine)

Our post-operative pain relief depot, POSIDUR, is a sustained release injectable using our SABER delivery system to deliver bupivacaine, an off-patent anesthetic agent. SABER is our patented controlled drug delivery technology that can be formulated for systemic or local administration of drugs via the parenteral (i.e., injectable) route. POSIDUR is designed to be administered to a surgical site at the time of surgery for post-operative pain relief and is intended to provide local analgesia for up to 3 days, which we believe coincides with the time period of the greatest need for post surgical pain control in most patients.

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In November 2006, we entered into a collaboration agreement with Nycomed Danmark, APS. Under the terms of the agreement, we licensed to Nycomed the exclusive commercialization rights to POSIDUR for the European Union (E.U.) and select other countries. Nycomed paid us an upfront license fee of $14.0 million in 2006 and an $8.0 million milestone payment in 2007, triggered by the achievement of a clinical development milestone, with future potential additional milestone payments of up to $180.0 million upon achievement of defined development, regulatory and sales milestones. We jointly direct and equally fund with Nycomed a development program for POSIDUR intended to secure regulatory approval in both the U.S. and the E.U. In addition, we will manufacture and supply the product to Nycomed for commercial sale in the territory licensed to Nycomed. Nycomed will pay us blended royalties on sales in the defined territory of 15-40% depending on annual sales, as well as a manufacturing markup. We retain full commercial rights to POSIDUR in the U.S., Canada, Asia and certain other countries.

In 2007, we successfully completed a 122 patient Phase IIb clinical trial of POSIDUR for treatment of post-operative pain in patients undergoing inguinal hernia repair. In this Phase IIb trial, POSIDUR at a dose of 5 mL demonstrated statistically significant reductions in pain and in total consumption of supplemental opioid analgesic medications versus placebo. These successful results triggered the $8.0 million milestone payment by Nycomed to us under our agreement with Nycomed.

Phase IIb Inguinal Hernia Trial

Design

This POSIDUR Phase IIb clinical trial was designed to evaluate the tolerability, activity, dose response and pharmacokinetics of POSIDUR in patients undergoing open inguinal hernia repair. The study was conducted in Australia and New Zealand as a multi-center, randomized, double blind, placebo-controlled study in 122 patients. Study patients were randomized into three treatment groups: patients that were treated with POSIDUR 2.5 mL (n=43), POSIDUR 5 mL (n=47) and placebo (n=32). The co-primary efficacy endpoints for the study were Mean Pain Intensity on Movement area under the curve (AUC), a measure of pain over a period of 1-72 hours post-surgery, and the proportion of patients requiring supplemental opioid analgesic medication during the study. Secondary efficacy endpoints included Mean Pain Intensity on Movement AUC over the period 1-48 hours post-surgery, mean total consumption of supplemental opioid analgesic medication, and time to first use of supplemental opioid analgesic medication. The threshold for statistical significance was considered to be at the p<0.05 level.

Results

Pain Control

In relation to the co-primary endpoint of pain reduction as measured by Mean Pain Intensity on Movement AUC 1-72 hours post-surgery, the patient group treated with POSIDUR 5 mL reported thirty-one percent (31%) less pain versus placebo (p=0.0033). A secondary endpoint measure reported a thirty-five percent (35%) reduction of pain as measured by Mean Pain Intensity on Movement AUC for the period 1-48 hours post-surgery between the POSIDUR 5 mL treatment group versus placebo (p=0.0007).

Consumption of Supplemental Opioid Analgesic Medication

Fifty-three percent (53%) of the study patients in the POSIDUR 5 mL group took supplemental opioid analgesic medications versus seventy-two percent (72%) of the placebo patients (p=0.0909). Although this positive trend for this co-primary endpoint in favor of the POSIDUR 5 mL group was not statistically significant, both secondary endpoints measuring opioid analgesic medication consumption were met at a statistically significant level. During the periods of 1-24 hours, 24-48 hours and 48-72 hours after surgery, placebo patients consumed approximately 3.5 (p=0.0009), 2.9 (p=0.0190) and 3.6 (p=0.0172) times more supplemental opioid analgesic medications (mean total daily consumption of opioid analgesic medication in morphine equivalents), respectively, than the POSIDUR 5 mL treatment group. In addition, the median time to first use of supplemental opioid analgesic medication after surgery for the placebo patients was 2.7 hours versus >72 hours for the POSIDUR 5 mL treatment group (p=0.0197).

Dose Finding

POSIDUR administered at the dose of 5 mL showed statistically significant activity relative to placebo whereas POSIDUR administered at 2.5 mL showed a positive trend relative to placebo on certain parameters but the results were not statistically significant.

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Safety

The patient groups treated with POSIDUR 5 mL and POSIDUR 2.5 mL showed comparable safety profiles as the patient groups treated with placebo, and the drug administration appeared well tolerated. The side effects commonly observed with opioid medication use were less frequent in the POSIDUR 5 mL and 2.5 mL treatment groups compared to placebo.

Other Exploratory Phase II studies

In addition to the Phase IIb study described above, we have also conducted smaller exploratory Phase II studies in hernia, shoulder arthroscopy and appendectomy surgeries to evaluate different application techniques, clinical design and conduct as well as other investigational factors. These trials have been conducted in multiple cohorts, generally consisting of approximately 6 to 21 patients in each treatment group. In all the exploratory studies, patient groups treated with POSIDUR 5 mL and POSIDUR 2.5 mL showed comparable safety profiles as the patient groups treated with placebo, and the drug administration appeared well tolerated. Some treatment groups from the hernia and shoulder exploratory studies utilizing POSIDUR have shown positive activity as measured by reduction of pain or consumption of supplemental opioid analgesic medication versus placebo, while other treatment groups have not.

