The following discussion may be understood more fully by reference to the financial statements, notes to the financial statements, and management's discussion and analysis of financial condition and results of operations contained in our Annual Report on Form 10-K for the year ended December 31, 2007, filed with the Securities and Exchange Commission on March 17, 2008.

This Quarterly Report on Form 10-Q contains forward-looking statements, which include, but are not limited to, statements of our expectations regarding our future financial results, and statements about future events and results regarding our drug development programs, clinical trials, sources of revenue, receipt of regulatory approvals, our expectations related to savings in facilities overhead attributable to scheduled lease expirations and subleasing of portions of our operating facilities, our expectations regarding future levels of research and development expenses and general and administrative expenses, our expectations related to our need to obtain additional funding to support the anticipated future needs of our research and development activities, and our estimates of the fair value of our securities portfolio at assumed market interest rates. In some cases, you can identify forward-looking statements by such terms as "may," "might," "can," "will," "should," "could," "would," "expect," "plan," "seek," "anticipate," "believe," "estimate," "project," "intend," "predict," "potential," "if" and similar expressions which imply that the statements relate to future events. These forward-looking statements are based on assumptions and are subject to risks and uncertainties. Given these uncertainties, you should not place undue reliance on these forward-looking statements. We discuss the risks we believe are most important in greater detail under the heading "Risk Relating to our Business" below. Also, these forward-looking statements represent our estimates and assumptions only as of the date of this Form 10-Q. We undertake no obligation to update any of the forward- looking statements contained in this report to reflect any future events or developments.

Overview

Avigen is a biopharmaceutical company focused on developing and commercializing small molecule therapeutics to treat serious neurological disorders. Our current product candidates primarily address neuropathic pain and opioid addiction and withdrawal.

In building our pipeline, we focus on selecting compounds with differentiating features from existing therapies that we believe could substantially change the standard of care for patients with chronic neurological conditions. In particular, we believe our drug candidates address needs currently unmet by current therapies through new mechanisms or offer reduced risks from side-effects. Moreover, AV411, one of our development products, is a commercially approved pharmaceutical outside the U.S. This compound is a New Molecular Entity in the U.S., and must be evaluated in all phases of clinical development; however, we believe its significant human experience in markets outside the U.S. should mitigate some development risks and may help accelerate the clinical development and approval for this product in North America. We are developing AV411 for neuropathic pain and other indications. As a result of the 2008 restructuring described below, our current plans are focused on monetizing our existing development assets through development partnerships or sales of assets. We intend to seek a development partner for AV411, and do not intend to initiate Phase 2 clinical trials with AV411 for neuropathic pain without the support of a partner.

In January 2006, we acquired exclusive license rights to develop and commercialize proprietary formulations of the compound tolperisone, which we have named AV650, for the North American market. These rights included relevant patent filings, as well as clinical data held by SDI Diagnostics International LTD, a division of Sanochemia Pharmazeutika AG, or Sanochemia, relating to AV650. Sanochemia agreed to supply AV650 to us exclusively for the North American market. Under the terms of the agreement, we made an upfront payment of $3.0 million with obligations for additional payments to Sanochemia based on the parties' achievement of clinical and regulatory product development milestones and commercial sales of AV650.

During 2007, we significantly expanded the scale and complexity of our clinical development activities over prior years. In 2007, we initiated Phase 2 clinical trials for AV650 in the United States and Europe, completed a Phase 2a clinical trial for AV411 in Australia, and initiated our clinical development of AV411 in the United States with a maximum-tolerable-dose trial. The operation of these trials and other development activities resulted in a significant increase in our operating expenses during 2007, which has continued in the first nine months of 2008. In July 2008, we amended the Sanochemia agreement to share the cost of development of a proprietary, purer form of AV650 and reduce certain sales-based milestones. During the quarter ended September 30, 2008, we made a payment of $2.5 million to Sanochemia upon the achievement of certain development-based milestones.

In November 2008, we announced a significant restructuring of the company aimed at preserving financial resources and reassessing strategic opportunities. This restructuring is expected to result in staff reductions of approximately 70 percent of our total workforce, or 27 positions. In addition, we announced our intention to seek a partner for the further development of AV411 for neuropathic pain and do not intend to initiate Phase 2 clinical trials with AV411 for neuropathic pain without the support of a partner. It is also our intention to monetize other current assets, including AV513 for multiple bleeding disorders, and to identify opportunities to acquire new assets for development through in-license or acquisition.

