Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-K

For the fiscal year ended December 31, 2006

OR

For the transition period from                      to                     .

Commission File Number: 000-50855

Auxilium Pharmaceuticals, Inc.

(Exact name of registrant as specified in its charter)

(484) 321-5900

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Securities Exchange Act of 1934:

Securities registered pursuant to Section 12(g) of the Securities Exchange Act of 1934:

None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes ¨    No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes ¨    No x

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    ¨

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

Large accelerated filer ¨                    Accelerated filer x                    Non-accelerated filer ¨

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

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant, based on the last sale price for such stock on The NASDAQ Global Market as of June 30, 2006, was approximately $97.7 million.

As of March 8, 2007, the number of shares outstanding of the issuer’s common stock, $0.01 par value per share, was 36,138,666.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s definitive Proxy Statement for its Annual Meeting of Stockholders to be held on June 13, 2007, to be filed with the Securities and Exchange Commission, are incorporated by reference into Part III of this Form 10-K.

Table of Contents

AUXILIUM PHARMACEUTICALS, INC.

FORM 10-K

December 31, 2006

TABLE OF CONTENTS

2

Table of Contents

This Report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, that involve risks and uncertainties. All statements other than statements of historical information provided herein are forward-looking statements and may contain projections relating to financial results, economic conditions, trends and known uncertainties. These statements are not guarantees of future performance or events. Our actual results may differ materially from those discussed in this Report. You should review the “Risk Factors” section of this Report for a discussion of the important factors that could cause actual results to differ materially from those described in or implied by the forward-looking statements contained in this Report. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis, judgment, belief or expectation only as of the date hereof. We undertake no obligation to publicly reissue these forward-looking statements to reflect events or circumstances that arise after the date hereof.

PART I

Company Overview

Company Description

We are a specialty biopharmaceutical company with a focus on developing and marketing products to urologists, endocrinologists, orthopedists and select primary care physicians. We currently have 269 full-time employees, including a sales and marketing organization of approximately 190 people. Our only marketed product, Testim^®, is a proprietary, topical 1% testosterone once-a-day gel indicated for the treatment of hypogonadism. Hypogonadism is defined as reduced or absent secretion of testosterone which can lead to symptoms such as low energy, loss of libido, adverse changes in body composition, irritability and poor concentration. We reported revenues in 2006 of $68.5 million, an increase of 60% over the $42.8 million reported in 2005. According to National Prescription Audit data from IMS Health, Inc., or IMS, a pharmaceutical market research firm, Testim’s share of total prescriptions for the gel segment of the testosterone replacement therapy, or TRT, market was 18.3% for the month of December 2006, compared with 16.3% for the month of December 2005. For the full year 2006, Testim’s share of total prescriptions for the TRT market was 17.7%, versus 13.8% for the full year 2005.

Our current product pipeline includes:

Phase III:

– AA4500, injectable collagenase enzyme for the treatment of Dupuytren’s contracture

Phase II:

– AA4500, injectable collagenase enzyme for the treatment of Peyronie’s disease

– AA4500, injectable collagenase enzyme for the treatment of Frozen Shoulder syndrome (or Adhesive

   Capsulitis)

Phase I:

– AA4010, treatment for overactive bladder using our transmucosal film delivery system

Preclinical:

– two pain products using our transmucosal film delivery system (with rights to develop six other compounds for the treatment of pain).

In addition to the above, we have the rights to develop other hormone and urologic products using our transmucosal film technology and the option to license other indications for AA4500 other than dermal products for topical administration.

3

Table of Contents

Company Strategy

Our goal is to build a leading specialty biopharmaceutical company by focusing on disease states that we believe can be addressed through sales to predominantly specialist audiences, such as urologists, endocrinologists, certain targeted primary care physicians and subsets of orthopedic surgeons. We have an experienced development and regulatory team that has a proven track record. We intend to draw upon our track record and experience to successfully develop our product candidates. Our strategy will focus on developing and commercializing AA4500, optimizing Testim’s commercial success and developing and commercializing products utilizing our transmucosal film technology delivery system.

Developing and Commercializing AA4500. We believe that AA4500 represents a significant opportunity for us, and we are devoting what we believe to be the appropriate resources to the development and pre-commercialization of this product. For Dupuytren’s contracture and Peyronie’s disease, we believe there is a large unmet medical need for a non-surgical solution to these debilitating diseases and that the data from our well-controlled phase II studies and from an initial phase III study are encouraging. The product has received orphan drug designation in the U.S. for both indications, and our preliminary market research leads us to believe that urologists and orthopedic surgeons would be very likely to use the product to delay or avoid surgery. We believe that there are approximately 450,000 patients, on an annual basis, who could be candidates for AA4500 for the treatment of Dupuytren’s contracture and Peyronie’s disease in the U.S. and Europe. These patients represent an annual market potential in excess of $1 billion, assuming that we are able to price treatments using AA4500 on a basis comparable to the cost of surgery for these indications. We have exclusive worldwide rights to develop, market and sell products containing AA4500, other than dermal formulations labeled for topical administration. Specifically, we currently have rights to AA4500 for the treatment of Dupuytren’s contracture, Peyronie’s disease and Frozen Shoulder syndrome.

Optimizing Testim’s Commercial Success. Testim has demonstrated an ability to capture market share in the gel segment of the TRT market and the total TRT market. We believe that we can continue to increase sales of Testim by capturing market share, expanding the use of TRT through increased physician and patient awareness and benefiting from the on-going demographic changes that could result in additional patient candidates for TRT treatment.

In addition, it has been demonstrated that low testosterone is associated with conditions such as diabetes, obesity, hyperlipidemia, chronic pain and HIV/AIDS. With improved medical and patient education around the implications of low testosterone and the favorable risk/benefit profile of treating

4

Table of Contents

with TRT, we believe physicians will be more proactive in identifying hypogonadism and treating patients. In 2006, the gel market increased 13.7% over 2005.

We will continue to incorporate focused educational efforts to both physicians and consumers to create an increased awareness of both the prevalence and medical need for identifying and treating hypogonadism.

Developing and Commercializing Transmucosal Film Technology. We believe delivery of pharmaceuticals across the mucosal membrane of the mouth offers important advantages to patients, including the possibility to achieve therapeutic benefits with significantly lower doses of drug, and the possibility of a convenient, once or twice daily dosing regimen.

AA4500 Opportunity

AA4500 is an injectable collagenase enzyme we in-licensed from BioSpecifics Technologies Corp., or BioSpecifics. Under our agreement with BioSpecifics, we have exclusive worldwide rights to develop, market and sell certain products containing AA4500. Our licensed rights concern the development of products, other than dermal formulations labeled for topical administration. Currently, we are developing AA4500 for the treatment of Dupuytren’s contracture, Peyronie’s disease and Frozen Shoulder syndrome. We may expand our agreement with BioSpecifics, at our option, to cover other indications as they are developed by us or BioSpecifics.

Dupuytren’s Contracture

Disease state and market: Dupuytren’s contracture is a condition that affects the connective tissue that lies beneath the skin in the palm. The disease is progressive in nature. Typically, painful nodules develop in the palm as collagen deposits accumulate. As the disease progresses, the collagen deposits form a cord that stretches from the palm of the hand to the base of the finger. Once this cord develops, the patient’s fingers contract and the function of the hand is impaired. Currently, surgery is the only effective treatment. According to Dupuytren’s Disease by Leclercq published in 2000, the global prevalence of Dupuytren’s contracture among today’s Caucasian population is estimated to range from 3% to 6%. Common co-morbidities include diabetes, epilepsy, alcoholism or HIV. Dupuytren’s contracture is most common in men. It usually starts in adult life, with a peak incidence in the forties and fifties. In about 50% of patients, the disease affects both hands, and recurrence after surgical treatment is common (as high as 30% the first two years post-surgery; and 55% within 10 years of surgery). Due to the recurrent nature of the disease, multiple corrective surgeries are often required, which become increasingly complex. AA4500 is injected directly into the cord and the procedure could be performed in a physician’s office. We believe AA4500 as a treatment for Dupuytren’s contracture represents an attractive and addressable market for us as a specialty biopharmaceutical company.

R&D status: An initial phase III study by the licensor of the product was comprised of a randomized, placebo-controlled, double-blind phase, as well as an open-label phase. Data from the double-blind phase showed that injecting the collagenase enzyme into study patients’ affected joints led to a 91% success rate in reducing joint contracture to within five degrees of normal, compared to the placebo arm in which no patients achieved success. In the open-label phase, in which patients had additional joints treated with AA4500, results showed that 88% of Metacarpophalangeal (MP) joints and 68% of Proximal Interphalangeal (PIP) joints were fully corrected. These results were consistent with phase II data previously published in The Journal of Hand Surgery in 2002. In December 2006, we suspended the dosing of patients in our ongoing phase III trials for AA4500 for the treatment of Dupuytren’s contracture in response to an issue related to the manufacture of clinical supplies. We expect to resume phase III trials in the fourth quarter of 2007.

Peyronie’s Disease

Disease state and market: Peyronie’s disease is characterized by a plaque or hard lump that occurs on the penis. It begins as a localized inflammation, which progresses to a hardened scar on the shaft of the penis that

5

Table of Contents

reduces flexibility and causes the penis to bend during erection. This may cause pain on erection and a deformity that may prevent sexual intercourse altogether. Our market research indicates that, aside from the physical consequences, depression and loss of self-esteem are common in men with Peyronie’s disease. According to Peyronie’s Disease, A Guide to Clinical Management by Levine, published in 2007, the prevalence of Peyronie’s disease has been increasing during the last 30 years and the now ranges between 3.7% and 7.1%, but the actual prevalence may be higher because of patients’ reluctance to report this embarrassing condition to their physicians. The pathogenesis of Peyronie’s disease appears to be multifactorial, with an interplay of genetic predisposition, trauma, and tissue ischemia. Generally, Peyronie’s disease is treated by urologists. To date, no medical therapy has been proven effective for the treatment of Peyronie’s disease. Surgical treatment may be an option for some patients, although complications as well as loss of penile length can occur.

Administration of AA4500 could be an in-office procedure in which the product is injected directly into the plaque causing the penile curvature. Early phase II clinical work with AA4500 in patients with Peyronie’s disease indicates that the product reduces scar tissue size, thereby improving the curvature of the penis, and in some cases, restoring the ability to have sexual intercourse. Additional dose optimization studies will be needed.

R&D status: Previous phase II studies by the licensor of the product indicate possible effectiveness of AA4500 in this disease state. We have begun an animal study requested by FDA to determine the local effects of AA4500 injected in normal penile tissue. We expect to commence a phase IIb dose ranging study for AA4500 as a treatment for Peyronie’s disease in the fourth quarter of 2007.

Frozen Shoulder Syndrome

Disease state and market: Frozen Shoulder syndrome is a disorder of diminished shoulder motion, characterized by restriction in both active and passive range of motion of the shoulder joint. Frozen Shoulder syndrome usually affects patients aged 40-70 years. According to Harrison’s Principles of Internal Medicine, it is estimated that 3% of people develop Frozen Shoulder syndrome over their lifetime and that women tend to be affected more frequently than men. The condition may affect both shoulders, either simultaneously or in sequence, in up to 16% of patients. Recurrence of Frozen Shoulder syndrome is common within five years of the onset of the disorder. According to Dahan et. al. in the 2005 eMedicine article “Adhesive Capsulitis,” a higher incidence of Frozen Shoulder syndrome exists among patients with diabetes (10-20%) compared to the general population (2-5%) and incidence among patients with insulin-dependent diabetes is even higher (36%), with an increased frequency of bilateral shoulder involvement. The most common treatment for Frozen Shoulder syndrome is extensive physical therapy, corticosteroids and/or arthroscopy. Drugs are used to manage pain, but none have been demonstrated to have an impact on Frozen Shoulder syndrome.

R&D status: Our licensor has conducted a phase II clinical trial using AA4500 for the treatment of Frozen Shoulder syndrome. Three different doses of the enzyme were compared to placebo in this prospective, randomized, 60-subject trial. The results from this trial suggest that local injection of the enzyme is well-tolerated and may be effective in patients suffering from Frozen Shoulder syndrome. Additional studies are needed to assess the optimal dose and dosing regimen of AA4500 for this indication.

6

Table of Contents

Testim Opportunity

Hypogonadism market

Hypogonadism, or low testosterone, is a disorder that affects millions of men in the U.S.A study in The International Journal of Clinical Practice was published in 2006 that showed 39% of men over 45 years of age have low testosterone (total testosterone levels below 300 ng / dL). Hypogonadism also affects a high percentage of men with certain co-morbidities regardless of age. This recent study documented associations with other co-morbidities such as: Obesity (52%), Diabetes (50%) and Rheumatoid Arthritis (47%)¹. Other articles have highlighted associations with other conditions: HIV (30%)², Erectile Dysfunction (18%)³ and up to 74% of men being treated with high doses of opioids for chronic pain⁴. The effects of low testosterone lead to symptoms such as low energy, diminished libido, adverse changes in body composition, irritability and poor concentration. According to a recent study, the impact of these symptoms on an afflicted person can be high.

TRT is the standard treatment for hypogonadism. According to IMS, the total number of prescriptions within the TRT market has grown from 1.0 million to 2.7 million prescriptions between 2000 and 2006. Before 2000, the TRT market consisted of oral, injectable and patch therapies. In 2000, the first topical gel was introduced, and this product segment has been the driver of much of the total growth in the TRT market. According to IMS, the gel segment accounted for approximately 71% of the total prescriptions in the TRT market in the fourth quarter of 2006. Despite this growth, we estimate that less than 10% of men with hypogonadism currently receive TRT. According to our physician research, this low diagnosis rate stems primarily from low patient and physician awareness of the symptoms, treatment options and monitoring requirements.

Testim has captured a significant portion of the gel prescription growth since its launch in early 2003, and Testim held an 18.3% prescription share of this market in December 2006. For the calendar year 2006, prescriptions of Testim grew by 44.1% compared to 2005. The gel market continued to drive the growth of the TRT market in 2006. Gel prescriptions grew 13.7% compared to 2005. All other formulations (injectables, patches, orals and buccals) combined increased less than 1% year over year.

7

Table of Contents

Source: IMS

We believe Testim’s growth has been due to Testim’s favorable clinical profile and our increased sales and marketing efforts in 2006. Our sales organization of approximately 150 representatives promotes Testim to urologists, endocrinologists and key primary care physicians. In September 2006, we mutually terminated our co-promotion agreement with Oscient and expanded our sales force from 94 to 150 representatives. The incremental headcount allows us to cover more of the top prescribing physicians with consistent frequency. We believe this focused, consistent messaging will continue to drive the recognition of hypogonadism and increased Testim prescriptions.

Testim is a proprietary, topical 1% testosterone once-a-day gel that treats hypogonadism by restoring testosterone blood levels back to normal for a 24-hour period following application. Testim is packaged in convenient, easy-to-open, single-use tubes. Patients apply Testim once per day to the upper arms and shoulders, enabling Testim’s active ingredient, testosterone, to be absorbed through the skin and into the bloodstream.

Clinical data supporting the advantages of Testim. We have designed and conducted our clinical trials to provide prescribing physicians with comprehensive information regarding Testim’s benefits. Since 2001, we have completed 14 clinical studies involving approximately 1,800 patients including the largest placebo controlled study (n=400) ever conducted to evaluate the benefits and risks of TRT. We conducted five of these studies using Testim and other TRT products, including a transdermal patch and the other commercial gel. The results from these five studies, taken together, demonstrate that in patients with hypogonadism, testosterone levels directly correlate with patient symptom improvement.

Cost effectiveness and convenience. We believe, based on clinical data regarding testosterone levels in patients, market feedback from physicians, and the results of our clinical trials, that a higher percentage of patients are treated with only one tube of Testim per day (one dose per day) compared to the other commercial gel. In a recent retrospective pharmacy analysis conducted by Verispan analyzing 12 month usage patterns in over 40,000 patients, we learned that 95% of the Testim treated patients utilized a daily 5 gram dose at month 3 and of patients who remain on Testim at month 12, 97% utilized this dose. We believe that one tube of Testim per day is an advantage for patients because of less volume of drug to apply, and for payors, because of lower cost.

8

Table of Contents

Broad prescription coverage. Currently, we have broad third-party payor reimbursement for Testim and Testim is covered by the majority of reimbursement plans.

Transmucosal Film Technology

We are developing product candidates using a new oral transmucosal drug delivery system based on patented technology licensed from Formulation Technologies, L.L.C., doing business as PharmaForm, or PharmaForm. The basis of this technology is a film that adheres to the upper gum. We have the exclusive worldwide right to use this technology platform in therapeutic products that contain hormones or that treat urologic disorders and in certain pain products. We currently have three product candidates using this technology:

In October 2006, we decided to discontinue the development of the formulation of TestoFilm™, our testosterone replacement transmucosal film product candidate for the treatment of hypogonadism and reallocate resources to our lead development project, AA4500. We determined that the current formulation of TestoFilm did not meet certain critical aspects of the target product profile and, as a result, would not be commercially viable. The Company believes that the transmucosal film delivery system remains viable and intends to develop opportunities in hormone replacement, urologic disease and pain.

Manufacturing

We currently use, and expect to continue to depend on, contract manufacturers to manufacture Testim. We may depend on contract manufacturers to manufacture any products for which we receive marketing approval, and to produce sufficient quantities of our product candidates for use in preclinical and clinical studies.

Testim is manufactured for us by DPT Laboratories, Ltd., or DPT, pursuant to a manufacturing and supply agreement that expires on December 31, 2010, the terms of which are summarized below in “Material Agreements.”

Testosterone, a non-animal derived hormone, is currently available to us from only two sources. We purchase testosterone from both sources but do not have an agreement with either of these suppliers. We acquire CPD, a critical ingredient for the manufacture of Testim, from a single source. We endeavor to maintain what we believe is an adequate inventory of the key ingredients of Testim.

For AA4500, we are responsible, at our own cost and expense, for developing the formulation and finished dosage form of products and arranging for the clinical supply of products. As permitted under the terms of our agreement with BioSpecifics, we have qualified Cobra Biologics Ltd., or Cobra, as a supplier of AA4500 for use in our clinical trials. The terms of our agreement with Cobra are summarized below under “Material Agreements.” Pursuant to our agreement with Althea Technologies, Inc., or Althea, Althea will fill and lyophilize the AA4500 bulk substance produced by Cobra, manufacture placebo and produce sterile diluent.

In September 2006, we leased a 50,000 square foot biological manufacturing facility in Horsham, Pennsylvania that we plan to use to produce the active ingredient of AA4500. The initial term of the lease expires on January 1, 2017.

Under the terms of our agreement with BioSpecifics, BioSpecifics has the option, exercisable no later than six months after FDA approval of the first New Drug Application or Biologics License Application with respect to a product, to assume the right and obligation to supply, or arrange for the supply from a third party other than a back-up supplier qualified by us, of a specified portion of commercial product required by us. The terms of our agreement with BioSpecifics are summarized below under “Material Agreements.”