We continue to be in dialogue with the FDA regarding the Phase III program and believe we are making progress in defining that program. In parallel with these discussions, we and our European collaborator, Nycomed, continue to advance development of this drug candidate. As one element in advancing the program, because an orthopedic surgical model will be part of our proposed studies for regulatory approval, we are commencing a 60-patient Phase IIb study in Australia using a 5 mL dose in shoulder surgery intended to allow us to confirm aspects of our clinical study design and conduct. Additionally, Nycomed is commencing Phase IIb studies in surgical models in Europe. These studies will contribute to the total number of patient exposures that will ultimately be required by the FDA and the European Medicines Agency (EMEA) as part of the product approval process in the U.S. and Europe.

Remoxy™ and other ORADUR-based opioid drug candidates licensed to Pain Therapeutics

In December 2002, we entered into an agreement with Pain Therapeutics, amended in December 2005, under which we granted Pain Therapeutics the exclusive, worldwide right to develop and commercialize selected long-acting oral opioid products using our ORADUR technology incorporating four specified opioid drugs. The first product being developed under the collaboration is Remoxy, a novel long-acting oral formulation of the opioid oxycodone targeted to decrease the potential for oxycodone abuse. Remoxy is intended for patients with chronic pain.

In December 2007, Pain Therapeutics and King Pharmaceuticals announced that t he pivotal Phase III trial for Remoxy successfully met its primary endpoint ( p< 0.01) that was prospectively defined by the FDA during the Special Protocol Assessment process. In addition, the study achieved statistically significant results in secondary endpoints such as Quality of Analgesia (p<0.01) and Global Assessment (p<0.01). Pain Therapeutics has stated that they submitted the NDA for Remoxy with the FDA in June 2008. In August 2008, Pain Therapeutics stated that the FDA had accepted the NDA submission and had granted it priority review status. A priority review designation is given to drugs that offer real advances in treatment, or provide a treatment where no adequate therapy exists. A priority review means that the time it takes FDA to review a NDA is reduced from 12 months to approximately 6 months. Remoxy will be the subject of an FDA public advisory committee meeting on November 13, 2008.

During the first nine months of 2008, we began to manufacture commercial lots of certain key components that are included in Remoxy to meet the anticipated requirements for these components. In addition, during the second and third quarters of 2008 we made our first shipments of these materials to meet the production requirements of King Pharmaceuticals, which has rights to commercialize Remoxy upon approval by the FDA. Revenue attributable to these arrangements aggregating $796,000 in the nine months ended September 30, 2008 has been deferred pending the execution of a final supply agreement with King Pharmaceuticals.

We have also worked with King and Pain Therapeutics on the development of ORADUR-based abuse-resistant opioid drug candidates in addition to Remoxy. In November 2006, Pain Therapeutics announced positive results from a Phase I clinical trial of an ORADUR-based opioid drug candidate. In addition, Pain Therapeutics has stated that it commenced a Phase I clinical study for a new ORADUR-based abuse-resistant opioid in August 2008.

TRANSDUR™-Sufentanil

Our transdermal sufentanil patch (TRANSDUR-Sufentanil) uses our proprietary TRANSDUR delivery system to deliver sufentanil, an opioid medication. TRANSDUR-Sufentanil is designed to provide extended chronic pain relief for up to seven days, as compared to the three days of relief provided with currently available opiate patches. We anticipate that the small size of our sufentanil patch (potentially as small as 1/5 ^th the size of currently marketed transdermal fentanyl patches for a therapeutically equivalent dose) may offer improved convenience and compliance for patients. In 2005, we successfully completed a Phase II clinical trial of TRANSDUR-Sufentanil in chronic pain. In March 2005, we entered into an agreement with Endo Pharmaceuticals (Endo) granting Endo exclusive rights to develop, market and commercialize TRANSDUR-Sufentanil in the U.S. and Canada. Endo has entered into an agreement with a contract manufacturer, 3M Company (3M), related to manufacturing process development and scale-up for TRANSDUR-Sufentanil. Endo commenced its Phase II program designed to evaluate the conversion of chronic pain patients treated with oral opioid products to TRANSDUR-Sufentanil in the second quarter of 2007. Endo has stated that they expect to have data from a Phase II study by the end of 2008 and expect to hold an end-of-Phase II meeting with the FDA in early 2009.

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ELADUR™ (TRANSDUR-Bupivacaine)

Our transdermal bupivacaine patch (ELADUR) uses our proprietary TRANSDUR transdermal technology and is intended to provide continuous delivery of bupivacaine for up to three days from a single application, as compared to a wearing time limited to 12 hours with currently available lidocaine patches.

In 2007, we successfully completed a 60 patient Phase IIa clinical trial for ELADUR. In this study of patients suffering from post-herpetic neuralgia, ELADUR showed improved pain control versus placebo during the 3-day continuous treatment period. In addition, ELADUR appeared well tolerated overall, and patients treated with ELADUR and placebo exhibited similar safety profiles.

During the third quarter of 2008, we continued to develop our clinical and regulatory strategy, and to conduct manufacturing scale-up and processing activities to secure additional Phase II and Phase III supplies. In June 2008, the FDA granted to DURECT orphan drug designation for bupivacaine for relief of persistent pain associated with post-herpetic neuralgia (PHN). If ELADUR is the first bupivacaine product approved for PHN, under the 1983 Orphan Drug Act, ELADUR will receive seven years of market exclusivity following the approval of the product by the FDA. There can be no assurance that ELADUR will be the first bupivacaine product approved for PHN, and therefore ELADUR may not be entitled to the seven year exclusivity for orphan drugs.

In September 2008, the Company and Alpharma Ireland Limited, an affiliate of Alpharma Inc. (Alpharma), entered into a development and license agreement granting Alpharma the exclusive worldwide rights to develop and commercialize ELADUR™, DURECT’s investigational transdermal bupivacaine patch currently under development for the treatment of pain associated with post-herpetic neuralgia (PHN). The agreement became effective in October 2008 after clearance under the Hart-Scott-Rodino (HSR) Antitrust Improvements Act of 1976.