We are a development stage company and have primarily supported the financial needs of our research and development activities since our inception through public offerings and private placements of our equity securities. We have not received any revenue from the sale of our products in development, and we do not anticipate generating revenue from the sale of products in the foreseeable future. As a result, we expect that we will need to obtain additional funding to support future needs of our research and development activities, including the costs to complete clinical trials, that are not supported through partners. We expect our source of revenue, if any, for the next several years to consist of
(1) payments under the Genzyme agreement, which we entered into in December 2005 and under which we assigned to Genzyme Corporation our rights to some of our gene-therapy related intellectual property, our gene therapy clinical trial programs for Parkinson's disease and hemophilia, some of our gene therapy-related contracts, and the use of previously manufactured clinical-grade vector materials; and (2) collaborative arrangements with third parties, government grants, and non-gene therapy-related license fees. We have incurred losses since our inception and expect to incur substantial losses over the next several years due to lack of any substantial revenue and the continuation of our ongoing and planned research and development efforts, including preclinical studies and clinical trials. There can be no assurance that we will successfully develop, commercialize, manufacture, or market our product candidates or ever achieve or sustain product revenue for profitability. At September 30, 2008 we had an accumulated deficit of $244.9 million and cash, cash equivalents, available-for-sale securities, and restricted investments of approximately $56.4 million. We believe that our capital resources at September 30, 2008, after considering our anticipated decrease in infrastructure costs as a result of the restructuring and staff reduction announced on November 3, 2008, and our intention not to initiate Phase 2 clinical trials with AV411 without the support of a partner, will be adequate to fund our operating needs for approximately four years.

Critical Accounting Policies and Significant Judgments and Estimates

Our financial statements have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported revenues and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and judgments related to revenue recognition, valuation of investments in financial instruments, impairment of property and equipment, asset retirement obligations, recognition of research and development expenses and stock-based compensation. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following accounting policies are critical to the process of making significant judgments and estimates in the preparation of our financial statements. These policies are consistent with those presented in our Annual Report on Form 10-K for the period ended December 31, 2007, filed with the Securities and Exchange Commission on March 17, 2008.

We recognize revenue when the four basic criteria for revenue recognition as described in SEC Staff Accounting Bulletin No. 104, Revenue Recognition, are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) the fee is fixed or determinable; and (4) collectibility is reasonably assured.

We recognize non-refundable license or assignment fees, including development milestone payments associated with license or assignment agreements, for which we have no further significant performance obligations and no continuing involvement requirements related to product development, on the earlier of the dates on when the payments are received or when collection is assured. For example, in 2005, we received a $12.0 million payment under the terms of our agreement with Genzyme. We recognized the payment as revenue, since we concluded that as of December 31, 2005, we did not have any significant future performance obligations under the agreement.

We recognize revenue associated with up-front license, technology access and research and development funding payments under collaborative agreements ratably over the relevant periods specified in the agreements, generally the development phase. This development phase can be defined as a specified period of time; however, in some cases, the collaborative agreement specifies a development phase that culminates with milestone objectives but does not have a fixed date and requires us to estimate the time period over which to recognize this revenue. Our estimated time periods are based on management's estimate of the time required to achieve a particular development milestone considering the projected level of effort and current stage of development. If our estimate of the development-phase time period changes, the amount of revenue we recognize related to up-front payments for a given period will accelerate or decrease accordingly.

Valuation of investments in financial instruments

We carry investments in financial instruments at fair value with unrealized gains and losses included in accumulated other comprehensive income or loss in stockholders' equity. Our investment portfolio does not include equity securities or derivative financial instruments that could subject us to material market risk; however, we do invest in corporate, asset-backed and other obligations that subject us to varying levels of credit risk. Management assesses whether declines in the fair value of investment securities are other-than-temporary. If a decline in fair value of a financial instrument is judged to be other-than-temporary, the cost basis of the individual security is written down to fair value and the amount of the write down is included in earnings. In determining whether a decline is other-than-temporary, management considers:

º the length of time and the extent to which the market value of the security has been less than cost;

º the financial condition and near-term prospects of the issuer; and

º our intent and ability to retain an investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value, which could be until maturity.

The determination of whether a decline in fair value is other-than-temporary requires significant judgment, and could have a material impact on our balance sheet and results of operations. We have not had any write-downs for other-than-temporary declines in the fair value of our financial instruments since our inception.

