Summary of AVALON PHARMACEUTICALS INC

Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion and analysis of our results of operations, financial condition and liquidity and capital resources should be read in conjunction with our unaudited consolidated financial statements and related notes contained in this Quarterly Report on Form 10-Q , as well as the audited financial statements and related notes for the fiscal year ended December 31, 2008 and "Management's Discussion and Analysis of Financial Condition and Results of Operations," contained in our Annual Report on Form 10-K , for the fiscal year ended December 31, 2008.
Overview
We are a biopharmaceutical company focused on the discovery, development and commercialization of first-in-class cancer therapeutics. We use AvalonRx ®, our proprietary platform, which is based on large-scale biomarker identification and monitoring, to discover and develop therapeutics for pathways that have historically been characterized as "undruggable." Since our inception, our operations have consisted primarily of developing AvalonRx ®, utilizing our technology to seek to discover and develop novel cancer therapeutics, and the in-license and development of AVN944. During that period, we have generated limited revenue from collaborative partners, and have had no revenue from product sales. Our operations have been funded principally through the offering of equity securities and debt financings.
We have never been profitable and, as of March 31, 2009, we had an accumulated deficit of $149.8 million. We had net losses of $3.6 million for the three months ended March 31, 2009 and net losses of $21.8 million for the year ended December 31, 2008. We expect to incur significant operating losses for the foreseeable future as we advance our drug candidates from discovery through preclinical testing and clinical trials and seek regulatory approval and eventual commercialization. We will need to generate significant revenues to achieve profitability, and we may never do so.
As of March 31, 2009, we had cash, cash equivalents and marketable securities of approximately $3.5 million. We currently estimate that our existing capital resources will not be sufficient to fund our current operations significantly beyond the end of May 2009, by which time our pending merger with a subsidiary of Clinical Data is expected to close. If our proposed merger does not close by the end of May 2009, we would need to raise additional funds to continue operations. See "-Recent Developments" below. In light of the proposed merger, we do not expect to seek to raise additional capital. Should the merger not close or if the closing is delayed beyond the end of May 2009, there is no assurance that we would be able to raise capital sufficient to enable us to continue our operations significantly beyond the end of May 2009. In the event we were unable to successfully raise additional capital in such circumstances, we will not have sufficient cash flows and liquidity to finance our business operations as currently contemplated. Accordingly, in such circumstances we would be compelled to reduce general and administrative expenses and delay research and development projects and the purchase of scientific equipment and supplies until we were able to obtain sufficient financing. Pending Acquisition by Clinical Data
On October 27, 2008, Avalon entered into a merger agreement with Clinical Data, Inc., or Clinical Data, and API Acquisition Sub II, LLC, an indirect wholly-owned subsidiary of Clinical Data, or API. The merger agreement provides that, upon the terms and subject to the conditions set forth in the merger agreement, API will be merged with and into Avalon, with Avalon continuing as the surviving corporation and a subsidiary of Clinical Data. In connection with entering into the merger agreement with Clinical Data, Avalon borrowed $4 million from Clinical Data under a note purchase agreement with Clinical Data, to fund Avalon's short-term on-going operations, entered into a license agreement with Clinical Data under which Clinical Data received an exclusive license (subject to certain exceptions) to AvalonRx® in exchange for a one time license fee of $1 million, and engaged in a private placement with Clinical Data of Avalon common stock and warrants for a cash payment of $237,338 from Clinical Data.

