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SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended March 31, 2004

OR

For the transition period from              to             

Commission file number 0-22332

INSITE VISION INCORPORATED

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code (510) 865-8800

Former name, former address and former fiscal year, if changed since last report.

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

APPLICABLE ONLY TO CORPORATE ISSUERS:

The number of shares of Registrant’s common stock, $0.01 par value, outstanding as of April 30, 2004: 33,145,018.

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QUARTERLY REPORT ON FORM 10-Q

FOR THE THREE MONTHS ENDED MARCH 31, 2004

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PART I FINANCIAL INFORMATION

Item 1. Financial Statements

InSite Vision Incorporated

Consolidated Balance Sheets

See accompanying notes to condensed consolidated financial statements.

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InSite Vision Incorporated

Condensed Consolidated Statements of Operations

(Unaudited)

No cash dividends were declared or paid during the periods.

See accompanying notes to condensed consolidated financial statements.

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InSite Vision Incorporated

Condensed Consolidated Statements of Cash Flows

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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InSite Vision Incorporated

Notes to Condensed Consolidated Financial Statements

March 31, 2004

(Unaudited)

Note 1 - Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information pursuant to the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation have been included. Operating results for the three-month period ended March 31, 2004 are not necessarily indicative of the results that may be expected for any future period.

The Company operates in one segment, using one measure of profitability to manage its business. Revenues are primarily from one customer located in the United States and all of the Company’s long-lived assets are located in the United States.

The Company’s condensed consolidated financial statements have been presented on a basis that contemplates the realization of assets and the satisfaction of liabilities in the normal course of business and assumes the Company will continue as a going concern. Except for 1999 and the quarter ended March 31, 2004, the Company has incurred losses since its inception and the Company expects to incur substantial additional development costs, including costs related to clinical trials and manufacturing expenses. The Company has incurred negative cash flows from operations since inception, including net cash used in operations of $1.0 million for the quarter ended March 31, 2004. As of March 31, 2004, the Company had an accumulated deficit of $113.4 million and a cash and cash equivalents balance of $1.5 million. In these circumstances the Company believes it may not have enough cash to meet its various cash needs for fiscal 2004 unless the Company is able to obtain stockholder approval for the issuance of additional shares related to the private placement it entered into in March 2004. The Company’s plans in this regard include active pursuit of stockholder approval for the final closing of the private placement it entered into in March 2004 and active pursuit of other sources of additional funds, including new license and collaboration agreements. There is no assurance that stockholder approval will be obtained or additional funds or license or collaborative agreements will be available for the Company to finance its operations on acceptable terms, if at all. If such funds are not available, management may cease operations altogether and liquidate its assets at or around the middle of June 2004. Such actions may include significantly reducing its anticipated level of expenditures and/or the sale of rights to certain of its technologies, product candidates or products. The condensed consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty.

The Company has continued a number of measures it took in 2003 to reduce its short term operating expenses. The measures taken in 2003 included: laying-off approximately 42% of its employees, voluntary salary reductions by its senior management team, ceasing work on all non-critical external activities, extending payment terms on its trade payables, and other cost containment measures. There is no assurance that these expense reduction efforts will enable the Company to continue operations or that if the Company does survive it has not significantly harmed its business or prospects.

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Any person considering an investment in the Company’s securities is urged to consider both the risk that the Company will cease operations at or around the middle of June 2004 if stockholder approval is not obtained related to the proposed financing transaction or an alternative source of funds is not obtained. All of the statements set forth in this report are qualified by reference to those facts.

These condensed consolidated financial statements and notes should be read in conjunction with our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2003.

Critical Accounting Policies and Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

The following are items in our financial statements that require significant estimates and judgments:

Inventories. Our inventories are stated at the lower of cost or market. The cost of the inventories are based on the first-in first-out method. If the cost of the inventory exceeds the expected market value a provision is recorded for the difference between cost and market. At March 31, 2004, our inventories solely consisted of OcuGene kits which are considered finished goods.

Property and Equipment. Property and equipment is stated at cost, less accumulated depreciation and amortization. Depreciation of property and equipment is provided over the estimated useful lives of the respective assets, which range from three to five years, using the straight-line method. Leasehold improvements are amortized over the lives of the related leases or their estimated useful lives, whichever is shorter, using the straight-line method. It is our policy to write-off our fully depreciated assets.

Additionally, we record impairment losses on long-lived assets used in operations when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amounts of those assets.

Revenue Recognition. Our revenue arrangements with multiple elements are divided into separate units of accounting if certain criteria are met, including whether the delivered element has standalone value to the customer and whether there is objective and reliable evidence of the fair value of the undelivered items. The consideration we receive is allocated among the separate units based on their respective fair values, and the applicable revenue recognition criteria are applied to each of the separate units.

We recognize up-front fees over the expected term of the related research and development services using the straight-line method. When changes in the expected term of ongoing services are identified, the amortization period for the remaining fees is appropriately modified.

Revenue related to performance milestones is recognized when the milestone is achieved if it is based on a substantive element in a multi-element agreement or if it reflects substantive progress toward the completion of the activities contemplated in a long-term contract, and the payment reflects the milestone achieved.

Revenue related to contract research services is recognized when persuasive evidence of an arrangement exists, the services have been rendered, the fee is fixed or determinable and collectibility is reasonably assured. During the quarter ended March 31, 2004, we recognized payments received under the December 2003 Bausch & Lomb agreement of $372,000 as contract and other revenue in accordance with EITF 01-14, Income Statement Characterization of Reimbursement for “Out of Pocket” Expenses Incurred. We incurred approximately $336,000 of costs related to the research and development activities under the related contract.

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We receive royalties from licensees based on third-party sales and the royalties are recorded as earned in accordance with contract terms, when third party results are reliably measured and collectibility is reasonably assured.

Revenue related to the sales of our product, the OcuGene glaucoma genetic test, is recognized when all related services have been rendered and collectibility is reasonably assured. The revenue in connection with the asset purchase agreement with Bausch and Lomb will be recognized over the contract period.

Cost of goods. We recognize the cost of inventory shipped and other costs related to our OcuGene glaucoma genetic test when they are incurred.

Research and Development (R&D) Expenses. R&D expenses include salaries, benefits, facility costs, services provided by outside consultants and contractors, administrative costs and materials for our research and development activities. We also fund research at a variety of academic institutions based on agreements that are generally cancelable. We recognize such costs as they are incurred. We directly reduce expenses for amounts reimbursed due to cost sharing agreements. We recognize the received cost sharing payments when persuasive evidence of an arrangement exists, the services have been rendered, the fee is fixed or determinable and collectibility is reasonably assured.

Selling, General and Administrative (SG&A) Expenses. SG&A expenses include salaries, benefits, facility costs, services provided by outside consultants and contractors, advertising and marketing, investor relations, financial reporting, materials and other expenses related to general corporate and sales and marketing activities.

Stock-Based Compensation. We have elected to continue to follow the intrinsic value method of accounting as prescribed by Accounting Principles Board Opinion No. 25 (or APB 25), “Accounting for Stock Issued to Employees,” to account for employee and director stock options. Accordingly, we do not recognize compensation expense for options granted to employees and directors at an exercise price equal to the fair value of the underlying common stock.

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting requirements and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in our opinion, the existing models do not necessarily provide a reliable single measure of the fair value of our employee stock options.

Pro forma information regarding net income (loss) and net income (loss) per share is required by Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock Based Compensation,” as amended by SFAS No. 148, and has been determined as if we had accounted for our employee stock options under the fair value method of that Statement. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following assumptions for the quarters ended March 31, 2004 and 2003, respectively: risk-free interest rates ranging from 0.91% to 4.26%; volatility factors for the expected market price of our common stock of 1.07 and 1.06; and a weighted-average expected life for the options of 4 years.

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The following table illustrates the effect on net income (loss) and net income (loss) per share as if the Company had applied the fair value recognition provisions of SFAS 123 to stock based employee compensation (in thousands, except per share amounts):

The weighted average grant date fair value of options granted during the quarters ended March 31, 2004 and 2003 was $0.88 and $0.75, respectively.

For purposes of pro forma disclosures pursuant to SFAS 123 as amended by SFAS 148, the estimated fair value of options is amortized to expense over the options’ vesting period.

The pro forma impact of options on the net loss for the quarters ended March 31, 2004 and 2003 is not necessarily representative of the effects on net income (loss) for future quarters, as future quarters will include the effects of additional stock grants.

Income (Loss) per Share. Basic and diluted net income (loss) per share information for all periods is presented under the requirement of SFAS No. 128, “Earnings per Share.” Basic earnings per share has been computed using the weighted-average number of common shares outstanding during the period. Dilutive earnings per share is computed using the sum of the weighted-average number of common shares outstanding and the potential number of dilutive common shares outstanding during the period. Potential common shares consist of the shares issuable upon exercise of stock options, warrants and convertible securities.

