This Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. Avigen's actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause or contribute to such differences include, but are not limited to, those discussed herein and in "Item 1A - Risk Factors."

Overview

Avigen is a biopharmaceutical company that has focused on identifying and developing differentiated products to treat patients with serious neurological and other disorders. Our strategy is to identify, acquire and develop opportunities that represent a positive return to Avigen's stockholders. Our current potential product is AV411, a glial attenuator, for neuropathic pain and opioid withdrawal and methamphetamine addiction.

Between January 2006 and October 2008, we were primarily focused on the development of AV650 for the treatment of spasticity and neuromuscular spasm. In January 2006, we acquired exclusive license rights from SDI Diagnostics International LTD, a division of Sanochemia Pharmazeutika AG, or Sanochemia, to develop and commercialize proprietary formulations of the compound tolperisone, which we named AV650, for the North American market. In 2007, we initiated Phase 2 clinical trials for AV650 in the United States and Europe and in July 2008, we expanded our agreement with Sanochemia for the development of a proprietary, purer form of AV650 that was identified and supported by patent filings during our clinical development. We paid Sanochemia $3.0 million in 2006 in connection with the initial license and $2.5 million in 2008 for the achievement of a development milestone on the purer form of the compound.

During 2007, we also expanded the scope of our clinical development activities to include a Phase 2a trial for AV411 in Australia, and a maximum-tolerable-dose trial for AV411 in the U.S. The operation of these trials and other development activities resulted in a significant increase in our operating expenses during 2007, which continued into 2008.

In October 2008, we announced that the results of the AV650 Phase 2 clinical trial in patients with spasticity associated with multiple sclerosis did not meet its primary endpoint and we terminated the program. We also immediately terminated our agreement with Sanochemia to avoid further financial obligations to them.

In November 2008, we announced a significant restructuring of the company aimed at preserving financial resources and reassessing strategic opportunities. This restructuring included a 70% reduction of our staff and consolidation and closure of portions of our leased facilities. While the NIDA-funded Phase 1b/2a trials for AV411 in opioid withdrawal and methamphetamine relapse will continue, we announced that it was our intention to seek a partner for the further development of AV411.

In December 2008, we entered into an agreement with Baxter Healthcare Corporation, Baxter International Inc., and Baxter Healthcare S.A. (collectively "Baxter"), providing for the sale of the rights to our early stage blood coagulation compound, AV513, to Baxter. We received a cash payment of $7.1 million from Baxter as proceeds from the sale of AV513.

As a result of the termination of the AV650 program and our subsequent restructuring, 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. We are reviewing strategic opportunities, including potential merger and acquisition transactions, which could increase stockholder value. The terms and structure of such a transaction could have a significant impact on our future sources of revenue and expense needs. Meanwhile, we expect our source of revenue, if any, for the next few 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 additional losses over the next few years due to lack of any substantial revenue. There can be no assurance that we will enter into a merger and acquisition transaction or successfully develop, commercialize, manufacture, or market our product candidates or ever achieve or sustain product revenue for profitability.

In May 2006, we completed a private placement of common stock with institutional investors for gross proceeds of $21.2 million. Under the terms of the transaction Avigen sold approximately 3.9 million shares of common stock at a purchase price of $5.37 per share. The transaction did not include any warrants or other enhancements.

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 commercial sale of our products in development, and we do not anticipate generating revenue from the commercialization of AV411 in the foreseeable future. Currently we have suspended development for AV411 for neuropathic pain and our ongoing clinical development for AV411 for opioid addition and withdrawal is being primarily funded by third-parties. We do not anticipate the need to obtain additional funding to support the needs of our current research and development activities. We currently expect that any expansion of our AV411 development activities will be supported through partners. However, if we are successful entering into a merger and acquisition transaction or in acquiring additional product candidates or pursuing additional indications for compounds in our portfolio, we may require additional funding to complete the research and development activities necessary to fully develop and commercialize such products.

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. See also Note 1 in the Notes to our Financial Statements in Item 8. of this Form 10-K.

Revenue recognition

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 2008, we received a $7.1 million payment under the terms of our agreement with Baxter Healthcare Corporation (see Note 10). We recognized the payment as revenue, since we concluded that as of December 31, 2008, 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 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.

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 intention and ability to retain our 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 December 31, 2008, management had not designated any individual securities as held-to-maturity for the purposes of avoiding an other-than-temporary impairment.