Recent Developments
Effective May 1, 2009, Avalon and Merck & Co., Inc., or Merck, agreed to terminate the Exclusive License and Research Collaboration Agreement between the parties (referred to as the "Merck Agreement") pursuant to the terms of the Merck Agreement. As part of the termination of the Merck Agreement, Merck agreed to pay Avalon a termination payment of $4 million. The $4 million termination payment was paid by Merck to Avalon on May 7, 2009. Avalon will recognize the termination payment as revenue in the second quarter of 2009.
Under the terms of the merger agreement with Clinical Data, the $4 million payment received by Avalon from Merck was required to be used to pay down the outstanding balance, including interest, of our secured loan with Clinical Data. See "-Liquidity and Capital Resources-Clinical Data Secured Loan" below. As of April 30, 2009, a total of approximately $4.1 million in principal and accrued interest remained outstanding under this secured loan. On May 8, 2009, Avalon paid Clinical Data a total of $4 million in respect of the secured loan, reducing the outstanding balance of the secured loan by that amount. Financial Operations Overview
Revenue
We have not generated any revenue from sales of commercial products and do not expect to generate any product revenue for the foreseeable future. To date, our revenue has consisted of collaboration revenue.
Collaboration Revenue. Since inception, we have generated revenue solely in connection with our collaboration and pilot study agreements. Our collaborations with Merck, AstraZeneca and Novartis include upfront payments, research funding, and/or payments for the achievement of certain discovery and development related milestones. During the first three months of 2009, we recognized no revenue from any of our collaborations. Research and Development Expense
Research and development expense consists of expenses incurred in connection with developing and advancing our drug discovery technology and identifying and developing our drug candidates and supporting our collaborative relationships. These expenses consist primarily of salaries and related expenses, the purchase of laboratory supplies, access to data sources, facility costs, costs for preclinical development and expenses related to our in-license and clinical trials of AVN944. Other than for advance payments for research and development costs, subject to the provisions of EITF 07-03, we charge all research and development expenses to operations as incurred.
We expect our research and development costs to be substantial as we advance our drug candidates into preclinical testing and clinical trials. Based on the results of our preclinical studies, we expect to selectively advance some drug candidates into clinical trials. We anticipate that we will select drug candidates and research projects for further development on an ongoing basis in response to their preclinical and clinical success and commercial potential. We are currently conducting Phase I clinical trials for AVN944 in patients with hematological cancer and Phase IIa clinical trials for patients with pancreatic cancer. In August 2008, we announced that we had reached a likely maximum tolerated dose of AVN944 in both the ongoing Phase I clinical trial and in the Phase IIa trial. We are currently assessing various alternatives regarding the internal or external development of AVN944. General and Administrative
General and administrative expense consists primarily of salaries and related expenses for personnel in administrative, finance, business development and human resource functions. Other costs include legal costs of pursuing patent protection of our intellectual property and other fees for legal services.

Results of Operations
Three Months Ended March 31, 2009 and 2008 Revenue. There were no revenues for the three months ended March 31, 2009, compared with $50,000 in the same period of the prior year. The reported revenues in 2008 were attributable to our collaboration agreement with Novartis.
Research and Development. Research and development expenses decreased by $1.7 million, or 39%, to $2.7 million for the three months ended March 31, 2009 from $4.4 million for the same period in 2007. The decrease in research and development expenses was primarily attributable to lower personnel and lab supplies costs due to the reduction in force in August 2008 as well as lower cost for clinical trials in the 2009 period.
General and Administrative. General and administrative expenses decreased by $1.2 million or 57% when comparing the three months ended March 31, 2009 with the three months ended March 31, 2008. The decrease is due primarily to lower personnel costs due to the reduction in force in August 2008 as well as lower stock compensation expense in 2009.
Interest Income. There was no interest income for the three months ended March 31, 2009, compared with $307,000 for the three months ended March 31, 2008. The decrease in interest income is due to lower balances of cash and investments and lower average interest rates.
Interest Expense. Interest expense decreased by $63,000, or 55%, to $52,000 for the three months ended March 31, 2009, compared to $115,000 for the three months ended March 31, 2008. The decrease in interest expense was due to lower debt balances in the 2009 period, principally related to paying off our loan the Maryland Industrial Development Financing Authority in October 2008.
Other Income. Other income was $80,000 for the three months ended March 31, 2009, compared with $2,000 for the three months ended March 31, 2008. The increase in other income was primarily related to income from subletting part of our facility and the provision of shared services to subtenants. Liquidity and Capital Resources
Our primary cash requirements are to:
• fund our research and development and clinical programs;

• obtain regulatory approvals;

• prosecute, defend and enforce any patent claims and other intellectual property rights;

• fund general corporate overhead; and

• support our debt service requirements and contractual obligations.

