You should read the following discussion and analysis of our financial condition and results of operations together with our financial statements and the related notes included in this quarterly report and our audited financial statements and Management's Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2008, which is on file with the SEC. In addition to historical information, the following discussion contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results, performance or experience could differ materially from those indicated by any forward-looking statement due to various important factors, risks and uncertainties, including, but not limited to, those set forth under "Cautionary Note Regarding Forward-Looking Statements" in Part I of this quarterly report and under "Risk Factors" in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2008 and other filings that we make with the SEC.

Overview

Background

We are a biopharmaceutical company engaged in the design, discovery and development of NNR Therapeutics, a new class of drugs for the treatment of diseases and disorders primarily of the central nervous system. Our NNR Therapeutics selectively target a class of receptors known as neuronal nicotinic receptors, or NNRs. NNRs are found on nerve cells throughout the nervous system and serve as key regulators of nervous system activity.

We have multiple clinical-stage product candidates and preclinical programs in areas where we believe there are significant medical need and commercial potential, as well as proprietary drug discovery technologies. We have a cognition-focused collaboration with AstraZeneca and a strategic alliance with GlaxoSmithKline. Our most advanced product candidates are described below.

• TC-5214. TC-5214 is a product candidate that we are developing as an augmentation therapy for major depressive disorder, or MDD. TC-5214, which is the S(+) enantiomer of mecamylamine hydrochloride, is a nicotinic channel blocker that inhibits the activity of various NNR subtypes, including multiple forms of the †4ß2 NNR. We are conducting two ongoing clinical trials of TC-5214 as an augmentation treatment, a Phase 2b study in subjects with MDD who do not respond well to first-line treatment with the marketed drug citalopram hydrobromide and a Phase 2 exploratory study in subjects with resistant hypertension.

• AZD3480 (TC-1734). AZD3480 is a novel small molecule that modulates the activity of the †4ß2 NNR. We have a collaborative research and license agreement with AstraZeneca AB for the development and worldwide commercialization of AZD3480 as a treatment for various conditions characterized by cognitive impairment, including Alzheimer's disease and attention deficit/hyperactivity disorder, or ADHD.

• TC-5619. TC-5619 is a novel small molecule that we plan to develop for cognitive dysfunction in schizophrenia or potentially one or more other conditions characterized by cognitive impairment. TC-5619 modulates the activity of the †7 NNR. We have completed a Phase 1 single rising dose clinical trial and a Phase 1 multiple rising dose clinical trial of TC-5619 in healthy

• AZD1446 (TC-6683). AZD1446 is the most advanced compound to arise from our preclinical research collaboration with AstraZeneca described below. AstraZeneca is currently conducting Phase 1 clinical development of AZD1446.

• TC-2216. TC-2216 is a product candidate for depression and anxiety disorders. TC-2216, which is a racemate, and its enantiomers inhibit the activity of the
†4ß2 NNR. We completed a Phase 1 single rising dose clinical trial of TC-2216 in healthy volunteers in the first quarter of 2008. Based on our current budget management plans, we do not expect that we will conduct further clinical development of TC-2216 or either of its enantiomers in 2009. If we elect to continue development in the future, we are likely to elect to develop one of the enantiomers of TC-2216 instead of conducting further clinical development of TC-2216.

Under our collaboration agreement with AstraZeneca, we and AstraZeneca are conducting a preclinical research collaboration that is designed to discover and develop additional compounds that act on the †4ß2 NNR as treatments for conditions characterized by cognitive impairment. The preclinical research collaboration has a planned four-year term, which began in January 2006 and is scheduled to expire in January 2010. AstraZeneca pays us research fees, based on a reimbursement rate specified under the agreement, for research services rendered in the preclinical research collaboration, subject to specified limits.

In addition to our collaboration with AstraZeneca, we have a strategic alliance with GlaxoSmithKline that is designed to discover, develop and market product candidates that selectively target specified NNR subtypes in five therapeutic focus areas - smoking cessation, pain, obesity, addiction and Parkinson's disease.

We trace our scientific lineage to a research program initiated by R.J. Reynolds Tobacco Company in 1982 to study the activity and effects of nicotine in the body. We were incorporated in 1997 as a wholly owned subsidiary of RJR. In August 2000, we became an independent company when we issued and sold stock to venture capital investors. Since our inception, we have had limited revenue from product sales and have funded our operations principally through the sale of equity securities, revenue from collaboration agreements, grants and equipment and building lease incentive financing. We have devoted substantially all of our resources to the discovery and development of our product candidates and technologies, including the design, conduct and management of preclinical and clinical studies and related manufacturing, regulatory and clinical affairs, as well as intellectual property prosecution.