Under the terms of the agreement, upon closing of the transaction, Alpharma paid the Company an upfront license fee of $20 million, with possible additional payments of up to $93 million upon the achievement of predefined development and regulatory milestones spread over multiple clinical indications and geographical territories as well as possible additional payments of up to $150 million in sales-based milestones. If ELADUR is commercialized, the Company would also receive royalties on product sales. Alpharma will control and fund further development of the program. The Company will perform development activities through completion of Phase 2, and formulation and manufacturing scale-up activities for the program, the costs of which shall be reimbursed by Alpharma. The term of the agreement will continue on a jurisdiction-by-jurisdiction basis until the later of fifteen (15) years from the date of first commercial sale of ELADUR or the expiration of patent coverage or data exclusivity in such jurisdiction. During the term of the agreement, subject to specified conditions, neither party nor their affiliates may develop or commercialize a transdermal patch containing bupivacaine. Upon expiration of the term of the agreement, the rights and licenses granted to Alpharma shall convert to fully paid-up, non-royalty bearing, perpetual rights and licenses. The agreement provides each party with specified termination rights, including the right of Alpharma to terminate at any time without cause and each party to terminate the agreement upon material breach of the agreement by the other party. The agreement also contains terms and conditions customary for this type of arrangement, including representations, warranties and indemnities.

Other Programs

Memryte™

In July 2002, we entered into a development and commercialization agreement, amended in January 2007 with Voyager under which we granted Voyager the exclusive, worldwide rights to develop and commercialize a product, Memryte, using the DURIN implant system to deliver the peptide leuprolide acetate to treat Alzheimer’s disease based on Voyager’s patented method of treatment.

In October 2005, Voyager initiated a Phase III clinical trial for Memryte, but the Phase III trial was truncated by Voyager in order to get an early look at potential efficacy. In the second quarter of 2007, Voyager informed its shareholders that it has observed positive outcome trends among women, but no positive effect among men in Voyager’s truncated Phase III clinical trial for Memryte. Based on these results, Voyager has stated that it intends to focus its efforts on developing Memryte for the treatment of Alzheimer’s disease in women and on seeking a potential collaborative partner for the program. There can be no assurance that Voyager or any other party will continue development of Memryte.

CHRONOGESIC ^® (sufentanil) Pain Therapy System

The CHRONOGESIC (sufentanil) Pain Therapy System is an osmotic implant that is intended to continuously deliver sufentanil for an extended duration. CHRONOGESIC is intended to treat chronic pain, and is based on the DUROS ^® System, a miniature osmotic pump capable of continuously delivering drugs for up to a year in duration. We granted to Endo exclusive commercialization rights for CHRONOGESIC in the U.S. and Canada pursuant to a Development, Commercialization and Supply License Agreement dated November 2002, which was terminated by Endo effective April 17, 2008, thus returning the rights to the product candidate back to us.

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Biologics Programs

The proteins and genes identified by the biotechnology industry are large, complex, intricate molecules, and many are difficult to use as drugs. If these molecules are given orally, they are often digested before they can have an effect; if given by injection, they may be destroyed by the body’s natural processes before they can reach their intended sites of action. The body’s natural elimination processes require frequent, high dose injections that may result in unwanted side effects. As a result, the development of biotechnology molecules for the treatment of human diseases has been limited, and advanced drug delivery systems such as we possess are required to realize the full potential of many of these protein and peptide drugs. We have active programs underway to apply our drug delivery systems to various biotechnology drugs and drug candidates, and have entered into a number of feasibility studies with biotechnology and pharmaceutical companies to test their products in our systems.

Research Programs in Other Therapeutic Categories

We have underway a number of research programs covering medical diseases and conditions other than pain. Such programs include various diseases and disorders of the central nervous system (CNS), including schizophrenia and attention deficit/hyperactivity disorder. Another area of focus includes cardiovascular disease, including congestive heart failure. In conducting our research programs and determining which particular efforts to prioritize for formal development, we employ a rigorous opportunity assessment process that takes into account the unmet medical need, commercial opportunity, technical feasibility, clinical viability, intellectual property considerations, and the development path including costs to achieve various critical milestones.

Collaborative Research and Development Revenues

Collaborative research and development revenues consist of three broad categories: (a) the amortization of upfront license payments on a straight-line basis over the period of our continuing involvement with the third party, (b) the reimbursement of qualified research expenses by third parties, and (c) milestone payments in connection with our collaborative agreements. During the last two and three-quarter years, we generated the majority of all collaborative research and development revenues from three collaborative agreements related to TRANSDUR-Sufentanil, Remoxy and other specified ORADUR-based oral opioids, and POSIDUR. Since the signing of the Nycomed agreement related to POSIDUR in November 2006, we have recognized collaborative research and development revenue from the amortization of the upfront payment of $14.0 million and milestone payment of $8.0 million received from Nycomed. However, in contrast to our other collaborations, due to the terms and nature of this collaboration, we do not recognize revenue from the reimbursement of qualified research expenses by Nycomed. Rather, we record research and development expense equal to our net share of the joint research and development expenses undertaken under the product development plan.

Product Revenues

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

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

Since our inception in 1998, we have had a history of operating losses. At September 30, 2008, we had an accumulated deficit of $265.2 million. Our net loss for the three and nine months ended September 30, 2008 was $9.2 million and $25.6 million, respectively. Our losses were $24.3 million, $33.3 million and $18.1 million for the years ended December 31, 2007, 2006 and 2005, respectively. These losses have resulted primarily from costs incurred to research and develop our product candidates and to a lesser extent, from selling, general and administrative costs associated with our operations and product sales. We expect our research and development expenses to increase in the near future as we expect to continue to expand our nonclinical studies, clinical trials and other research and development activities. We expect selling, general and administrative expenses to increase in the near future due to expected increases in patent and employee related costs to support our business activities. We do not anticipate meaningful revenues from our pharmaceutical systems, should they be approved, for at least the next twelve months. Therefore, we expect to incur continuing losses and negative cash flow from operations for the foreseeable future.