In addition, when management commits to holding individual securities until maturity in order to avoid the recognition of an other-than-temporary impairment, those securities would no longer be classified as available-for-sale. In addition, management would evaluate these securities to determine whether the security, based on the remaining duration until its scheduled maturity, should be identified as a current or long-term asset. As of September 30, 2008, management had not designated any individual securities as held-to-maturity for the purposes of avoiding an other-than-temporary impairment.

We have invested significant amounts in construction for improvements to leased facilities we use for our research and development activities, with the largest portion of our spending made to modify manufacturing facilities that are intended to comply with requirements of government mandated manufacturing rules for pharmaceutical production. Management assesses whether the carrying value of long-lived assets is impaired whenever events or changes in circumstances indicate that the asset may not be fully recoverable. We recognize an impairment loss when the total of the estimated future cash flows expected to result from the use of the asset and its eventual disposition are less than its carrying value or appraised value, as appropriate. If we judge the value of our long-lived assets to be impaired, we write down the cost basis of the property and equipment to fair value and include the amount of the write down in our net loss. In determining whether the value of our property and equipment is impaired, management considers:

º failure of manufacturing facilities and equipment to comply with government mandated policies and procedures;

º failure of the product candidates for which the manufacturing facilities have been constructed to receive regulatory approval; and

º the extent that facilities could be idled or abandoned due to a decrease in the scope of our research and development activities for an other-than-temporary period, resulting in excess capacity.

The determination of whether the value of our property and equipment is impaired requires significant judgment, and could have a material impact on our balance sheet and results of operations. For example, in 2005, we determined that the scope of our research and development activities had changed such that we would not effectively utilize some portions of our leased facilities that had been designed to support our gene therapy programs. After considering alternative uses for these spaces, we decided it was not cost effective to re-engineer the rooms representing approximately 40,000 square feet of manufacturing, laboratory, and office space under lease through May 2008 and approximately 11,000 square feet of similar space we have under lease through November 2010. We determined we would maximize our potential cost savings by subleasing the properties. Based on market conditions for rental property at the time of the reduction in the scope of our research and development activities, and our subsequent completion of sublease agreements for approximately 26,000 square feet, we did not expect to fully recover the value invested in leasehold improvements and equipment, and reduced our net carrying value for these assets to their then current fair value, resulting in an impairment loss for the year ended December 31, 2005 of approximately $6.1 million. This impairment loss does not impact our cash flows and primarily represents an acceleration of depreciation charges that would have been recognized over the subsequent three and five year lease periods. As a result of the discontinuing all AV650-related activities, we will evaluate whether the value of our property and equipment has been further impaired as of December 31, 2008.

Under the original terms of our building lease that expired in May 2008, we had an obligation, at our landlord's sole discretion, to remove, reconfigure or otherwise alter some improvements we have made to the facility. We determined the fair value of asset retirement obligations based on our assessment of a range of possible settlement dates and amounts. Considerable management judgment is required in estimating these obligations. Important assumptions include estimates of retirement costs, the timing of the future retirement activities, and the likelihood of retirement provisions being enforced. Changes in these assumptions based on future information could result in adjustments to estimated liabilities. As a result of a change in estimate in December 2006, we remeasured the fair value of this contingent asset retirement obligation and recognized a liability for $450,000. In order to evaluate the sensitivity of the fair value calculations in measuring the obligation, we applied a hypothetical 10% increase to the expected future costs underlying the fair value calculation. This hypothetical increase would have caused a comparable increase in the retirement charge. The recognition of this liability would have resulted in an adjustment to the carrying value of the underlying long-lived assets. However, in June 2005, we determined that these leasehold improvements were impaired and wrote them off with a charge to our net loss. Since there was no carrying value of the underlying assets at December 31, 2006, the recognition of our asset retirement obligation resulted in an additional charge in 2006 to impairment loss related to long-lived assets. As of December 31, 2007, there were no material changes in our expectations with regard to this obligation. In March 2008, we amended the lease which resulted in a settlement of the obligation at an amount below the value of the liability and recorded the difference in our statement of operations as a credit to impairment loss related to long-lived assets.

Research and development expenses consist of expenses incurred in performing research and development activities including related salaries and benefits, facilities and other overhead costs, clinical trial and related drug product costs, contract services and other outside service expenses. We charge research and development expenses to operating expense in the period incurred. These expenses consist of costs incurred for our independent, as well as our collaborative, research and development activities.