Impairment of property and equipment and asset retirement obligation

Prior to 2003, we have invested significant amounts in construction for modifications and improvements to leased facilities we previously used for our research and development activities. Most of our spending was made to modify facilities for manufacturing, general laboratory, and other research facilities which we either no longer lease or, in connection with our November 2008 restructuring, no longer use. Management assesses whether the carrying value of long-lived assets is impaired whenever events or changes in circumstances, such as the November 2008 restructuring, 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 November 2008, in connection with the termination of our AV650 program, we determined that the scope of our research and development activities had changed and we would no longer effectively utilize approximately 12,000 square feet of general laboratories in our leased facilities 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 assessment, and our subsequent completion of a sublease agreement for the majority of the general laboratory space, 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, 2008 of approximately $413,000. This impairment loss does not impact our cash flows and primarily represents an acceleration of depreciation charges that would have been recognized through 2009.

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.

Recognition of Research and Development Expenses

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 123(R), ("FAS 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, FAS 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 granted, exercised and cancelled.

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.

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Results of Operations

   Revenue

                                                      Year Ended December 31,
         (In thousands, except percentages)          2008         2007      2006
         Revenue                                  $    7,100      $   -     $ 103

Revenue in 2008 reflected income from the sale of the rights to our early stage blood coagulation compound, AV513, to Baxter. We recognized no revenue in 2007. Revenue for 2006 represented income from our participation with the University of Colorado on a grant that was funded by the National Institutes of Health.

Historically, we have maintained a small staff level and subleased portions of our leased operating facilities to reduce our overhead costs. In November 2008, we completed a significant restructuring plan to further reduce infrastructure expenses including a reduction of our staff level by approximately 70 percent. All remaining research and development activities associated with our potential products are performed with external resources to optimize the pace and cost of these activities. This is intended to preserve our financial resources, minimize our exposure to fixed costs for staff and facilities and increase our control over the strategic timing and use of all of our resources.

Prior to the restructuring in November 2008, 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.

At December 31, 2008, the number of our staff overseeing research and development activities associated with AV411 and related compounds, was four, compared to the number of staff we employed in connection with all our research and development activities at December 31, 2007 and 2006 of 23 and 21, respectively.

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

                                                                       Percentage
                                                 Year Ended            (decrease)        Year Ended        Percentage
                                                December 31,          increase 2008     December 31,      increase 2007
                                              2008         2007         over 2007           2006            over 2006
Research and preclinical development        $ 10,177     $ 11,004         (8%)          $      10,454          5%
Clinical development                          13,430        9,577          40%                  4,765         101%
Total research and development expenses     $ 23,607     $ 20,681          14%          $      15,219          36%

During these years, a significant percentage of our research and development resources contributed to multiple development programs, the majority of our costs were not directly attributed to individual development programs. We based 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 were 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.

Research and preclinical development

We have reclassified some prior period amounts within research and preclinical, clinical development and general and administrative expenses to conform to our current period's presentation. The reclassifications had no impact on our financial condition, results of operations, or the net cash flow from operating activities reported on our statement of cash flow.

                                                                                                                    Percentage
                                                                                   Percentage                        increase
                                                              Year Ended           (decrease)      Year Ended       (decrease)
                                                             December 31,             2008        December 31,         2007
(In thousands, except percentages)                         2008         2007       over 2007          2006          over 2006
Personnel-related                                        $  1,957     $  1,977        (1%)        $       1,891         5%
Share-based compensation                                      516          522        (1%)                  382        37%
Severance                                                     682            -        n/a                     -        n/a
External research and development                           4,131        4,346        (5%)                3,954        10%
Depreciation                                                  579        1,454       (60%)                1,075        35%
Other expenses including facilities overhead                2,312        2,805       (18%)                3,152       (11%)
Total research and preclinical development expenses      $ 10,177     $ 11,104        (8%)        $      10,454         6%

Comparison of Years Ended December 31, 2008 and 2007. The decreases in our total research and preclinical development expenses for the year ended December 31, 2008, compared to 2007, of $927,000, were primarily due to changes in costs for the following:

º lower depreciation expenses of $875,000, reflecting the acceleration of depreciation expense in 2007 in connection with a change in estimate that shortened the depreciable life for approximately $2.7 million of leasehold improvements and other assets, and the fact that almost all of our other depreciable equipment had reached their original depreciable life early in 2008,

. . .