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Critical Accounting Policies and Estimates

General

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The most significant estimates and assumptions relate to revenue recognition, the recoverability of our long-lived assets, including goodwill and other intangible assets, accrued liabilities, contract research liabilities and stock-based compensation. Actual amounts could differ significantly from these estimates.

Revenue Recognition

Revenue from the sale of products is recognized when there is persuasive evidence that an arrangement exists, the product is shipped and title transfers to customers, provided no continuing obligation exists, the price is fixed or determinable and the collectability of the amounts owed is reasonably assured. We recognize revenue from the sale of our products and license and collaboration agreements pursuant to Staff Accounting Bulletin No. 104, Revenue Recognition , and Emerging Issues Task Force (EITF) Issue 00-21 Revenue Arrangements with Multiple Deliverables . Multiple element agreements entered into are evaluated under the provision of EITF 00-21. We evaluate whether there is stand-alone value for the delivered elements and objective and reliable evidence of fair value to allocate revenue to each element in multiple element agreements. When the delivered element does not have stand-alone value or there is insufficient evidence of fair value for the undelivered element(s), we recognize the consideration for the combined unit of accounting in the same manner as the revenue is recognized for the final deliverable, which is generally ratably over the longest period of involvement.

Upfront payments received upon execution of collaborative agreements are recorded as deferred revenue and recognized as collaborative research and development revenue based on a straight-line basis over the period of our continuing involvement with the third party collaborator pursuant to the applicable agreement. Such period generally represents the research and development period set forth in the work plan defined in the respective agreements between us and our third-party collaborators.

Research and development revenue related to services performed under the collaborative arrangements with our corporate collaborators is recognized as the related research and development services are performed and the collectability of the amounts owed is reasonably assured. These research payments received under each respective agreement are not refundable and are generally based on reimbursement of qualified expenses, as defined in the agreements. Research and development expenses under the collaborative research and development agreements generally approximate or exceed the revenue recognized under such agreements over the term of the respective agreements. Deferred revenue may result when we do not expend the required level of effort during a specific period in comparison to funds received under the respective agreement. Of note, in regard to our collaboration with Nycomed, in contrast to our other collaborations, because we and Nycomed jointly control and fund the development of POSIDUR, we do not recognize revenue from the reimbursement of qualified research expenses from Nycomed but instead those reimbursements receivable from Nycomed are recorded as a reduction in research and development expense.

Milestone payments under collaborative arrangements are recognized as collaborative research and development revenue upon achievement of the milestone events, which represent the culmination of the earnings process related to that milestone as defined in the agreement. Milestone payments are triggered either by the results of our research and development efforts or by events external to us, such as regulatory approval to market a product or the achievement of specified sales levels by a third-party collaborator. As such, the milestones are substantially at risk at the inception of the collaboration agreement, and revenue is only recognized upon the achievement of a milestone event if we have no future performance obligations related to that milestone payment.

Research and Development Expenses

Research and development expenses are primarily comprised of salaries and benefits associated with research and development personnel, overhead and facility costs, preclinical and non-clinical development costs, clinical trial and related clinical manufacturing costs, contract services, and other outside costs. Research and development costs are expensed as incurred. Research and development costs paid to third parties under sponsored research agreements are recognized as expense as the related services are performed, generally ratably over the period of service. In addition, reimbursements by Nycomed for research and development expenses incurred by the Company are recorded as a reduction to research and development expenses. Research and development expenses incurred by Nycomed and reimbursable by the Company are recorded as an addition to the Company’s research and development expenses.

Accrued Liabilities and Contract Research Liabilities

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

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Stock-Based Compensation

We use the Black-Scholes option pricing model to value our stock options. The expected life computation is based on historical exercise patterns and post-vesting termination behavior. We considered our historical volatility in developing our estimate of expected volatility. All options are amortized over the requisite service periods of the awards, which are generally the vesting periods. We may elect to use different assumptions under the Black-Scholes option valuation model in the future, which could materially affect our net income or loss and net income or loss per share.

Fair Value Measurements

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). In February 2008, the FASB issued FASB Staff Position No. FAS 157-2, “Effective Date of FASB Statement No. 157”, which provides a one year deferral of the effective date of SFAS 157 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed in the financial statements at fair value at least annually. Therefore, we have adopted the provisions of SFAS 157 with respect to its financial assets and liabilities only. SFAS 157 defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles and enhances disclosures about fair value measurements. Fair value is defined under SFAS 157 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value under SFAS 157 must maximize the use of observable inputs and minimize the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value. These levels of inputs are the following:

We do not believe that the adoption of SFAS 157 had a material impact on our financial statements.

Recent Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). In February 2008, the FASB issued FASB Staff Position No. FAS 157-2, “Effective Date of FASB Statement No. 157”, which provides a one year deferral of the effective date of SFAS 157 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed in the financial statements at fair value at least annually. Therefore, we have adopted the provisions of SFAS 157 with respect to its financial assets and liabilities only. SFAS 157 defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles and enhances disclosures about fair value measurements. Fair value is defined under SFAS 157 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value under SFAS 157 must maximize the use of observable inputs and minimize the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value. The adoption of SFAS 157 did not have a material impact on our financial statements.

In February 2007, FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB No. 115 (“SFAS 159”). The Statement permits entities to choose, at specified election dates, to measure many financial instruments and certain other items at fair value that are not currently measured at fair value. Unrealized gains and losses on items for which the fair value option has been elected would be reported in earnings at each subsequent reporting date. SFAS 159 also establishes presentation and disclosure requirements in order to facilitate comparisons between entities choosing different measurement attributes for similar types of assets and liabilities. SFAS 159 does not affect existing accounting requirements for certain assets and liabilities to be carried at fair value. This statement is effective for fiscal years beginning after November 15, 2007 and is required to be adopted by the Company for the fiscal year ending December 31, 2008. The adoption of SFAS 159 did not have a material impact on our financial statements.