9

Table of Contents

We and our contract manufacturers are subject to an extensive governmental regulation process. Regulatory authorities in our markets require that drugs be manufactured, packaged and labeled in conformity with current good manufacturing practices, or cGMP. The cGMP requirements govern quality control of the manufacturing process and documentation policies and procedures. We have established an internal quality control and quality assurance program, including a set of standard operating procedures and specifications that we believe is cGMP-compliant.

Material Agreements

We have entered into agreements for the in-licensing of technology and products and for the manufacture of our products. Additionally, we have secured collaboration partners for the sale of Testim in geographic locations where we do not have our own sales force. We intend to pursue other licensing agreements and collaborations in the future.

Bentley Pharmaceuticals

We entered into two separate license agreements with Bentley Pharmaceuticals, Inc., or Bentley, that give us access to Bentley’s patented transdermal gel technology. In May 2000, Bentley granted us an exclusive, worldwide, royalty-bearing license to make and sell products incorporating Bentley’s formulation technology that contains testosterone. The term of this agreement is determined on a country by country basis and extends until the later of patent right termination in a country or 10 years from the date of first commercial sale. We produce Testim under this license. Bentley has filed patent applications in the U.S., Europe and Japan, which, if issued, could provide additional patent protection for Testim. In May 2001, Bentley granted us similar rights for a product containing another hormone, the term of which is perpetual. Under these agreements, we are required to make up-front and milestone payments to Bentley upon contract signing, the decision to develop the underlying product, and the receipt of FDA approval.

In addition to our royalty obligations, to date, we have paid Bentley approximately $0.6 million of up-front payments and milestones under the in-license agreements. If all events under our in-license agreements with Bentley occur, we would be obligated to pay a maximum of approximately $1.0 million in milestone payments. The timing of these payments, if any, is uncertain.

DPT

Testim is manufactured for us by DPT under the terms of a manufacturing and supply agreement that we entered into in April 2002 as amended most recently on September 14, 2005. This agreement expires on December 31, 2010. During the term of the agreement, subject to our right to qualify and order Testim from a back-up supplier, and subject to DPT’s ability to qualify its Lakewood, New Jersey facility as a secondary site for the production of Testim, DPT is required to manufacture all of our worldwide commercial requirements of Testim. We have qualified a back-up supplier. Upon DPT’s qualification of the Lakewood facility, we will no longer be permitted to order commercial supply of Testim from the back-up supplier. However, in the event that DPT is unable to meet our Testim supply requirements, Testim may be manufactured for us by a back-up supplier. The manufacturing fees paid to DPT are based upon the specified annual volume of Testim ordered by us. If we order less than a specified amount of Testim in any calendar year, the parties are required to negotiate to establish new manufacturing fees, with the understanding that DPT will continue to produce Testim for a specified minimum period in order to enable us to identify and utilize another supplier. DPT may terminate the agreement only upon our insolvency or bankruptcy or upon our breach of the agreement.

BioSpecifics

In June 2004, we entered into a development and license agreement with BioSpecifics and amended the agreement in May 2005 and December 2005 (the BioSpecifics Agreement). Under the BioSpecifics Agreement,

10

Table of Contents

we were granted exclusive worldwide rights to develop, market and sell certain products containing BioSpecifics’ enzyme, which we refer to as AA4500. Our licensed rights concern the development of products, other than dermal formulations labeled for topical administration, and currently, our licensed rights cover the indications of Dupuytren’s contracture, Peyronie’s disease and Frozen Shoulder syndrome. We may further expand the BioSpecifics Agreement, at our option, to cover other indications as they are developed by us or BioSpecifics.

The BioSpecifics Agreement extends, on a country-by-country and product-by-product basis, for the longer of the patent life, the expiration of any regulatory exclusivity period or 12 years. We may terminate the BioSpecifics Agreement upon 90 days prior written notice.

We are responsible, at our own cost and expense, for developing the formulation and finished dosage form of products and arranging for the clinical supply of products. As permitted under the BioSpecifics Agreement, we have qualified Cobra as a supplier of clinical products under the agreement.

BioSpecifics has the option, exercisable no later than six months after FDA approval of the first New Drug Application or Biologics License Application with respect to a product, to assume the right and obligation to supply, or arrange for the supply from a third party other than a back-up supplier qualified by us, of a specified portion of our commercial product requirements. The BioSpecifics Agreement provides that we may withhold a specified amount of a milestone payment until (i) BioSpecifics executes an agreement, containing certain milestones, with a third party for the commercial manufacture of the product, (ii) BioSpecifics commences construction of a facility, compliant with cGMP, for the commercial supply of the product, or (iii) 30 days after BioSpecifics notifies us in writing that it will not exercise the supply option.

If BioSpecifics exercises the supply option, commencing on a specified date, BioSpecifics will be responsible for supplying either by itself or through a third party other than a back-up supplier qualified by us, a specified portion of the commercial supply of the product. If BioSpecifics does not exercise the supply option, we will be responsible for arranging for the entire commercial product supply. In the event BioSpecifics exercises the supply option, we and BioSpecifics are required to use commercially reasonable efforts to enter into a commercial supply agreement on customary and reasonable terms and conditions which are not worse than those with back-up suppliers qualified by us.

We must pay BioSpecifics on a country-by-country and product-by-product basis a specified percentage of net sales for products covered by the BioSpecifics Agreement. Such percentage may vary depending on whether BioSpecifics exercises the supply option. In addition, the percentage may be reduced if (i) BioSpecifics fails to supply commercial product supply in accordance with the terms of the BioSpecifics Agreement; (ii) market share of a competing product exceeds a specified threshold; or (iii) we are required to obtain a license from a third party in order to practice BioSpecifics’ patents without infringing such third party’s patent rights.

In addition to the payments set forth above, we must pay BioSpecifics an amount equal to a specified mark-up of the cost of goods sold for products sold by us that are not manufactured by or on behalf of BioSpecifics, provided that, in the event BioSpecifics exercises the supply option, no payment will be due for so long as BioSpecifics fails to supply the commercial supply of the product in accordance with the terms of the BioSpecifics Agreement.

Finally, we will be obligated to make contingent milestone payments upon the filing of regulatory applications and receipt of regulatory approval. Through December 31, 2006, we paid up-front and milestone payments under the BioSpecifics Agreement of $8.5 million. We could make up to an additional $5.5 million of contingent milestone payments under the BioSpecifics Agreement if all existing conditions are met. Additional milestone obligations will be due if we exercise an option to develop and license AA4500 for additional medical indications.

11

Table of Contents

Cobra

In July 2005, we entered into an agreement with Cobra for the process development, scale up and manufacture of AA4500 for phase II/III clinical trials (the Manufacturing Agreement). Through an agreement dated July 14, 2006 (the Amended Manufacturing Agreement), we terminated the Manufacturing Agreement and agreed that Cobra will manufacture the AA4500 batches needed for clinical trials and for the Biological License Application (BLA) to be filed under the U.S. Federal Food, Drug and Cosmetic Act and related applicable regulations and will provide related services upon our request. In November 2006, we entered into a letter agreement with Cobra (the Amendment) that further amended the Amended Manufacturing Agreement. Under the Amendment, we paid $1.1 million and Cobra agreed to complete only one BLA batch of the active ingredient for AA4500 and perform certain other services as may be agreed to by the parties. Through December 31, 2006, we incurred $12.8 million of costs under the Manufacturing Agreement, Amended Manufacturing Agreement and Amendment.

PharmaForm

In June 2003, we entered into a license agreement with PharmaForm. Under this agreement, as amended, we were granted an exclusive, worldwide, royalty-bearing license to develop, make and sell products that contain hormones or that are used to treat urologic disorders incorporating PharmaForm’s oral transmucosal film technology for which there is an issued patent in the U.S. The term of this license agreement is for the life of the licensed patents.

In February 2005, we entered into an additional license agreement with PharmaForm. Under this agreement, we were granted exclusive, worldwide royalty-bearing rights to develop, manufacture and market eight compounds using PharmaForm’s proprietary transmucosal film technology for the management of pain, including acute and chronic pain. The term of this license agreement continues on a product by product and country by country basis until the later of ten years after the first commercial sale or last to expire patent covering the licensed technology. The compounds that may be developed include opioids as well other types of analgesics. In 2005, we paid an up-front payment of $0.5 million and could make up to an additional $21.2 million in contingent milestone payments if all underlying events for these eight products occur. In addition, we will have on-going royalty payment obligations to PharmaForm. The timing of the remaining payments, if any, is uncertain.

We entered into a research and development agreement with PharmaForm on a fee for service basis. We will be the sole owner of any intellectual property rights developed in connection with this agreement. Through December 31, 2006, we incurred $5.4 million under the research and development agreement.

Bayer

In December 2006, we mutually agreed with Bayer to terminate our exclusive marketing and distribution agreement to commercialize Testim in Canada with no payments made from either party related to the termination. Non-refundable up-front and milestone fees collected under this agreement amounted to $0.6 million.

Ipsen

We entered into a license and distribution agreement with Ipsen in March 2004. This agreement is exclusive and royalty-bearing for the longer of ten years from the date of first commercial sale by country or the life of the Bentley patent, including any newly issued patents. The European patent that we license from Bentley for Testim expired in November 2006. Bentley has filed a patent application in the U.S., Europe and Japan, which, if issued, could provide additional patent protection for Testim. Ipsen is a European pharmaceutical company with a worldwide commercial presence and a strong urology focus. Under this agreement, we granted Ipsen an

12

Table of Contents

exclusive license to use and sell Testim on a worldwide basis outside the U.S., Canada, Mexico and Japan. The terms of this agreement require Ipsen to purchase all Testim supply from us or exercise their conditional option for a technology transfer and to make up-front, milestone and royalty payments. Future milestone payments will be due upon regulatory approval, product launch in various countries and supply price reductions. The royalty payments are based on net product revenue and are similar to royalty payments due to Bentley.

Through December 31, 2006, we have collected $11.7 million in up-front and milestone fees from Ipsen. We can potentially collect up to an additional $5.3 million in milestone fees under the Ipsen collaboration. The timing of these payments, if any, is uncertain.

We do not expect sales of Testim outside of the U.S. pursuant to our current collaboration agreements to have a material impact on our revenues or profitability. We believe that the primary benefit of these agreements is the demonstration of our global development and commercialization capabilities to future licensors, as well as providing us with up-front and milestone payments and opportunities for manufacturing efficiencies through increased sales of Testim.

Oscient Pharmaceuticals

In April 2005, we entered into a co-promotion agreement (the Oscient Agreement) with Oscient. The Oscient Agreement provided that Oscient would have the exclusive right to co-promote Testim to primary care physicians in the U.S. using its 300-person sales force, while we would continue to promote Testim using our specialty sales force that calls on urologists, endocrinologists and select primary care physicians. Oscient’s compensation for its services was based on a specified percentage of gross profit from Testim sales attributable to primary care physicians in the U.S. (the “Oscient co-promotion fees”). In addition, we and Oscient agreed to utilize a joint marketing and promotion plan and to share equally in such expenses. The initial term of the Oscient Agreement extended to April 30, 2007. On September 1, 2006, we entered into a letter agreement with Oscient which sets forth the terms and conditions upon which we and Oscient mutually agreed to terminate the Oscient Agreement prior to the expiration of its initial term. Pursuant to the Termination Agreement, we paid Oscient the sum of $1.8 million for the early termination and the Oscient Agreement terminated at the close of business on August 31, 2006, with certain specified provisions surviving termination, and Oscient ceased all promotion activities related to Testim at that time. Under the Oscient Agreement, we paid a total of $8.0 million in Oscient co-promotion fees.

Competition

We face competition in North America, Europe and elsewhere from larger pharmaceutical companies, specialty pharmaceutical companies and biotechnology firms, universities and other research institutions and government agencies that are developing and commercializing pharmaceutical products. Many of our competitors have substantially greater resources than we have and subsequently may develop products that are more effective, safer or less costly than any that have been or are being developed by us or that are generics. Our success will depend on our ability to acquire, develop and commercialize products and our ability to establish and maintain markets for Testim or any products for which we receive marketing approval.

AndroGel

The primary competition for Testim in the TRT market is AndroGel, marketed by Solvay Pharmaceuticals, Inc., or Solvay. Solvay has the advantage of having launched AndroGel three years prior to Testim. Watson Pharmaceuticals, Inc., or Watson, began co-promoting AndroGel with Solvay in late 2006, and Par Pharmaceutical Companies, Inc., or Par, began co-promoting AndroGel in early 2007. Solvay and its co-promotion partners collectively have more than 600 sales representatives detailing AndroGel. According to IMS, as of December 31, 2006, AndroGel accounted for 81.7% of the gel prescriptions, although this share declined each quarter in 2006, while Testim’s share of the gel market increased.

13

Table of Contents

Other Delivery Options

Testim also competes with other TRTs such as injectables, patches, orals and a buccal tablet. The injectables have maintained presence in the market due to the low cost compared to the transdermal options. There are also a significant number of patients who prefer getting a shot every two to three weeks instead of utilizing a daily application of another product. Physicians perceive the disadvantage of the injectables as being the fact that many patients’ testosterone levels rise past the normal barrier of 1000 ng/dl which leads to a wide flux of levels in a patient and the potential for side effects such as gynecomastia. Androderm is a transdermal testosterone patch marketed by Watson. Androderm is the leading patch product and accounted for approximately 9% of total TRT prescriptions in December of 2006. The number of Androderm prescriptions has decreased. We believe this trend may be due to the number of patients who experience skin rash. The buccal therapy retains less than 1% share in the market as of December 31, 2006.

Generic Competition

In July 2003, Watson and Par filed abbreviated new drug applications, or ANDAs, with the FDA to be approved as generics for AndroGel. In response to these ANDAs, Solvay filed patent infringement lawsuits against these two companies to block the approval and marketing of the generic products. In 2006, all the subject companies reached an agreement pursuant to which no generic to AndroGel will enter the market until 2015. During this time frame, Solvay, Watson and Par will co-promote AndroGel. Any generic for AndroGel will not be a generic for Testim, since Testim is BX rated (or non-substitutable) with AndroGel. Other pharmaceutical companies may develop generic versions of any products that we commercialize that are not subject to patent protection or other proprietary rights. Governmental and other cost containment pressures may result in physicians writing prescriptions for these generic products.

Future Delivery Options

In addition to potential generic competition, several other pharmaceutical companies have TRT products in development that may be approved for marketing in the U.S. MacroChem Corp. has developed a testosterone gel that is currently in phase I studies. Ardana plc, a U.K. company, has announced plans to develop a testosterone cream for the U.S. market. Indevus Pharmaceuticals, Inc. has licensed a long acting testosterone injection that is currently marketed in Europe under the trade name, Nebido. We believe that this product could be launched in the U.S. in 2008 if approved by the FDA. This product may enhance compliance with some patients and should be considered as competition to Testim if it were to launch. Another potential introduction into the marketplace is an oral therapy, called Androxal, from Repros Therapeutics, or Repros. This molecule is designed to restore normal testosterone production in males rather than externally replacing testosterone like the current alternatives. According to Repros, an additional phase III study was requested by the FDA and this study should be started in late 2006 or early 2007. Other new treatments are being sought for TRT, including a new class of drugs called Selective Androgen Receptor Modulators, or SARMs. These products are in development and their future impact on the treatment of testosterone deficiency is unknown.

Finally, we face extensive competition in the acquisition or in-licensing of pharmaceutical products to enhance our portfolio of products. A number of more established companies, which have strategies to in-license or acquire products, may have competitive advantages, as may other emerging companies taking similar or different approaches to product acquisitions. In addition, a number of established research-based pharmaceutical and biotechnology companies may acquire products in late stages of development to augment their internal product lines. These established companies may have a competitive advantage over us due to their size, resources and experience.

Government Regulation

Government authorities in the U.S., at the federal, state, and local level, and foreign countries extensively regulate, among other things, the following areas relating to our products and product candidates:

14

Table of Contents

All of our products require regulatory approval by government agencies prior to commercialization. In particular, human therapeutic products are subject to rigorous preclinical and clinical trials to demonstrate safety and efficacy and other approval procedures of the FDA and similar regulatory authorities in foreign countries. Various federal, state, local, and foreign statutes and regulations also govern testing, manufacturing, labeling, distribution, storage and record-keeping related to such products and their promotion and marketing. The process of obtaining these approvals and the compliance with federal, state, local, and foreign statutes and regulations require the expenditure of substantial time and financial resources. In addition, the current regulatory and political environment at FDA could lead to increased testing and data requirements which could impact regulatory timelines and costs.

We have received marketing approval for Testim for the indication of hypogonadism in the U.S., the U.K., Belgium, Denmark, Finland, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain and Sweden. Approval in the specified European countries was via the Mutual Recognition Procedure. In May 2006, we received marketing approval for Testim in Canada. In Europe, Testim has been launched in Belgium, Denmark, Finland, Germany, Greece, Ireland, Italy, Luxembourg, The Netherlands, Portugal, Spain, Sweden, and the U.K. None of our other product candidates has received marketing approval.

U.S. Government Regulation

In the U.S., the FDA regulates drugs under the Federal Food, Drug, and Cosmetic Act and implementing regulations. If we fail to comply with the applicable requirements at any time during the product development process, approval process, or after approval, we may become subject to administrative or judicial sanctions. These sanctions could include:

Any agency enforcement action could have a material adverse effect on us.

Currently there is a substantial amount of congressional and administration review of the FDA and the regulatory approval process for drug candidates in the U.S. As a result, there may be significant changes made to the regulatory approval process in the U.S.

The steps required before a drug may be marketed in the U.S. include:

15

Table of Contents

Preclinical studies generally are conducted in laboratory animals to evaluate the potential safety and activity of a product. Violation of the FDA’s good laboratory practices regulations can, in some cases, lead to invalidation of the studies, requiring these studies to be replicated. In the U.S., drug developers submit the results of preclinical trials, together with manufacturing information and analytical and stability data, to the FDA as part of the IND, which must become effective before clinical trials can begin in the U.S. An IND becomes effective 30 days after receipt by the FDA unless before that time the FDA raises concerns or questions about the proposed clinical trials outlined in the IND. In that case, the IND sponsor and the FDA must resolve any outstanding FDA concerns or questions before clinical trials can proceed. If these concerns or questions are unresolved, the FDA may not allow the clinical trials to commence.

