This discussion and analysis of our financial condition and results of operations contains forward-looking statements that involve risks and uncertainties. We have based these forward-looking statements on our current expectations and projections of future events. Such statements reflect our current views with respect to future events and are subject to unknown risks, uncertainty and other factors that may cause results to differ materially from those contemplated in such forward looking statements. In addition, the following discussion should be read in conjunction with the audited consolidated financial statements and the related notes thereto included elsewhere in this report.

Executive Summary

The results for the year ended December 31, 2007 and 2006 were a net loss of $15.6 million and $35.1 million or a loss per share of $.61 and $1.74, respectively.

The operating expenses for 2007 were $17.6 million, primarily comprised of $10.6 million research and development expenses primarily relating to the commencement of the dextofisopam Phase 2b clinical trial, and $6.7 million of general and administration expenses.

In 2007 the Company commenced the dextofisopam Phase 2b clinical trial with 72 randomized patients enrolled as of December 31, 2007 of an anticipated 480 patient trial.

General and administrative expenses included severance payments aggregations $1,014,732 relating to the departure of three senior executives.

Critical Accounting Policies

The preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the amounts reported in our consolidated financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements. The listing below is not intended to be a comprehensive list of all of our accounting policies. The Company considers certain accounting policies related to stock-based compensation, tax valuation allowance and asset impairments to be critical policies due to the estimation process involved in each.

Equity based compensation

Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123R, "Share-Based Payment" ("SFAS 123R"), which establishes the financial accounting and reporting standards for stock-based compensation plans. SFAS 123R requires the measurement and recognition of compensation expense for all stock-based awards made to employees and directors, including employee stock options and restricted stock units, and employee stock purchases related to the ESPP. Under the provisions of SFAS 123R, stock-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as an expense over the requisite service period of the entire award (generally the vesting period of the award). The Company has elected to expense these awards on a straight line basis over the life of the awards. As a result of adopting SFAS 123R, the Company's net loss before income taxes and net loss for the years ended December 31,2007 and 2006 were $1,076,606 and $939,500 more than if the Company had continued to account for stock-based compensation under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and its related interpretations. Basic and diluted net loss per share for the years ended December 31, 2007 and 2006 of $(0.61) and $(1.74) are $0.04 and $0.05 more as a result of adopting SFAS 123R.

The Company elected to use the modified prospective transition method as permitted by SFAS 123R and, therefore, financial results for prior periods have not been restated. Under this transition method, stock-based compensation expense for the years ended December 31, 2007 and 2006 include expense for all equity awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123,") as amended by SFAS 148, "Accounting for Stock-Based Compensation-Transition and Disclosure." Compensation expense for all stock-based compensation awards granted subsequent to January 1, 2006 was based on the grant-date fair value determined in accordance with the provisions of SFAS 123R. During the years ended December 31, 2007 and 2006, the Company recognized compensation expense of $1,076,606 and $939,500 for stock options which were recognized in the Consolidated Statement of Operations. As of December 31, 2007 and 2006, the total compensation costs related to non-vested awards not yet recognized is $510,000 which will be recognized over the next three and one-quarter years.

Prior to January 1, 2006, the Company accounted for stock-based compensation in accordance with APB 25 and also followed the disclosure requirements of SFAS
123. Under APB 25, the Company accounted for stock-based awards to employees and directors using the intrinsic value method as allowed under SFAS 123.

The following table illustrates the effect on net loss and loss per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation. The estimated fair value of each option is calculated using the Black-Scholes option-pricing model.