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The following table sets forth the computation of basic and diluted net income (loss) per share:

Due to the net loss applicable to common stockholders, loss per share for the quarter ended March 31, 2003 is based on the weighted average number of common shares only, as the effect of including equivalent shares from stock options would be anti-dilutive. If the Company had recorded net income, the calculation of earnings per share would have been impacted by the dilutive effect of the Series A-1 Preferred Shares but would not have been effected by the outstanding stock options and warrants priced below the market price of the common shares at March 31, 2003. The following securities have not been included in the calculation of diluted net income (loss) per share as their inclusion would have been anti-dilutive:

Note 2 - Common Stock

On March 26, 2004, the Company received, net of placement fees, approximately $1.7 million from the initial closing of a private placement totaling $16.5 million. At the initial closing the Company issued 3,880,000 shares of Common Stock and warrants to purchase 1,940,000 shares of Common Stock at an exercise price of $0.75 per share. These warrants were valued using a Black-Scholes option pricing model, assuming no dividend yield, with the following assumptions: risk-free interest rate of 2.64%, volatility of 1.0679 and an expected life of 5 years, resulting in the recording of a stock issue cost of $1.5 million. The final closing is contingent upon the Company receiving stockholder approval for the financing and for an amendment to the Certificate of Incorporation increasing the authorized shares of Common Stock by 60,000,000, and other standard closing conditions. The Company will seek stockholder approval at its June 1, 2004 Annual Meeting.

Note 3 - Subsequent Event

On May 3, 2004, the Company redeemed approximately $18,000 of convertible notes payable assumed by the Company as part of its acquisition of Ophthalmic Solutions, Inc., for approximately $25,000, which included a 40% redemption premium. After this redemption, all of the convertible notes payable have been cancelled either through conversion into the Company’s common stock or redemption.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Except for the historical information contained herein, the discussion in this Quarterly Report on Form 10-Q contains certain forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. The cautionary statements made in this document should be read as applicable to all related forward-looking statements wherever they appear in this document. Our actual results could differ materially from those discussed herein. Factors that could cause or contribute to such differences include those discussed below in “Risk Factors,” as well as those discussed elsewhere herein. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to update any forward- looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence or identification of unanticipated events or previously unidentified events.

The following discussion should be read in conjunction with the financial statements and notes thereto included in this Quarterly Report and in our Annual Report on Form 10-K for the year ended December 31, 2003.

Overview

As of March 31, 2004, our accumulated deficit was approximately $113.4 million and our cash and cash equivalents were $1.5 million. Absent additional funding from the final closing of the private placement we entered into in March 2004 or other private or public equity or debt financings, collaborative or other partnering arrangements, or other sources, as of March 31, 2004 we expect that our cash on hand, anticipated cash flow from operations and current cash commitments to us will only be sufficient to fund our operations until approximately the middle of June 2004. If we are unable to complete the final closing related to the March 2004 private placement, there is no assurance that such additional funds will be available for us to finance our operations on acceptable terms, if at all. If such funds are not available, management will be required to cease all operations and liquidate our remaining assets, most of which are pledged as security for to an officer who is also a board member. Our condensed consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from our inability to obtain funding and resultant ceasing of operations. There can be no assurance that we will ever achieve or be able to maintain either significant revenues from product sales or profitable operations.

We are an ophthalmic product development company focused on developing genetically-based technology, for the diagnosis, prognosis and management of glaucoma, as well as ophthalmic pharmaceutical products based on our proprietary DuraSite^® eyedrop-based drug delivery technology. In addition, we have a retinal program that includes both a therapeutic agent and a retinal drug delivery technology.

In 2003 we faced significant challenges related to our lack of financial resources. To continue our operations we took actions to reduce our cash usage including:

With our limited resources we are focusing our research and development and commercial efforts on the following:

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ISV-403. In February 2003 we filed an IND for our ophthalmic antibiotic product candidate ISV-403, which was the first milestone under the August 2002 license agreement with Bausch & Lomb and resulted in the receipt of $2.0 million from the sale of Series A-1 Preferred Stock. In April 2003 we began a Phase 1 clinical trial of ISV-403 and in June 2003 the dosing for the study was completed. In December 2003 we sold the ISV-403 product candidate to Bausch & Lomb, which resulted in the receipt of $1.5 million in cash, the return of the $4.0 million of Series A-1 Preferred Stock, and the related dividends, to us for cancellation, and provides for royalties on future product sales, if any. While we will be providing contract research services into the second quarter of 2004, due to the sale, Bausch & Lomb now is responsible for the further clinical development of the product and we will be able to focus our development efforts on our ISV-401 product candidate.

ISV-401. We have developed a topical formulation of the antibiotic azithromycin, an antibiotic with a broad spectrum of activity that is widely used to treat respiratory and other infection in its oral and parenteral forms, to treat bacterial conjunctivitis and other infections of the outer eye. The key advantages of ISV-401 include a significantly reduced dosing regimen (6 doses vs. 36 doses for comparable products), the high and persistent levels of azithromycin achieved in the tissues of the eye and its wide spectrum of activity. Product safety and efficacy have been demonstrated, respectively, in Phase 1 and Phase 2 clinical trials. The Phase 2 study compared an ISV-401 formulation containing 1% azithromycin to a placebo. The results of this study showed that the ISV-401 formulation was statistically significantly more effective than placebo in bacterial eradication and clinical cure, which includes reduction in inflammation and redness. As a result of our ‘End of Phase 2 Meeting’ with the FDA early in 2003, we intended to initiate two pivotal Phase 3 clinical trials. Due to our financial constraints the initiation of the trials was delayed and currently is planned for the second quarter of 2004. We anticipate conducting the trials in the United States including both children and adults to permit aggressive enrollment of the subjects necessary to complete the studies. We further anticipate that the primary endpoints of both trials will be microbial eradication and clinical cure. Our ability to execute on these clinical plans will be dependent upon the receipt of funds from the final closing related to our March 2004 private placement.

In 2003 we secured a new source for the active ingredient and have a contract-manufacturing site for production of clinical trial supplies and registration batches. The supplies are being manufactured under the supervision of our personnel. We are planning to manufacture the registration batches needed to support the filing of the NDA at this contract facility in the second quarter of 2004. We anticipate that our contract manufacturing facility will be ready for inspection by the FDA at the time of our NDA submission.

OcuGene. Our OcuGene glaucoma genetic test is based on our glaucoma genetics program, which has been pursued in collaboration with academic researchers, is focused on discovering genes that are associated with glaucoma, and the mutations on these genes that cause and regulate the severity of the disease. In June 2003, a peer-reviewed study was published in Clinical Genetics titled “Association of the Myocilin mt.1 Promoter Variant with the Worsening of Glaucomatous Disease Over Time,” (2003: 64: 18-27). “The results of this study indicate substantial evidence that the TIGR/MYOC mt.1(+) variant provides a strong marker for accelerated worsening of both optic disc and visual field measures of glaucoma progression above and beyond other baseline risk factors,” stated one of the authors of the study, Jon Polansky, M.D., University of California, San Francisco, who also serves on our Scientific Advisory Board.

In 2003, the information from this article and previous publications was used to target specific thought leaders and ophthalmic centers in an effort to support the focused introduction of the OcuGene glaucoma genetic test. Expanded marketing efforts were curtailed as we contained our cash use.

Since our inception through the end of 2001, we had not received any revenues from the sale of our products, although we have received a small amount of royalties from the sale of our AquaSite product by CIBA Vision and Global Damon. In the fourth quarter of 2001, we commercially launched our OcuGene glaucoma

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genetic test and early in 2002 we began to receive a small amount of revenues from the sale of this test. With the exception of 1999 and the quarter ended March 31, 2004, we have been unprofitable since our inception due to continuing research and development efforts, including preclinical studies, clinical trials and manufacturing of our product candidates. We have financed our research and development activities and operations primarily through private and public placement of our equity securities, issuance of convertible debentures and, to a lesser extent, from collaborative agreements and bridge loans.

Results of Operations

Revenues.

We had total net revenues in the first quarter of 2004 and 2003 of $374,000 and $4,000, respectively. In the first quarter of 2004, 99% of the net revenues was from contract research activities. Sales of OcuGene represented 1% and 100% of the net revenues in the first quarter of 2004 and 2003, respectively. The increase in revenue is due to contract research activities conducted for Bausch & Lomb in 2004 under the ISV-403 Asset Purchase Agreement. We recognize revenue when all services have been performed and collectibility is reasonably assured. Accordingly, revenue for the sales of OcuGene may be recognized in a later period than the associated recognition of costs of the services provided, especially during the initial launch of the product.

Cost of goods.

Cost of goods of $5,000 and $8,000 for the first quarter of 2004 and 2003 respectively, reflect the cost of OcuGene tests performed as well as the cost of sample collection kits distributed for use. The decrease reflects the lower number of sample collection kits distributed for use in the first quarter of 2004.

Research and development.

Research and development expenses decreased to $0.9 million during the first quarter of 2004 from $1.4 million during the first quarter of 2003. This 36% decrease reflects the continuation of the cost containment efforts initiated in the second quarter of 2003. Research and development personnel decreased by 54% resulting mainly from the lay-offs we effected in June 2003. The reduction in personnel and the voluntary salary reductions by our senior management resulted in a decrease in personnel related costs of 64% in the first quarter of 2004 compared to the first quarter of 2003. Additionally, we also continued to reduce our financial support of the research related to our genetics programs by not renewing certain research contracts pending the receipt of additional funding. As much of this research is conducted at external academic centers, we were able to scale back this research without incurring termination costs.

Selling, general and administrative.

Selling, general and administrative expenses decreased to $556,000 in the first quarter of 2004 from $833,000 in the first quarter of 2003. This decrease reflects the 70% reduction in personnel-related costs due to the impact of voluntary salary reductions by members of our senior management and the layoff of 3 people in June 2003. Additionally, selling expenses related to the initial market introduction of OcuGene, such as advertising and our consultants decreased 68%.