Clinical trials involve the administration of the investigational product candidate or approved products to human subjects under the supervision of qualified investigators. Clinical trials are conducted under protocols detailing, among other things, the objectives of the study, the parameters to be used in assessing the safety and the effectiveness of the drug. Typically, clinical evaluation involves a time-consuming and costly three-phase sequential process, but the phases may overlap. Each trial must be reviewed, approved and conducted under the auspices of an independent institutional review board, and each trial must include the patient’s informed consent. The following sets forth a brief description of the typical phases of clinical trials:

16

Table of Contents

Clinical testing may not be completed successfully within any specified time period, if at all. The FDA closely monitors the progress of each of the first three phases of clinical trials that are conducted in the U.S. and may, at its discretion, reevaluate, alter, suspend or terminate the testing based upon the data accumulated to that point and the FDA’s assessment of the risk/benefit ratio to the patient. The FDA can also provide specific guidance on the acceptability of protocol design for clinical trials. The FDA or we may suspend or terminate clinical trials at any time for various reasons, including a finding that the subjects or patients are being exposed to an unacceptable health risk. The FDA can also request additional clinical trials be conducted as a condition to product approval. During all clinical trials, physicians monitor the patients to determine effectiveness and to observe and report any reactions or other safety risks that may result from use of the drug candidate.

Assuming successful completion of the required clinical trial, drug developers submit the results of preclinical studies and clinical trials, together with other detailed information including information on the chemistry, manufacture and control of the product, to the FDA, in the form of an NDA or BLA, requesting approval to market the product for one or more indications. In most cases, the NDA/BLA must be accompanied by a substantial user fee. The FDA reviews an NDA/BLA to determine, among other things, whether a product is safe and effective for its intended use.

Before approving an application, the FDA will inspect the facility or facilities where the product is manufactured. The FDA will not approve the application unless cGMP compliance is satisfactory. The FDA will issue an approval letter if it determines that the application, manufacturing process and manufacturing facilities are acceptable. If the FDA determines that the application, manufacturing process or manufacturing facilities are not acceptable, it will outline the deficiencies in the submission and will often request additional testing or information. Notwithstanding the submission of any requested additional information, the FDA ultimately may decide that the application does not satisfy the regulatory criteria for approval and refuse to approve the application by issuing a “not approvable” letter.

The testing and approval process requires substantial time, effort and financial resources, which may take several years to complete. The FDA may not grant approval on a timely basis, or at all. We may encounter difficulties or unanticipated costs in our efforts to secure necessary governmental approvals, which could delay or preclude us from marketing our products. Furthermore, the FDA may prevent a drug developer from marketing a product under a label for its desired indications or place other conditions, including restrictive labeling, on distribution as a condition of any approvals, which may impair commercialization of the product. After approval, some types of changes to the approved product, such as adding new indications, manufacturing changes and additional labeling claims, are subject to further FDA review and approval.

If the FDA approves the new drug application or biologics application, the drug can be marketed to physicians to prescribe in the U.S. After approval, the drug developer must comply with a number of post-approval requirements, including delivering periodic reports to the FDA (i.e., annual reports), submitting descriptions of any adverse reactions reported, biological product deviation reporting, and complying with drug sampling and distribution requirements. The holder of an approved NDA/BLA is required to provide updated safety and efficacy information and to comply with requirements concerning advertising and promotional labeling. Also, quality control and manufacturing procedures must continue to conform to cGMP after approval. Drug manufacturers and their subcontractors are required to register their facilities and are subject to periodic unannounced inspections by the FDA to assess compliance with cGMP which imposes procedural and documentation requirements relating to manufacturing, quality assurance and quality control. Accordingly, manufacturers must continue to expend time, money and effort in the area of production and quality control to

17

Table of Contents

maintain compliance with cGMP and other aspects of regulatory compliance. The FDA may require post-market testing and surveillance to monitor the product’s safety or efficacy, including additional studies to evaluate long-term effects.

In addition to studies requested by the FDA after approval, a drug developer may conduct other trials and studies to explore use of the approved drug for treatment of new indications, which require submission of a supplemental or new NDA and FDA approval of the new labeling claims. The purpose of these trials and studies is to broaden the application and use of the drug and its acceptance in the medical community.

We use, and will continue to use, third-party manufacturers to produce our products in clinical and commercial quantities. Future FDA inspections may identify compliance issues at our facilities or at the facilities of our contract manufacturers that may disrupt production or distribution, or require substantial resources to correct. In addition, discovery of problems with a product or the failure to comply with requirements may result in restrictions on a product, manufacturer or holder of an approved NDA/BLA, including withdrawal or recall of the product from the market or other voluntary or FDA-initiated action that could delay further marketing. Newly discovered or developed safety or effectiveness data may require changes to a product’s approved labeling, including the addition of new warnings and contraindications. Also, new government requirements may be established that could delay or prevent regulatory approval of our products under development.

The Controlled Substances Act imposes various registration, record-keeping and reporting requirements, procurement and manufacturing quotas, labeling and packaging requirements, security controls, prescription and order form requirements and restrictions on prescription refills on some kinds of pharmaceutical products. A principal factor in determining the particular requirements of this act, if any, applicable to a product is its actual or potential abuse profile. A pharmaceutical product may be listed as a Schedule I, II, III, IV or V substance, with Schedule I substances considered to present the highest risk of substance abuse and Schedule V substances the lowest. Testosterone, the active drug substance in Testim, has been scheduled under the Controlled Substances Act as a Schedule III substance. All regular Schedule III drug prescriptions must be signed by a physician and may not be refilled. Furthermore, the amount of Schedule III substances we can obtain for clinical trials and commercial distribution is limited by the DEA, and our quota may not be sufficient to complete clinical trials or meet commercial demand, if any. In addition to federal scheduling, Testim is subject to state-controlled substance regulation and may be placed in more restrictive schedules than those determined by the U.S. Drug Enforcement Agency and the FDA. However, to date, testosterone has not been placed in a more restrictive schedule by any state.

Foreign Regulation

Whether or not we obtain FDA approval for a product, we must obtain approval of a clinical trial or product by the comparable regulatory authorities of foreign countries before we can commence clinical trials or marketing of the product in those countries. The approval process varies from country to country, and the time may be longer or shorter than that required for FDA approval. The requirements governing the conduct of clinical trials, product licensing, pricing and reimbursement also vary greatly from country to country. Although governed by the applicable country’s regulations, clinical trials conducted outside of the U.S. typically are administered with the three-phase sequential process that is discussed above under “U.S. Government Regulation.” However, the foreign equivalent of an IND is not a prerequisite to performing pilot studies or phase I clinical trials.

Under European Union, or E.U., regulatory systems, we may submit marketing authorization applications either under centralized or decentralized procedures. The centralized procedure which is available for medicines produced by biotechnology or which are highly innovative, provides for the grant of a single marketing authorization that is valid for all E.U. member states. This authorization is a marketing authorization approval. Two decentralized procedures exist as alternatives for approval of products that are not obligated to be submitted by the centralized procedure. The first is the Mutual Recognition procedure, or MRP, which provides for mutual

18

Table of Contents

recognition of national approval decisions. Under this procedure, the holder of a national marketing authorization for a product may submit an application to the remaining member states. Within 90 days of receiving the applications and assessment report, each member state must decide whether to recognize approval. The second procedure, the Decentralized Procedure, was newly established in 2005. This procedure is available to products that have not been approved anywhere in the E.U. The application is submitted simultaneously in the reference member state chosen by the applicant and in as many other member states as required. The reference member state carries out the main assessment and consults with the other member states during the process. Like the MRP, approval via this process results in national marketing approvals in the territories where scientific approval was received. All products, irrespective of the route of filing, are afforded 10 years of market exclusivity and eight years of data protection. An additional year of market exclusivity, providing a total of 11 years of market exclusivity, can be obtained for products on approval of an additional indication where that indication represents a significant clinical benefit and significant pre-clinical or clinical studies were carried out in support of the additional indication.

We received approval for Testim in the U.K. in June 2003. A mutual recognition application based on the U.K. approval was initiated in March 2004. The procedure was completed in June 2004 and resulted in scientific approval in the following 14 additional countries: Belgium, Denmark, Finland, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain and Sweden. Marketing approvals have been issued in each of these countries. Testim has been launched in Belgium, Denmark, Finland, Germany, Greece, Ireland, Italy, Luxembourg, The Netherlands, Portugal, Spain, Sweden, and the UK. In addition, in May 2006, we received marketing approval for Testim in Canada.

Furthermore, regulatory approval of prices is required in most countries other than the U.S. We face the risk that the resulting prices would be insufficient to generate an acceptable return to us or our collaborators.

Fraud and Abuse Laws

We are subject to various federal and state laws pertaining to health care fraud and abuse, including anti-kickback laws, false claims laws and physician self-referral laws. Violations of these laws are punishable by criminal, civil and/or administrative sanctions, including, in some instances, imprisonment and exclusion from participation in federal and state health care programs, including Medicare, Medicaid and veterans’ health programs. Because of the far-reaching nature of these laws, there can be no assurance that the occurrence of one or more violations of these laws would not result in a material adverse effect on our business, financial condition and results of operations.

Anti-Kickback Laws. Our operations are subject to federal and state anti-kickback laws. Certain provisions of the Social Security Act prohibit entities such as us from knowingly and willingly offering, paying, soliciting or receiving any form of remuneration (including any kickbacks, bribe or rebate) in return for the referral of items or services for which payment may be made under a federal health care program, or in return for the recommendation, arrangement, purchase, lease or order of items or services for which payment may be made under a federal health care program. Violation of the federal anti-kickback law is a felony, punishable by criminal fines and imprisonment for up to five years or both. In addition, the Department of Health and Human Services may impose civil penalties and exclude violators from participation in federal health care programs such as Medicare and Medicaid. Many states have adopted similar prohibitions against payments intended to induce referrals of products or services paid by Medicaid or other third party payors.

Physician Self-Referral Laws. We also may be subject to federal and/or state physician self-referral laws. Federal physician self-referral legislation (known as the Stark law) prohibits, subject to certain exceptions, a physician from referring Medicare or Medicaid patients to an entity to provide designated health services, including, among other things, certain radiology and radiation therapy services and clinical laboratory services in which the physician or a member of his immediate family has an ownership or investment interest or has entered into a compensation arrangement. The Stark law also prohibits the entity receiving the improper referral from

19

Table of Contents

billing any good or service furnished pursuant to the referral. The penalties for violations include a prohibition on payment by these government programs and civil penalties of as much as $15,000 for each improper referral and $100,000 for participation in a circumvention scheme. Various state laws also contain similar provisions and penalties.

False Claims. The federal False Claims Act imposes civil and criminal liability on individuals or entities who submit (or cause the submission of) false or fraudulent claims for payment to the government. Violations of the federal False Claims Act may result in penalties equal to three times the damages which the government sustained, an assessment of between $5,000 and $10,000 per claim, civil monetary penalties and exclusion from participation in the Medicare and Medicaid programs.

The federal False Claims Act also allows a private individual to bring a qui tam suit on behalf of the government against an individual or entity for violations of the False Claims Act. In a qui tam suit, the private plaintiff is responsible for initiating a lawsuit that may eventually lead to the government recovering money of which it was defrauded. After the private plaintiff has initiated the lawsuit, the government must decide whether to intervene in the lawsuit and become the primary prosecutor. In the event the government declines to join the lawsuit, the private plaintiff may choose to pursue the case alone, in which case the private plaintiff’s counsel will have primary control over the prosecution (although the government must be kept apprised of the progress of the lawsuit). In return for bringing the suit on the government’s behalf, the statute provides that the private plaintiff is entitled to receive up to 30% of the recovered amount from the litigation proceeds if the litigation is successful plus reasonable expenses and attorneys fees. Recently, the number of qui tam suits brought against entities in the health care industry has increased dramatically. In addition, a number of states have enacted laws modeled after the False Claims Act that allow those states to recover money which was fraudulently obtained from the state.

Other Fraud and Abuse Laws. The Health Insurance Portability and Accountability Act of 1996 created, in part, two new federal crimes: Health Care Fraud and False Statements Relating to Health Care Matters. The Health Care Fraud statute prohibits the knowing and willful execution of a scheme or artifice to defraud any health care benefit program. A violation of the statute is a felony and may result in fines and/or imprisonment. The False Statements statute prohibits knowingly and willfully falsifying, concealing or covering up a material fact by any trick, scheme or device or making any materially false, fictitious or fraudulent statement in connection with the delivery of or payment for health care benefits, items or services. A violation of this statute is a felony and may result in fines and/or imprisonment.

There are also several new state laws that require the reporting and disclosure of gifts or other value given to health care providers. We also comply with specific state laws which require the posting of our compliance plan and the reporting of certain expenditures on healthcare providers.

Compliance Program

The healthcare laws and fraud and abuse laws applicable to our business are complex and subject to variable interpretations. We maintain certain compliance, review, education and training and other programs to further our commitment to high standards of ethical and legal conduct and to minimize the likelihood that we would engage in conduct or enter into arrangements in violation of applicable authorities. For example, we have (i) established a compliance team consisting of representatives from our Legal, Human Resources and Regulatory Affairs/Quality Assurance departments that meets regularly; (ii) established a compliance hotline that permits our employees to report anonymously any compliance issues that may arise; and (iii) instituted other safeguards intended to help prevent any violations of the applicable fraud and abuse laws and healthcare laws, and to remediate any situations that could give rise to violations. We also review our transactions and agreements, both past and present, to help assure they are compliant.

20

Table of Contents

Through our compliance efforts, we constantly strive to structure our business operations and relationships with our customers to comply with all applicable legal requirements. However, it is possible that governmental entities or other third parties could interpret these laws differently and assert non-compliance with respect to our business operations and relationships including these isolated arrangements. While there have been no claims asserted against us, if a claim were asserted and we were not to prevail, possible penalties and sanctions could have a material effect on our financial statements or our ability to conduct our operations.

Third-party Reimbursement and Pricing Controls

In the U.S. and elsewhere, sales of pharmaceutical products depend in significant part on the availability of reimbursement to the consumer from third-party payors, such as government and private insurance plans. To date, we have not experienced any problems with third-party payors; however, third-party payors increasingly are challenging the prices charged for medical products and services. It is, and will be, time consuming and expensive for us to go through the process of seeking reimbursement from Medicaid, Medicare and private payors. Our products may not be considered cost effective, and coverage and reimbursement may not be available or sufficient to allow us to sell our products on a competitive and profitable basis. The passage of the Medicare Prescription Drug and Modernization Act of 2003 imposes new requirements for the distribution and pricing of prescription drugs through Medicare which may affect the marketing of our products. We elected to participate in the newly enacted Medicare Part D program at the beginning of 2006. The impact that this program will have on Testim may take several more months to determine as the competitive environment develops. We feel given the age of the population that suffers from hypogonadism that more men will have access to this therapy than previously.

In many foreign markets, including the countries in the E.U., pricing of pharmaceutical products is subject to governmental control. In the U.S., there have been, and we expect that there will continue to be, a number of federal and state proposals to implement similar governmental pricing control. While we cannot predict whether such legislative or regulatory proposals will be adopted, the adoption of such proposals could have a material adverse effect on our business, financial condition and profitability.

Patents and Proprietary Rights

Our success will depend in part on our ability to protect our existing products and the products we acquire or in-license by obtaining and maintaining a strong proprietary position both in the U.S. and in other countries. To develop and maintain such a position, we intend to continue relying upon patent protection, trade secrets, know-how, continuing technological innovations and licensing opportunities. In addition, we intend to seek patent protection whenever available for any products or product candidates and related technology we develop or acquire in the future.

Bentley. We have licensed the underlying technology for Testim, our only approved product, from Bentley. The patent that we license from Bentley for Testim expires in June 2008 in the U.S. and in January 2010 in Canada and has expired in Europe and Japan. This patent covers methods and compositions for administering drugs, such as testosterone, across the skin and mucus membranes. Bentley has submitted a patent application in the U.S. for an additional formulation patent for Testim that, if issued, would provide us with further market protection around the world until approximately 2023, with a potential for patent term adjustment to 2025. Bentley also has submitted a patent application to the European Patent Office, or EPO. Bentley also has submitted a patent application in Japan that is awaiting examination. In July 2005, an additional patent covering Testim issued in Canada, and this patent is included in our license from Bentley. This patent expires in 2023. Testosterone, the active ingredient in Testim, does not have patent protection and is included in competing TRT products.

BioSpecifics. We licensed AA4500, our product candidate for the treatment of Dupuytren’s contracture and Peyronie’s disease as well as Frozen Shoulder syndrome, from BioSpecifics. In addition to the marketing

21

Table of Contents

exclusivity which comes with its orphan drug status as a treatment for Dupuytren’s contracture and Peyronie’s disease, the enzyme underlying this product candidate is covered by two use patents in the U.S., one for the treatment of Dupuytren’s contracture and one for the treatment of Peyronie’s disease. The Dupuytren’s patent expires in 2014, and the Peyronie’s patent expires in 2019. The patent relating to Dupuytren’s contracture is the subject of a reissue application in the U. S. Patent and Trademark Office, or USPTO, for, among other things, the purpose of submitting prior art that was not previously submitted during the prosecution of the Dupuytren’s patent. As a result, the patent may or may not be allowed by the USPTO, and therefore, may or may not be valid and enforceable. Both patents are limited to the use of the enzyme for the treatment of Dupuytren’s contracture and Peyronie’s disease within certain dose ranges. While we believe that dose optimization trials will demonstrate that effective dosing will fall within the patented range, currently, there is not enough data to establish whether the ultimate approved product will be covered by the patents. Foreign patents also cover these products in certain countries. In January 2005, a patent application was filed with regard to AA4500 for the treatment of Frozen Shoulder syndrome. If this patent is granted, it would expire in 2026. In January 2006, we filed a patent application with regard to the manufacturing process for AA4500; if this patent is granted, it would expire in January 2027.

PharmaForm. We have licensed the transmucosal film technology for our overactive bladder and pain product candidates from PharmaForm. The U.S. patent that we license from PharmaForm expires in 2020. We have filed three patent applications in the U.S. covering this technology. If patents issue from these applications, they would expire in 2026.

The scope of the intellectual property rights held by pharmaceutical firms involves complex legal, scientific and factual questions and consequently is generally uncertain. In addition, the coverage claimed in a patent application can be significantly reduced before the patent is issued. Consequently, we do not know whether any of our current patent applications, or the products or product candidates we develop, acquire or license will result in the issuance of patents or, if any patents are issued, whether they will provide significant proprietary protection or will be challenged, circumvented or invalidated. Because patent applications in the U.S. and some other jurisdictions are sometimes maintained in secrecy until patents issue, and since publication of discoveries in the scientific or patent literature often lags behind actual discoveries, we cannot be certain of the priority of inventions covered by pending patent applications. Moreover, we may have to participate in interference proceedings declared by the USPTO or a foreign patent office to determine priority of invention, or in opposition proceedings in a foreign patent office, either of which could result in substantial cost to us, even if the eventual outcome is favorable to us. There can be no assurance that the patents, if issued and challenged, in a court of competent jurisdiction would be found valid or enforceable. An adverse outcome could subject us to significant liabilities to third parties, require disputed rights to be licensed from third parties or require us to cease using such technology.