                                                            Year Ended
                                                        December 31, 2005
                                                     ------------------------
Net loss as reported                                   ($      2,929,872 )
Add: Stock-based employee compensation expense
included in reported net loss                                  1,171,728

Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards                                                (4,578,359 )
                                                     ---- --------------
Pro forma net loss                                     ($      6,336,503 )
                                                     ---- --------------

Loss per share:
Basic and diluted, as reported                         ($           0.15 )
Basic and diluted, pro forma                           ($           0.33 )

For disclosure purposes under SFAS No. 123, the fair value of each option grant was estimated on the date of grant using the Black-Scholes option valuation model with the following weighted-average assumption:

                                2005
                            ------------
Risk-free interest rate       3.71-4.45%
Expected lives (in years)         5
Dividend yield                    0%
Expected volatility            99 -107%

On June 28, 2005, the Company accelerated the vesting of unvested stock options awarded under its stock option plans that had exercise prices greater than $9.00; the closing price was $2.43 on June 28, 2005. Unvested options to purchase approximately 200,000 shares became exercisable as a result of the vesting acceleration. Typically, the Company grants stock options that vest over a four-year period. The purpose of the accelerated vesting was to enable the Company to avoid recognizing, in its consolidated statement of operations, compensation expense associated with these options in future periods, upon adoption of SFAS 123R (Share-Based Payment) in January 2006. The impact of this acceleration resulted in a $2.6 million increase in proforma stock-based compensation expense in 2005.

Options issued to non-employees other than directors are accounted for under the fair value method in accordance with SFAS 123 and EITF Issue No. 96-18, "Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling Goods or Services." Under the fair value method, compensation cost is measured at the grant date of the option based on the value of the award using the Black-Scholes method. Compensation cost is periodically remeasured as the underlying options vest in accordance with EITF Issue No. 96-18 and is recognized over the service period.

On September 6, 2004, the Board of Directors approved the Retention Award Agreements and Pharmos entered into Retention Award Agreements with each of Dr. Haim Aviv, its then Chairman and Chief Executive Officer, and Dr. Gad Riesenfeld, its then President and Chief Operating Officer. The Company granted retention awards consisting of cash and restricted stock units to Dr. Aviv. The Company granted retention awards consisting of cash and restricted stock to Dr. Riesenfeld (the "Awards"). Under the agreement, one-half of the Awards vested on December 31, 2005 and the balance shall vest and become non-forfeitable on June 30, 2007, subject to certain accelerated vesting provisions. Under the terms of Dr. Riesenfeld's severance agreement, the balance of his Awards vested on his departure from the Company on April 2, 2006 and the expense of those awards was accelerated through April 2, 2006. The fair value of the restricted shares was based on the fair value of the stock on the issuance date. The aggregate fair value of the restricted stock awards totaled $2 million. For financial reporting purposes, the cash awards and the fair value of the restricted stock awards, which totaled $2,500,000, will be expensed pro rata over the vesting periods. Per the Awards, only Dr. Riesenfeld was issued the restricted stock; Dr. Aviv received restricted stock units.

Impairment of Long-Lived Assets

We review long-lived assets for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable or that the useful lives of these assets are no longer appropriate. Each impairment test is based on a comparison of the undiscounted cash flow to the recorded value of the asset. Subsequent impairment assessments could result in future impairment charges. Any

impairment charge would result in the reduction in the carrying value of long-lived assets and would increase our net loss in the period in which the charge arose.

Tax Valuation Allowance

The Company has assessed the likelihood of realizing future taxable income and has determined that a 100% deferred tax valuation allowance is deemed necessary. In the event the Company were to determine that it would be able to realize its deferred tax asset, an adjustment to the valuation allowance would increase income or decrease the loss in the period such determination is made.

Results of Operations

The Company recorded no product sales revenue and cost of sales during 2007 and 2006.

During 2007, the Company increased its expenditures on research and development activities. In 2006, the Company completed its acquisition of Vela Pharmaceuticals, Inc. which included $20,608,000 of in-process research and development costs. The Vela operations have been integrated into Pharmos and the Company currently operates as one operating segment. Thus research and development expenditures in 2007 were greater than in 2006. From the Vela acquisition, the Company initiated a large Phase 2b study of Dextofisopam for the treatment of IBS in the first half of 2007.

The acquisition of Vela resulted in the Company acquiring three potential drug candidates in various stages of development. The Company initiated a large scale Phase IIb trial involving approximately 480 patients with Dextofisopam for irritable bowel syndrome (IBS) in June 2007. The second drug acquired through Vela was VPI-013 for female sexual dysfunction and neuropathic pain. This drug candidate has completed Phase IIa testing and the Company intends to seek to license this to a partner. The Company also intends to license out the third drug candidate, Tianeptine, also for IBS which has completed pre-clinical testing. Significant additional clinical testing and related expenses will be needed before these drugs reach the market if at all. The additional expenses cannot be quantified at this time.

A Phase 2a clinical trial with the Company's NanoEmulsion delivery technology for topical application of analgesic and anti-inflammatory agents commenced in June 2007 targeting 126 patients. Completion is expected in mid 2008.

During the first half of 2007 the Company completed two Phase 2a proof of principle trials for Cannabinor with the iv formulation, a drug candidate for treating pain. Cannabinor is a CB2 selective agonist and is the first of the CB2 molecules tested in humans.

During 2007 the Company focused on lowering its general and administrative costs. During 2006, the Company incurred higher professional fees primarily in connection with legal fees related to the proxy contest including the coverage of Lloyd Miller's legal costs, higher investor relation costs related to the acquisition and proxy preparation.

Included in the 2007 general and administrative costs are costs relating to the departure of three senior executives. These payments were made under contractual agreements. After including these expenses in 2007, the aggregate general and administrative costs are lower than in 2006 due in part to cost management efforts and the scaling back of activities not core to the Company's research and development efforts.

The Company is currently dependent upon external financing, interest income, and research and development contracts to pursue its intended business activities. The Company has not been profitable since its inception, except for 2001. During 2007, the Company funded the majority of its expenses and other capital requirements with $13 million of common stock issued in conjunction with the Vela acquisition, utilization of cash and short term investments available from external financing in earlier years, income from grants received from the Office

of the Chief Scientist of Israel and the sale of NJ Net Operating Losses. At December 31, 2007, the Company has an accumulated deficit of $197 million and expects to continue to incur losses going forward. Losses have resulted principally from costs incurred in research activities aimed at identifying and developing the Company's product candidates, clinical research studies, the write-off of purchased research and development, and general and administrative expenses. The Company expects to incur additional losses over the next several years as the Company's research and development and clinical trial programs continue. The Company's ability to achieve profitability, if ever, is dependent on its ability to develop and obtain regulatory approvals for its product candidates, to enter into agreements for product development and commercialization with strategic corporate partners and contract to develop or acquire the capacity to manufacture and sell its products. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources."

Research efforts in 2007 and 2006 have been focused on the identification of new, potentially more potent CB2 agonists, completion of preclinical toxicology and safety pharmacology studies of an oral formulation of Cannabinor, scale-up manufacturing, technology transfer to the active ingredient supplier, and clinical trial finished material at Pharmos' facility in Rehovot, Israel. The major increase in year-to-date operating expenses year-over-year reflects the shift from primarily in-house research & development activities in 2005 to preclinical and clinical trials in 2006.

The Company considers major research & development projects to be those projects that have reached at least Phase II level of clinical development. In June 2007 the Company announced that patient screening had commenced in the Phase 2b trial for Dextofisopam for IBS with a target of 480 patients. Through December 31, 2007 expenditures on this trial amounted to $5,188,539.

The Cannabinor expenditures for the two Phase 2a trials amounted to $1,180,952 and the costs of the NanoEmulsion Phase 2a trial aggregated $313,038 in 2007.

Gross expenses for other research and development projects in early stages of development for the year ended December 31, 2007 and 2006 were $4,350,348 and $ 6,477,805, respectively. Research & development (R&D) gross expenses increased by $2,500,745 or 28% from $8,956,821 in 2006 to $11,457,566 in 2007 due to the commencement of the Dextofisopam Phase 2b clinical trial and a $1.0 million milestone payment made by Pharmos upon the study's commencement. The Company recorded research and development grants received from the Office of the Chief Scientist of Israel's Ministry of Industry and Trade of $812,042 and $1,445,513 during 2007 and 2006, respectively, which reduced research and development expenses. The decrease in grants is directly related to the decrease in the underlying eligible activity for the grants in 2007 over 2006 as the Company focused more research funds on the US based Phase 2b clinical trial of Dextofisopam. Total research and development expenses, net of grants, increased by $3,134,216 or 42% from $7,511,308 in 2006 to $10,645,524 in 2007.

In process acquired research and development costs decreased by $20,607,575 from $$20,607,575 in 2006 to $0 in 2007. The in process acquired research and development costs were acquired in conjunction with the acquisition of Vela in 2006.

General and administrative expenses decreased by $2,410,266 or 26%, from $9,108,867 in 2006 to $6,698,601 in 2007. The decrease in general and administrative expenses is due to lower, professional fees, investor relations and insurance costs by $1,933,000, $358,000, and $348,000 respectively, in 2007 compared to 2006. These decreases were offset in part by an increase in salary and benefit costs of $547,000 in 2007 as compared to 2006. The lower professional fees in 2007 are due to non-recurring legal and consulting fees that were incurred in 2006 related to the Vela acquisition and business development. The decrease in investor relation costs is primarily related to 2006 non recurring proxy printing and distribution costs associated with the Vela acquisition. The decline in insurance costs reflect favorable renewal rates and reduced policy coverage limits. The increase in salary and benefit costs is primarily attributed to severance costs associated with the departure of several executives.

The Company recorded no product sales revenue and cost of sales during 2006 and 2005.

Total operating expenses increased by $21,833,631 or 139%, to $37,542,519 in 2006 from $15,708,888 in 2005. In 2006, the Company completed its acquisition of Vela Pharmaceuticals, Inc. which included $20,608,000 of in-process research and development costs. The Vela operations have been integrated into Pharmos and the Company currently operates as one operating segment. From the Vela acquisition, the Company expects to initiate a large Phase 2b study of Dextofisopam for the treatment of IBS in the first half of 2007. During 2006, the Company has completed the Phase I trial and one of two proof-of-principle Phase IIa testing for its lead candidate for treating pain, a CB-2 selective agonist, Cannabinor with the IV formulation and is scheduled to complete the second proof-of-principle Phase IIa testing and for a Phase I testing with the oral formulation during 2007. The Company's NanoEmulsion delivery technology for topical application of analgesic and anti-inflammatory agents has completed in 2006 the second Phase I trial with Diclofenac cream and is scheduled in 2007 for a Phase IIa clinical trial in Osteoarthritis patients. During 2006, the Company incurred higher professional fees primarily in connection with legal fees related to the proxy contest including the coverage of Lloyd Miller's legal costs, higher investor relation costs related to the acquisition and proxy preparation, higher costs for the clinical trial activity for Cannabinor and NanoEmulsion and higher salaries costs for severance for a number of executives and the 2006 implementation of the equity based compensation of SFAS 123R.

During 2006, Pharmos completed the Phase I trial and one of two proof-of-principle Phase IIa testing for its lead candidate for treating pain from its proprietary platform of CB2-selective synthetic cannabinoid compounds, Cannabinor with IV formulation as well as the preclinical toxicology and safety pharmacology studies of an oral formulation of Cannabinor. Cannabinor and other platform compounds were designed to reduce the side effects caused by natural cannabinoids. In a number of animal models, these compounds have demonstrated efficacy as analgesics to treat moderate to severe pain, as anti-inflammatory agents, and immunomodulation agents to treat diseases such as multiple sclerosis, rheumatoid arthritis and inflammatory bowel disease. The preliminary results of one of two proof-of-principle Phase IIa testing of Cannabinor in capsaicin-induced pain model of neuropathic pain didn't meet the primary endpoint defined by analgesic effects compared to placebo, but confirmed safety and tolerability observed in previous studies. The Company expects in 2007 to complete the analysis of the Cannabinor proof-of-principle Phase IIa testing in capsaicin-induced pain model of neuropathic pain results, to complete the proof-of-principle Phase IIa testing Cannabinor in patients experiencing nociceptive pain from 3rd molar extraction and to conduct a Phase I safety study with the Cannabinor oral formulation.

During 2006, Pharmos completed the second Phase I study with its proprietary NanoEmulsion drug delivery technology in healthy volunteers that confirmed the safety and tolerability as well as the low systemic exposure of a Diclofenac NE topical cream. The Company plans to initiate a Phase IIa clinical trial in Osteoarthritis patients in 2007.

The acquisition of Vela resulted in the Company acquiring three potential drug candidates in various stages of development. The Company is planning to initiate a large scale Phase IIb trial involving approximately 480 patients with Dextofisopam for irritable bowel syndrome (IBS). The second drug acquired through Vela VPI-013 for female sexual dysfunction and neuropathic pain. This drug candidate has completed Phase IIa testing and the Company intends to seek to license this to a partner. The Company also intends to license out the third drug candidate, Tianeptine, also for IBS, which has completed pre-clinical testing. Significant additional clinical testing and related expenses will be needed before these drugs reach the market, if at all. The additional expenses cannot be quantified at this time.

The Company is currently dependent upon external financing, interest income, and research and development contracts to pursue its intended business activities. The Company has not been profitable since its inception, except for 2001. During 2006, the Company funded the majority of its expenses and other capital requirements with $13 million of common stock issued in conjunction with the Vela acquisition, utilization of cash and short term investments available from external financing in earlier years, income from grants received from the Office of the Chief Scientist of Israel and the sale of NJ Net Operating Losses. At December 31, 2006, the Company

has an accumulated deficit of $181 million and expects to continue to incur losses going forward. Losses have resulted principally from costs incurred in research activities aimed at identifying and developing the Company's product candidates, clinical research studies, the write-off of purchased research and development, and general and administrative expenses. The Company expects to incur additional losses over the next several years as the Company's research and development and clinical trial programs continue. The Company's ability to achieve profitability, if ever, is dependent on its ability to develop and obtain regulatory approvals for its product candidates, to enter into agreements for product development and commercialization with strategic corporate partners and contract to develop or acquire the capacity to manufacture and sell its products. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources."

Research efforts in 2006 have been focused on the identification of new, potentially more potent CB2 agonists, completion of preclinical toxicology and safety pharmacology studies of an oral formulation of Cannabinor, scale-up manufacturing, technology transfer to the active ingredient supplier, and clinical trial finished material at Pharmos' facility in Rehovot, Israel. The major increase in year-to-date operating expenses year-over-year reflects the shift from primarily in-house research & development activities in 2005 to preclinical and clinical trials in 2006.

The Company considers major research & development projects to be those projects that have reached at least Phase II level of clinical development. The Company's Phase II project is the development of Cannabinor. During 2006, the gross cost of development and review was approximately $2.5 million. Total costs since the Cannabinor project entered Phase II development in 2006 through December 31, 2006 were $2.5 million,

Gross expenses for other research and development projects in early stages of development for the year ended December 31, 2006 and 2005 were $6,477,805 and $ 6,257,498, respectively: 75% in 2006 and 87% in 2005 of the spending was related to cannabinor and other CB2 compounds. Research & development (R&D) gross expenses decreased by $611,472 or 6% from $9,568,293 in 2005 to $8,956,821 in 2006 due to a reduction in clinical activity that was related to Dexanabinol. The Company recorded research and development grants received from the Office of the Chief Scientist of Israel's Ministry of Industry and Trade of $1,445,513 and $1,406,508 during 2006 and 2005, respectively, which reduced research and development expenses. The increase in grants is directly related to the increase in the underlying eligible activity for the grants for 2006 over 2005. Total research and development expenses, net of grants, decreased by $650,477 or 8% from $8,161,785 in 2005 to $7,511,308 in 2006.

In process acquired research and development costs increased by $20,607,575 from $0 in 2005 to $20,607,575 in 2006. The in process acquired research and development costs were acquired in conjunction with the acquisition of Vela.

General and administrative expenses increased by $1,943,576 or 27%, from $7,165,291 in 2005 to $9,108,867 in 2006. The increase in general and administrative expenses is due to higher compensation, professional fees, and investor relations by $1,086,000, $695,000, and $304,000 respectively, in 2006 compared to 2005. There were also decreases in general and administrative expenses related to lower consultant expenses of $239,000. The increase in compensation is attributed to severance costs, and the cost of stock based compensation awards associated with the adoption of FAS 123R. The higher professional fees in 2006 are attributed to legal fees related to the proxy and the Vela acquisition. The increase in investor relation costs is primarily . . .