Our expenses for the year ended December 31, 2004 will be dependent upon the final closing of the March 26, 2004 private placement. If the final closing occurs, we anticipate that our R&D expenses will increase by approximately 50% from levels incurred in the year ended December 31, 2003. This increase will mainly reflect the anticipated initiation of two Phase 3 clinical trials for our ISV-401 product candidate. We anticipate that we will continue the suspension of activity on our other product candidates absent additional funding. Also, we anticipate that if the final closing of the March 2004 private placement occurs, our selling, general and administrative costs will remain consistent with 2003 levels. We anticipate that the expense reductions related to the scale-back of marketing activities related to OcuGene will continue in 2004 and selective additions may be made to headcount. We also anticipate that salaries voluntarily reduced for the members of senior management will be increased to their previous levels. If we are unable to complete the final closing of the March 2004 private placement, there is no

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assurance that additional funds will be available for us to finance our operations on acceptable terms, if at all. If such funds are not available, management will likely be required to cease all operations and liquidate our remaining assets, most of which is secured by a note to an officer who is also a board member.

Gain on sale of assets.

The gain on sale of assets reflects the sale of the ISV-403 product candidate to Bausch & Lomb in December 2003. We received $1.5 million in cash and Bausch & Lomb surrendered the $4.0 million of Series A-1 Preferred Stock, plus accumulated dividends, we issued to them under the August 2002 License and Preferred Stock Purchase Agreements. The total gain will be recognized over the five-month period that we have an obligation to provide contract research support for ISV-403, which began in December 2003. We recognized $3.5 million of the gain in the first quarter of 2004.

Interest, other income and expenses.

Net interest, other income and expense was an expense of $8,000 in the first quarter of 2004 compared to income of $3,000 in 2003. This change principally reflects the interest expense related to the debt discount of the convertible debentures, interest expense related to the short-term notes payable and to lower average cash balances.

Liquidity and Capital Resources

We have financed our operations since inception primarily through private placements and public offerings of debt and equity securities, equipment and leasehold improvement financing, other debt financing and payments under corporate collaborations. At March 31, 2004, our cash and cash equivalents balance was $1.5 million. It is our policy to invest our cash and cash equivalents, if any, in highly liquid securities, such as interest bearing money market funds, Treasury and federal agency notes and corporate debt.

In March 2004, we received approximately $1.7 million, net of placement fees, from the initial closing of a total private placement of up to $16.5 million. Our ability to receive the remainder of the funds at the final closing is subject to receipt of stockholder approval of the final closing of the placement and of the increase in our authorized shares necessary to issue both the Common Stock to be issued in the final closing of the placement and the Common Stock issuable upon the exercise of the warrants issued as part of the final closing of the placement, and satisfaction of other standard conditions contained in the subscription agreements. We will be seeking the necessary stockholder approval at our Annual Meeting, which is scheduled to take place on June 1, 2004.

Our auditors have included an explanatory paragraph in their audit report referring to our recurring operating losses and a substantial doubt about our ability to continue as a going concern. Absent additional funding from the final closing related to the March 2004 private placement, other private or public equity or debt financings, collaborative or other partnering arrangements, asset sales, or other sources, we expect that our cash on hand, anticipated cash flow from operations and current cash commitments to us will only be adequate to fund our operations until approximately the middle of June 2004. If we are unable to complete the final closing of the March 2004 private placement or secure sufficient additional funding prior to the middle of June 2004, we will need to cease operations and liquidate our assets, most of which is pledged as security to an officer who is also a board member. Our financial statements were prepared on the assumption that we will continue as a going concern and do not include any adjustments that might result should we be unable to continue as a going concern.

Even if we are able to complete the final closing of the March 2004 private placement, in order to continue long-term operations beyond approximately the third quarter of 2005, we will require and are seeking additional funding through collaborative or other partnering arrangements, public or private equity or debt financings, asset sales and from other sources. However, there can be no assurance that we will obtain interim or longer-term financing or that such funding, if obtained, will be sufficient to continue our operations as currently conducted or in a manner necessary for the long-term success of our company. If we raise funds through the issuance of debt securities, such debt will be secured by a security interest or pledge of all of our assets, will require us to make principal and interest payments, would likely include the issuance of warrants and may subject us to restrictive covenants. In addition, our stockholders may suffer substantial dilution if we raise additional funds by issuing equity securities.

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Net cash used in operating activities was $1.0 million and $2.3 million for the three months ended March 31, 2004 and 2003, respectively. The decrease in net cash used in operating activities reflected the recognition of $374,000 of contract revenue from Bausch & Lomb in the first quarter of 2004 and expense reductions due to the cost containment efforts initiated in the second quarter of 2003. Operating activities in the first quarter of 2004 related primarily to research and development expenditures for our antibiotic program ISV-401 and under the research contract with Bausch & Lomb on ISV-403.

Net cash used in investing activities of $23,000 in the first quarter 2003 reflected the acquisition of laboratory and other equipment related to the manufacture of Phase 1 and Phase 2 clinical units in our pilot facility.

Net cash provided by financing activities was $1.4 million in the first quarter of 2004 compared to $2.0 million in the first quarter of 2003. We received net proceeds of $1.7 million from the issuance of 3.9 million shares of common stock in the initial closing of the March 2004 private placement. We received $2.0 million in the first quarter of 2003 from the issuance of our 2,000 shares of our Series A-1 preferred stock to Bausch & Lomb related to the ISV-403 license agreement. We received $4,000 and $4,000 in the first quarter of 2004 and 2003, respectively from the issuance of our common stock from the exercise of stock options by employees. In the first quarter of 2004, we also made $254,000 of payments on our short-term borrowings and $4,000 of payments on capital leases for certain laboratory equipment in the first quarter of 2004 compared to $9,000 in the first quarter of 2003.

Assuming we are able to obtain additional financing and continue our operations, our future capital expenditures and requirements will depend on numerous factors, including the progress of our clinical testing, research and development programs and preclinical testing, the time and costs involved in obtaining regulatory approvals, our ability to successfully commercialize OcuGene and any other products that we may launch in the future, our ability to establish collaborative arrangements, the cost of filing, prosecuting, defending and enforcing patent claims and other intellectual property rights, competing technological and market developments, changes in our existing collaborative and licensing relationships, acquisition of new businesses, products and technologies, the completion of commercialization activities and arrangements, and the purchase of additional property and equipment.

We anticipate no material capital expenditures to be incurred for environmental compliance in fiscal year 2004. Based on our environmental compliance record to date, and our belief that we are current in compliance with applicable environmental laws and regulations, environmental compliance is not expected to have a material adverse effect on our operations.

RISK FACTORS

We Require Immediate Significant Additional Funding to Continue our Operations and If We Are Unable to Complete the Final Closing Related to a March 2004 Private Placement Agreement We Have Entered Into, or If We Do Not Receive Additional Funding From Other Sources, We Will Cease Operations and Liquidate our Assets

Our independent auditors included an explanatory paragraph in their audit report referring to our recurring operating losses and a substantial doubt about our ability to continue as a going concern. On March 26, 2004, we raised gross proceeds of $1.9 million (before transaction fees and expenses) through the initial closing of a private placement of our common stock and warrants to purchase common stock which we believe will provide us the funds to operate for an additional 60 to 90 days after the initial closing. During this period we will be seeking the

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stockholder approval necessary to complete the final closing related to this private placement, which if it occurs will yield additional proceeds of approximately $14.6 million (before transaction fees and expenses). We will be unable to complete the final closing if we are unable to obtain the required stockholder approval, if we suffer a “material adverse change” (as such term is defined in the Subscription Agreement related to the private placement) which is not waived by investors in the private placement or if any other condition to the final closing is not met and not waived by the Subscribers if capable of being waived. Also, pursuant to the terms of the private placement we are generally prohibited from raising additional financing through the issuance of securities during the period from the initial closing through the earlier to occur of the final closing or June 30, 2004 a date that at our sole discretion we can extend, which could significantly harm our ability to continue operations if the final closing does not occur. If we are unable to complete the final closing or obtain additional funding from private or public equity or debt financings, collaborative or other partnering arrangements, asset sales or other sources, management will be required to cease all operations and liquidate our remaining assets. If this occurs, our stockholders would likely lose their entire investment in us.

We are seeking longer term additional funding through the final closing of the private placement we entered into in March 2004 and through potential public or private equity or debt financings, collaborative or other partnering arrangements, asset sales and from other sources. However, our current financial situation may harm our ability to obtain additional funding and could make the terms of any such funding, if available, significantly less favorable than would otherwise be the case. Our board of directors has the authority to determine the price and terms of any sale of common stock and the rights, preferences and privileges of any preferred stock or debt or other security that is convertible into or exercisable for the common stock. The terms of any securities issued to future investors may be superior to the rights of our common stockholders and could result in substantial dilution and could adversely affect the market price for our common stock. If we raise funds through the issuance of debt securities, such debt will likely be secured by a security interest or pledge of all of our assets, will require us to make principal and interest payments, would likely include the issuance of warrants, and may subject us to restrictive covenants. If we do not obtain such long term financing either through the final closing of the March 2004 private placement or otherwise, we would have to cease operations and liquidate our assets.