Although we believe these patent applications, if they issue as patents, will provide a competitive advantage, the patent positions of pharmaceutical and biotechnology companies are highly uncertain and involve complex legal and factual questions. We may not be able to develop patentable products or processes and may not be able to obtain patents from pending applications. Even if patent claims are allowed, the claims may not issue, or in the event of issuance, may not be sufficient to protect our technology. In addition, any patents or patent rights we obtain may be circumvented, challenged or invalidated by our competitors.

While we attempt to ensure that our product candidates and the methods we employ to manufacture them do not infringe other parties’ patents and proprietary rights, competitors or other parties may assert that we infringe on their proprietary rights. Additionally, because patent prosecution can proceed in secret prior to issuance of a patent, third parties may obtain other patents without our knowledge prior to the issuance of patents relating to our product candidates which they could attempt to assert against us.

Although we believe that our product candidates, production methods and other activities do not currently infringe the intellectual property rights of third parties, we cannot be certain that a third party will not challenge

22

Table of Contents

our position in the future. If a third party alleges that we are infringing its intellectual property rights, we may need to obtain a license from that third party, but there can be no assurance that any such license will be available on acceptable terms or at all. Any infringement claim that results in litigation could result in substantial cost to us and the diversion of management’s attention away from our core business and could also prevent us from marketing our products. To enforce patents issued to us or to determine the scope and validity of other parties’ proprietary rights, we may also become involved in litigation or in interference proceedings declared by the USPTO, which could result in substantial costs to us or an adverse decision as to the priority of our inventions. We may be involved in interference and/or opposition proceedings in the future. We believe there will continue to be litigation in our industry regarding patent and other intellectual property rights.

We also rely on trade secret protection for our confidential and proprietary information. No assurance can be given that others will not independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets or disclose such technology or that we can meaningfully protect our trade secrets.

It is our policy to require our employees, consultants, outside scientific collaborators, sponsored researchers and other advisors to execute confidentiality agreements upon the commencement of employment or consulting relationships with us. These agreements provide that all confidential information developed or made known to the individual during the course of the individual’s relationship with us is to be kept confidential and not disclosed to third parties except in specific circumstances. In the case of employees, the agreements provide that all inventions conceived by the individual shall be our exclusive property. There can be no assurance, however, that these agreements will provide meaningful protection or adequate remedies for our trade secrets in the event of unauthorized use or disclosure of such information.

Orphan Drug Status

The Orphan Drug provisions of the Federal Food, Drug, and Cosmetic Act provide incentives to drug and biologics suppliers to develop and supply drugs for the treatment of rare diseases, currently defined as diseases that affect fewer than 200,000 individuals in the U.S. or, for a disease that affects more than 200,000 individuals in the U.S. and for which there is no reasonable expectation that the cost of developing and making available in the U.S. a drug for such disease or condition will be recovered from its sales in the U.S. Under these provisions, a supplier of a designated orphan product can seek tax benefits, and the holder of the first FDA approval of a designated orphan product will be granted a seven-year period of marketing exclusivity for that product for the orphan indication. The marketing exclusivity of an orphan drug would prevent other sponsors from obtaining approval of the same drug for the same indication except under limited circumstances. It would not prevent other drugs from being approved for the same indication.

The FDA granted orphan drug status to AA4500 in the U.S. for each of the treatments of Dupuytren’s contracture and Peyronie’s disease. The designations for the treatment of Dupuytren’s contracture and Peyronie’s disease have been transferred to us. Orphan drug status means that, if AA4500 is the first product to receive FDA approval for the orphan indications, another application to market the same drug for the same indication may not be approved, except in limited circumstances, for a period of up to seven years in the U.S.

The Hatch-Waxman Act

Under the U.S. Drug Price Competition and Patent Term Restoration Act of 1984, known as the Hatch-Waxman Act, newly approved drugs and indications benefit from a statutory period of non-patent marketing exclusivity. The Hatch-Waxman Act provides five-year marketing exclusivity to the first applicant to gain approval of an NDA for a new chemical entity, meaning that the FDA has not previously approved any other new drug containing the same active ingredient. The Hatch-Waxman Act prohibits an abbreviated new drug application, or ANDA, where the applicant does not own or have a legal right of reference to all the data required for approval, to be submitted by another company for another version of such drug during the five-year exclusive

23

Table of Contents

period. Protection under the Hatch-Waxman Act will not prevent the filing or approval of another full NDA, however, the applicant would be required to conduct its own pre-clinical, adequate and well-controlled clinical trials to demonstrate safety and effectiveness. The Hatch-Waxman Act also provides three years of marketing exclusivity for the approval of new NDAs with new clinical trials for previously approved drugs and supplemental NDAs, for example, for new indications, dosages, or strengths of an existing drug, if new clinical investigations are essential to the approval. This three-year exclusivity covers only the new changes associated with the supplemental NDA and does not prohibit the FDA from approving ANDAs for drugs containing the original active ingredient or indications.

The Hatch-Waxman Act also permits a patent extension term of up to five years as compensation for patent term lost during product development and the FDA regulatory review process. However, patent extension cannot extend the remaining term of a patent beyond a total of 14 years. The patent term restoration period is generally one-half the time between the effective date of an IND and the submission date of an NDA, plus the time between the submission date of an NDA and the approval of that application. Only one patent applicable to an approved drug is eligible for the extension and it must be applied for prior to expiration of the patent. The USPTO, in consultation with the FDA, reviews and approves the application for patent term extension.

Employees

As of December 31, 2006, we had 269 full-time employees and 9 part-time employees. We believe that our relations with our employees are good and we have no history of work stoppages. Generally, our employees are at-will employees. However, we have entered into employment agreements with certain of our executive officers.

Available Information

We file annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission, or SEC. You may read and copy any document we file with the SEC at the SEC’s public reference room at 100 F. Street, N.E., Washington, D.C. 20549, at prescribed rates. Please call the SEC at 1-800-SEC-0330 for further information on the public reference room. You may also obtain our SEC filings free of charge from the SEC’s Internet Web site at www.sec.gov.

Our Internet Web site address is www.auxilium.com. We make available free of charge through our Web site’s “Investor Relations” page most of our filings with the SEC, including our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and other information. These reports and information are available as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC.

Our Board of Directors has various committees including an audit and compliance committee, compensation committee and nominating and corporate governance committee. Each of these committees has a formal charter. We also have Corporate Governance Guidelines and a Code of Conduct. Copies of these charters, guidelines and codes, and any waivers or amendments to such codes which are applicable to our executive officers, senior financial officers or directors, can be obtained free of charge from our Web site. The references to our Web site and the SEC’s Web site are intended to be inactive textual references only, and the contents of those Web sites are not incorporated by reference herein.

In addition, you may request a copy of the foregoing filings, charters, guidelines and codes, and any waivers or amendments to such codes which are applicable to our executive officers, senior financial officers or directors, at no cost by writing us at the following address or telephoning us at the following telephone number:

Auxilium Pharmaceuticals, Inc.

40 Valley Stream Parkway

Malvern, PA 19355

Attention: Investor Relations

Telephone: (484) 321-5900

24

Table of Contents

In addition to the other information included in this Report, the following factors should be considered in evaluating our business and future prospects. Any of the following risks, either alone or taken together, could materially and adversely affect our business, financial position or results of operations. If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, our actual results may vary materially from what we projected. There may be additional risks that we do not presently know or that we currently believe are immaterial which could also impair our business or financial position.

Risks Related to Our Financial Results and Need for Additional Financing

We have incurred significant losses since our inception and may not achieve profitability in the foreseeable future.

We have incurred significant losses since our inception, including net losses of $45.9 million for the twelve months ended December 31, 2006. As of December 31, 2006, we had an accumulated deficit of $183.5 million. We expect to continue to incur substantial expenses, including milestone payments, as we:

Accordingly, we expect to continue to incur substantial additional losses for the foreseeable future. In order to achieve and maintain profitability, we will need to generate significantly greater revenues from Testim and any other product candidate for which we receive marketing approval. As a result, we are unsure when we will become profitable, if at all. If we fail to achieve profitability within the time frame expected by investors, the value of our common stock may decline substantially.

Because we have a limited operating history, our future results are unpredictable, and therefore, our common stock is a highly speculative investment.

We commenced operations in the fourth quarter of 1999 and have a limited operating history for you to evaluate our business. Accordingly, you must consider our prospects in light of the risks and difficulties encountered by companies in their early stages. The risks and difficulties that we may encounter include:

25

Table of Contents

All of our revenues to date have been generated from the sale or out-licensing of Testim, and, if these revenues do not grow, and we cannot commercialize new products, we will not become profitable.

Our only product with marketing approval is Testim and our product revenues to date have been generated solely from the sale and out-licensing of Testim. Until such time as we develop, acquire or in-license additional products that are approved for marketing, we will continue to rely on Testim for all of our revenues. Accordingly, our success depends significantly on our ability to increase sales of Testim. Our sales and marketing efforts may not be successful in increasing prescriptions for Testim. Sales of Testim are subject to the following risks, among others:

For the foreseeable future, if we are unable to grow Testim sales and out-licensing revenues, we will be unable to increase our revenues or achieve profitability and we may be forced to delay or change our current plans to develop other product candidates.

If we are unable to meet our needs for additional funding in the future, we may be required to limit, scale back or cease our operations.

Our operations to date have generated substantial and increasing needs for cash. Our negative cash flows from operations are expected to continue for at least the foreseeable future. Our strategy contains elements that we will not be able to execute without outside funding. Specifically, we may need to raise additional capital to:

We believe that our existing cash resources and interest on these funds will be sufficient to meet our anticipated operating requirements until at least March 2008. Our future funding requirements will depend on many factors, including:

26

Table of Contents

These factors could result in variations from our currently projected operating and liquidity requirements. If our existing resources are insufficient to satisfy our liquidity requirements, we may need to borrow money or sell additional equity or debt securities. We may not be able to borrow money on commercially reasonable terms. Moreover, the terms of the sale of any equity or debt securities may not be acceptable to us and could result in substantial dilution of your investment. If we are unable to obtain this additional financing, we may be required to:

Our revenues, operating results and cash flows may fluctuate in future periods and we may fail to meet investor expectations, which may cause the price of our common stock to decline.

Variations in our quarterly operating results are difficult to predict and may fluctuate significantly from period to period. We are a relatively new company and our sales prospects are uncertain. We have been selling Testim, our only approved product, since the first quarter of 2003 and cannot predict with certainty the timing or level of sales of Testim in the future. If our quarterly sales or operating results fall below the expectations of investors or securities analysts, the price of our common stock could decline substantially. In addition to the

27

Table of Contents

other factors discussed under these “Risk Factors,” specific factors that may cause fluctuations in our operating results include:

Forecasting our revenues is further complicated by difficulties in estimating inventory levels at our wholesaler and chain drug store customers, prescription levels, the timing of purchases by wholesalers and retailers to replenish inventory and the occurrence and amount of product returns.

As a result of these factors, we believe that period-to-period comparisons of our operating results are not a good indication of our future performance.

Risks Related to Development of Our Product Candidates

We may not be able to develop product candidates into viable commercial products, which would impair our ability to grow and could cause a decline in the price of our stock.

The process of developing product candidates involves a high degree of risk and may take several years. Product candidates that appear promising in the early phases of development may fail to reach the market for several reasons, including:

28

Table of Contents

Success in preclinical and early clinical trials does not ensure that large-scale clinical trials will be successful. Clinical results are frequently susceptible to varying interpretations that may delay, limit or prevent regulatory approvals. The length of time necessary to complete clinical trials and to submit an application for marketing approval for a final decision by a regulatory authority varies significantly and may be difficult to predict. Currently, there is substantial congressional and administration review of the regulatory approval process for drug candidates in the U.S. Any changes to the U.S. regulatory approval process could significantly increase the timing or cost of regulatory approval for our product candidates making further development uneconomical or impossible.

In addition, developing product candidates is very expensive and will have a significant impact on our ability to generate profits. Factors affecting our product development expenses include:

Our product development efforts also could result in large and immediate write-offs, significant milestone payments, incurrence of debt and contingent liabilities or amortization of expenses related to intangible assets, any of which could negatively impact our financial results. Additionally, if we are unable to develop our product candidates into viable commercial products, we may remain reliant solely on Testim sales for our revenues, potentially limiting our growth opportunities. In October 2006, we decided to discontinue the development of the current formulation of TestoFilm™, our testosterone replacement transmucosal film product candidate for the treatment of hypogonadism and reallocate resources to our lead development project, AA4500. Based on an evaluation, we determined that the current formulation of TestoFilm did not meet certain critical aspects of the target product profile and, as a result, would not be commercially viable.

If clinical trials for our product candidates are delayed, we would be unable to commercialize our product candidates on a timely basis, which could materially harm our business.

Clinical trials that we may conduct may not begin on time or may need to be restructured or temporarily suspended after they have begun. Clinical trials can be delayed or may need to be restructured for a variety of reasons, including delays or restructuring related to:

29

Table of Contents

Prior to commencing clinical trials in the U.S., we must have an effective IND for each of our product candidates. An IND has been filed and is effective for AA4500 for the treatment of Dupuytren’s contracture, AA4500 for the treatment of Peyronie’s disease, and AA4500 for the treatment of Frozen Shoulder syndrome; however, INDs have not been filed for AA4010 or our pain transmucosal film product candidates. We will not be able to commence clinical trials in the U.S. for these product candidates until we file, and the FDA fails to object to, an IND for each candidate.

We have four projects in clinical development, specifically AA4500 for the treatment of Dupuytren’s contracture, Peyronie’s disease and Frozen Shoulder syndrome, and AA4010. Completion of clinical trials for each product candidate will be required before commercialization. In December 2006, we suspended the dosing of patients in our ongoing phase III trials for AA4500 for the treatment of Dupuytren’s contracture in response to an issue related to the manufacture of clinical supplies. If we experience delays in, or termination of, clinical trials, or fail to resume clinical trials in a timely manner or if the cost or timing of the regulatory approval process increases, our financial results and the commercial prospects for our product candidates will be adversely impacted. In addition, our product development costs would increase and our ability to generate additional revenue from new products could be impaired.

Adverse events or lack of efficacy in our clinical trials may force us to stop development of our product candidates or prevent regulatory approval of our product candidates, which could materially harm our business.

Patients participating in the clinical trials of our product candidates may experience serious adverse health events. A serious adverse health event includes death, a life-threatening condition, hospitalization, disability, congenital anomaly, or a condition requiring intervention to prevent permanent impairment or damage. The occurrence of any of these events could interrupt, delay, suspend or halt clinical trials of our product candidates and could result in the FDA, or other regulatory authorities, denying approval of our product candidates for any or all targeted indications. An institutional review board or independent data safety monitoring board, the FDA, other regulatory authorities or we may suspend or terminate clinical trials at any time. Our product candidates may prove not to be safe for human use. Any delay in the regulatory approval of our product candidates could increase our product development costs and allow our competitors additional time to develop or market competing products. If our product candidates do not receive the necessary regulatory approval, we may remain reliant on sales of Testim as our sole source of revenue.

Our failure to successfully in-license or acquire additional technologies, product candidates or approved products could impair our ability to grow.

We intend to in-license, acquire, develop and market additional products and product candidates so that we are not solely reliant on Testim sales for our revenues. Because we have limited internal research capabilities, we

30

Table of Contents

are dependent upon pharmaceutical and biotechnology companies and other researchers to sell or license products or technologies to us. The success of this strategy depends upon our ability to identify, select and acquire the right pharmaceutical product candidates, products and technologies. To date, we have in-licensed the formulation technology underlying Testim from Bentley, the transmucosal film technology underlying AA4010 and pain transmucosal film product candidates from PharmaForm, and the enzyme underlying AA4500 from BioSpecifics.

We may not be able to successfully identify any other commercial products or product candidates to in-license, acquire or internally develop. Moreover, negotiating and implementing an economically viable in-licensing arrangement or acquisition is a lengthy and complex process. Other companies, including those with substantially greater resources, may compete with us for the in-licensing or acquisition of product candidates and approved products. We may not be able to acquire or in-license the rights to additional product candidates and approved products on terms that we find acceptable, or at all. If we are unable to in-license or acquire additional commercial products or product candidates, we may be reliant solely on Testim sales for revenues. As a result, our ability to grow our business or increase our profits could be severely limited.

If we engage in any acquisition, we will incur a variety of costs, and we may never realize the anticipated benefits of the acquisition.

Since our inception, we have acquired the underlying technology for Testim and all of our product candidates through in-licensing arrangements. The underlying technology for Testim was licensed from Bentley. The transmucosal film technology underlying AA4010 and the pain product candidates was licensed from PharmaForm. AA4500, our product candidate for Dupuytren’s contracture, Peyronie’s disease and Frozen Shoulder syndrome, was licensed from BioSpecifics. One of our strategies for business expansion is the acquisition of additional products and product candidates. We may attempt to acquire these product candidates, or other potentially beneficial technologies, through in-licensing or the acquisition of businesses, services or products that we believe are a strategic fit with our business. If we undertake an acquisition, the process of integrating any newly acquired business, technology, service or product into our existing operations could be expensive and time consuming and may result in unforeseen operating difficulties and expenditures and may divert significant management attention from our ongoing business operations. Moreover, we may fail to realize the anticipated benefits of any acquisition for a variety of reasons, such as an acquired product candidate proving to not be safe or effective in later clinical trials or not reaching its forecasted commercial potential. We may fund any future acquisition by issuing equity or debt securities, which could dilute your ownership percentage or limit our financial or operating flexibility as a result of restrictive covenants related to new debt. Acquisition efforts can consume significant management attention and require substantial expenditures, which could detract from our other programs. In addition, we may devote resources to potential acquisitions that are never completed. If we are unable to acquire and successfully integrate product candidates through in-licensing or the acquisition of businesses, services or products, we may remain reliant solely on Testim sales for revenue. In pursuing our acquisition strategy, we have expended significant management time, consulting costs and legal expenses without consummating a transaction.

Risks Related to Regulatory Approval of Our Product Candidates

We are subject to numerous complex regulatory requirements and failure to comply with these regulations, or the cost of compliance with these regulations, may harm our business.

The testing, development, manufacture and distribution of our products are subject to regulation by numerous governmental authorities in the U.S., Europe and elsewhere. These regulations govern or affect the testing, manufacture, safety, labeling, storage, record-keeping, approval, distribution, advertising and promotion of Testim and our product candidates, as well as safe working conditions and the experimental use of animals. Noncompliance with any applicable regulatory requirements can result in refusal of the government to approve facilities for testing or manufacture of products as well as refusal to approve products for commercialization.