We generated net income for the fourth quarter and year ended December 31, 2006 due primarily to the achievement of a milestone event related to AZD3480 under our agreement with AstraZeneca. Except for these periods, we have never been profitable. As of March 31, 2009, we had an accumulated deficit of $194.6 million. We expect to incur substantial losses for the foreseeable future as our clinical-stage and preclinical product candidates advance through the development cycle, as we progress our programs in the therapeutic focus areas of our alliance with GlaxoSmithKline and as we invest in additional product opportunities and research programs. Clinical trials and preclinical studies are time-consuming, expensive and may never yield a product that will generate revenue.

We believe that period-to-period comparisons of our results of operations are not meaningful and should not be relied upon as indicative of our future performance.

Recent Developments

On May 11, 2009, we announced preliminary results showing that AZD3480 (TC-1734) met the primary outcome measure in a Phase 2 clinical study in adults with ADHD. In the study, adult subjects received in random order daily doses of 5mg of AZD3480, 50mg of AZD3480 and placebo, each for two weeks with the dosing periods separated by a three-week washout period. At 50mg AZD3480, subjects showed statistically significant (p<.01) improvement in symptoms of ADHD as measured by the study's primary outcome measure, total symptom score on the Conners Adult ADHD Rating Scale - Investigator Rating. Statistically significant results were also achieved at 50mg AZD3480 on a number of secondary outcome measures in the study, including Stop Signal Reaction Time, a computerized assessment of behavioral inhibition, which is a core cognitive deficit of ADHD. AZD3480 was well tolerated in the study, and there were no serious adverse events.

Analyses of the full dataset from the study remain ongoing. AstraZeneca is expected to determine whether to conduct further development of AZD3480 in either or both of ADHD and Alzheimer's disease in the second quarter of 2009.

Revenue

As of March 31, 2009, we had received $34.2 million in aggregate upfront fees and milestone payments under our collaboration agreement with AstraZeneca and had recognized an additional $22.0 million in collaboration research and development revenue for research services that we provided in the preclinical research collaboration that we are conducting with AstraZeneca under the agreement. As of March 31, 2009, we had also received $43.0 million in aggregate payments under our alliance agreement with GlaxoSmithKline. We initially deferred recognition of $41.5 million of the amounts received from AstraZeneca and GlaxoSmithKline and are recognizing such amounts into revenue over the periods discussed in Note 2 to our unaudited financial statements included in this quarterly report. As of March 31, 2009, we had $28.7 million of these deferred amounts remaining to be recognized in future periods.

We acquired rights to Inversine in August 2002. Inversine is our only product approved for marketing by the U.S. Food and Drug Administration, or FDA. Inversine is approved for the management of moderately severe to severe essential hypertension and in uncomplicated cases of malignant hypertension, which are high blood pressure disorders. However, we believe that Inversine is prescribed predominantly for the treatment of neuropsychiatric disorders, such as Tourette's syndrome, autism and bipolar disorder. Sales of Inversine generated net revenue of $251,000 and $188,000 for the three months ended March 31, 2009 and 2008, respectively. We instituted a price increase of 19% for Inversine at the beginning of 2009 and a price increase of 62% for Inversine at the beginning of 2008 to help offset the impact of increased cost of product sales resulting primarily from FDA product and establishment fees. We experienced decreased sales volume during 2008. As a result of increased FDA fees and declining prescriptions for Inversine in recent years, we notified the FDA in March 2009 that we will discontinue Inversine effective as of

September 30, 2009. Product sales of Inversine resulted in a net loss of $31,000 for the year ended December 31, 2008. We do not expect our discontinuation of Inversine to have a material impact on our cash flows or results of operations in future periods.

From time to time we seek and are awarded grants or work to be performed under grants awarded to third-party collaborators from which we derive revenue. As of March 31, 2009, we are a named subcontractor under a grant awarded to The California Institute of Technology by the National Institute on Drug Abuse, or NIDA, part of the National Institutes of Health, to fund research on innovative NNR-based approaches to the development of therapies for smoking cessation. We expect to receive approximately $1.1 million in the aggregate over a five-year period that began in July 2006 in connection with the NIDA grant. Funding for awards under federal grant programs is subject to the availability of funds as determined annually in the federal appropriations process.

A substantial portion of our revenue depends on the successful achievement of milestone events under our agreements with AstraZeneca and GlaxoSmithKline. Our revenue may vary substantially from quarter to quarter and year to year.

Research and Development Expenses

Since our inception, we have focused our activities on our drug discovery and development programs. We record research and development expenses as they are incurred. Research and development expenses represented approximately 85% and 83% of our total operating expenses for the three months ended March 31, 2009 and 2008, respectively.

We utilize our research and development personnel and infrastructure resources across several programs. We currently have clinical, preclinical and early research programs, and many of our costs are not specifically attributable to a single program. Instead, these costs are directed to broadly applicable research efforts. Accordingly, we cannot state precisely our total costs incurred on a program-by-program basis.