We Will Need Stockholder Approval to Amend Our Certificate of Incorporation and to Comply with Regulations of The American Stock Exchange in Order to Conduct the Final Closing of the March 2004 Private Placement and If We Do Not Receive such Stockholder Approval, We Will Not Be Able to Complete the Final Closing, We Will Be Required to Pay Certain Penalties, and We May be Required to Cease Operations and Liquidate our Assets

We do not currently have enough authorized shares of common stock to issue the shares of our common stock and warrants to purchase common stock in the final closing of the March 2004 private placement. Prior to and as a condition of the final closing of such private placement, the holders of a majority of the shares of our common stock will need to approve an amendment to our certificate of incorporation to increase the number of shares of Common Stock we are authorized to issue in an amount sufficient to enable us to issue the common stock and related warrants to be issued in the final closing of the private placement and we will need to file this amendment with the Secretary of State of the State of Delaware. In addition, since our stock is listed on The American Stock Exchange, or AMEX, under applicable AMEX regulations prior to and as a condition of the final closing of the private placement, the holders of a majority of our common stock must approve the issuance of the securities to be issued in the final closing since such issuance will constitute an issuance of 20% or more of our outstanding common stock immediately prior to the initial closing at a price per share below the fair market value of our common stock at the initial closing.

Our stockholders will incur substantial dilution if the final closing of the March 2004 private placement occurs, and this might negatively affect our chances of receiving stockholder approval. Moreover, if we do not receive the requisite stockholder approval within the required period, we will be required to pay certain cash penalties to the investors in the March 2004 private placement and even if we subsequently receive stockholder approval the investors in the private placement can refuse to invest in the final closing, either of which would significantly harm our business and our financial condition. In addition, if we are unable to complete the final

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closing, we will likely not have sufficient funds to continue our business, and we will have to attempt to conduct another round of financing, if available, or go out of business, in which case our stockholders will likely be significantly diluted or lose their entire investment. Furthermore, in between the initial closing and final closing of the March 2004 private placement, provisions in the subscription agreements for that private placement impose significant restrictions on our ability to raise capital through the sale of additional securities other than those contemplated by the private placement.

Even if the Final Closing of the March 2004 Private Placement Occurs, or We Are Able to Secure Alternative Long Term Financing in the Event the Final Closing Does Not Occur, the Proceeds From Such Financings Will Not Fund Our Business Indefinitely. We Will Eventually Need to Seek Additional Funding or Partnering Arrangements that Could Be Dilutive to Our Stockholders and Could Negatively Affect Us and Our Stock Price.

Assuming we are able to raise additional funding to continue our operations beyond the next 60 to 90 days, either through the final closing of the March 2004 private placement or an alternative financing arrangement if the final closing does not occur, we only expect the proceeds to us expected from the private placement to enable us to continue our operations as currently planned until approximately the third quarter of 2005. At that point, or earlier if circumstances change from our current expectations, we will require additional funding. The terms of any securities issued to future investors may be superior to the rights of our then current stockholders, and could result in substantial dilution and could adversely affect the market price for our common stock. If we raise funds through the issuance of debt securities, such debt will likely be secured by a security interest or pledge of all of our assets, will require us to make principal and interest payments, would likely include the issuance of warrants, and may subject us to restrictive covenants. If we do not obtain such additional financing when required, we would likely have to cease operations and liquidate our assets.

In addition, we expect to enter into partnering and collaborative arrangements in the future as part of our business plan, regardless of whether we require additional funding to continue our operations. Such arrangements could include the licensing or sale of certain assets or the issuance of securities, which may adversely affect the market price of our Common Stock. It is difficult to know our future capital requirements precisely and such requirements depend upon many factors, including:

If We Do Not Receive Additional Funding When Needed to Continue Our Operations, Whether Before or After the Final Closing of the March 2004 Private Placement, We Will Likely Cease Operations and Liquidate Our Assets, Which are Secured by Notes Payable to Our Chief Executive Officer

In the event that we are unable to secure additional funding when required to continue our operations, we will likely be forced to wind down our operations, either through liquidation, voluntary or involuntary bankruptcy or a sale of our assets, regardless of whether such event occurred before or after the final closing of the March 2004

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private placement. Our chief executive officer has outstanding loans to us in an aggregate principal amount of $503,000, $400,000 of which is secured by a lien on substantially all of our assets including our intellectual property. The notes issued by us in connection with these loans are due on the earlier to occur of March 31, 2007 or 30 days subsequent to the successful completion of a pivotal Phase III clinical trial with ISV 401. In the event that we wind down operations, whether voluntarily or involuntarily, while these secured loans are outstanding, this security interest enables our chief executive officer to control the disposition of these assets. If we are unable to repay the amounts due under the secured notes when due, our chief executive officer could cause us to enter into involuntary liquidation proceedings in the event we default on our obligations. If we wind down our operations for any reason, it is likely that our stockholders will lose their entire investment in us.

Our Management has Undertaken a Number of Measures to Reduce our Operating Expenses, but These Measures Will Not Alone be Sufficient to Enable us To Continue Operations Beyond the Middle of June 2004 and May Have Other Negative Consequences

Our management has implemented plans designed to reduce our cash requirements through reductions in operating expenditures. The actions we took during the year ended December 31, 2003 included laying-off approximately 42% of our employees, voluntary salary reductions by our senior management team, ceasing work on all non-critical projects, extending payment terms on our trade payables, working with our landlord to restructure our lease obligations, and other cost containment measures. Of the 16 employees laid-off, 3 were general and administrative personnel and 13 were across the various research and development departments. These lay-offs resulted in savings of approximately $530,000 in compensation and benefit costs. The voluntary salary reductions agreed upon between senior management and the Company resulted in approximately $720,000 of savings in compensation and benefit costs. The Company scaled back its marketing and sales activities related to the OcuGene product, which resulted in approximately $950,000 of savings. Additionally, the Company placed development of its ISV-014 retinal device, its ISV-900 genetic research and ISV-205 glaucoma product candidate on hold, which resulted in expense reductions of approximately $1,040,000. The Company also minimized its operating expenses by reducing its travel and entertainment, renegotiated or terminated facility and equipment support contracts where possible, limiting expenditures for equipment and taking other similar expense reduction actions. Although it is not possible to anticipate all potential effects the implementation of these expense control measures will have on us or our development, these activities have and could continue to delay the initiation of Phase 3 clinical trials on ISV-401 and have and could continue to impact our ability to promote OcuGene. The extent and ramifications of these delays will be dependent upon our ability to raise additional financing, the timing of the receipt of financing and the amount of such financing, if any. However, even with these expense reductions, the funds from the initial closing of the March 2004 private placement, our current cash on hand, anticipated cash flow from operations and current cash commitments to us are only sufficient to fund our operations through approximately the middle of June 2004. If we are unable to complete the final closing of the March 2004 private placement or another financing transaction, collaborative arrangement or asset sale prior to that time, we will cease operations and liquidate our assets. In addition, there is no assurance that these expense reduction efforts will enable us to continue operations or that if we do survive we have not significantly harmed our business or prospects.

Questions Concerning Our Financial Condition May Cause Customers and Current and Potential Partners to Reduce or Not Conduct Business with Us

Due to our present financial condition and concerns regarding our ability to continue operations, customers and current and potential partners may decide not to conduct business with us, may reduce or terminate the business they conduct with us, or may conduct business with us on terms that are less favorable than those customarily offered by them. In that event, our sales would likely decrease, our product development efforts would suffer and our business will be significantly harmed.

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The Initial Closing of the March 2004 Private Placement Triggered Anti-Dilution Adjustments Under the Terms of Certain Outstanding Securities Convertible into or Exercisable for Shares of Our Common Stock and Additional Anti-Dilution Adjustments Could Be Triggered by the Final Closing of the March 2004 Private Placement, Which Would Be Dilutive to Our Stockholders.

Immediately prior to the initial closing of the March 2004 private placement, warrants we issued to Xmark were exercisable for 250,000 shares of our Common Stock at a price of $0.58 per share. Pursuant to anti-dilution provisions contained in these warrants, following the initial closing of the private placement these warrants became exercisable for 254,386 shares of our common stock at a price of $0.57 per share. If any of these warrants are outstanding on the date of the final closing, the exercise price of the warrants will be adjusted downwards at such closing as follows:

Adjusted Warrant Price = (A x B) + D

                                                     A+C

where:

A = the number of shares of common stock outstanding immediately preceding the final closing

B = the exercise price of the warrant in effect immediately preceding the final closing

C = the number of additional shares of common stock outstanding as a result of the final closing

D = the aggregate consideration received by us upon the final closing

Additionally, upon each adjustment in the exercise price of the Xmark warrants, the number of shares purchasable under these warrants is adjusted, to the nearest whole share, to the product obtained by multiplying the number of shares purchasable immediately prior to such adjustment by a fraction, the numerator of which is the exercise price immediately prior to such adjustment, and the denominator of which is the exercise price immediately thereafter.

It Is Difficult to Evaluate Our Business Because We Are in an Early Stage of Development and Our Technology Is Untested

We are in an early stage of developing our business. We have only received an insignificant amount of royalties from the sale of one of our products, an over-the-counter dry eye treatment, and in 2002 we began to receive a small amount of revenues from the sale of our OcuGene glaucoma genetic test. Before regulatory authorities grant us marketing approval for additional products, we need to conduct significant additional research and development and preclinical and clinical testing. All of our products are subject to risks that are inherent to products based upon new technologies. These risks include the risks that our products:

Therefore, our research and development activities may not result in any commercially viable products.

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We Have a History of Operating Losses and We Expect to Continue to Have Losses in the Future

We have incurred significant operating losses since our inception in 1986 and have pursued numerous drug development candidates that did not prove to have commercial potential. As of March 31, 2004, our accumulated deficit was approximately $113.4 million. We expect to incur net losses for the foreseeable future or until we are able to achieve significant royalties or other revenues from sales of our products. In addition, we recognize revenue when all services have been performed and collectibility is reasonably assured, accordingly, revenue for the sales of OcuGene may be recognized in a later period than the associated recognition of costs of the services provided, especially during the initial launch of the product. In addition, due to this delay in revenue recognition, our revenues recognized in any given period may not be indicative of our then current viability and market acceptance of our OcuGene product.

Attaining significant revenue or profitability depends upon our ability, alone or with third parties, to successfully develop our potential products, conduct clinical trials, obtain required regulatory approvals and successfully manufacture and market our products. We may not ever achieve or be able to maintain significant revenue or profitability.

We May Not Successfully Manage Our Growth

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

We Are Dependent Upon Key Employees and We May Not Be Able to Retain or Attract Key Employees, and Our Ability to Attract and Retain Key Employees is Likely to be Harmed by Our Current Financial Situation

We are highly dependent on Dr. Chandrasekaran, who is our chief executive officer, president and chief financial officer, and Dr. Lyle Bowman, our vice president, development and operations. The loss of services from either of these key personnel might significantly delay or prevent the achievement of planned development objectives. We carry a $1.0 million life insurance policy on Dr. Chandrasekaran under which we are the sole beneficiary, however in the event of the death of Dr. Chandrasekaran such policy would be unlikely to fully compensate us for the hardship such a loss would cause us. Furthermore, a critical factor to our success will be recruiting and retaining qualified personnel. Competition for skilled individuals in the biotechnology business is highly intense, and we may not be able to continue to attract and retain personnel necessary for the development of our business. Our ability to attract and retain such individuals is likely to be significantly reduced by our current financial situation and our past reductions in force. For example, we have recently laid-off approximately 42% of our employees and our senior management has agreed to accept reduced salaries. Although we are not aware of any plans of our management or scientific personnel to leave us, these measures and other cost reduction measures we have undertaken make it more likely that such individuals will seek other employment opportunities and may leave our company permanently. The loss of key personnel or the failure to recruit additional personnel or to develop needed expertise could harm our business.

Our Strategy for Research, Development and Commercialization of Our Products Requires Us to Enter Into Various Arrangements With Corporate and Academic Collaborators, Licensors, Licensees and Others. Furthermore, We Are Dependent on the Diligent Efforts and Subsequent Success of These Outside Parties in Performing Their Responsibilities.

Because of our reliance on third parties for the development, marketing and sale of our products, any revenues that we receive will be dependent on the efforts of these third parties, such as our corporate collaborators. These partners may terminate their relationships with us and may not diligently or successfully market our products. In addition, marketing consultants and contract sales organizations, such as those deployed by us currently or in the

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future for OcuGene, may market products that compete with our products and we must rely on their efforts and ability to effectively market and sell our products. We may not be able to conclude arrangements with other companies to support the commercialization of our products on acceptable terms, or at all. Moreover, our current financial condition may make us a less attractive partner to potential collaborators. In addition, our collaborators may take the position that they are free to compete using our technology without compensating or entering into agreements with us. Furthermore, our collaborators may pursue alternative technologies or develop alternative products either on their own or in collaboration with others, including our competitors, as a means for developing treatments for the diseases or disorders targeted by these collaborative programs.

Our Business Depends Upon Our Proprietary Rights, and We May Not Be Able to Adequately Protect, Enforce or Secure Our Intellectual Property Rights

Our future success will depend in large part on our ability to obtain patents, protect trade secrets, obtain and maintain rights to technology developed by others, and operate without infringing upon the proprietary rights of others. A substantial number of patents in the field of ophthalmology and genetics have been issued to pharmaceutical, biotechnology and biopharmaceutical companies. Moreover, competitors may have filed patent applications, may have been issued patents or may obtain additional patents and proprietary rights relating to products or processes competitive with ours. Our patent applications may not be approved. We may not be able to develop additional proprietary products that are patentable. Even if we receive patent issuances, those issued patents may not be able to provide us with adequate protection for our inventions or may be challenged by others. Furthermore, the patents of others may impair our ability to commercialize our products. The patent positions of firms in the pharmaceutical and genetic industries generally are highly uncertain, involve complex legal and factual questions, and have recently been the subject of much litigation. Neither the United States Patent and Trademark Office nor the courts has developed, formulated, or presented a consistent policy regarding the breadth of claims allowed or the degree of protection afforded under pharmaceutical and genetic patents. Despite our efforts to protect our proprietary rights, others may independently develop similar products, duplicate any of our products or design around any of our patents. In addition, third parties from which we have licensed or otherwise obtained technology may attempt to terminate or scale back our rights.

A number of pharmaceutical and biotechnology companies and research and academic institutions have developed technologies, filed patent applications or received patents on various technologies that may be related to our business. Some of these technologies, applications or patents may conflict with our technologies or patent applications. Such conflicts could limit the scope of the patents, if any, we may be able to obtain or result in the denial of our patent applications or block our rights to exploit our technology. In addition, if the United States Patent and Trademark Office or foreign patent agencies have issued or issue patents that cover our activities to other companies, we may not be able to obtain licenses to these patents at all, or at a reasonable cost, or be able to develop or obtain alternative technology. If we do not obtain such licenses, we could encounter delays in or be precluded altogether from introducing products to the market. For example, we are aware that the European Patent Office has issued a notice of allowance to Pfizer on a patent covering the use of azithromycin once a day in a topical formulation to treat bacterial infections in the eye. We may conclude that we require a license under this patent to develop or sell ISV-401 in Europe, which may not be available on reasonable commercial terms if at all.

We may need to litigate in order to defend against or assert claims of infringement, to enforce patents issued to us or to protect trade secrets or know-how owned or licensed by us. Litigation could result in substantial cost to and diversion of effort by us, which may harm our business. We have also agreed to indemnify our licensees against infringement claims by third parties related to our technology, which could result in additional litigation costs and liability for us. In addition, our efforts to protect or defend our proprietary rights may not be successful or, even if successful, may result in substantial cost to us.

We also depend upon unpatented trade secrets to maintain our competitive position. Others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets. Our trade secrets may also be disclosed, and we may not be able to effectively protect our rights to unpatented trade secrets. To the extent that we or our consultants or research collaborators use intellectual property owned by others, disputes also may arise as to the rights in related or resulting know-how and inventions.

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Our Current Financial Situation May Impede Our Ability to Adequately Protect or Enforce Our Legal Rights Under Agreements and to Our Intellectual Property

We currently do not have sufficient funds, anticipated cash flow from operations and current cash commitments to us to continue our operations beyond approximately the middle of June 2004. Our current financial situation may impede our ability to enforce our legal rights under various agreements we are currently a party to or may become a party to due to our inability to incur the costs associated with such enforcement. Similarly, our lack of financial resources makes it more difficult for us to enforce our intellectual property rights, through the filing or maintenance of patents, taking legal action against those that may infringe on our proprietary rights, defending infringement claims against us, or otherwise. Our inability to adequately protect our legal and intellectual property rights may make us more vulnerable to infringement and could harm our business.

If We Infringe the Rights of Third Parties We Could Be Prevented From Selling Products, Forced to Pay Damages, and Defend Against Litigation

If our products, methods, processes and other technologies infringe the proprietary rights of other parties, we could incur substantial costs and we may have to:

We Rely on Third Parties to Develop, Market and Sell Our Products, We May Not Be Able to Continue or Enter into Third Party Arrangements, and these Third Parties’ Efforts May Not Be Successful

Following the termination of our ISV-900 agreement with Pharmacia in December 2000, we began to develop a marketing organization focused on the launch of our OcuGene glaucoma genetic test. We do not plan on establishing a dedicated sales force or a marketing organization for our other product candidates and primarily use external marketing and sales resources even for OcuGene. We also rely on third parties for clinical testing or product development. In addition, in May 2001, Pharmacia terminated the licensing agreement we had entered into with them in January 1999, that granted Pharmacia an exclusive worldwide license for ISV-205 for the treatment of glaucoma. We now must enter into another third party collaboration agreement for the development, marketing and sale of our ISV-205 product or develop, market and sell the product ourselves. There can be no assurance that we will be successful in finding a new corporate partner for our ISV-205 program or that any collaboration will be successful, either of which could significantly harm our business. In addition, we have no experience in marketing and selling products and we cannot assure you that we would be successful in marketing ISV-205 ourselves. If we are to successfully develop and commercialize our product candidates, including ISV-205, we will be required to enter into arrangements with one or more third parties that will:

In December 2003, we completed the sale of our drug candidate ISV-403 for the treatment of ocular infections to Bausch & Lomb Incorporated. Bausch & Lomb has assumed all future ISV-403 development and commercialization expenses and, following a transfer period, will be responsible for all development activities, with our assistance, as appropriate. The Bausch & Lomb Purchase Agreement and License Agreement grants Bausch & Lomb rights to develop and market ISV-403, subject to payment of royalties, in all geographies except Japan (which were retained by SSP, in connection with a separate license agreement between us and SSP), with such rights being shared with SSP in Asia (except Japan) and exclusive elsewhere. This sale resulted in the termination of the August

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2002 license agreement we entered into with Bausch & Lomb related to ISV-403. Our ability to generate royalties from this agreement will be dependent upon Bausch & Lomb’s ability to complete the development of ISV-403, obtain regulatory approval for the product and successfully market it. In addition, under the Bausch & Lomb Purchase Agreement, we also have certain potential indemnification obligations to Bausch & Lomb in connection with the Asset Sale which, if triggered, could significantly harm our business and our financial position.

We are marketing and selling our OcuGene glaucoma genetic test mainly using external marketing and sales resources that include:

We may not be able to enter into arrangements with third parties with ophthalmic or diagnostic industry experience on acceptable terms or at all. If we are not successful in concluding such arrangements on acceptable terms, or at all, we may be required to establish our own sales force and significantly expand our marketing organization, despite the fact that we have no experience in sales, marketing or distribution. Even if we do enter into collaborative relationships, as we have experienced with Pharmacia, these relationships can be terminated forcing us to seek alternatives. We may not be able to build a marketing staff or sales force and our sales and marketing efforts may not be cost-effective or successful.

In addition, we currently contract with a third party to assemble the sample collection kits used in our OcuGene glaucoma genetic test. If our assembler should encounter significant delays or we have difficulty maintaining our existing relationship, or in establishing a new one, our sales of this product could be adversely affected.

We Have No Experience in Performing the Analytical Procedures Related to Genetic Testing and Have Established an Exclusive Commercial Agreement with a Third Party to Perform These Procedures For Our OcuGene Glaucoma Genetic Test. If We Are Unable to Maintain this Arrangement, and Are Unable to Establish New Arrangements with Third Parties, We Will Have to Establish Our Own Regulatory Compliant Analytical Process for Genetic Testing and May Not Have the Financial Resources to Do So

We have no experience in the analytical procedures related to genetic testing. We have entered into an agreement with Quest Diagnostics Incorporated under which Quest exclusively performs OcuGene genetic analytical procedures at a commercial scale in the United States. Accordingly, we are reliant on Quest for all of our OcuGene analytical procedures. If we are unable to maintain this arrangement, we would have to contract with another clinical laboratory or would have to establish our own facilities. We cannot assure you that we will be able to contract with another laboratory to perform these services on a commercially reasonable basis, or at all.

Clinical laboratories must adhere to Good Laboratory Practice regulations that are strictly enforced by the FDA on an ongoing basis through the FDA’s facilities inspection program. Should we be required to perform the analytical procedures for genetic testing ourselves, we:

We cannot assure you we will be able to successfully enter into another genetic testing arrangement or perform these analytical procedures ourselves on a cost-efficient basis, or at all.

We Rely on a Sole Source for Some of the Raw Materials in Our Products, and the Raw Materials We Need May Not be Available to Us

SSP is the sole source for the active drug incorporated into the ISV-403 product candidate we sold to Bausch & Lomb for further development and commercialization. SSP has submitted a Drug Master file on the

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compound with the FDA and is subject to the FDA’s review and oversight. If SSP is unable to obtain and maintain FDA approval for their production of the drug or is otherwise unable to supply Bausch & Lomb with sufficient quantities of the drug, Bausch & Lomb’s ability to continue with the development, and potentially the commercial sale if the product is approved, would be interrupted or impeded, our royalties from commercial sales of the ISV-403 product could be delayed or reduced and our business could be harmed.

We currently have a single supplier for azithromycin, the active drug incorporated into our ISV-401 product candidate. The supplier has submitted a Drug Master File on the compound with the FDA and is subject to the FDA’s review and oversight. If the FDA were to identify issues in the production of the drug that the supplier was unable to quickly resolve, or other issues were to arise that impact production, our ability to continue with the development, and potentially the commercial sale if the product is approved, could be interrupted and would harm our business. Additional suppliers for this drug exist, but qualification of an alternative source could be time consuming, expensive and could result in a delay that could harm our business and there is no guarantee that these additional suppliers can supply sufficient quantities at a reasonable price, or at all. In addition, we do not currently have a contractual agreement with this supplier of azithromycin and consequently this supplier is not obligated to provide us any particular quantities of the drug.

In addition, certain of the raw materials we use in formulating our DuraSite drug delivery system are available only from Goodrich Corporation. Although we do not have a current supply agreement with the Goodrich Corporation, to date we have not encountered any difficulties obtaining necessary materials from them. Any significant interruption in the supply of these raw materials could delay our clinical trials, product development or product sales and could harm our business.

We Have No Experience in Commercial Manufacturing and Need to Establish Manufacturing Relationships with Third Parties, and If Contract Manufacturing Is Not Available to Us or Does Not Satisfy Regulatory Requirements, We Will Have to Establish Our Own Regulatory Compliant Manufacturing Capability and May Not Have the Financial Resources to Do So

We have no experience manufacturing products for Phase 3 and commercial purposes. We have a pilot facility licensed by the State of California to manufacture a number of our products for Phase 1 and Phase 2 clinical trials but not for late stage clinical trials or commercial purposes. Any delays or difficulties that we may encounter in establishing and maintaining a relationship with qualified manufacturers to produce, package and distribute our finished products may harm our clinical trials, regulatory filings, market introduction and subsequent sales of our products.

We currently contract with a third party to assemble the sample collection kits used in our OcuGene glaucoma genetic test. If our assembler should encounter significant delays or we have difficulty maintaining our existing relationship, or in establishing a new one, our sales of this product could be adversely affected.

Contract manufacturers must adhere to Good Manufacturing Practices regulations that are strictly enforced by the FDA on an ongoing basis through the FDA’s facilities inspection program. Contract manufacturing facilities must pass a pre-approval plant inspection before the FDA will approve a new drug application. Some of the material manufacturing changes that occur after approval are also subject to FDA review and clearance or approval. The FDA or other regulatory agencies may not approve the process or the facilities by which any of our products may be manufactured. Our dependence on third parties to manufacture our products may harm our ability to develop and deliver products on a timely and competitive basis. Should we be required to manufacture products ourselves, we:

Therefore, we may not be able to manufacture any products successfully or in a cost-effective manner.

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We Compete in Highly Competitive Markets and Our Competitors’ Financial, Technical, Marketing, Manufacturing and Human Resources May Surpass Ours and Limit Our Ability to Develop and/or Market Our Products and Technologies

Our success depends upon developing and maintaining a competitive advantage in the development of products and technologies in our areas of focus. We have many competitors in the United States and abroad, including pharmaceutical, biotechnology and other companies with varying resources and degrees of concentration in the ophthalmic market. Our competitors may have existing products or products under development which may be technically superior to ours or which may be less costly or more acceptable to the market. Competition from these companies is intense and is expected to increase as new products enter the market and new technologies become available. Many of our competitors have substantially greater financial, technical, marketing, manufacturing and human resources than we do, particularly in light of our current financial condition. In addition, they may succeed in developing technologies and products that are more effective, safer, less expensive or otherwise more commercially acceptable than any that we have or will develop. Our competitors may obtain cost advantages, patent protection or other intellectual property rights that would block or limit our ability to develop our potential products. Our competitors may also obtain regulatory approval for commercialization of their products more effectively or rapidly than we will. If we decide to manufacture and market our products by ourselves, we will be competing in areas in which we have limited or no experience such as manufacturing efficiency and marketing capabilities. See “— We Have No Experience in Commercial Manufacturing and Need to Establish Manufacturing Relationships with Third Parties, and if Contract Manufacturing is Not Available to Us or Does Not Satisfy Regulatory Requirements, We Will Have to Establish Our Own Regulatory Compliant Manufacturing Capability.”

If We Cannot Compete Successfully for Market Share Against Other Drug Companies, We May Not Achieve Sufficient Product Revenues and Our Business Will Suffer

The market for our product candidates is characterized by intense competition and rapid technological advances. If our product candidates receive FDA approval, they will compete with a number of existing and future drugs and therapies developed, manufactured and marketed by others. Existing or future competing products may provide greater therapeutic convenience or clinical or other benefits for a specific indication than our products, or may offer comparable performance at a lower cost. If our products fail to capture and maintain market share, we may not achieve sufficient product revenues and our business will suffer.

We will compete against fully integrated pharmaceutical companies and smaller companies that are collaborating with larger pharmaceutical companies, academic institutions, government agencies and other public and private research organizations. Many of these competitors have compounds competitive with ours already approved or in development including Zymar and Ocuflox by Allergan, Vigamox and Ciloxan by Alcon, Quixin by Santen and Chibroxin by Merck. In addition, many of these competitors, either alone or together with their collaborative partners, operate larger research and development programs and have substantially greater financial resources than we do, as well as significantly greater experience in:

Clinical Trials Are Very Expensive, Time-Consuming and Difficult to Design and Implement

Human clinical trials are very expensive and difficult to design and implement, in part because they are subject to rigorous regulatory requirements. The clinical trial process is also time consuming. We estimate that clinical trials of our product candidates will take at least several years to complete once initiated. Furthermore, failure can occur at any stage of the trials, and we could encounter problems that cause us to abandon or repeat clinical trials, further

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delaying or preventing the completion of such trials. The commencement and completion of clinical trials may be delayed by several factors, including:

In addition, we or the FDA may suspend our clinical trials at any time if it appears that we are exposing participants to unacceptable health risks or if the FDA finds deficiencies in our submissions or the conduct of these trials.

The Results of Our Clinical Trials May Not Support Our Product Candidate Claims

Even if our clinical trials are completed as planned, we cannot be certain that their results will support our product candidate claims. Success in pre-clinical testing and early clinical trials does not ensure that later clinical trials will be successful, and we cannot be sure that the results of later clinical trials will replicate the results of prior clinical trials and pre-clinical testing. The clinical trial process may fail to demonstrate that our product candidates are safe for humans and effective for indicated uses. This failure would cause us to abandon a product candidate and may delay development of other product candidates. Any delay in, or termination of, our clinical trials will delay the filing of our NDAs with the FDA and, ultimately, our ability to commercialize our product candidates and generate product revenues. In addition, our clinical trials involve a small patient population. Because of the small sample size, the results of these clinical trials may not be indicative of future results.

Physicians and Patients May Not Accept and Use Our Drugs

Even if the FDA approves our product candidates, physicians and patients may not accept and use them. Acceptance and use of our product will depend upon a number of factors including:

Because we expect sales of our current product candidates, if approved, to generate substantially all of our product revenues for the foreseeable future, the failure of any of these drugs to find market acceptance would harm our business and could require us to seek additional financing.

Our Products Are Subject to Government Regulations and Approval Which May Delay or Prevent the Marketing of Potential Products and Impose Costly Procedures Upon Our Activities

The FDA and comparable agencies in state and local jurisdictions and in foreign countries impose substantial requirements upon preclinical and clinical testing, manufacturing and marketing of pharmaceutical products. Lengthy and detailed preclinical and clinical testing, validation of manufacturing and quality control processes, and other costly and time-consuming procedures are required. Satisfaction of these requirements typically takes several years and the time needed to satisfy them may vary substantially, based on the type, complexity and novelty of the pharmaceutical product. The effect of government regulation may be to delay or to prevent marketing of potential products for a considerable period of time and to impose costly procedures upon our activities. The FDA or any other regulatory agency may not grant approval for any products we develop on a timely basis, or at all. Success in preclinical or early stage clinical trials does not assure success in later stage clinical trials. Data obtained

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from preclinical and clinical activities are susceptible to varying interpretations that could delay, limit or prevent regulatory approval. If regulatory approval of a product is granted, such approval may impose limitations on the indicated uses for which a product may be marketed. Further, even after we have obtained regulatory approval, later discovery of previously unknown problems with a product may result in restrictions on the product, including withdrawal of the product from the market. Moreover, the FDA has recently reduced previous restrictions on the marketing, sale and prescription of products for indications other than those specifically approved by the FDA. Accordingly, even if we receive FDA approval of a product for certain indicated uses, our competitors, including our collaborators, could market products for such indications even if such products have not been specifically approved for such indications. Additionally, the FDA recently issued an advisory that microarrays used for diagnostic and prognostic testing may need regulatory approval. The need for regulatory approval of multiple gene analysis is uncertain at this time. Delay in obtaining or failure to obtain regulatory approvals would make it difficult or impossible to market our products and would harm our business.

The FDA’s policies may change and additional government regulations may be promulgated which could prevent or delay regulatory approval of our potential products. Moreover, increased attention to the containment of health care costs in the United States could result in new government regulations that could harm our business. Adverse governmental regulation might arise from future legislative or administrative action, either in the United States or abroad. See “—Uncertainties Regarding Healthcare Reform and Third-Party Reimbursement may Impair Our Ability to Raise Capital, Form Collaborations and Sell Our Products.”

Uncertainties Regarding Healthcare Reform and Third-Party Reimbursement May Impair Our Ability to Raise Capital, Form Collaborations and Sell Our Products

The continuing efforts of governmental and third-party payers to contain or reduce the costs of healthcare through various means may harm our business. For example, in some foreign markets the pricing or profitability of health care products is subject to government control. In the United States, there have been, and we expect there will continue to be, a number of federal and state proposals to implement similar government control. The implementation or even the announcement of any of these legislative or regulatory proposals or reforms could harm our business by impeding our ability to achieve profitability, raise capital or form collaborations.

In addition, the availability of reimbursement from third-party payers determines, in large part, the demand for healthcare products in the United States and elsewhere. Examples of such third-party payers are government and private insurance plans. Significant uncertainty exists as to the reimbursement status of newly approved healthcare products, and third-party payers are increasingly challenging the prices charged for medical products and services. If we succeed in bringing one or more products to the market, reimbursement from third party payers may not be available or may not be sufficient to allow us to sell our products on a competitive or profitable basis.

Our Insurance Coverage May Not Adequately Cover Our Potential Product Liability Exposure

We are exposed to potential product liability risks inherent in the development, testing, manufacturing, marketing and sale of human therapeutic products. Product liability insurance for the pharmaceutical industry is extremely expensive. Although we believe our current insurance coverage is adequate to cover likely claims we may encounter given our current stage of development and activities, our present product liability insurance coverage may not be adequate to cover all potential claims we may encounter. In addition, our existing coverage will not be adequate as we further develop, manufacture and market our products, and we may not be able to obtain or afford adequate insurance coverage against potential claims in sufficient amounts or at a reasonable cost.

Our Use of Hazardous Materials May Pose Environmental Risks and Liabilities Which May Cause Us to Incur Significant Costs

Our research, development and manufacturing processes involve the controlled use of small amounts of hazardous solvents used in pharmaceutical development and manufacturing, including acetic acid, acetone, acrylic acid, calcium chloride, chloroform, dimethyl sulfoxide, ethyl alcoholc hydrogen chloride, nitric acid, phosphoric acid and other similar solvents. We retain a licensed outside contractor that specializes in the disposal of hazardous materials used in the biotechnology industry to properly dispose of these materials, but we cannot completely

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eliminate the risk of accidental contamination or injury from these materials. Our cost for the disposal services rendered by our outside contractor was approximately $6,000. $17,000 and $7,000 for the years ended 2003, 2002 and 2001, respectively. In the event of such an accident involving these materials, we could be held liable for any damages that result, and any such liability could exceed our resources. Moreover, as our business develops we may be required to incur significant costs to comply with federal, state and local environmental laws, regulations and policies, especially to the extent that we manufacture our own products.

If We Engage in Acquisitions, We Will Incur a Variety of Costs, and the Anticipated Benefits of the Acquisition May Never be Realized

We may pursue acquisitions of companies, product lines, technologies or businesses that our management believes are complementary or otherwise beneficial to us. Any of these acquisitions could have negative effects on our business. Future acquisitions may result in substantial dilution to our stockholders, the incurrence of additional debt and amortization expenses related to goodwill, research and development and other intangible assets. Any of these results could harm our financial condition. In addition, acquisitions would involve several risks for us, including:

Management and Principal Stockholders May Be Able to Exert Significant Control On Matters Requiring Approval by Our Stockholders and Security Interests in Our Assets Held by Management May Enable Them to Control the Disposition of Such Assets

As of March 26, 2004, our management and principal stockholders together beneficially owned approximately 20% of our outstanding shares of common stock. As a result, these stockholders, acting together, may be able to effectively control all matters requiring approval by our stockholders, including the election of a majority of our directors and the approval of business combinations.

In July 2003, we issued a $400,000 short-term senior secured note payable to Dr. Chandrasekaran, our chief executive officer, chief financial officer and a member our board of directors, for cash. This note bear an interest rate of five and one-half percent (5.5%) and is due on the earlier to occur of March 31, 2007 or 30 days subsequent to the successful completion of a pivotal Phase III clinical trial with ISV 401 and is secured by a lien on substantially all of our assets including our intellectual property and certain other equipment secured by the lessor of such equipment.

This security interest enables Dr. Chandrasekaran to control the disposition of these assets in the event of our liquidation. If we are unable to repay the amounts due under this note, he could, or cause us to, enter into involuntary liquidation proceedings in the event we default on our obligation.

In addition, investors in our March 2004 private placement, as a group, own approximately 17% of our outstanding shares of common stock. If the final closing occurs, we anticipate that such investors would own approximately 63% of our then outstanding shares of common stock. As a result, these stockholders, acting together, may be able to effectively control all matters requiring approval by our stockholders, including the election of a majority of our directors and approval of business combinations.

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The Market Prices For Securities of Biopharmaceutical and Biotechnology Companies such as Ours Have Been and Are Likely to Continue to Be Highly Volatile Due to Reasons that Are Related and Unrelated to the Operating Performance and Progress of Our Company

The market prices for securities of biopharmaceutical and biotechnology companies, including ours, have been highly volatile. The market has from time to time experienced significant price and volume fluctuations that are unrelated to the operating performance of particular companies. In addition, future announcements and circumstances, such as our current financial condition, the audit report included in this filing that includes an explanatory paragraph referring to our recurring operating losses and a substantial doubt about our ability to continue as a going concern, our ability to obtain new financing, the results of testing and clinical trials, the status of our relationships with third-party collaborators, technological innovations or new therapeutic products, governmental regulation, developments in patent or other proprietary rights, litigation or public concern as to the safety of products developed by us or others and general market conditions, concerning us, our competitors or other biopharmaceutical companies, may have a significant effect on the market price of our common stock.

Further, conversions of convertible securities and the sale of the shares of our Common Stock underlying those convertible securities, such as the warrants issued to Xmark and others, could cause a significant decline in the market price for our common stock. Additionally, the warrants issued to Xmark contain anti-dilution provisions that would decrease the conversion or exercise price of these instruments and, in the case of the Xmark warrants, result in increase in the number of shares of our common stock issuable under them. We have not paid any cash dividends on our common stock, and we do not anticipate paying any dividends on our common stock in the foreseeable future.

In addition, the terrorist attacks in the U.S. and abroad, the U.S. retaliation for these attacks, the war in Iraq and continued worldwide economic weakness and the related decline in consumer confidence have had, and may continue to have, an adverse impact on the U.S. and world economy. These and similar events, as well as, fluctuations in our operating results and market conditions for biopharmaceutical and biotechnology stocks in general, could have a significant effect on the volatility of the market price for our common stock and on the future price of our common stock.

We Have Adopted and Are Subject to Anti-Takeover Provisions That Could Delay or Prevent an Acquisition of Our Company and Could Prevent or Make it More Difficult to Replace or Remove Current Management

Provisions of our certificate of incorporation and bylaws may constrain or discourage a third party from acquiring or attempting to acquire control of us. Such provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. In addition, such provisions could also prevent or make it more difficult for our stockholders to replace or remove current management and could adversely affect the price of our common stock if they are viewed as discouraging takeover attempts, business combinations or management changes that stockholders consider in their best interest. Our board of directors has the authority to issue up to 5,000,000 shares of preferred stock, 15,000 of which have been designated as Series A-1 Preferred Stock. Our board of directors has the authority to determine the price, rights, preferences, privileges and restrictions, including voting rights, of the remaining unissued shares of preferred stock without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of preferred stock, while providing desirable flexibility in connection with possible financings, acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock, even if the transaction might be desired by our stockholders. Provisions of Delaware law applicable to us could also delay or make more difficult a merger, tender offer or proxy contest involving us, including Section 203 of the Delaware General Corporation Law, which prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years unless conditions set forth in the Delaware General Corporation Law are met. The issuance of preferred stock or Section 203 of the Delaware General Corporate Law could also be deemed to benefit incumbent management to the extent these provisions deter offers by persons who would wish to make changes in management or exercise control over management. Other provisions of our

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certificate of incorporation and bylaws may also have the effect of delaying, deterring or preventing a takeover attempt or management changes that our stockholders might consider in their best interest. For example, our bylaws limit the ability of stockholders to remove directors and fill vacancies on our board of directors. Our bylaws also impose advance notice requirements for stockholder proposals and nominations of directors and prohibit stockholders from calling special meetings or acting by written consent.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The following discusses our exposure to market risk related to changes in interest rates.

We invest our excess cash in investment grade, interest-bearing securities. At March 31, 2004, we had approximately $1.5 million invested in money market mutual funds. While a hypothetical decrease in market interest rates by 10 percent from the March 31, 2004 levels would cause a decrease in interest income, it would not result in a loss of the principal. Additionally, the decrease in interest income would not be material.

Item 4. Controls and Procedures

As of the end of the period covered by this report, the Chief Executive Officer, President and Chief Financial Officer (the “Certifying Officer”) evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). These disclosure controls and procedures are designed to ensure that the information required to be disclosed by the Company in its periodic reports filed with the Commission is recorded, processed, summarized and reported within the time periods specified by the Commission’s rules and forms, and that the information is communicated to the certifying officers on a timely basis. The Certifying Officer concluded, based on his evaluation, that the Company’s disclosure controls and procedures are effective for the Company, taking into consideration the size and nature of the Company’s business and operations.

Part II OTHER INFORMATION

Item 1. Legal Proceedings.

On or about October 8, 2003, Thai Nguyen (“Nguyen”) filed a complaint in the Superior Court of California, County of San Francisco (No. CGC 03425230) against us, our CEO Kumar Chandrasekaran, the Regents of the University of California (“Regents”) and two individuals associated with Regents. In essence, Nguyen alleges that we breached an obligation to continue supporting his research; he has also made a variety of other related claims and allegations against us and the other defendants. Nguyen filed a motion to enjoin us during the pendency of the litigation from alienating the license rights held by us relating to the subject of Nguyen’s research, and this motion was denied. We (and Dr. Chandrasekaran) filed a demurrer challenging certain aspects of the complaint which was granted in large part by written order dated April 7, 2004. The Court permitted Nguyen to file a First Amended Complaint, and Nguyen in fact did so on or about April 22, 2004. A response to the First Amended Complaint has not yet been filed by either us or by Dr. Chandrasekaran.

While the amount of monetary relief is not specifically quantified in the First Amended Complaint, in general Nguyen seeks to enforce a claimed agreement which states that we would pay him between $100,00 and $200,000 in annual laboratory support “for the life of patent” and bonus payments of approximately $60,000. Nguyen also seeks relief in connection with 30,000 shares of our stock provided to him by us but which he gave back at the direction of Regents. The First Amended Complaint also seeks unspecified punitive damages, attorneys’ fees and other damages and relief (including an exclusive, royalty free license to certain patents).

Item 2. Changes in Securities and Use of Proceeds.

On March 26, 2004, we completed the initial closing of a private placement to accredited investors of

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shares of our common stock and warrants to purchase shares of common stock pursuant to subscription agreements entered into between us and such investors. These securities were sold pursuant to Rule 506 promulgated under the Securities Act of 1933, as amended and Section 4(2) of the Securities Act of 1933, as amended. Pursuant to the terms of the subscription agreements the subscribers agreed to purchase from us an aggregate of 1,650 units at an aggregate offering price of $16.5 million, of which 194 units, consisting of an aggregate of 3,880,000 shares of our common stock and warrants to purchase 1,940,000 shares of our common stock were sold at the initial closing and the remaining 1,456 units, consisting of an aggregate of 29,120,000 shares of our common stock and warrants to purchase 14,560,000 shares of our common stock, will be sold at the final closing. The final closing is subject to and conditioned upon approval of such closing and the transactions contemplated thereby by our stockholders and certain other conditions set forth in the subscription agreements.

Each unit consists of 20,000 shares of common stock at $0.50 per share, redeemable “Class A” warrants exercisable for 5,000 shares at an exercise price of $0.75 per share and redeemable “Class B” warrants exercisable for 5,000 shares at an exercise price of $0.75 per share. The Class A Warrants and Class B Warrants may be exercised at any time prior to the earlier of the date on which they are redeemed and the fifth anniversary of their issuance. Outstanding Class A Warrants may be redeemed by us upon 30 days advanced written notice to the holder at a per warrant share redemption price of $0.75 if the average closing price of the common stock on the American Stock Exchange for any 20 consecutive trading days is at least $1.50. Outstanding Class B Warrants may be redeemed by us upon 30 days advanced written notice to the holder at a per warrant share redemption price of $1.75 if the average closing price of the common stock on the American Stock Exchange for any 20 consecutive trading days is at least $2.50. The Class A Warrants and Class B Warrants are referred to as the “Warrants”, the shares of common stock issuable upon exercise of the Warrants are referred to as the “Warrant Shares” and the term “Securities” means collectively the shares of Common stock included in the units, the Warrants and the Warrant Shares.

Paramount BioCapital, Inc. acted as the placement agent for the March 2004 private placement and received, in the aggregate, approximately $120,000 in fees for such services in the initial closing. In addition, if the final closing occurs, the placement agent will receive a non-redeemable five year warrant exercisable for 750,000 shares of common stock at an exercise price of $0.55 per share and will receive additional fees for services. As long as the placement agent and its affiliates beneficially own at least 33% of the Securities issued to them in the March 2004 private placement, the placement agent will be entitled to designate a nonvoting observer who may attend all meetings of our Board of Directors.

The final closing will not occur, and we will not issue any common stock or Warrants at the final closing or receive any proceeds therefore, unless we receive approval from our stockholders to:

If we do not receive stockholder approval within 90 days of the initial closing, subject to certain limited extensions (the “Termination Date”), the obligation of each subscriber to purchase the balance of the Securities in the final closing will be terminable at the option of the subscriber. In addition, if stockholder approval is not obtained by the Termination Date, we are required to pay the subscribers liquidated damages equal in the aggregate to 2% of the gross proceeds received at the initial closing, for each week beyond the Termination Date that stockholder approval is not obtained, up to a maximum of 8% in the aggregate of the gross proceeds received at the initial closing.

In addition, not later than 15 days after the final closing, we are required to file a registration statement with the Securities and Exchange Commission, or the SEC, with respect to the resale of the shares of Common stock

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(i) included in the units; (ii) issuable upon exercise of the Warrants included in the units; (iii) issuable upon exercise of the placement warrants, and issuable pursuant to any penalties under the subscription agreements (collectively, the “Registrable Shares”). If we fail to file the registration statement within such period, we are required to issue to the subscribers (on a pro-rata basis) additional Class B Warrants to purchase a number of shares of common stock equal to 1% of the shares of common stock, on a fully diluted basis, issued to subscribers in the March 2004 private placement for each 15 day period the registration statement remains unfiled, up to a maximum of Class B Warrants in the aggregate (on a pro-rata basis) to purchase an additional 4% of the common stock, on a fully diluted basis, issued to subscribers in the private placement.

If we do not receive stockholder approval by 15 days after the Termination Date, we must file a registration statement with the SEC with respect to the resale of the shares of common stock (i) included in the units sold in the initial closing and (ii) issuable upon exercise of the Warrants included in the units sold in the initial closing. If we fail to file the registration statement within such period then it is required to pay to subscribers (on a pro-rata basis) a cash payment equal to 1% of the gross proceeds raised in the initial closing for each 15 day period the registration atatement remains unfiled, up to a maximum (on a pro-rata basis) of 4% of the initial closing gross proceeds.

Item 3. Defaults Upon Senior Securities.

None.

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

None.

Item 5. Other Information.

None.

Item 6. Exhibits and Reports on Form 8-K.

a) The exhibits listed on the Exhibit Index (following the signature section of this Quarterly Report) are included or incorporated by reference, in this Quarterly Report.

b) Reports of Form 8-K

On January 14, 2004, we filed a Current Report on Form 8-K reporting under Item 2 the completed the sale of our drug candidate ISV-403 to Bausch & Lomb Incorporated pursuant to an ISV-403 Purchase Agreement on December 19, 2003 and a License Agreement on December 30, 2003.

On February 24, 2004, we filed a Current Report on Form 8-K reporting under Item 4 that we had engaged Burr, Pilger & Mayer LLP as our new independent accountant.

On March 29, 2004, we filed a Current Report on Form 8-K reporting under Item 5 the completion of the initial closing of a private placement entered into on March 26, 2004.

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SIGNATURES

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

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EXHIBIT INDEX

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