31

Table of Contents

Noncompliance with any applicable regulatory requirements also can result in criminal prosecution and fines, recall or seizure of products, total or partial suspension of production, prohibitions or limitations on the commercial sale of products or refusal to allow the entering into of federal and state supply contracts. FDA and comparable governmental authorities have the authority to withdraw product approvals that have been previously granted. Currently, there is a substantial amount of congressional and administrative review of the FDA and the regulatory approval process for drug candidates in the U.S. As a result, there may be significant changes made to the regulatory approval process in the U.S. In addition, the regulatory requirements relating to the manufacturing, testing, labeling, promotion, marketing and distribution of our products may change in the U.S. or the other jurisdictions in which we may have obtained or be seeking regulatory approval for our products or product candidates. Such changes may increase our costs and adversely affect our operations.

Testosterone is listed by the U.S. Drug Enforcement Agency, or DEA, as a Schedule III substance under the Controlled Substances Act of 1970. The DEA classifies substances as Schedule I, II, III, IV or V substances, with Schedule I substances considered to present the highest risk of substance abuse and Schedule V substances the lowest risk. Our pain transmucosal film product candidates may also involve the use of scheduled substances. Scheduled substances are subject to DEA regulations relating to manufacturing, storage, distribution and physician prescription procedures. For example, all regular Schedule III drug prescriptions must be signed by a physician and may not be refilled. Furthermore, the amount of Schedule III substances we can obtain for clinical trials and commercial distribution is limited by the DEA and our quota may not be sufficient to complete clinical trials or meet commercial demand, if any.

Entities must be registered annually with the DEA to manufacture, distribute, dispense, import, export and conduct research using controlled substances. State controlled substance laws also require registration for similar activities. In addition, the DEA requires entities handling controlled substances to maintain records and file reports, follow specific labeling and packaging requirements, and provide appropriate security measures to control against diversion of controlled substances. Failure to follow these requirements can lead to significant civil and/or criminal penalties and possibly even lead to a revocation of a DEA registration.

Products containing controlled substances may generate public controversy. As a result, these products may have their marketing rights or regulatory approvals withdrawn. Political pressures and adverse publicity could lead to delays in, and increased expenses for, and limit or restrict the introduction and marketing of our product candidates. For some scheduled substances or any product, the FDA may require us to develop a comprehensive risk management program to reduce the inappropriate use of our products and product candidates, including the manner in which they are marketed and sold, so as to reduce the risk of improper patient selection and diversion or abuse of the product. Developing such a program in consultation with the FDA may be a time-consuming process and could delay approval of any of our product candidates. Such a program or delays of any approval from the FDA could increase our product development costs and may allow our competitors additional time to develop or market competing products.

Additionally, failure to comply with or changes to the regulatory requirements that are applicable to Testim or our other product candidates may result in a variety of consequences, including the following:

32

Table of Contents

If our product candidates are not demonstrated to be sufficiently safe and effective, they will not receive regulatory approval and we will be unable to commercialize them.

Other than Testim, all of our other product candidates are in preclinical or clinical development and have not received regulatory approval from the FDA or any foreign regulatory authority. An IND has been filed and is effective for AA4500 for the treatment of Dupuytren’s contracture, AA4500 for the treatment of Peyronie’s disease, and AA4500 for the treatment of Frozen Shoulder syndrome; however, INDs have not been filed for AA4010 or our pain transmucosal film product candidates. The regulatory approval process typically is extremely expensive, takes many years and the timing or likelihood of any approval cannot be accurately predicted.

As part of the regulatory approval process, we must conduct preclinical studies and clinical trials for each product candidate to demonstrate safety and efficacy. The number of preclinical studies and clinical trials that will be required varies depending on the product candidate, the indication being evaluated, the trial results and regulations applicable to any particular product candidate.

The results of preclinical studies and initial clinical trials of our product candidates do not necessarily predict the results of later-stage clinical trials. Product candidates in later stages of clinical trials may fail to show the desired safety and efficacy despite having progressed through initial clinical trials. We cannot assure you that the data collected from the preclinical studies and clinical trials of our product candidates will be sufficient to support FDA or other regulatory approval. In addition, the continuation of a particular study after review by an institutional review board or independent data safety monitoring board does not necessarily indicate that our product candidate will achieve the clinical endpoint.

The FDA and other regulatory agencies can delay, limit or deny approval for many reasons, including:

Any delay in, or failure to receive, approval for any of our product candidates or the failure to maintain regulatory approval for Testim could prevent us from growing our revenues or achieving profitability.

Our corporate compliance program cannot guarantee that we are in compliance with all potentially applicable regulations.

We are a relatively small company and we rely heavily on third parties to conduct many important functions. As a biopharmaceutical company, we are subject to a large body of legal and regulatory requirements.

33

Table of Contents

In addition, as a publicly traded company we are subject to significant regulations, including the Sarbanes-Oxley Act of 2002, or SOA, some of which have either only recently been adopted or are currently proposals subject to change. We cannot assure you that we are or will be in compliance with all potentially applicable laws and regulations. Failure to comply with all potentially applicable laws and regulations could lead to the imposition of fines, cause the value of our common stock to decline, impede our ability to raise capital or lead to the de-listing of our stock.

Our controls over external financial reporting may fail or be circumvented.

We regularly review and update our internal controls, disclosure controls and procedures, and corporate governance policies. In addition, we are required under SOA to report annually on our internal control over financial reporting. If we, or our independent registered public accounting firm, determine that our internal control over financial reporting is not effective, this shortcoming could have an adverse effect on our business and financial results and the price of our common stock could be negatively affected. This new reporting requirement could also make it more difficult or more costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. Any system of internal controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the controls and procedures or failure to comply with regulation concerning control and procedures could have a material effect on our business, results of operation and financial condition. The impact of these events could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, our board committees and as executive officers.

Risks Related to Commercialization

If medical doctors do not prescribe our products or the medical profession or patients do not accept our products, our ability to grow or maintain our revenues will be limited.

Our business is dependent on market acceptance of our products by physicians, healthcare payors, patients and the medical community. Medical doctors’ willingness to prescribe, and patients’ willingness to accept, our products depend on many factors, including:

Even though we have received regulatory approval for Testim, and even if we receive regulatory approval and satisfy the above criteria for any of our other product candidates, physicians may not prescribe, and patients may not accept, our products if we do not promote our products effectively. Factors that could affect our success in marketing our products include:

34

Table of Contents

If any of our products or product candidates fails to achieve market acceptance, we may not be able to market and sell the products successfully, which would limit our ability to generate revenue and could harm our business.

If testosterone replacement therapies are perceived to create or create health risks, our sales of Testim may decrease and our operations may be harmed.

Recent studies of female hormone replacement therapy products have reported an increase in health risks. As a result of such studies, some companies that sell or develop female hormone replacement products have experienced decreased sales of these products, and in some cases, a decline in the value of their stock. Publications have, from time to time, suggested potential health risks associated with TRT. Potential health risks are described in various articles, including a 2002 article published in Endocrine Practice and a 1999 article published in the International Journal of Andrology. The potential health risks detailed are fluid retention, sleep apnea, breast tenderness or enlargement, increased red blood cells, development of clinical prostate disease, including prostate cancer, increased cardiovascular disease risk and the suppression of sperm production. It is possible that studies on the effects of TRT could demonstrate these or other health risks. This, as well as negative publicity about the risks of hormone replacement therapy, including TRT, could adversely affect patient or prescriber attitudes and impact Testim sales. In addition, investors may become concerned about these issues and decide to sell our common stock. These factors could adversely affect our business and the price of our common stock.

Testim competes in a very competitive market, and if we are unable to compete effectively with the other companies that produce products for the treatment of urologic or sexual health disorders, our ability to generate revenues will be limited.

The pharmaceutical industry is highly competitive. Our success will depend on our ability to acquire, develop and commercialize products and our ability to establish and maintain markets for Testim or any products for which we receive marketing approval. Potential competitors in North America, Europe and elsewhere include major pharmaceutical companies, specialty pharmaceutical companies and biotechnology firms, universities and other research institutions and government agencies. The primary competition for Testim is AndroGel^®, marketed by Solvay and its co-promotion partners. AndroGel was launched approximately three years before Testim. Testim also competes with other forms of testosterone replacement therapies such as oral treatments, patches, injectables and a buccal tablet. Androderm^® is a transdermal testosterone patch marketed by Watson Pharmaceuticals, Inc., or Watson. Many of our competitors have more substantial resources, than we do. Accordingly, our competitors may:

Additional mergers, acquisitions and strategic alliances in the pharmaceutical industry may result in even more resources being concentrated in our competitors. Competition may increase further as a result of advances made in the commercial applicability of technologies and greater availability of capital for investment in these fields. In addition, other companies are developing other new treatments for hypogonadism, including a new gel, a testosterone cream, a long-acting testosterone injection, an oral therapy, new isomer of an old product for centrally mediated treatment of primary hypogonadism, as well as a new class of drugs called Selective Androgen Receptor Modulators (SARMs). These products are in development and their future impact on the treatment of testosterone deficiency is unknown.

35

Table of Contents

If other pharmaceutical companies develop generic versions of any products that compete with our commercialized products or any of our products, our business may be adversely affected.

Other pharmaceutical companies may develop generic versions of any products that compete with our commercialized products or any of our products that are not subject to patent protection or other proprietary rights. For example, because the ingredients of Testim are commercially available to third parties, it is possible that competitors may design formulations, propose dosages or develop methods of administration that would be outside the scope of the claims of one or more, or of all, of the patent rights that we in-license. This would enable their products to effectively compete with Testim. Governmental and other pressures to reduce pharmaceutical costs may result in physicians writing prescriptions for these generic products. Increased competition from the sale of competing generic pharmaceutical products could cause a material decrease in revenue from our products.

The primary competition for Testim is AndroGel, marketed by Solvay, and its co-promotion partners. According to public announcements by Solvay, Watson and Par Pharmaceutical Companies, Inc., pursuant to separate settlements of patent litigation in September 2006, no generic to AndroGel will be sold until 2015. Any generic for AndroGel will not be a generic for Testim, since Testim is BX rated (or non-substitutable) with AndroGel. Other pharmaceutical companies may develop generic versions of any products that we commercialize that are not subject to patent protection or other proprietary rights. Governmental and other cost containment pressures may result in physicians writing prescriptions for these generic products.

If third-party payors do not reimburse customers for Testim or any of our product candidates that are approved for marketing, they might not be used or purchased, and our revenues and profits will not grow.

Our revenues and profits depend heavily upon the availability of coverage and reimbursement for the use of Testim, and any of our product candidates that are approved for marketing, from third-party healthcare and state and federal government payors, both in the U.S. and in foreign markets. Reimbursement by a third-party payor may depend upon a number of factors, including the third-party payor’s determination the product is:

Since reimbursement approval for a product is required from third-party and government payors, seeking this approval, particularly when seeking approval for a preferred form of reimbursement over other competitive products, is a time-consuming and costly process. Third-party payors may require cost-benefit analysis data from us in order to demonstrate the cost-effectiveness of any product we might bring to market. For any individual third-party payor, we may not be able to provide data sufficient to gain reimbursement on a similar or preferred basis to competitive products or at all. Once reimbursement at an agreed level is approved by a third-party payor, we may lose that reimbursement entirely or we may lose the similar or better reimbursement we receive compared to competitive products. As reimbursement is often approved for a period of time, this risk is greater at the end of the time period, if any, for which the reimbursement was approved. To date, we have not experienced any problems with third-party payors. This does not mean that we will not experience any problems with third-party payors in the future. We do not know what the impact of changes to reimbursement programs, including Medicare Part D, might be.

International commercialization of Testim and our product candidates faces significant obstacles.

As with Testim, we may commercialize some of our product candidates internationally on our own or through collaborative relationships with foreign partners. We have limited foreign regulatory, clinical and

36

Table of Contents

commercial resources. We may not be able to enter into collaboration agreements with appropriate partners for important foreign markets on acceptable terms, or at all. Future collaborations with foreign partners may not be effective or profitable for us.

Healthcare reform measures could adversely affect our business.

The business and financial condition of pharmaceutical companies is affected by the efforts of governmental and third-party payors to contain or reduce the costs of healthcare. In the U.S. and in foreign jurisdictions there have been, and we expect that there will continue to be, a number of legislative and regulatory proposals aimed at changing the healthcare system. For example, in some countries other than the U.S., pricing of prescription drugs is subject to government control, and we expect proposals to implement similar controls in the U.S. to continue. In particular, in January 2006, new Medicare prescription drug coverage legislation (Medicare Part D) was implemented. The prescription drug program established by this legislation and future amendments or regulatory interpretations of the legislation could have the effect of reducing the prices that we are able to charge for any products we develop and sell through these plans. This prescription drug legislation and related amendments or regulations could also cause third-party payors other than the federal government, including the states under the Medicaid program, to discontinue coverage for Testim or any products we develop or to lower reimbursement amounts that they pay. The impact that this program will have on Testim will take more time to determine as the competitive environment develops.

Further federal, state and foreign healthcare proposals and reforms are likely. While we cannot predict the legislative or regulatory proposals that will be adopted or what effect those proposals may have on our business, including the future reimbursement status of any of our product candidates, the pendency or approval of such proposals could result in a decrease in our stock price or limit our ability to raise capital or to obtain strategic partnerships or licenses.

We could be negatively impacted by future interpretation or implementation of federal and state fraud and abuse laws, including anti-kickback laws, false claims laws and federal and state anti-referral laws.

We are subject to various federal and state laws pertaining to health care fraud and abuse, including anti-kickback laws, false claims laws and physician self-referral laws. Violations of these laws are punishable by criminal and/or civil sanctions, including, in some instances, imprisonment and exclusion from participation in federal and state health care programs, including Medicare, Medicaid, Department of Defense and Veterans’ health programs. We have not been challenged by a governmental authority under any of these laws and believe that our operations are in compliance with such laws.

However, because of the far-reaching nature of these laws, we may be required to alter one or more of our practices to be in compliance with these laws. Health care fraud and abuse regulations are complex, and even minor, inadvertent irregularities can potentially give rise to claims that the law has been violated. Any violations of these laws could result in a material adverse effect on our business, financial condition and results of operations. If there is a change in law, regulation or administrative or judicial interpretations, we may have to change our business practices or our existing business practices could be challenged as unlawful, which could have a material adverse effect on our business, financial condition and results of operations.

We could become subject to false claims litigation under federal or state statutes, which can lead to civil money penalties, criminal fines and imprisonment, and/or exclusion from participation in federal health care programs. These false claims statutes include the federal False Claims Act, which allows any person to bring suit alleging the false or fraudulent submission of claims for payment under federal programs or other violations of the statute and to share in any amounts paid by the entity to the government in fines or settlement. Such suits, known as qui tam actions, have increased significantly in recent years and have increased the risk that companies like us may have to defend a false claim action. We could also become subject to similar false claims litigation under state statutes. If we are unsuccessful in defending any such action, such action may have a material adverse effect on our business, financial condition and results of operations.

37

Table of Contents

If product liability lawsuits are brought against us, we may incur substantial liabilities.

The commercialization of Testim and the clinical testing, manufacture and commercialization of our product candidates, if approved, involves significant exposure to product liability claims. We have clinical trial and product liability insurance that covers Testim and the clinical trials of our other product candidates that we believe is adequate in both scope and amount and has been placed with what we believe to be reputable insurers. We are self-insured for the first $1.0 million of liability under these policies. Our product liability policies have been written on a claims-made basis. If any of our product candidates are approved for marketing, we may seek additional coverage. We cannot predict all of the adverse health events that Testim or our product candidates may cause. As a result, our current and future coverages may not be adequate to protect us from all the liabilities that we may incur. If losses from product liability claims exceed our insurance coverage, we may incur substantial liabilities that exceed our financial resources. Whether or not we are ultimately successful in product liability litigation, such litigation could consume substantial amounts of our financial and managerial resources, and might result in adverse publicity, all of which would impair our business. We may not be able to maintain our clinical trial insurance or product liability insurance at an acceptable cost, if at all, and this insurance may not provide adequate coverage against potential claims or losses. If we are required to pay a product liability claim, we may not have sufficient financial resources and our business and results of operations may be harmed.

We may be exposed to liability claims associated with the use of hazardous materials and chemicals.

Our research and development activities and our commercial product, Testim, involve the use of testosterone and large amounts of alcohol which are classified as hazardous materials and chemicals. AA4500, our product candidate for the treatment of Dupuytren’s contracture, Peyronie’s disease and Adhesive Capsulitis, or Frozen Shoulder syndrome, is a biologic product. Biologic products may present a manufacturing health hazard due to risk of infection with the bacterial cell line used to produce the product or with potential bacteriophage contamination with the fermentation. Although we believe that our safety procedures for using, storing, handling, manufacturing and disposing of these materials comply with federal, state and local laws and regulations, we cannot completely eliminate the risk of accidental injury or contamination from these materials. In the event of such an accident, we could be held liable for any resulting damages and any liability could materially adversely affect our business, financial condition and results of operations. In addition, the federal, state and local laws and regulations governing the use, manufacture, storage, handling and disposal of hazardous or radioactive materials and waste products may require us to incur substantial compliance costs that could materially adversely affect our business and financial condition. To our knowledge, we have not been the subject of any investigation by any agency or authority for failure to comply with any rules or regulations applicable to hazardous materials or chemicals. We do not maintain specific insurance for the handling of biological, hazardous and radioactive materials. We have contracts with third-party providers for the storage and disposal of hazardous waste and believe that any claims against us in these areas would be the responsibility of these third parties. However, we may be held responsible for these claims despite the fact that we have contracted with third parties for the storage and disposal of hazardous waste. If we are exposed to these types of claims, we could be held responsible for liabilities that exceed our financial resources, which could severely affect our operations.

Risks Related to the Manufacture of AA4500

We have limited experience in manufacturing pharmaceutical products and may encounter difficulties in the manufacture of the active ingredient of AA4500 at our facility in Horsham, Pennsylvania which could materially adversely affect our results of operations or delay or disrupt our development timelines for AA4500.

The manufacture of pharmaceutical products requires significant expertise and capital investment. Although we leased our facility in Horsham in order to have direct control over the manufacturing of the active ingredient of AA4500, we have limited experience in manufacturing AA4500 or any other pharmaceutical product. We may encounter difficulties with the manufacture of the active ingredient of AA4500 which could materially adversely affect our results of operations or delay or disrupt our development timelines for AA4500. These problems may include:

38

Table of Contents

Furthermore, our manufacturing operations expose us to a variety of significant risks, including:

If we are unable to gain regulatory approval for AA4500, we may not have an alternate use for our Horsham facility but will be required to make payments under our lease.

We have entered into a lease for our facility in Horsham, which expires on January 1, 2017. If we are unable to gain regulatory approval for AA4500, we may not have an alternate use for the manufacturing facility but will be required to make payments under our lease. As of December 31, 2006, the future minimum lease payments of this lease during its initial noncancellable term total approximately $23.7 million.

Our Horsham facility is subject to regulatory oversight, which may delay or disrupt our development and commercialization efforts for AA4500.