In June 2007, the Emerging Issues Task Force of the FASB reached a consensus on Issue No. 07-3 (“EITF 07-3”), Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities . Under EITF 07-3, nonrefundable advance payments for goods or services that will be used or rendered for research and development activities should be deferred and capitalized. Such payments should be recognized as an expense as the goods are delivered or the related services are performed, not when the advance payment is made. If a company does not expect the goods to be delivered or services to be rendered, the capitalized advance payment should be charged to expense. EITF 07-3 is effective for new contracts entered into in fiscal years beginning after December 15, 2007, and interim periods within those fiscal years. The adoption of EITF 07-3 did not have a material impact on our financial statements.

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In November 2007, the Emerging Issues Task Force of the FASB issued a consensus on Issue No. 07-1 (“EITF 07-1”), Accounting for Collaborative Arrangements. The scope of EITF 07-1 is limited to collaborative arrangements where no separate legal entity exists and in which the parties are active participants and are exposed to significant risks and rewards that depend on the success of the activity. The Task Force concluded that revenue transactions with third parties and associated costs incurred should be reported in the appropriate line item in each company’s financial statements pursuant to the guidance in EITF 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent . The Task Force also concluded that the equity method of accounting under Accounting Principles Board Opinion 18, The Equity Method of Accounting for Investments in Common Stock , should not be applied to arrangements that are not conducted through a separate legal entity. The Task Force also concluded that the income statement classification of payments made between the parties in an arrangement should be based on a consideration of the following factors: the nature and terms of the arrangement; the nature of the entities’ operations; and whether the partners’ payments are within the scope of existing GAAP. To the extent such costs are not within the scope of other authoritative accounting literature, the income statement characterization for the payments should be based on an analogy to authoritative accounting literature or a reasonable, rational, and consistently applied accounting policy election. The provisions of EITF 07-1 are effective for fiscal years beginning on or after December 15, 2008, and companies will be required to apply the provisions through retrospective application to all collaborative arrangements existing at adoption as a change in accounting principle. The adoption of EITF 07-1 did not have a material impact on our financial statements.

In December 2007, the FASB issued SFAS No. 141R, Business Combinations (“SFAS No. 141R”). SFAS No. 141R amends SFAS 141 and provides revised guidance for recognizing and measuring identifiable assets and goodwill acquired, liabilities assumed, and any noncontrolling interest in the acquiree. It also provides disclosure requirements to enable users of the financial statements to evaluate the nature and financial effects of the business combination. It is effective for fiscal years beginning on or after December 15, 2008 and will be applied prospectively. We do not believe that the adoption of SFAS 141R will have a material impact on our financial statements.

Results of Operations

Three and nine months ended September 30, 2008 and 2007

Revenues. Net revenues were $6.6 million and $19.4 million in the three and nine months ended September 30, 2008, respectively, compared to $4.9 million and $24.1 million for the corresponding periods in 2007. We recognized $850,000 of milestone revenue in the three and nine months ended September 30, 2008 as compared to zero and $8.0 million of milestone revenue recognized in the three and nine months ended September 30, 2007, respectively. Excluding the milestone revenue, total revenue in the three and nine months ended September 30, 2008 increased compared to the same periods in 2007 primarily due to higher collaborative research and development revenue recognized from our agreement with Pain Therapeutics and higher product revenue, partially offset by lower collaborative research and development revenue from Endo and from feasibility agreements with various third parties.

Collaborative research and development and other revenue

We recognize revenues from collaborative research and development activities and service contracts. We recorded $4.3 million and $12.5 million of collaborative research and development revenue for the three and nine months ended September 30, 2008, respectively, compared to $3.0 million and $17.9 million for the corresponding periods in 2007. Collaborative research and development revenue primarily represents reimbursement of qualified expenses related to collaborative agreements with various third parties to research, develop and commercialize potential products using our drug delivery technologies, amortization of upfront fees and milestone payments associated with the license agreements.

The increase in collaborative research and development revenue in the three months ended September 30, 2008 was primarily due to higher revenue recognized in connection with our agreement for Remoxy and other ORADUR-based opioid drug candidates (collaboration with Pain Therapeutics) compared with the same period in 2007. We recognized $850,000 of milestone revenue in connection with our collaboration with Pain Therapeutics in the three and nine months ended September 30, 2008. The decrease in collaborative research and development revenue in the nine months ended September 30, 2008, as compared to the same period in 2007, was primarily attributable to our recognition of $8.0 million of milestone revenue in connection with our agreement for POSIDUR (collaboration with Nycomed) for the nine months ended September 30, 2007. Excluding the impact of milestone revenue, collaborative research and development revenue increased in the nine months ended September 30, 2008 due to higher revenue recognized in connection with our agreement for Remoxy and other ORADUR-based opioid drug candidates (collaboration with Pain Therapeutics), partially offset by lower collaborative research and development revenue recognized in connection with our agreement for TRANSDUR-Sufentanil (collaboration with Endo) and from feasibility agreements compared with the same periods in 2007.

We received a $10.0 million up-front fee in connection with the license agreement signed with Endo in March 2005 relating to TRANSDUR-Sufentanil. The $10.0 million up-front fee is recognized as revenue ratably over the term of our continuing involvement

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with Endo with respect to TRANSDUR-Sufentanil. For each of the three and nine months ended September 30, 2008 and 2007, we recognized $547,000 and $1.6 million in collaborative research and development revenue related to this up-front fee. The term of the continuing involvement has been estimated based on the current product development plan pursuant to the agreement.

We also received a $14.0 million up-front fee in connection with the development and license agreement with Nycomed in November 2006 relating to POSIDUR. The $14.0 million up-front fee is recognized as collaborative research and development revenue ratably over the term of our continuing involvement with Nycomed with respect to POSIDUR. The amount recognized in each of the three and nine months ended September 30, 2008 and 2007 as collaborative research and development revenue from the amortization of the up-front fee was $763,000 and $2.3 million, respectively.