We have not received FDA or foreign regulatory marketing approval for any of our product candidates that are in development. Our current and future expenditures on preclinical and clinical development programs are subject to numerous uncertainties in timing and cost to completion. In particular, our strategy includes entering into alliances and collaborations with third parties to participate in the development and commercialization of some of our product candidates. Where a third party has responsibility for or authority over the preclinical or clinical development of a particular product candidate, the estimated completion date is largely under control of that third party and not under our control. We cannot forecast with any degree of certainty whether AstraZeneca or GlaxoSmithKline will exercise any options to license particular product candidates that become exercisable under the terms of our respective agreements, which of our product candidates will be subject to future alliances or collaborations or how such arrangements would affect our development plans or capital requirements. Because of this uncertainty, and because of the numerous uncertainties related to clinical trials and drug development generally, we are unable to determine the duration and completion costs of our research and development programs or whether or when we will generate revenue from the commercialization and sale of any of our product candidates in development.

General and Administrative Expenses

General and administrative expenses consist principally of salaries and other related costs for personnel in executive, finance, accounting, business development, legal and human resource functions. Other general and administrative expenses include expenses associated with stock options and other stock-based awards granted to personnel in those functions, depreciation and other facility costs not otherwise included in research and development expenses, patent-related costs, insurance costs and professional fees for consulting, legal, accounting and public and investor relations services.

Income Taxes

We recognized a $73,000 income tax benefit for the three months ended March 31, 2009 due to an election to forgo certain "bonus depreciation" for federal income tax purposes in exchange for a refundable research and development tax credit provided initially under the Housing Assistance Tax Act of 2008 and extended by the American Recovery and Reinvestment Act of 2009.

We generated net income for the three months and year ended December 31, 2006 due primarily due to the achievement of a milestone event related to AZD3480 under our agreement with AstraZeneca. We incurred net operating losses for each other period since inception and consequently have not paid federal, state or foreign income taxes in any period. As of March 31, 2009, we had net operating loss carryforwards of $118.3 million for federal income tax purposes and $118.2 million for state income tax purposes. We also had $6.0 million in research and development federal income tax credits as of March 31, 2009. The federal net operating loss carryforwards begin to expire in 2020. The state net operating loss carryforwards begin to expire in 2015. The research and development tax credits begin to expire in 2023. Utilization of the net operating loss carryforwards and credits may be subject to a substantial annual limitation due to ownership change limitations provided by Section 382 of the Internal Revenue Code of 1986, as amended, and similar state provisions. When an ownership change, as defined by Section 382, occurs, an annual limitation is imposed on a company's use of net operating loss and credit carryforwards attributable to periods before the change. As a result of a series of stock issuances, we had such an ownership change in November 2002. Consequently, an annual limitation is imposed on our use of net operating loss and credit carryforwards that are attributable to periods before November 2002 and a portion of the net operating loss carryforwards described above may potentially not be usable by us. We could experience additional ownership changes in the future. For financial reporting purposes, we have recorded a valuation allowance to fully offset the deferred tax asset related to these carryforwards because realization of the benefit is uncertain.

Fair Value

The carrying amounts of our cash and cash equivalents, short-term investments, accounts receivable, accounts payable, accrued expenses and long-term debt are considered to be representative of their respective fair values due to the short-term nature of our cash and cash equivalents, short-term investments, accounts receivable, accounts payable and accrued expenses and the market interest rates of our short-term investments and long-term debt. Our short-term investments in certificates of deposit of $37.2 million at March 31, 2009 are recorded at quoted prices of an active market.

Critical Accounting Policies and Estimates

Our management's discussion and analysis of our financial condition and results of operations are based on our unaudited financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate these estimates and judgments. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances. These estimates and assumptions form the basis for making judgments about the carrying values of assets and liabilities and the recording of revenues and expenses that are not readily apparent from other sources. Actual results and experiences may differ materially from these estimates. In addition, our reported financial condition and results of operations could vary if new accounting standards are enacted that are applicable to our business.

Our significant accounting policies are described in Note 2 to our audited financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2008 and in the notes to our financial statements included in this quarterly report. We believe that our accounting policies relating to revenue recognition, accrued expenses and stock-based compensation are the most critical to understanding and evaluating our reported financial results. We have identified these policies as critical because they are important to the presentation of our financial condition and results of operations and require us to make judgments and estimates on matters that are inherently uncertain and may change in future periods. These policies are described under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates" in our Annual Report on Form 10-K for the year ended December 31, 2008.

Results of Operations

Three Months ended March 31, 2009 and 2008

Net Operating Revenues



                                                       Three Months ended March 31,
                                                         2009                2008           Change
                                                                    (in thousands)
Operating revenues:
Collaboration research and development              $         1,544     $         2,258     $  (714 )
Milestones and license fees from collaborations               4,120               1,620       2,500
Product sales, net                                              251                 188          63
Grant revenue                                                   226                 210          16

Net operating revenues                              $         6,141     $         4,276     $ 1,865

Net operating revenues for the three months ended March 31, 2009 increased by $1.9 million as compared to the three months ended March 31, 2008. The higher net operating revenues were primarily attributable to an increase of $2.5 million in milestones and license fees from collaborations revenue, partially offset by a decrease of $714,000 in collaboration research and development revenue. The increase in milestones and license fees from collaborations revenue reflected $2.5 million in aggregate payments received from GlaxoSmithKline upon achievement of milestone events under our alliance agreement related to progress in preclinical

programs. The decrease in collaboration research and development revenue for the 2009 period reflects reduced services rendered by us in our preclinical research collaboration with AstraZeneca resulting from progress previously made towards meeting the objectives of the research plan. Based on progress made to date in the preclinical research collaboration with AstraZeneca and the objectives and budget established for the preclinical research collaboration for 2009, we expect collaboration research and development revenue to decrease for future 2009 periods, as compared to the corresponding 2008 periods. The preclinical research collaboration with AstraZeneca is scheduled to expire in January 2010.

Research and Development Expenses

Research and development expenses for the three months ended March 31, 2009 increased by $413,000 as compared to the three months ended March 31, 2008. The higher research and development expenses were primarily attributable to an increase of $586,000 in costs incurred for third-party research and development services in connection with our preclinical programs to $1.1 million for the 2009 period, from $526,000 for the 2008 period, partially offset by a decrease of $218,000 in costs incurred for third-party research and development services in connection with our clinical-stage product candidates (including costs for clinical trial activities, formulation activities, production of clinical trial materials, and pharmacology, toxicology and other non-clinical studies) to $2.2 million for the 2009 period, from $2.4 million for the 2008 period. The higher costs in connection with our preclinical programs were primarily related to the programs in the therapeutic focus areas of our alliance with GlaxoSmithKline.

The costs that we incurred for the three-month periods ended March 31, 2009 and 2008 for third-party services in connection with research and development of clinical-stage product candidates are show in the table below:

                                  Three months ended March 31,
                                    2009                2008         Change
                                              (in thousands)
           TC-5214             $         1,343     $           764   $   579
           TC-5619                         879               1,022      (143 )
           AZD3480 (TC-1734)                17                   2        15
           TC-2216                          -                  321      (321 )

In addition to the product candidates shown in the table above, for the three months ended March 31, 2008, we incurred $329,000 in expenses for third-party research and development services in connection with TC-2696 and TC-6499, product candidates that we have since ceased developing.

General and Administrative Expenses

General and administrative expenses for the three months ended March 31, 2009 decreased by $221,000 as compared to the three months ended March 31, 2008. The lower general and administrative expenses were primarily attributable to a decrease of $271,000 in patent-related expenses, which reflects differences in the timing of nationalization.

Interest Income and Interest Expense



                                  Three months ended March 31,
                                   2009                 2008         Change
                                              (in thousands)
           Interest income    $           362      $           970   $  (608 )
           Interest expense                60                   51         9

Interest income for the three months ended March 31, 2009 decreased by $608,000 as compared to the three months ended March 31, 2008. The decrease was primarily attributable to lower short-term interest rates and a lower average cash and investment balance during the 2009 period. Interest expense for the three months ended March 31, 2009 increased by $9,000 as compared to the three months ended March 31, 2008. The increase was attributable to higher average indebtedness under our loan facilities.

Liquidity and Capital Resources

Sources of Liquidity

We received from GlaxoSmithKline a $2,000,000 payment in April 2009 and a $500,000 payment in March 2009 upon achievement of milestone events under our alliance agreement related to progress in preclinical programs.

We made our final monthly payment of $23,000 on a loan facility that we had with R.J. Reynolds Tobacco Holdings, Inc., or RJRT, on the maturity date of January 1, 2009.

In March 2008, we entered into a loan agreement with a bank that provided borrowing capacity of $5.3 million to fund the purchase of equipment, furnishings, software and other fixed assets and enable the refinancing of our then-existing loan facility with RJRT. We borrowed $4.8 million upon entering into the loan agreement and borrowed the remaining $489,000 in September 2008. Pursuant to the loan agreement, we granted a first priority security interest in favor of the bank in the assets acquired with the proceeds of the loan facility. The March 2008 loan bears interest at a fixed rate of 5.231% per annum and is repayable in equal monthly installments of $112,000 beginning April 1, 2008 and continuing through the maturity date of March 1, 2012. We used $1.7 million of the proceeds from the March 2008 loan to pay and satisfy in full the principal and interest outstanding on two of the tranches under the loan facility with RJRT and granted a first priority security interest in favor of the bank in assets previously

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