We must ensure that all of the processes, methods, equipment and facilities employed in the manufacture of AA4500 at our Horsham facility are compliant with the current Good Manufacturing Practices (cGMP). The cGMP requirements govern quality control of the manufacturing process and documentation policies and procedures. Compliance with cGMP requires record keeping and quality control to assure that the clinical and commercial product meets applicable specifications and other requirements. Our Horsham facility will be subject to inspection by regulatory agencies upon the manufacture of AA4500 that is used in a clinical trial or the filing for approval of AA4500 with regulatory authorities. If an inspection by regulatory authorities indicates that there are deficiencies including non-compliance with regulatory requirements, we could be required to take remedial actions, stop production or close our Horsham facility, which would disrupt the manufacturing processes, limit the supplies of AA4500 and delay clinical trials and subsequent licensure. If we fail to comply with these requirements, we may not be permitted to sell our products or may be limited in the jurisdictions in which we are permitted to sell them.

Following approval of AA4500 for commercialization and licensure of our Horsham facility, noncompliance with any applicable regulatory requirements may result in refusal by regulatory authorities to allow use of AA4500 made at our Horsham facility in clinical trials, refusal of the government to allow distribution of AA4500 for commercialization, criminal prosecution and fines, recall or seizure of products, total or partial suspension of production, prohibitions or limitations on the commercial sale of products or refusal to allow the entering into of federal and state supply contracts.

39

Table of Contents

Risks Related to Our Dependence on Third-Party Manufacturers and Service Providers

Since we currently rely on third-party manufacturers and suppliers, we may be unable to control the availability or cost of manufacturing our products, which could adversely affect our results of operations.

We currently do not manufacture Testim or any of our product candidates, except for the active ingredient for AA4500. Testim is manufactured for us by DPT Laboratories, Ltd., or DPT, under a contract that expires on December 31, 2010. We have qualified a back-up supplier to manufacture Testim.

Although we manufacture the active ingredient for AA4500, we have contracted with Cobra Biologics Ltd., or Cobra, for the production of our clinical supply of AA4500, our product candidate for the treatment of Dupuytren’s contracture, Peyronie’s disease and Frozen Shoulder syndrome.

The manufacture of pharmaceutical products requires significant expertise and capital investment. DPT, Cobra, our back-up supplier for Testim, or any other third-party manufacturer may encounter difficulties in production. These problems may include:

DPT, PharmaForm, Cobra, or any of our other third-party manufacturers may not perform as agreed or may terminate its agreement with us, which would adversely impact our ability to produce and sell Testim or our ability to produce AA4500 or other product candidates for clinical trials. The number of third-party manufacturers with the expertise, required regulatory approvals and facilities to manufacture bulk drug substance on a commercial scale is limited, and it would take a significant amount of time to arrange and receive regulatory approval for alternative arrangements. We may not be able to contract for the manufacturing of Testim or any of our product candidates on acceptable terms, if at all, which would materially impair our business.

Any of these factors could increase our costs and result in us being unable to effectively commercialize or develop our products. Furthermore, if DPT, our back-up supplier for Testim or any other third-party manufacturer fails to deliver the required commercial quantities of finished product on a timely basis and at commercially reasonable prices, we may be unable to meet the demand for our products and we may lose potential revenues.

We rely on a single source supplier and a limited number of suppliers for two of the primary ingredients for Testim and the loss of any of these suppliers could prevent us from selling Testim, which would materially harm our business.

We rely on third-party suppliers for our supply of testosterone and CPD, two key ingredients of Testim. Testosterone is available to us from only two sources. We rely exclusively on one outside source for our supply of CPD. We do not have any agreements with these suppliers regarding these key ingredients. If either of the two sources that produce testosterone stops manufacturing it, or if we are unable to procure testosterone on commercially favorable terms, we may be unable to continue to produce or sell Testim on commercially viable terms, if at all. In addition, if our third-party source of CPD stops manufacturing pharmaceutical grade CPD, or does not make CPD available to us on commercially favorable terms, we may be unable to continue to produce

40

Table of Contents

or sell Testim on commercially viable terms, if at all. Furthermore, the limited number of suppliers of testosterone and CPD may provide such companies with greater opportunity to raise their prices. Any increase in price for testosterone or CPD may reduce our gross margins.

Due to our reliance on contract research organizations or other third parties to assist us in conducting clinical trials, we are unable to directly control all aspects of our clinical trials.

Currently, we rely in part on third parties to conduct our clinical trials for the expansion of Testim and the development of our product candidates. As a result, we have had and will continue to have less control over the conduct of the clinical trials, the timing and completion of the trials and the management of data developed through the trial than would be the case if we were relying entirely upon our own staff. Communicating with outside parties can also be challenging, potentially leading to mistakes as well as difficulties in coordinating activities. Outside parties may:

These factors may adversely affect their willingness or ability to conduct our trials. We may experience unexpected cost increases that are beyond our control. Problems with the timeliness or quality of the work of a contract research organization may lead us to seek to terminate the relationship and use an alternative service provider. However, making this change may be costly and may delay our trials, and contractual restrictions may make such a change difficult or impossible. Our contracts with the contract research organizations on which we currently rely are each terminable upon 30-days prior written notice. If we must replace any of these contract research organizations or any other contract research organization we may use in the future to conduct our clinical trials, our trials may have to be suspended until we find another contract research organization that offers comparable services. The time that it takes us to find alternative organizations may cause a delay in the commercialization of our product candidates or may cause us to incur significant expenses to replicate data that may be lost. Although we do not believe that the contract research organizations on which we rely offer services that are not available elsewhere, it may be difficult to find a replacement organization that can conduct our trials in an acceptable manner and at an acceptable cost. Any delay in or inability to complete our clinical trials could significantly compromise our ability to secure regulatory approval of the relevant product candidate and preclude our ability to commercialize the product, thereby limiting our ability to generate revenue from the sales of products other than Testim, which may result in a decrease in our stock price.

Our third-party manufacturers are subject to regulatory oversight, which may delay or disrupt our development and commercialization efforts.

Third-party manufacturers of our products or product candidates must ensure that all of the processes, methods and equipment are compliant with the current Good Manufacturing Practices, or cGMP, and conduct extensive audits of vendors, contract laboratories and suppliers. The cGMP requirements govern quality control of the manufacturing process and documentation policies and procedures. Compliance by third-party manufacturers with cGMP requires record keeping and quality control to assure that the product meets applicable specifications and other requirements. Manufacturing facilities are subject to inspection by regulatory agencies at any time. If an inspection by regulatory authorities indicates that there are deficiencies, third-party manufacturers could be required to take remedial actions, stop production or close the facility, which would disrupt the manufacturing processes and limit the supplies of Testim or our product candidates. If they fail to comply with these requirements, we also may be required to curtail the clinical trials of our product candidates, which are also supplied by these manufacturers, and may not be permitted to sell our products or may be limited in the jurisdictions in which we are permitted to sell them.

41

Table of Contents

Approximately 93% of our product shipments are to only three customers; if any of these customers refuse to distribute Testim on commercially favorable terms, or at all, our business will be adversely affected.

We sell Testim to wholesale drug distributors and chain drug stores who generally sell products to retail pharmacies, hospitals and other institutional customers. We do not promote Testim to these customers, and they do not determine Testim prescription demand. However, approximately 93% of our product shipments during the period covered by this Report were to only three customers: Cardinal Health, Inc., McKesson Corporation and AmerisourceBergen Corporation. Our business would be harmed if any of these customers refused to distribute Testim or refuse to purchase Testim on commercially favorable terms to us.

It is possible that wholesalers could decide to change their policies or fees, or both, in the future. This could result in their refusal to distribute smaller volume products, or cause higher product distribution costs, lower margins or the need to find alternative methods of distributing products. Such alternative methods may not exist or may not be economically viable.

If we are unable to grow our sales, marketing or distribution capabilities or enter into agreements with third parties to perform some of these functions, we will not be able to grow our business.

As an organization, we have a limited history in sales, marketing and distribution. To directly market and distribute Testim or any of our product candidates which receive regulatory approval, we must continue to enhance our sales and marketing efforts. For our direct sales efforts, we will need to hire additional salespeople in order to grow and manage any turnover that occurs in our sales force. For some market opportunities, we may need to enter into co-promotion agreements or other licensing arrangements with pharmaceutical or biotechnology firms in order to increase the commercial success of our products.

We may not be able to grow our direct sales, marketing and distribution capabilities or enter into future co-promotion or similar licensing arrangements with third parties in a timely manner, or on acceptable terms. To the extent that we enter into future co-promotion or other licensing arrangements, our product revenues may be lower than if we directly marketed and sold our products, and some or all of the revenues we receive will depend upon the efforts of third parties, and these efforts may not be successful or our future partners may not devote sufficient resources to our products. Additionally, building marketing and distribution capabilities may be more expensive than we anticipate, requiring us to divert capital from other intended purposes or preventing us from building our marketing and distribution capabilities to the desired levels.

Risks Related to Intellectual Property

If we breach any of the agreements under which we license commercialization rights to products or technology from others, we could lose license rights that are critical to our business.

We are a party to a number of license agreements by which we have rights to use the intellectual property of third parties that are necessary for us to operate our business. In particular, we have obtained the exclusive right to develop and commercialize Testim pursuant to a license agreement with Bentley. Bentley may unilaterally terminate the agreement if we fail to make payments under this agreement and this failure continues for a period of 30 days following written notice to us by Bentley. If the agreement is properly terminated by Bentley, we may not be able to manufacture or sell Testim.

Additionally, we have obtained exclusive rights to make and sell products that are used for hormone replacement, to treat any type of urologic disorder or as a pain therapy incorporating PharmaForm’s transmucosal film technology. This agreement continues for the life of the licensed patent rights. Either party may terminate this agreement under certain events of bankruptcy or insolvency by the other party. PharmaForm may unilaterally terminate this agreement if:

42

Table of Contents

If our agreement with PharmaForm is properly terminated by PharmaForm, we may not be able to execute our strategy to develop, manufacture or sell transmucosal film products. To the extent that unpatented PharmaForm trade secrets are necessary for the manufacture of the transmucosal product candidates, our license to such trade secrets would expire with the expiration of the licensed patents in 2020 or later and potentially impair our continued commercialization of our transmucosal product candidates thereafter.

We have also obtained exclusive worldwide rights from BioSpecifics to develop, market and sell products, other than dermal formulations labeled for topical administration, that contain BioSpecifics’ enzyme, which we refer to as AA4500, for the treatment of Dupuytren’s contracture, Peyronie’s disease and Frozen Shoulder syndrome. We may expand the agreement, at our option, to license products which contain BioSpecifics’ enzyme for other indications, excluding dermal formulations labeled for topical administration, as they are developed by BioSpecifics or by us. This agreement continues on a product by product and country by country basis until the later of:

Upon expiration of the agreement pursuant to the preceding sentence, we will have a fully paid-up license to the products developed under the agreement. Either party may terminate this agreement in the event of bankruptcy or insolvency by the other party. Additionally, either party may terminate this agreement if the other party is in material breach of its obligations under the agreement which continues for a period of 90 days following receipt of written notice of such material breach. We may terminate this agreement in its entirety, or on a country by country basis, on an indication by indication basis, or on a product by product basis, at any time upon 90 days prior written notice to BioSpecifics. If this agreement is properly terminated by BioSpecifics, we may not be able to execute our strategy to develop and commercialize AA4500 for the treatment of Dupuytren’s contracture, Peyronie’s disease and Frozen Shoulder syndrome or to develop and commercialize future product candidates utilizing BioSpecifics’ enzyme.

We expect to enter into additional licenses in the future. These licenses may impose various development, commercialization, funding, royalty, diligence or other obligations on us. If we breach any of these obligations, the licensor may have the right to terminate the license or render the license non-exclusive, which could make it impossible for us to develop, manufacture or sell the products covered by the license.

Disputes may arise with respect to our licensing agreements regarding manufacturing, development and commercialization of any products relating to our in-licensed intellectual property, including Testim. These disputes could lead to delays in or termination of the development, manufacture and commercialization of Testim or our product candidates or to litigation.

We have only limited patent protection for Testim and our product candidates, and we may not be able to obtain, maintain and protect proprietary rights necessary for the development and commercialization of Testim or our product candidates.

Our business and competitive positions are dependent upon our ability to obtain and protect our proprietary position for Testim and our product candidates in the U.S., Europe and elsewhere. Because of the substantial length of time and expense associated with development of new products, we, along with the rest of the biopharmaceutical industry, place considerable importance on obtaining and maintaining patent protection for new technologies, products and processes. The patent positions of pharmaceutical, biopharmaceutical and

43

Table of Contents

biotechnology companies, including ours, are generally uncertain and involve complex legal and factual questions. Our and our licensors’ patents and patent applications may not protect our technologies and products because, among other things:

We attempt to protect our intellectual property position by filing or obtaining licenses to patent applications and, where appropriate, patent applications in other countries related to our proprietary technology, inventions and improvements that are important to the development of our business. Our PharmaForm transmucosal film product candidates are covered by a formulation patent in the U.S. only. This patent expires in 2020. Testosterone, the active ingredient in Testim, is off-patent and is included in competing TRT products. The U.S. patent that we license from Bentley covers the composition of matter and formulation of Testim and expires in June 2008. The European and Japanese patents that we license from Bentley for Testim expired in November 2006. The Canadian patents that we license from Bentley expire in January 2010. In July 2005, an additional patent covering Testim issued in Canada, and this patent is included in our license from Bentley. This patent expires in 2023. Bentley has filed a new patent application in the U.S., Europe and Japan which, if issued, could provide additional patent protection for Testim.

AA4500 licensed from BioSpecifics is covered by two method of use patents in the U.S., one for the treatment of Dupuytren’s contracture and one for the treatment of Peyronie’s disease. The Dupuytren’s patent expires in 2014, and the Peyronie’s patent expires in 2019. The patents are limited to the use of AA4500 for the treatment of Dupuytren’s contracture and Peyronie’s disease, respectively, with certain dose ranges and/or concentration ranges. The patent relating to Dupuytren’s contracture is the subject of a reissue application in the USPTO for, among other things, the purpose of submitting prior art that was not previously submitted during the prosecution of the Dupuytren’s patent. As a result, the patent may not be allowed by the USPTO, and therefore, may not be valid and enforceable. In January 2005, a patent application was filed with regard to AA4500 for the treatment of Frozen Shoulder syndrome. If this patent is granted, it would expire in 2026. Currently there is not enough data to establish whether any approved product for Dupuytren’s contracture or Peyronie’s disease or Frozen Shoulder syndrome will be covered by these patents. In January 2006, we filed a patent application with regard to the manufacturing process for AA4500; if this patent is granted, it would expire in January 2027.

Foreign patents and pending applications may also cover these products in certain countries depending upon the concentration and dosage ranges of such products. Some countries will not grant patents on patent applications that are filed after the public sale or disclosure of the material claimed in the patent application. The U.S., by contrast, allows a one year grace period after public disclosure in which to file a patent application. Because the European patent application was filed after Testim went on the market in the U.S., our ability to obtain additional patent protection outside of the U.S. may be limited.

The standards that the USPTO and its foreign counterparts use to grant patents are not always applied predictably or uniformly and can change. Limitations on patent protection in some countries outside the U.S., and the differences in what constitutes patentable subject matter in these countries, may limit the protection we seek outside of the U.S. For example, methods of treating humans are not patentable subject matter in many countries outside of the U.S. In addition, laws of foreign countries may not protect our intellectual property to the same

44

Table of Contents

extent as would laws of the U.S. In determining whether or not to seek a patent or to license any patent in a particular foreign country, we weigh the relevant costs and benefits, and consider, among other things, the market potential of our product candidates in the jurisdiction, and the scope and enforceability of patent protection afforded by the law of the jurisdiction. Failure to obtain adequate patent protection for our proprietary product candidates and technology would impair our ability to be commercially competitive in these markets. Accordingly, we do not know the degree of future protection for our proprietary rights or the breadth of claims allowed in any patents issued to us or others.

We intend to seek patent protection whenever it is available for any products or product candidates we acquire in the future. However, any patent applications for future products may not issue as patents, and any patent issued on such products may be challenged, invalidated, held unenforceable or circumvented. Furthermore, the claims in patents which have been issued on products we may acquire in the future may not be sufficiently broad to prevent third parties from commercializing competing products. If we fail to obtain adequate patent protection for our products, our ability to compete could be impaired.

Technology in-licensed by us is important to our business. We may not control the patent prosecution, maintenance or enforcement of our in-licensed technology. Accordingly, we may be unable to exercise the same degree of control over this intellectual property as we would over our internally developed intellectual property. For example, in-licensed patents for which our rights are limited to a particular field of use could be or become licensed in other fields to other licensees and, therefore, become subject to enforcement by such other licensees without our participation. Consequently, such licensed patents could be held invalid or unenforceable or could have claims construed in a manner adverse to our interests in litigation, which we would not control or to which we would not be a party. If any of the intellectual property rights of our licensors is found to be invalid, this could have a material adverse impact on our operations.

If we are not able to protect and control unpatented trade secrets, know-how and other technological innovation, we may suffer competitive harm. We also rely on trade secrets, know-how and technology, which are not protected by patents, to maintain our competitive position. However, trade secrets are difficult to protect. To maintain the confidentiality of trade secrets and proprietary information, we generally seek to enter into confidentiality agreements with our employees, consultants and collaborators upon the commencement of a relationship with us. However, we may not obtain these agreements in all circumstances. Nor can we guarantee that these agreements will provide meaningful protection, that these agreements will not be breached, or that we will have an adequate remedy for any such breach. In addition, adequate remedies may not exist in the event of unauthorized use or disclosure of this information. Others may have developed, or may develop in the future, substantially similar or superior know-how and technology. The loss or exposure of our trade secrets, know-how and other proprietary information, as well as independent development of similar or superior know-how, could harm our operating results, financial condition and future growth prospects. Many of our employees and consultants were, and many of our consultants may currently be, parties to confidentiality agreements with other companies. Although our confidentiality agreements with these employees and consultants require that they do not bring to us, or use without proper authorization, any third party’s proprietary technology, if they violate their agreements, we could suffer claims or liabilities.

We may have to engage in costly litigation to enforce or protect our proprietary technology or to defend challenges to our proprietary technology by our competitors, which may harm our business, results of operations, financial condition and cash flow.

The pharmaceutical field is characterized by a large number of patent filings involving complex legal and factual questions, and, therefore, we cannot predict with certainty whether our licensed patents will be enforceable. Competitors may have filed applications for or have been issued patents and may obtain additional patents and proprietary rights related to products or processes that compete with or are similar to ours. We may not be aware of all of the patents potentially adverse to our interests that may have been issued to others. Litigation may be necessary to protect our proprietary rights, and we cannot be certain that we will have the required resources to pursue litigation or otherwise to protect our proprietary rights.