We expect our collaborative research and development revenue to fluctuate in future periods pending our efforts to enter into potential new collaborations and our existing third party collaborators’ commitment to and progress in the research and development programs. The collaborative research and development revenues associated with our major collaborators are as follows (in thousands):

Notes:

We amortize up-front fees on a straight-line basis over the period in which we have continuing involvement with the third-party collaborator pursuant to the applicable agreement. Such period generally represents the research and development period set forth in the work plan under each collaboration agreement between us and our third-party collaborator.

Milestone payments under collaborative arrangements are recognized as revenue upon achievement of the milestone events, which represent the culmination of the earnings process related to that milestone. Milestone payments are triggered either by the results of our research and development efforts or by events external to us, such as regulatory approval to market a product or the achievement of specified sales levels by a third-party collaborator. As such, the milestones are substantially at risk at the inception of the collaboration agreement, and revenue is only recognized upon the achievement of a milestone event if we have no future performance obligations related to that milestone payment. We recorded $850,000 of milestone revenue from our Pain Therapeutics collaboration related to the achievement of clinical and regulatory milestones for each of the three and nine months ended September 30, 2008 compared with zero and $8.0 million of milestone revenue from our Nycomed collaboration due to the achievement of a clinical development milestone for POSIDUR in the corresponding periods in 2007.

We recognized $30,000 and $78,600 in revenue from service contracts in the three and nine months ended September 30, 2008 compared to $0 in the same periods in 2007. Service contract revenues recognized in 2008 were related to certain polymer-related service contracts we signed with various customers. We currently do not expect to increase our effort to generate significant revenue from such polymer-related service contracts in the future.

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Product revenue

A portion of our revenues is derived from our product sales, which include our ALZET mini pump product line, and to a lesser extent our LACTEL biodegradable polymer product line. Net product revenues were $2.3 million and $6.9 million in the three and nine months ended September 30, 2008, respectively, compared to $1.9 million and $6.2 million for the corresponding periods in 2007. The increase was primarily due to higher average selling prices from our ALZET product line and LACTEL polymer product line in the three and nine months ended September 30, 2008, compared with the same periods in 2007. Product revenues attributable to the shipments of key components of REMOXY in 2008 aggregating $266,000 and $796,000 in the three and nine months ended September 30, 2008 have been deferred pending the execution of a final supply agreement with King Pharmaceuticals. We expect product revenue to increase as we begin to generate product revenue from selling these excipients to King Pharmaceuticals in the future.

Cost of revenues. Cost of revenues was $870,000 and $2.7 million for the three and nine months ended September 30, 2008, respectively, compared to $780,000 and $2.4 million for the corresponding periods in 2007. The increase in the cost of product revenue in the three and nine months ended September 30, 2008 was primarily the result of higher product revenue by our ALZET and LACTEL product lines in these periods. Cost of service revenue was $8,600 and $27,600 for the three and nine months ended September 30, 2008, respectively, compared to $0 for the corresponding periods in 2007 due to an increase in our service contract revenue related to our polymer business in 2008. Stock based compensation expense recognized under SFAS 123(R) related to cost of revenues was $44,000 and $31,000 for the three months ended September 30, 2008 and 2007, and $110,000 and $98,000 for the nine months ended September 30, 2008 and 2007, respectively.

As of September 30, 2008 and 2007, we had 30 and 22 manufacturing employees, respectively. The increase in 2008 was due to the shifting of research and development employees to manufacturing as we began commercial manufacturing of certain excipients that are components of Remoxy. We expect cost of revenue to increase in the future as we begin to generate product revenue from selling these excipients to King Pharmaceuticals.

Research and Development. Research and development expenses are primarily comprised of salaries and benefits associated with R&D personnel, overhead and facility costs, preclinical and non-clinical development costs, clinical trial and related clinical manufacturing costs, contract services, and other outside costs. Research and development expenses were $11.4 million and $31.0 million for the three and nine months ended September 30, 2008, respectively, compared to $8.9 million and $28.8 million for the corresponding periods in 2007. The increase in the three and nine months ended September 30, 2008 was primarily attributable to higher development costs associated with ELADUR, Remoxy and other ORADUR-based opioid drug candidates licensed to Pain Therapeutics, and our biologics programs, partially offset by decreased clinical trial expenses for POSIDUR, decreased development costs associated with CHRONOGESIC, TRANSDUR-Sufentanil and other research programs compared with the same period in 2007 as more fully discussed below. In addition, we paid $2.25 million to EpiCept in the third quarter of 2008 under the amended agreement with EpiCept and recorded this amount as a research and development expense in the three and nine months ended September 30, 2008. Stock based compensation expense recognized under SFAS 123(R) related to research and development personnel was $1.3 million and $4.3 million for the three and nine months ended September 30, 2008, respectively, and $1.0 million and $3.3 million for the three and nine months ended September 30, 2007, respectively.

ELADUR

Our research and development expenses for ELADUR increased to $4.6 million and $9.0 million in the three and nine months ended September 30, 2008 from $1.4 million and $4.0 million in the same periods in 2007. The increases were primarily due to higher employee costs and contract manufacturing expenses related to manufacturing scale-up and processing activities to secure additional Phase II and Phase III supplies for this product candidate in 2008. In addition, we paid $2.25 million to EpiCept in the third quarter of 2008 related to certain intellectual property for ELADUR under the amended agreement with EpiCept.

POSIDUR

Our research and development expenses for POSIDUR decreased to $2.0 million and $6.3 million in the three and nine months ended September 30, 2008 from $2.1 million and $8.8 million in the same period in 2007. The decreases were primarily due to lower costs associated with clinical trial expenses and contract manufacturing development activities. Research and development expenses for POSIDUR incurred by us but reimbursable by Nycomed under the terms of our agreement with Nycomed were $960,000 and $2.6 million in the three and nine months ended September 30, 2008, respectively, compared to $1.1 million and $5.2 million for the corresponding periods in 2007, which are accounted for as a reduction of research and development expenses. Research and development expenses for POSIDUR incurred by Nycomed but reimbursable by us under the terms of our agreement with Nycomed were $441,000 and $1.5 million in the three and nine months ended September 30, 2008, respectively, compared to $107,000 and $957,000 for the corresponding periods in 2007, which are accounted for as additional research and development expenses. As a result of the collaboration agreement with Nycomed, our research and development expenses were reduced by $519,000 and $1.1 million in the three and nine months ended September 30, 2008, respectively, compared to $997,000 and $4.3 million for the corresponding periods in 2007. The net reduction in research and development expenses represents a net reimbursement from Nycomed reflecting that both parties bore 50% of the development expenses defined under the collaboration agreement for POSIDUR.

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Remoxy and other ORADUR-based opioid drug candidates

Our research and development expenses for Remoxy and other opioids partnered with Pain Therapeutics increased to $1.3 million and $4.8 million in the three and nine months ended September 30, 2008 from $687,000 and $2.2 million in the same periods in 2007. The increases were primarily due to increased NDA support activities for Remoxy as well as additional formulation and clinical manufacturing activities for other ORADUR-based opioid drug candidates in 2008.

Biologics Programs

Our research and development expenses for biologics programs increased to $1.4 million and $3.7 million in the three and nine months ended September 30, 2008, respectively, compared to $732,000 and $2.0 million for the corresponding periods in 2007. The increases were primarily due to higher external costs and employee related costs in support of these programs in 2008.

TRANSDUR-Sufentanil

Our research and development expenses for TRANSDUR-Sufentanil decreased to $471,000 and $1.1 million in the three and nine months ended September 30, 2008, respectively, compared to $730,000 and $2.3 million for the corresponding periods in 2007. The decreases were primarily due to lower development support activities performed in support of this drug candidate in 2008.

CHRONOGESIC ^® (sufentanil) Pain Therapy System

Our research and development expenses for CHRONOGESIC decreased to $11,000 and $94,000 in the three and nine months ended September 30, 2008, respectively, compared to $289,000 and $1.6 million for the corresponding periods in 2007. The decreases were primarily due to lower employee related costs and external development expenses for this drug candidate in 2008.

Memryte

Our research and development expenses for Memryte decreased to zero in both the three and nine months ended September 30, 2008, respectively, compared to $31,000 and $1.2 million for the corresponding periods in 2007 as we did not engage in any development activities related to Voyager in the first nine months of 2008. The reported research and development expense in the nine months ended September 30, 2007 includes a one-time cash payment of $1.0 million which we made in January 2007 as part of the amendment of our license agreement with Voyager.

Other DURECT Research Programs

Our research and development expenses for all other programs decreased to $1.6 million in the three months ended September 30, 2008 compared to $2.9 million for the corresponding period in 2007 primarily due to lower employee related costs for these programs in the third quarter of 2008. Our research and development expenses for all other programs decreased to $5.9 million in the nine months ended September 30, 2008 compared to $6.7 million for the corresponding period in 2007 primarily due to lower employee related costs and increased formulation and clinical development activities for these programs.

As of September 30, 2008, we had 113 research and development employees compared with 112 as of the corresponding date in 2007. We expect our research and development expenses to increase in the near future as we expect to continue to expand our nonclinical studies, clinical trials and other research and development activities.

The research and development expenses associated with our major development programs approximate the following (in thousands):

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We cannot reasonably estimate the timing and costs of our research and development programs due to the risks and uncertainties associated with developing pharmaceutical systems as outlined in the “Risk Factors” section of this report. The duration of development of our research and development programs may span as many as ten years or more, and estimation of completion dates or costs to complete would be highly speculative and subjective due to the numerous risks and uncertainties associated with developing pharmaceutical products, including significant and changing government regulation, the uncertainties of future preclinical and clinical study results, the uncertainties with our collaborators’ commitment and progress to the programs and the uncertainties associated with process development and manufacturing as well as sales and marketing. In addition, with respect to our collaborative development programs with third-parties, the timing and expenditures to complete the programs are subject to the control of our collaborators. Therefore, we cannot reasonably estimate the timing and estimated costs of the efforts necessary to complete the research and development programs. For additional information regarding these risks and uncertainties, see “Risk Factors” below.

Selling, General and Administrative. Selling, general and administrative expenses are primarily comprised of salaries and benefits associated with finance, legal, business development, sales and marketing and other administrative personnel, overhead and facility costs, and other general and administrative costs. Selling, general and administrative expenses were $3.8 million and $11.8 million for the three and nine months ended September 30, 2008, respectively, compared to $3.1 million and $10.4 million for the corresponding periods in 2007. The increase in the three and nine months ended September 30, 2008 was primarily attributable to higher patent related costs as we continue to expand our patent portfolio and higher stock based compensation expense. Stock-based compensation expense recognized under SFAS 123(R) related to selling, general and administrative personnel was $620,000 and $2.1 million for the three and nine months ended September 30, 2008, compared to $497,000 and $1.7 million for the three and nine months ended September 30, 2007, respectively.

As of September 30, 2008, we had 38 selling, general and administrative personnel compared with 37 as of the corresponding date in 2007. We expect selling, general and administrative expenses to increase in the near future due to expected increases in patent related costs and in employee related costs to support our business activities.

Amortization of intangible assets . Amortization of intangible assets was $12,000 and $35,000 for the three and nine months ended September 30, 2008, respectively, compared to $8,000 and $23,000 for the corresponding periods in 2007, respectively. The amortization of intangible assets increased in the three and nine months ended September 30, 2008 as we acquired additional patents in the fourth quarter of 2007 and the first quarter of 2008. We continue to amortize the existing intangible assets at a constant rate over their estimated useful lives. In 2007, goodwill was evaluated for impairment in accordance with SFAS 142. Based on our evaluation, no indicators of impairment were noted. Should goodwill become impaired in the future, we may be required to record an impairment charge to write the goodwill down to its estimated fair value.

The net amount of intangible assets at September 30, 2008 was $170,000, which will be amortized as follows: $12,000 in the three months ending December 31, 2008, $48,700 in 2009, $37,000 in 2010, $17,800 in each of the years from 2011 to 2014, and $900 in 2015. Should any intangible assets become impaired, the Company will write them down to their estimated fair value.

Other Income (Expense). Interest and other income was $349,000 and $1.3 million for the three and nine months ended September 30, 2008, respectively, compared to $906,000 and $2.8 million for the corresponding periods in 2007, respectively. The decrease in interest income was primarily the result of lower yields as well as lower average cash and investment balances during the three and nine months ended September 30, 2008 compared with the same periods in 2007.

Interest and other expense was $14,000 and $773,000 for the three and nine months ended September 30, 2008, respectively, compared to $716,000 and $2.2 million for the corresponding periods in 2007, respectively. The decrease in interest expense was primarily due to lower outstanding balances on our convertible notes in the three and nine months ended September 30, 2008 compared with the same periods of 2007.

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Debt conversion expense was zero for both the three and nine months ended September 30, 2008, compared to $223,000 for the corresponding periods in 2007. The debt conversion expense in the three and nine months ended September 30, 2007 was recorded in connection with the conversion of $4.2 million in principal amount of the 6.25% convertible notes into 1.3 million shares of our common stock in September 2007.

Liquidity and Capital Resources

We had cash, cash equivalents and investments totaling $38.9 million at September 30, 2008 compared to $62.0 million at December 31, 2007. These balances include $1.0 million of interest-bearing marketable securities classified as restricted investments on our balance sheets as of September 30, 2008 and December 31, 2007. The decrease in cash, cash equivalents and investments during the nine months ended September 30, 2008 was primarily the result of ongoing operating expenses, partially offset by payments received from customers.

Working capital was $30.2 million and $25.7 million at September 30, 2008 and December 31, 2007, respectively. The increase was primarily attributable to the exchange of the $23.6 million in aggregate principal amount of convertible notes at maturity in June 2008 into approximately 7.5 million shares of common stock, partially offset by $22.8 million of cash used for operations during the nine months ended September 30, 2008.

We used $22.8 million of cash for operations for the nine months ended September 30, 2008 compared to $13.9 million for the corresponding period in 2007. The cash used for operations was primarily to fund operations as well as our working capital requirements. The increase in cash used for operations was primarily attributable to a one-time milestone payment of $8.0 million received from Nycomed in 2007 and to the decreases in accounts receivable from our third party collaborators, contract research liability and accounts payable for the nine months ended September 30, 2008, partially offset by an increase in net loss compared to the same period in 2007.

We received $7.6 million of cash from investing activities for the nine months ended September 30, 2008 compared to $7.4 million for the corresponding period in 2007. The increase in cash provided by investing activities was primarily due to higher net proceeds received from the maturing of our investments and a decrease in purchases of short-term and long-term investments for the nine months ended September 30, 2008 compared to the same period in 2007.

We received $704,000 of cash from financing activities for the nine months ended September 30, 2008 compared to $992,000 for the corresponding period in 2007. The decrease was primarily due to lower proceeds from exercises of stock options in the nine months ended September 30, 2008 compared to the same period in 2007.

In June and July 2003, we completed a private placement of an aggregate of $60.0 million in convertible subordinated notes and received net proceeds of approximately $56.7 million after deducting underwriting fees of $3.0 million and related expenses of $300,000. The notes bore interest at a fixed rate of 6.25% per annum and were due on June 15, 2008. The notes were convertible at the option of the note holders into our common stock at a conversion rate of 317.4603 shares per $1,000 principal amount of notes, or $3.15 per share. Interest on the notes was payable semi-annually in arrears in June and December. From the third quarter of 2005 through October 2007, we exchanged an aggregate of approximately $36.4 million in principal amount of our 6.25% convertible subordinated notes in individually negotiated transactions with note holders, pursuant to which we issued approximately 11.6 million shares of our common stock, and made cash payments in the aggregate amount of approximately $3.8 million. In June 2008, the remaining $23.6 million in aggregate principal amount of convertible notes were converted into approximately 7.5 million shares of our common stock.

In conjunction with the acquisition of SBS in April 2001, we assumed SBS Bonds with remaining principal payments of $1.7 million as of April 30, 2001, and an interest rate of 6.35% increasing each year up to 7.20% at maturity on November 1, 2009. As part of the acquisition agreement, we were required to guarantee and collateralize these bonds with a letter of credit of approximately $2.4 million that we secured with investments deposited with a financial institution in July 2001. Interest payments are due semi-annually and principal payments are due annually. Principal payments increase in annual increments from $150,000 to $240,000 over the term of the bonds until the principal is fully amortized in 2009. We have an option to call the SBS Bonds at any time. On December 31, 2002, SBS was merged into DURECT, and the SBS bonds were assigned to DURECT with the terms unchanged. At September 30, 2008, the remaining principal payments on the bonds were $465,000.

We anticipate that cash used in operating and investing activities will increase in the near future as we continue to research, develop and manufacture our products through internal efforts and partnering activities.

During the nine months ended September 30, 2008, we believe there have been no significant changes in our future payments due under contractual obligations as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2007 other than the elimination of $23.6 million convertible subordinated notes due to their exchange in June 2008 into common stock.

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We anticipate incurring capital expenditures of approximately $2.0 million over the next 12 months to purchase research and development and other capital equipment. The amount and timing of these capital expenditures will depend on, among other things, the timing of clinical trials for our products and our collaborative research and development activities.

We believe that our existing cash, cash equivalents and investments will be sufficient to fund our planned operations, existing debt and contractual commitments, and planned capital expenditures through at least the next 12 months. We may consume available resources more rapidly than currently anticipated, resulting in the need for additional funding. Additionally, we do not expect to generate significant revenues from our pharmaceutical systems currently under development for at least the next twelve months, if at all. Depending on whether we enter into additional collaborative agreements in the near term and the extent to which we earn milestone revenues, we may be required to raise additional capital through a variety of sources, including:

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

We have not utilized “off-balance sheet” arrangements to fund our operations or otherwise manage our financial position.

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

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