Our cash requirements could change materially as a result of the progress of our research and development and clinical programs, licensing activities, acquisitions, divestitures or other corporate developments.
We have incurred operating losses since our inception and historically have financed our operations principally through public stock offerings, debt financings, private placements of equity securities, strategic collaborative agreements that include research and development funding and development milestones, and investment income.
In evaluating alternative sources of financing we consider, among other things, the dilutive impact, if any, on our stockholders, the ability to leverage stockholder returns through debt financing, the particular terms and conditions of each alternative financing arrangement and our ability to service our obligations under such financing arrangements.
As of March 31, 2009, we had cash, cash equivalents and marketable securities of approximately $3.5 million.

Clinical Data Secured Loan
As a part of the proposed merger, we entered into a note purchase agreement with Clinical Data pursuant to which Clinical Data made a series of loans to us evidenced by term notes in the aggregate principal amount of $4 million. The term notes bear interest at a fixed rate of 7% per annum and mature on May 31, 2009 unless accelerated pursuant to their terms. The original amount of the loan from Clinical Data under the note purchase agreement was $3 million and matured on March 31, 2009. On January 12, 2009, Clinical Data extended the maturity of the original $3 million term note evidencing the loan until April 30, 2009. On March 30, 2009, Avalon and Clinical Data amended the note purchase agreement and the original $3 million term note to further extend the $3 million term note's maturity date to May 31, 2009 and Clinical Data and Avalon also increased the amount borrowed by Avalon under the note purchase agreement from $3 million to $4 million through the issuance by Avalon of an additional $1 million term note. We have the right to prepay the term notes, together with any accrued interest, at any time without penalty. The maturity of the term notes accelerates if there is a default under the terms of the note purchase agreement or related documents, including any default, breach or termination of Clinical Data's license agreement with us relating to AvalonRx® or of the merger agreement (other than a termination of the merger agreement as a result of a failure to obtain the approval by our stockholders of the merger). The term notes are secured by collateral consisting of certain of our intellectual property rights.
Sources and Uses of Cash
Operating Activities. Net cash used in operating activities for the three months ended March 31, 2009 was $3.3 million, compared to $4.8 million for the same period in fiscal 2008. During the first three months of fiscal year 2009, our net loss of $3.6 million was reduced by non-cash charges of $430,000, primarily for stock compensation, depreciation and amortization, offset by changes in our net operating assets and liabilities.
Investing Activities. Net cash provided by investing activities for the three months ended March 31, 2009 was $894,000, compared to net cash used in investing activities of $4.2 million for the same period in 2008. Proceeds from the sale and maturity of marketable securities were the primary source of cash from investing activities, providing $899,000 in the first three months of 2009 and $9.2 million in the comparable period of 2008. Cash used in investing activities principally represents the amount used to purchase marketable securities, net of proceeds from the sale and maturity of marketable securities.
Financing Activities. Net cash provided by financing activities for the three months ended March 31, 2009 was $1.0 million, compared to $43,000 of net cash used in financing activities for the same period in 2008. In March 2009, we borrowed an additional $1.0 million from Clinical Data under a secured loan to fund our short-term operations.
Item 3. Quantitative and Qualitative Disclosures About Market Risk Not applicable pursuant to the rules of the Securities and Exchange Commission relating to the disclosure requirements for a "smaller reporting company."
Item 4T. Controls and Procedures
Disclosure Controls and Procedures: Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures, as of March 31, 2009 (the "Evaluation Date"). Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the Evaluation Date, our disclosure controls and procedures were effective.
Changes in Internal Control over Financial Reporting: There have been no changes in our internal control over financial reporting during the quarter ended on the Evaluation Date that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.