45

Table of Contents

Competitors may infringe our patents or successfully avoid them through design innovation. To prevent infringement or unauthorized use, we may need to file infringement lawsuits, which are expensive and time-consuming. In particular, if a competitor were to file a paragraph IV certification under the U.S. Drug Price Competition and Patent Term Restoration Act of 1984, known as the Hatch-Waxman Act, in connection with that competitor’s submission to the FDA of an abbreviated new drug application, or ANDA, for approval of a generic version of any of our products for which we believed we held a valid patent, then we would have 45 days in which to initiate a patent infringement lawsuit against such competitor. In any infringement proceeding, a court may decide that a patent of ours is not valid or is unenforceable, may narrow our patent claims or may refuse to stop the other party from using the technology at issue on the grounds that our patents do not cover its technology. If a court so found that one of our patents was invalid or not infringed in an infringement suit under paragraph IV of the Hatch-Waxman Act, then the FDA would be permitted to approve the competitor’s ANDA resulting in a competitive generic product.

Our ability to market our products may be impaired by the intellectual property rights of third parties.

Our commercial success will depend in part on not infringing the patents or proprietary rights of third parties. We are aware of competing intellectual property relating to the TRT gel market. While we currently believe we have freedom to operate in the TRT gel market, others may challenge our position in the future. We are also aware of at least one third-party patent relating to BioSpecifics’ enzyme that may impair BioSpecifics’ freedom to operate in the manufacture of AA4500. We are also aware of third-party patents relating to PharmaForm’s transmucosal film delivery system that may impair PharmaForm’s freedom to operate in the manufacture of product candidates using a transmucosal film delivery system. There has been, and we believe that there will continue to be, significant litigation in the pharmaceutical industry regarding patent and other intellectual property rights.

Third parties could bring legal actions against us claiming damages and seeking to enjoin clinical testing, manufacturing and marketing of the affected product or products. A third party might request a court to rule that the patents we in-license are invalid or unenforceable. In such a case, even if the validity or enforceability of those patents were upheld, a court might hold that the third party’s actions do not infringe the patent we in-license thereby, in effect, limiting the scope of our patent rights. If we become involved in any litigation, it could consume a substantial portion of our resources, regardless of the outcome of the litigation. If any of these actions are successful, in addition to any potential liability for damages, we could be required to obtain a license to continue to manufacture or market the affected product, in which case we may be required to pay substantial royalties or grant cross-licenses to our patents. However, there can be no assurance that any such license will be available on acceptable terms or at all. Ultimately, we could be prevented from commercializing a product, or forced to cease some aspect of our business operations, as a result of patent infringement claims, which could harm our business.

We may not be able to obtain or maintain orphan drug exclusivity for our product candidates, and our competitors may obtain orphan drug exclusivity prior to us, which could significantly harm our business.

Some jurisdictions, including Europe and the U.S., may designate drugs for relatively small patient populations as orphan drugs. The FDA granted orphan drug status to AA4500 in the U.S. for the treatment of Dupuytren’s contracture and Peyronie’s disease. Orphan drug designation must be requested before submitting an application for marketing authorization. Orphan drug designation does not convey any advantage in, or shorten the duration of, the regulatory review and approval process, but does make the product eligible for orphan drug exclusivity and specific tax credits in the U.S. Generally, if a product with an orphan drug designation subsequently receives the first marketing approval for the indication for which it has such designation, the product is entitled to orphan drug exclusivity. Orphan drug exclusivity means that another application to market the same drug for the same indication may not be approved, except in limited circumstances, for a period of up to 10 years in Europe and for a period of seven years in the U.S. Obtaining orphan drug designations and orphan drug exclusivity for our product candidates, including AA4500 for the

46

Table of Contents

treatment of Dupuytren’s contracture and Peyronie’s disease, may be critical to the success of these product candidates. Our competitors may obtain orphan drug exclusivity for products competitive with our product candidates before we do, in which case we would be excluded from that market. Even if we obtain orphan drug exclusivity for any of our product candidates, we may not be able to maintain it. For example, if a competitive product is shown to be clinically superior to our product, any orphan drug exclusivity we have obtained will not block the approval of such competitive product. In addition, even if we obtain orphan drug exclusivity for any of our product candidates, a viable commercial market may never develop and we may never derive any meaningful revenues from the sales of these products.

If Testim or our future products or product candidates infringe the intellectual property of our competitors or other third parties, we may be required to pay license fees or cease these activities and pay damages, which could significantly harm our business.

Even though Testim and our product candidates may be covered by patents, they may nonetheless infringe the patents or violate the proprietary rights of third parties. In these cases, we may be required to obtain-licenses to patents or proprietary rights of others in order to continue to sell and use Testim and develop and commercialize our product candidates. We may not, however, be able to obtain any licenses required under any patents or proprietary rights of third parties on acceptable terms, or at all. Even if we were able to obtain rights to a third party’s intellectual property, these rights may be non-exclusive, thereby giving our competitors potential access to the same intellectual property.

Third parties may assert patent or other intellectual property infringement claims against us, or our licensors or collaborators, with respect to technologies used in potential product candidates. Any claims that might be brought against us relating to infringement of patents may cause us to incur significant expenses and, if successfully asserted against us, may cause us to pay substantial damages. We may not have sufficient resources to effectively litigate these claims. Even if we were to prevail, any litigation could be costly and time-consuming and could divert the attention of our management and key personnel from business operations. In addition, any patent claims brought against our licensors or collaborators could affect their ability to carry out their obligations to us.

Furthermore, if a patent infringement suit were brought against us, or our licensors or collaborators, the development, manufacture or potential sale of product candidates claimed to infringe a third party’s intellectual property may have to cease or be delayed. Ultimately, we may be unable to commercialize one or more of our product candidates, our patent claims may be substantially limited or may have to cease some portion of our operations as a result of patent infringement claims, which could severely harm our business.

Risks Related to Employees and Growth

If we are not able to retain our current management team or attract and retain qualified scientific, technical and business personnel, our business will suffer.

We are dependent on the members of our management team for our business success. In addition, an important element of our strategy is to leverage the development, regulatory and commercialization expertise of our current management in our development activities. Our employment agreements with our executive officers are terminable on short notice or no notice. The loss of key employees may result in a significant loss in the knowledge and experience that we, as an organization, possess and could cause significant delays, or outright failure, in the further commercialization of Testim or the development and commercialization of our product candidates. If we are unable to attract and retain qualified and talented senior management personnel, our business may suffer.

To grow we will need to hire a significant number of qualified commercial, scientific and administrative personnel. However, there is intense competition for human resources, including management in the technical fields in which we operate, and we may not be able to attract and retain qualified personnel necessary for the

47

Table of Contents

successful commercialization of Testim and the development and commercialization of our product candidates. As we grow, the inability to attract new employees when needed or to retain existing employees could severely limit our growth and harm our business.

Changes in the expensing of stock-based compensation have resulted in unfavorable accounting charges and may require us to change our compensation practices. Any change in our compensation practices may adversely affect our ability to attract and retain qualified scientific, technical and business personnel.

We rely heavily on stock options to compensate existing employees and attract new employees. We also have an employee stock purchase plan under which employees can purchase our common stock at a discount. The FASB has announced new rules for recording expense for the fair value of stock options and purchase rights under employee stock purchase plans. As a result of these new rules, commencing on January 1, 2006, we began expensing the fair value of stock options and purchase rights under our employee stock purchase plan, thereby increasing our operating expenses and reported losses. Although we intend to continue to include various forms of equity in our compensation plans, if the extent to which we use forms of equity in our plans is reduced due to the negative effects on earnings, it may be difficult for us to attract and retain qualified scientific, technical and business personnel.

Our operations may be impaired unless we can successfully manage our growth.

As of December 31, 2006, we had 269 full-time and 9 part-time employees. In order to continue to expand Testim’s sales and commercialize our other product candidates, we currently anticipate that we will need to add some managerial, selling, operational, financial and other employees to our existing departments over each of the next two years. Expansion may place a significant strain on our management, operational and financial resources. Moreover, higher than expected market growth of Testim, the acquisition or in-licensing of additional products, as well as the development and commercialization of our other product candidates or marketing arrangements with third parties, could accelerate our hiring needs beyond our current expectations. To manage further growth, we will be required to continue to improve existing, and implement additional, operational and financial systems, procedures and controls, and hire, train and manage additional employees. Our current and planned personnel, systems, procedures and controls may not be adequate to support our anticipated growth and we may not be able to hire, train, retain, motivate and manage required personnel. Our failure to manage growth effectively could limit our ability to achieve our business goals. In addition, our direct sales force consists of relatively newly hired employees. Turnover in our direct sales force or marketing team could adversely affect Testim and future product sales growth.

Risks Related to Stock Market Price

The market price of our common stock is likely to be volatile.

Prior to our initial public offering in July 2004, there was no public market for our common stock. Since our initial public offering, our stock price has, at times, been volatile. We cannot assure you that an active trading market for our common stock will exist at any time. Holders of our common stock may not be able to sell shares quickly or at the market price if trading in our common stock is not active. Substantially all of our outstanding shares of our common stock are eligible for sale in the public market. For the 30 days prior to the end of the period covered by this Report, our average daily trading volume was approximately 321,000 shares. Sales of a substantial number of shares of our common stock in the public market, or the perception in the market that holders of a large number of shares intend to sell shares, could depress the market price of our common stock and impair our ability to raise capital through the sale of additional equity securities, even if our business is doing well. In addition, the market price of our common stock could be subject to wide fluctuations in price in response to various factors, many of which are beyond our control, including:

48

Table of Contents

Furthermore, market prices for securities of pharmaceutical, biotechnology and specialty biopharmaceutical companies have been particularly volatile in recent years. The broad market and industry factors may seriously harm the market price of our common stock, regardless of our operating performance. If any of these risks occurs, it could cause our stock price to fall and may expose us to class action lawsuits that, even if unsuccessful, could be costly to defend and a distraction to management.

If we do not comply with registration rights, we may be required to pay substantial damages to certain holders of our restricted securities.

In June 2005, we entered into securities purchase agreements with certain qualified purchasers pursuant to which we sold an aggregate of 8,242,796 shares of common stock and warrants to purchase an aggregate of 2,060,687 shares of common stock with an exercise price of $5.84 per share in a private placement transaction. As required by the terms of the securities purchase agreements, we filed a registration statement with the SEC in August 2005 to register for resale of the shares of common stock and the shares of common stock issuable upon the exercise of the warrants sold in the private placement. Such registration statement was declared effective by the SEC. Under the terms of the securities purchase agreements, as amended, we are obligated to use our reasonable best efforts to maintain the effectiveness of the registration statement. If we fail to meet this obligation through September 2007, certain holders of our securities may bring breach of contract claims against

49

Table of Contents

us, and even if such suit is without merit, we may incur substantial costs in defending these claims and substantial damages if we are found to be in breach.

Possible dilutive effect of outstanding options and warrants.

At the end of the period covered by this Report, stock options to purchase 3,548,903 shares of common stock and warrants to purchase 2,903,257 shares of common stock were outstanding. In addition, as of December 31, 2006, a total of 1,634,920 stock options are available for grant under our 2004 Equity Compensation Plan. A total of 4,196,618 of the outstanding options and warrants are “in the money” and exercisable as of December 31, 2006. “In the money” means that the current market price of the common stock is above the exercise price of the shares subject to the warrant or option. The issuance of common stock upon the exercise of these options and warrants could adversely affect the market price of the common stock or result in substantial dilution to our existing stockholders.

Provisions in our certificate of incorporation and bylaws and under Delaware law may prevent or frustrate a change in control in management that stockholders believe is desirable.

Provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a merger, acquisition or other change in control that stockholders may consider favorable, including transactions in which you might otherwise receive a premium for your shares. These provisions may also prevent or frustrate attempts by our stockholders to replace or remove our management. These provisions include:

The affirmative vote of the holders of at least two-thirds of our shares of capital stock entitled to vote is necessary to amend or repeal the above provisions of our certificate of incorporation. In addition, absent approval of our board of directors, our bylaws may only be amended or repealed by the affirmative vote of the holders of at least two-thirds of our shares of capital stock entitled to vote.

In addition, Section 203 of the General Corporation Law of the State of Delaware prohibits a publicly held Delaware corporation from engaging in a business combination with an interested stockholder, generally a person which together with its affiliates owns or within the last three years has owned 15% of our voting stock, for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. Accordingly, Section 203 may discourage, delay or prevent a change in control of our company.

None.

We currently lease approximately 47,146 square feet of space for our headquarters in Malvern, Pennsylvania, of which approximately 42,184 square feet is dedicated to office space and approximately 4,962 square feet is dedicated to warehousing and packaging operations. The initial term of this lease ends on June 25, 2012. We also lease a 50,000 square foot biological manufacturing facility in Horsham, Pennsylvania that we plan to use to produce the active ingredient of AA4500. The initial term of this lease ends on January 1, 2017.

50

Table of Contents

We are not engaged in any material legal proceedings.

No matters were submitted to the vote of stockholders through the solicitation of proxies or otherwise during the quarter ended December 31, 2006.

51

Table of Contents

PART II

Market Information

Our common stock began trading on The NASDAQ Global Market on July 23, 2004 under the symbol “AUXL.” Prior to that time, there had been no market for our common stock. In November 2006, we were included in the NASDAQ Biotechnology Index. The following table sets forth the high and low closing sales prices per share for our common stock for the periods indicated, as reported by The NASDAQ Global Market:

Holders of Record

As of March 8, 2007, there were approximately 67 holders of record of our common stock. Because many of such shares are held by brokers and other institutions on behalf of stockholders, the Company is unable to estimate the total number of stockholders represented by these record holders.

Dividends

We have never paid or declared any cash dividends on our common stock. We currently intend to retain any earnings for future growth and, therefore, do not expect to pay cash dividends in the foreseeable future.

Securities Authorized for Issuance Under Equity Compensation Plans

The information under the heading "Equity Compensation Plan Information" in our definitive Proxy Statement for our Annual Meeting of Stockholders to be held on June 13, 2007, to be filed with the SEC, is incorporated herein by reference.

Recent Sales of Unregistered Securities

During the quarter ended December 31, 2006, we did not issue any unregistered shares of our common stock.

52

Table of Contents

Comparative Stock Performance Graph

The graph below compares the cumulative total stockholder return on our common stock with the cumulative total stockholder return of (i) the NASDAQ Composite Index, and (ii) the NASDAQ Biotechnology Index, assuming an investment of $100 on July 23, 2004, the date our shares began public trading on NASDAQ, in each of our common stock; the stocks comprising the NASDAQ Composite Index; and the stocks comprising the NASDAQ Biotechnology Index.

Comparison of Cumulative Total Return* Among Auxilium Pharmaceuticals, Inc, the NASDAQ Composite Index, and the NASDAQ Biotechnology Index

SELECTED CONSOLIDATED FINANCIAL DATA

(In thousands, except share and per share data)

The following selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes appearing elsewhere in this Report. The consolidated statements of operations data for the years ended December 31, 2006, 2005 and 2004 and the consolidated balance sheet data as of December 31, 2006 and 2005 have been derived from our audited consolidated financial statements and related

53

Table of Contents

notes, which are included elsewhere in this Report. The consolidated statement of operations data for the years ended December 31, 2003 and 2002 and the consolidated balance sheet data as of December 31, 2004, 2003 and 2002 have been derived from audited financial statements which do not appear in this Report. The historical results presented are not necessarily indicative of results to be expected in any future period.

54

Table of Contents

You should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and the related notes appearing at the end of this Report. Some of the information contained in this discussion and analysis or set forth elsewhere in this Report, including information with respect to our plans and strategy for our business and related financing, includes forward-looking statements that involve risks and uncertainties. You should review the “Risk Factors” section of this Report for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis.

Overview

We are a specialty biopharmaceutical company with a focus on developing and marketing products to urologists, endocrinologists, orthopedists and select primary care physicians. We currently have a sales and marketing organization of approximately 190 people. Our only marketed product, Testim^®, is a proprietary, topical 1% testosterone once-a-day gel indicated for the treatment of hypogonadism. Hypogonadism is defined as reduced or absent secretion of testosterone which can lead to symptoms such as low energy, loss of libido, adverse changes in body composition, irritability and poor concentration.

Our current product pipeline includes:

Phase III:

- AA4500, injectable collagenase enzyme for the treatment of Dupuytren’s contracture

Phase II:

- AA4500, injectable collagenase enzyme for the treatment of Peyronie’s disease

- AA4500, injectable collagenase enzyme for the treatment of Frozen Shoulder syndrome, or Adhesive Capsulitis

Phase I:

- AA4010, treatment for overactive bladder using our transmucosal film delivery system

Preclinical:

- two pain products using our transmucosal film delivery system, with rights to develop six other compounds for the treatment of pain.

In addition to the above, we have the rights to develop other hormone and urologic products using the transmucosal film technology and the option to license other indications for AA4500 other than dermal products for topical administration.

In October 2006, we decided to discontinue the development of the current formulation of TestoFilm™, our testosterone replacement transmucosal film product candidate for the treatment of hypogonadism and reallocate resources to our lead development project, AA4500. We determined that the current formulation of TestoFilm does not meet certain critical aspects of the target product profile and, as a result, would not be commercially viable.

After mutually agreeing with Oscient Pharmaceuticals Corp., or Oscient, to terminate our co-promotion agreement effective August 31, 2006, we expanded our sales force to approximately 150 representatives. We believe that expanding our own sales force with employees consistently dedicated to Testim throughout the entire year will allow us to better control our promotional efforts for Testim.

55

Table of Contents

In September 2006, we entered into a lease agreement for an existing biologics manufacturing facility in Horsham, Pennsylvania. We plan to use the facility to produce the active ingredient of AA4500 and have completed the initial engineering batch of AA4500. As of December 31, 2006, our future minimum lease payments during the initial, noncancellable term ending January 1, 2017 total approximately $23.7 million. Prior to leasing this facility, we relied solely on a third party to manufacture the active ingredient for AA4500. Furthermore, we have hired employees with expertise in the manufacturing of biological products.

In December 2006, we suspended our phase III trials for AA4500 for the treatment of Dupuytren’s contracture because of a manufacturing issue. We have conducted detailed investigations that have helped us to understand what we believe may have contributed to the issue and how we can minimize the risk that this issue will occur in the future. We are continuing to test corrective actions and monitor stability data for several lots and over various time points. We expect to resume phase III clinical trials for AA4500 for the treatment of Dupuytren’s contracture in the fourth quarter of 2007.

We have never been profitable and have incurred an accumulated deficit of $183.5 million as of December 31, 2006. We expect to incur significant operating losses for the foreseeable future. We anticipate that commercialization expenses, development costs, and in-licensing milestone payments related to existing and new product candidates and to enhance our core technologies will continue to increase in the near term. In particular, we expect to incur increased costs for selling and marketing as we continue to market Testim, additional development and pre-commercialization costs for:

We will need to generate significant revenues to achieve profitability.