Pursuant to management's assessment of the services that have been performed on clinical trials and other contracts, we recognize expenses as the services are provided. Several of our contracts extend across multiple reporting periods. Management assessments include, but are not limited to, an evaluation by the project manager of the work that has been completed during the period, measurement of progress prepared internally, estimates of incurred costs by the third-party service providers, and management's judgment. The determination of the percentage of work completed that determines the amount of research and development expense that should be recognized in a given period requires significant judgment, and could have a material impact on our balance sheet and results of operations. These estimated expenses may or may not match the actual fees billed by the service providers as determined by actual work completed. We monitor service provider activities to the extent possible; however, if we underestimate activity levels associated with various studies at a given point in time, we could record significant research and development expenses in future reporting periods.

Share-based compensation expense

Effective January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123(R), ("SFAS 123(R)"), Share-Based Payment, using the modified prospective transition method, and recognize share-based compensation expense based on the grant-date fair value of share-based awards in the results of our operations. For awards that were granted but not yet vested prior to January 1, 2006, we calculate the share-based compensation expense using the same estimate of grant-date fair value previously disclosed under FAS 123 in a pro forma manner. Fair value methods require management to make several assumptions, the most significant of which are the selection of a fair value model, stock price volatility and the expected average life of an option. We have available data of all grant-by-grant historical activity for stock options we have granted that we use in developing some of our assumptions. We use the Black-Scholes method to value stock options. We estimate the expected average life of options granted based on historic behavior of our option holders and we estimate the volatility of our common stock at the date of grant based on the historical volatility of our common stock. The assumptions we use in calculating the fair value of our share-based awards represent our best estimates, but these estimates involve inherent uncertainties and the application of management judgment. In addition, SFAS 123(R) requires we estimate forfeitures at the time of grant and only recognize expense for the portion of awards that are expected to vest. Our estimate of the forfeiture rate is based on historical experience of our share-based awards that are forfeited prior to vesting.

If factors change and we use different assumptions for calculating fair value of our share-based awards, or if our actual forfeiture rate is materially different from our estimate, our share-based compensation expense could be materially different in future periods.

We recognized no revenue for the three- and nine-month periods ended September 30, 2008 and 2007.

Research and development expenses

We maintain a small staff level, which was approximately 34 employees at September 30, 2008, and sublease portions of our leased operating facilities to reduce our overhead costs. In November 2008, we initiated a restructuring plan to further reduce infrastructure expenses that is expected to reduce our staff level to approximately 10 employees. In addition, we use external resources to optimize the pace and cost of development of our product candidates. As a result, our current business model reduces our exposure to fixed costs for manufacturing staff and facilities and increases our control over the strategic timing and application of our resources.

Our research and development expenses can be divided into two primary functions: (1) costs to support research and preclinical development, and (2) costs to support preparation for and implementation of human clinical trials. Research and preclinical development costs include activities associated with general research and exploration, animal studies, non-clinical studies to support the design of human clinical trials, and in-house and independent third-party validation testing of potential acquisition or in-license drug candidates. Clinical development costs include activities associated with preparing for regulatory approvals, maintaining regulated and controlled processes, purchasing manufactured drug substances for use in human clinical trials, and supporting subject enrollment and subject administration within clinical trials.

The costs associated with these two primary functions of our research and development activities approximate the following (in thousands, except percentages):

                                                          Percentage
                                                          (decrease)                                       Percentage
                               Three Months Ended          increase            Nine Months Ended            increase
                                 September 30,            over prior             September 30,             over prior
                               2008          2007            year             2008           2007             year
Research and preclinical
development                 $    2,309    $    3,007          (23 %)       $     8,008    $     7,829            2 %
Clinical development             3,369         2,945           14 %              9,833          7,320           34 %
Total research and
development expenses        $    5,678    $    5,952           (5 %)       $    17,841    $    15,149           18 %

Because a significant percentage of our research and development resources contribute to multiple development programs, the majority of our costs are not directly attributed to individual development programs. We base decisions regarding our project management and resource allocation primarily on interpretations of scientific data, rather than cost allocations. Our estimates of costs between research and preclinical development and clinical development activities are primarily based on staffing roles within our research and development departments. As such, costs allocated to specific projects may not necessarily reflect the actual costs of those efforts and, therefore, we do not generally evaluate actual costs-incurred information on a project-by-project basis. In addition, we are unable to estimate the future costs to complete any specific projects.

                                                                                    Percentage                                       Percentage
                                                                                    (decrease)                                        increase
                                                        Three Months Ended           increase            Nine Months Ended           (decrease)
                                                          September 30,             over prior             September 30,             over prior
                                                       2008           2007             Year             2008           2007             year
. . .