We expect that quarterly and annual results of operations will fluctuate for the foreseeable future due to several factors including:

Our limited operating history makes accurate prediction of future operating results difficult.

Net revenues. To date, all of our net revenues have been generated by the sales and out-licensing of Testim. For the near term, we expect Testim to continue to be the primary source of our net revenues. We sell Testim to pharmaceutical wholesalers, who have the right to return Testim prior to the units being dispensed through patient prescriptions. Prior to 2006, we recognized revenue based on prescription units dispensed to patients, since they are not subject to return and we did not have sufficient historical experience to reasonably estimate product returns. Based on the product return history gathered through the end of the first quarter of 2006, we determined we had the information to reasonably estimate customer returns. Therefore, in the first quarter of 2006, we began recognizing revenue for Testim sales at the time of shipment of the product to customers, net of appropriate allowances for cash discounts, rebates, patient coupons and product returns. We do not anticipate sales of Testim outside of the U.S., pursuant to our current agreements for international distribution rights of Testim, will have a material impact on our revenues or profitability. In addition to the up-front and milestone payments these agreements afford us, we believe they also benefit us by providing opportunities for manufacturing efficiencies through increased sales of Testim, as well as, making us an attractive partner to future

56

Table of Contents

licensors by providing us with global development and commercialization capabilities. We are a relatively new company and our sales prospects are uncertain. We expect our revenues to fluctuate due to:

We use a third-party distributor, ICS, a division of AmerisourceBergen, for commercial distribution activities. The majority of our sales in the U.S. are to pharmaceutical wholesalers that, in turn, distribute product to chain and other retail pharmacies, hospitals, mail-order providers and other institutional customers. Approximately 93% of Testim purchases are from three customers: AmerisourceBergen, Cardinal Health, and McKesson. Outside of the U.S., we currently rely on third parties to market, sell and distribute Testim and any of our product candidates for which we receive marketing approval from any foreign jurisdictions. For Canada, we have an agreement with Paladin Labs, Inc. to market and distribute Testim. We have entered into an agreement with Ipsen Farmaceutica, B.V. for the rest of the world, excluding the U.S., Canada, Japan and Mexico.

Cost of goods sold. All of our cost of goods sold currently relate to the sale of Testim and consists of:

We do not anticipate any material changes in our gross margin rate in the U.S. We anticipate our gross margins for sales outside the U.S. will continue to be significantly lower than those seen in the U.S. This is due to a combination of factors which include the terms of our distribution agreements and the royalty payments due to our licensor.

Research and development. Our research and development expenses consist of:

Due to the significant risks and uncertainties inherent in the clinical development and regulatory approval processes, the cost to complete projects in development cannot be reasonably estimated. Currently, Testim is our only marketed product. AA4500 has completed phase II of development for the treatment of Dupuytren’s contracture. AA4500 is in phase II of development for the treatment of Peyronie’s disease and Frozen Shoulder syndrome. We believe AA4010 is in phase I of development. Results from clinical trials may not be favorable. Further, data from clinical trials is subject to varying interpretation, and may be deemed insufficient by the regulatory bodies reviewing applications for marketing approvals. As such, clinical development and regulatory programs are subject to risks and changes that may significantly impact cost projections and timelines. We

57

Table of Contents

expect our research and development expenses for our current products to increase as a result of further development of AA4500 for Dupuytren’s contracture, Peyronie’s disease and Frozen Shoulder syndrome, and AA4010 for overactive bladder. In addition, the current regulatory and political environment at the U.S. Food and Drug Administration, or FDA, could lead to increased data requirements which could impact regulatory timelines and costs. We expect further significant increases in our expenditures to develop any other potential new product candidates that we would in-license or acquire. Expenditures will increase to develop any other product candidates that we in-license or acquire.

Selling, general and administrative. Selling, general and administrative expenses consist primarily of salaries and other related costs for personnel, marketing and promotion costs, professional fees and facilities costs. We anticipate increases in selling, general and administrative expenses due to sales and marketing costs associated with Testim, hiring of additional personnel, investor relations and other activities associated with operating as a publicly traded company.

Results of Operation

Accounting changes

As discussed in Note 2(e) to the Company’s consolidated financial statements contained herein and under the heading “Critical Accounting Policies and Significant Judgments and Estimates” set forth below, in the first quarter of 2006 the Company began recognizing revenue for Testim sales at the time of shipment of the product to customers. Prior to 2006, the recognition of revenue on shipments of Testim units to customers was deferred until the units were dispensed through patient prescriptions. As a result of this change in revenue recognition, net revenues for year ended December 31, 2006 include a one-time benefit of $1.2 million and the net loss for the year ended December 31, 2006 includes a one-time benefit of $0.7 million, or $0.02 per share.

In addition, as discussed in Note 2(o) to the Company’s consolidated financial statements contained herein, the Company adopted SFAS No. 123R effective January 1, 2006 using the modified prospective transition method, which requires the application of SFAS No. 123R as of January 1, 2006, the first day of the Company’s calendar year. The Company’s consolidated financial statements as of and for the year ended December 31, 2006 reflect the application of SFAS No.123R. This accounting standard requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. In accordance with the modified prospective method, the Company’s consolidated financial statements for periods prior to 2006 have not been restated and do not include the effect of SFAS 123R. Prior to 2006, the Company recognized the compensation expense related to stock-based awards measured by the intrinsic value of the award at grant date in accordance with APB No. 25. As a result of this change, the Company’s net loss for the year ended December 31, 2006 is $2.6 million (or $0.08 per share) higher than if the Company had continued to account for share-based compensation under APB No. 25.

Years Ended December 31, 2006 and 2005

Net revenues. For fiscal year 2006, net revenues totaled $68.5 million compared to net revenues of $42.8 million for the year 2005, an increase of 60%. This increase in net revenues resulted primarily from substantial growth in Testim demand resulting from increased prescriptions and increases in pricing, net of discounts, rebates and coupons. According to National Prescription Audit (NPA) data from IMS Health (IMS), a pharmaceutical market research firm, Testim total prescriptions for 2006 grew 37.7% compared to 2005. We believe that Testim prescription growth in the 2006 period over the 2005 period was driven by physician and patient acceptance that Testim provides better patient outcomes, the shift in prescriptions away from the testosterone patch product and the other gel product to Testim, the continued focus of our sales force on the promotion of Testim to urologists, endocrinologists and select primary care physicians, and our co-promotion agreement with Oscient. Net revenues for 2006 benefited from price increases having a cumulative impact of 10% over the comparable 2005 period, which was partially offset by increases in wholesaler discounts due to increased distribution costs and product rebates as Testim became more widely prescribed by managed care

58

Table of Contents

providers. Net revenues for 2006 include one-time benefits of $1.2 million recorded in the first quarter upon adoption of the wholesaler method of revenue recognition and of $0.6 million recorded in the fourth quarter representing previously received non-refundable payments that were forfeited upon the mutual termination of the Bayer distribution agreement. Net revenues in 2006 and 2005 also include $0.6 million and $1.0 million, respectively, of product shipped to Ipsen and $0.7 million and $0.6 million, respectively, of revenues related to up-front and milestone payments.

Cost of goods sold. Cost of goods sold were $17.7 million and $13.1 million for the years ended December 31, 2006 and 2005, respectively. The increase in cost of goods sold in 2006 over 2005 was directly attributable to the increase in Testim prescription revenue. Gross margin on net revenues was 74.2% in 2006 compared to 69.4% for 2005. The improvement in gross margin in 2006 over 2005 principally reflects the year-over-year price increases, a reduction in the royalty rate paid to the Company’s licensor, and manufacturing cost reductions, as well as the one-time revenue benefits discussed above. The cost of goods sold for product shipped to Ipsen in 2006 and 2005 amounted to $0.6 million and $0.9 million, respectively. Excluding the impact of the change in revenue recognition discussed above, gross margin for U.S. revenues was 74.6% in 2006 compared to 70.4% for 2005.

Research and development expenses. Research and development expenses were $37.9 million and $24.3 million for the years ended December 31, 2006 and 2005, respectively. The increase in 2006 over 2005 was primarily due to $9.0 million increase in cost associated with AA4500 due to the increased spending for development and manufacturing scale and the $1.1 million payment to Cobra upon amendment of the manufacturing agreement with Cobra, a $2.4 million increase in development spending for TestoFilm prior to discontinuance of its development in October 2006 and a $1.7 million increase in administrative costs due primarily to an increase in headcount. These increases were offset by a $1.1 million decrease in costs associated with phase IV clinical trials for Testim.

Selling, general and administrative expenses. Selling, general and administrative expenses were $61.3 million and $43.9 million for the years ended December 31, 2006 and 2005, respectively. The increase in 2006 over 2005 was due primarily to selling and marketing expenses increasing by $13.7 million resulting from higher marketing costs and co-promotion and termination fees associated with the terminated co-promotion agreement with Oscient, the increases in our Testim sales force made in late 2006, and pre-launch marketing for AA4500. General and administrative expenses increased by $3.6 million as a result of the additional stock-based compensation expense resulting from the adoption of SFAS 123R and the costs associated with compliance with Section 404 of the Sarbanes-Oxley Act of 2002.

Interest income (expense), net. Interest income (expense), net was $2.4 million and $1.5 million for the years ended 2006 and 2005, respectively. Net interest income in 2006 and 2005 relates primarily to interest earned on the invested proceeds from our registered direct offering in September of 2006 and our private placement in June of 2005.

Other Income (expense), net. Other income (expense), net was $0 and $(1.2) million for the years ended December 31, 2006 and 2005, respectively. Other income (expense), net in 2005 relates to $0.2 million of placement agent fees and transaction costs associated with our private placement in June of 2005 which were allocated to the financing-related liability and the non-cash change in the fair value of the financing-related liability of $1.0 million during 2005. On December 30, 2005, the financing related liability of $7.2 million was reclassified to permanent equity as a result of amendments to the Securities Purchase Agreements. There were no such costs incurred in 2006.

At December 31, 2006, we had federal net operating loss carryforwards of approximately $146.4 million, which will expire in 2019 through 2026, if not utilized. In addition, we had state net operating loss carryforwards of approximately $122.0 million, of which $62.9 million relate to Pennsylvania, which will expire 2010 through 2026 if not utilized. Future utilization of Pennsylvania net operating losses is limited to the greater of 12.5% of

59

Table of Contents

Pennsylvania taxable income or $3.0 million per year. At December 31, 2006, we had federal research and development credits of approximately $3.0 million that will expire in 2020 through 2026, if not utilized.

The Internal Revenue Code provides for a limitation on the annual use of net operating loss and research and development tax credit carryforwards following certain ownership changes that could limit our ability to utilize these carryforwards. We may have experienced various ownership changes, as a result of past financings. Accordingly, our ability to utilize the aforementioned carryforwards may be limited. Additionally, U.S. tax laws limit the time during which these carryforwards may be applied against future taxes; therefore, we may not be able to take full advantage of these carryforwards for federal income tax purposes

Years Ended December 31, 2005 and 2004

Net revenues. Net revenues were $42.8 million and $27.0 million for the years ended December 31, 2005 and 2004, respectively. Prescription units dispensed increased from approximately 203,900 in 2004 to approximately 303,500 in 2005. We believe that Testim prescription growth in 2005 over 2004 was attributed to increasing physician and patient awareness that Testim provides better patient outcomes, the shift in prescriptions away from the testosterone patch product to Testim, the continued focus of our sales force on the promotion of Testim to urologists, endocrinologists and select primary care physicians, and our co-promotion agreement with Oscient, which focused on broadening our exposure to primary care physicians. The increase in net revenues in 2005 over 2004 also are a result of price increases having a cumulative impact of 11% offset by increases in wholesaler discounts due to increased distribution costs, product rebates as Testim became more widely prescribed by managed care providers and had experienced an increased utilization of patient coupons. Net revenues in 2005 also include $1.0 million of product shipped to Ipsen and $0.5 million of revenues related to up-front and milestone payments for which there are no comparable amounts in 2004. Shipments in the U.S. not recognized as revenue, net of anticipated cash discounts, were $2.2 million and $3.7 million at December 31, 2005 and 2004, respectively and are reflected in deferred revenue, current portion.

Cost of goods sold. Cost of goods sold were $13.1 million and $8.1 million for the years ended December 31, 2005 and 2004, respectively. The increase in cost of goods sold in 2005 over 2004 was directly attributable to the increase in Testim prescription revenue in the U.S. and $0.9 million of costs associated with product shipped to Ipsen for which there is no comparable amount in 2004. Cost of goods sold in the 2004 period would have been approximately $0.4 million higher had purchases of a key raw material not been charged-off in 2002. Gross margin on our net revenues was 69.4% in 2005 compared to 69.9% in 2004. Gross margin for U.S. revenues was 70.4% in 2005 and would have been 68.4% in 2004 had purchases of a key raw material not been charged-off in 2002. The improvement in gross margin in 2005 over 2004 resulted primarily from the net effect of price increases offset by increases in wholesaler discounts, product rebates and increased utilization of patient coupons. In 2002, we purchased approximately $0.9 million of this raw material prior to FDA approval of Testim and, based on our policy, charged the purchase price to research and development expense because we would have had no alternative use for the raw material if Testim were not approved. As of December 31, 2004, we did not have any of the raw material with zero book value remaining in inventory.

Research and development expenses. Research and development expenses were $24.3 million and $16.0 million for the years ended December 31, 2005 and 2004, respectively. The increase in 2005 over 2004 was primarily due to $5.9 million increase in development work for AA4500, a $1.7 million increase in costs associated with phase IV Clinical Trials for Testim, a $1.0 million increase in development work for AA2600, and the $0.5 million up-front payment for the in-license of eight separate pain products using the transmucosal film technology in February 2005. These increases were offset by a $1.5 million decrease in milestone payments for AA4500, our Dupuytren’s contracture, Peyronie’s disease and Frozen Shoulder syndrome product candidate.

Selling, general and administrative expenses. Selling, general and administrative expenses were $43.9 million and $31.2 million for the years ended December 31, 2005 and 2004, respectively. The increase in 2005 over 2004 was due primarily to selling and marketing expenses increasing by $9.8 million resulting from

60

Table of Contents

increases in our sales force made in late 2004, higher marketing costs associated with our co-promote agreement with Oscient and the Oscient co-promotion fees. General and administrative expenses increased by $2.9 million as a result of the investigation initiated by the Audit Committee of our Board of Directors into certain transactions and the effectiveness of our internal disclosure controls and procedures, severance accruals related to the termination of our former President and Chief Operating Officer, an increase in recruiting costs, costs associated with moving to our new headquarters and incremental costs associated with operating as a publicly traded company.

Interest income (expense), net. Interest income (expense), net was $1.5 and $(0.2) million for the years ended 2005 and 2004, respectively. Net interest income in 2005 relates primarily to interest earned on the invested proceeds from our initial public offering in July of 2004 and our private placement in June of 2005. The expense in 2004 relates primarily to non-cash amortization of deferred debt issuance costs related to a line of credit and to interest paid on the line of credit, which was repaid and terminated in March 2004.

Other income (expense), net. Other income (expense), net was $(1.2) million and $0 for the years ended December 31, 2005 and 2004, respectively. Other income (expense), net in 2005 relates to $0.2 million of placement agent fees and transaction costs associated with the June 30, 2005 private placement which were allocated to the financing-related liability and the non-cash change in the fair value of the financing-related liability of $1.0 million during 2005. On December 30, 2005, we reclassified the financing related liability of $7.2 million to permanent equity as a result of amendments to the Securities Purchase Agreements.

Dividends and accretion of redeemable convertible preferred stock. Accretion of redeemable convertible preferred stock was $0 and $0.6 million for the years ended December 31, 2005 and 2004, respectively. In 2004, we were accreting the carrying value of redeemable convertible preferred stock to its redemption value. There is no corresponding accretion in 2005 as all previously outstanding shares of this stock were converted into our common stock in connection with our initial public offering.

Liquidity and Capital Resources

Since inception through December 31, 2006, we have financed our product development, operations and capital expenditures primarily from private and public sales of equity securities. Since inception through December 31, 2006, we received net proceeds of approximately $219.8 million from our initial public offering, registered direct offering, private sales of securities and the exercise of stock options and warrants. We had approximately $54.7 million and $56.7 million in cash, cash equivalents and short-term investments as of December 31, 2006 and December 31, 2005, respectively.

We believe that our current financial resources and sources of liquidity will be adequate to fund our anticipated operations until at least March 2008. We may, however, need to raise additional funds prior to this time in order to enhance our sales and marketing efforts for additional products we may acquire, commercialize any product candidates that receive regulatory approval, acquire or in-license approved products or product candidates or technologies for development and to maintain adequate cash reserves to minimize financial market fundraising risks. Insufficient funds may cause us to delay, reduce the scope of, or eliminate one or more of our development, commercialization or expansion activities. Our future capital needs and the adequacy of our available funds will depend on many factors, including the effectiveness of our sales and marketing activities, the cost of clinical studies and other actions needed to obtain regulatory approval of our products in development, and the timing and cost of any acquisitions. If additional funds are required, we may raise such funds from time to time through public or private sales of equity or debt securities or from bank or other loans. Financing may not be available on acceptable terms, or at all, and our failure to raise capital when needed could materially adversely impact our growth plans and our financial condition or results of operations. Additional equity financing, if available, may be dilutive to the holders of our common stock and may involve significant cash payment obligations and covenants that restrict our ability to operate our business.

61

Table of Contents

Sources and Uses of Cash

Cash used in operations was $43.6 million, $28.8 million and $16.8 million for 2006, 2005 and 2004, respectively. Negative operating cash flows during 2006 and 2005 were caused primarily by operating losses. Negative operating cash flows during 2004 result from operating losses offset primarily by $8.1 million of cash collections of up-front and milestone payments.

Cash provided by (used in) investing activities was $11.8 million, $(12.5) million and $(15.3) million for 2006, 2005 and 2004, respectively. Cash provided by (used in) investing activities relates primarily to the net effect of purchases short-term investments with part of the proceeds from our equity offerings in each of these years and redemptions of short-term investments for operational cash needs, together with our investments in property and equipment and, in 2006, the investment of $1.9 million to secure the lease of a manufacturing facility.

Cash provided by financing activities was $45.2 million, $40.0 million and $36.4 million in 2006, 2005 and 2004, respectively. Cash provided by financing activity in 2006 results primarily from the $43.3 million in net proceeds we received in the September 2006 registered direct offering, $1.0 million cash received from warrant exercises and $1.2 million in cash receipts from stock option exercises and employee stock purchases. Cash provided by financing activity in 2005 results primarily from the $39.0 million received from the June 30, 2005 private placement and the $0.7 million in cash receipts from stock option exercises. Cash provided by financing activities in 2004 was related primarily to the initial public offering of our common stock.

Our actual cash needs might vary materially from those now planned because of a number of factors, including: