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 what is 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, Item 1A of Part II of this quarterly report 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, which we refer to as 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 a form of the †4฿2 NNR and positively modulates the activity of another form of the †4฿2 NNR. In July 2009, we announced positive top-line results from a Phase 2b clinical trial of TC-5214 as an augmentation (add-on) treatment in subjects with MDD who did not respond adequately to first-line treatment with citalopram hydrobromide, a selective serotonin reuptake inhibitor marketed as Celexaฎ in the United States.

In addition, we initiated a Phase 2 exploratory study of TC-5214 as an augmentation treatment for resistant hypertension in the second quarter of 2009. In light of the favorable outcome of the completed MDD trial and slow enrollment in the resistant hypertension study, we have determined to allocate resources to preparation for Phase 3 MDD development of TC-5214 and not to continue the resistant hypertension study.

• AZD3480 (TC-1734). AZD3480 is a novel small molecule that acts as an agonist of one or more forms of the †4฿2 NNR. We have a collaborative research and license agreement with AstraZeneca AB for the development and worldwide

• AZD1446 (TC-6683). AZD1446 is a novel small molecule that acts as an agonist of one or more forms of the †4฿2 NNR and is the most advanced product candidate to arise from our preclinical research collaboration with AstraZeneca described below. AZD1446 is planned for development in Alzheimer's disease and potentially one or more other conditions characterized by cognitive impairment. AstraZeneca is currently conducting Phase 1 clinical development of AZD1446.

• 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 volunteers. Following our completion of a planned Phase 2 clinical proof of concept trial of TC-5619, AstraZeneca has the right to license TC-5619 on terms specified in our agreement.

• TC-5685. TC-5685 is a preclinical product candidate for depression and anxiety disorders. TC-5685 inhibits the activity of one or more forms of the
†4฿2 NNR and is one of the constituent enantiomers of the racemate TC-2216. 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 progress the development of TC-5685 or TC-2216 in 2009. If we elect to continue development in the future, we are likely to elect to develop TC-5685 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 †4฿2 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 June 30, 2009, we had an accumulated deficit of $204.2 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.

As a clinical-stage company, our results of operations are likely to fluctuate significantly from quarter to quarter and year to year. We believe that period-to-period comparisons of our results of operations should not be relied upon as indicative of our future performance.

Revenue

As of June 30, 2009, we had received $34.4 million in aggregate upfront fees and milestone payments under our collaboration agreement with AstraZeneca and had recognized an additional $23.9 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. In July 2009, under an amendment to the agreement, we received a $10.0 million payment from AstraZeneca as a result of the achievement of the objective in the completed Phase 2 trial of AZD3480 in adults with ADHD. The $10.0 million payment will be reflected in our results of operations for the three months ending September 30, 2009. As of June 30, 2009, we had also received $45.0 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 and Note 4 to our unaudited financial statements included in this quarterly report. As of June 30, 2009, we had $27.3 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. Sales of Inversine generated net revenue of $104,000 and $199,000 for the three months ended June 30, 2009 and 2008, respectively, and $355,000 and $387,000 for the six months ended June 30, 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 and through June 30, 2009. Product sales of Inversine resulted in a net loss of $130,000 for the six months ended June 30, 2009 and $31,000 for the year ended December 31, 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. Because we have no further plans to

manufacture Inversine, we recorded a charge of $52,000 in cost of product sales related to the impairment of our raw materials inventory during the three months ended June 30, 2009. We do not expect the 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 June 30, 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.

In July 2009, we were awarded a grant from The Michael J. Fox Foundation for Parkinson's Research. The grant is designed to fund preclinical research involving the use of compounds that modulate NNRs to address Levodopa-induced abnormal involuntary movements, known as dyskinesias. The terms of the award provide for us to receive $641,000 in aggregate payments as we conduct the funded research over an expected period of one year.

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 87% and 84% of our total operating expenses for the three months ended June 30, 2009 and 2008, respectively, and 86% and 83% of our total operating expenses for the six months ended June 30, 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 the control of that third party and not under our control. We cannot forecast with 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, if any, will be subject to future alliances or collaborations or how any such arrangement 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 an income tax benefit of $73,000 for the six months ended June 30, 2009 as a result of our 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 primarily due to the achievement of a milestone event related to AZD3480 under our agreement with AstraZeneca. We have 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 June 30, 2009, we had net operating loss carryforwards of $128.7 million for federal income tax purposes and $128.6 million for state income tax purposes. The federal net operating loss carryforwards begin to expire in 2020. The state net operating loss carryforwards begin to expire in 2015. We also had $6.0 million in research and development federal income tax credits as of June 30, 2009. The federal 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 $27.2 million at June 30, 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 June 30, 2009 and 2008

Net Operating Revenues



                                                       Three Months ended June 30,
                                                        2009                2008           Change
                                                                   (in thousands)

Operating revenues:
Collaboration research and development             $         1,121     $         2,637    $ (1,516 )
Milestones and license fees from collaborations              1,605               2,320        (715 )
Product sales, net                                             104                 199         (95 )
Grant revenue                                                   -                   -           -

Net operating revenues                             $         2,830     $         5,156    $ (2,326 )

Net operating revenues for the three months ended June 30, 2009 decreased by $2.3 million as compared to the three months ended June 30, 2008. The lower net operating revenues for the 2009 period as compared to the 2008 period were principally attributable to a decrease of $1.5 million in collaboration research and development revenue and a decrease of $715,000 in milestones and license fees from collaborations revenue. 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 as a result of progress previously made towards meeting the objectives of the research plan. We expect collaboration research and development revenue for future 2009 periods to continue to be lower than the corresponding 2008 periods. The preclinical research collaboration with AstraZeneca is scheduled to expire in January 2010.

The decrease in milestones and license fees from collaborations revenue for the 2009 period was principally attributable to the timing of our achievement of milestone events under our alliance agreement with GlaxoSmithKline related to progress in preclinical programs, as well as recognition of less deferred license fee revenue. We recognized less deferred license fee revenue for the 2009 period as a result of an extension of the estimated development period for AZD3480, based on AstraZeneca's plans to conduct further Phase 2 clinical development prior to the planned initiation of Phase 3 clinical development, and an extension of the estimated development period for TC-5619 to reach Phase 2 clinical proof of concept.

Research and Development Expenses

Research and development expenses $ 11,049 $ 10,518 $ 531

Research and development expenses for the three months ended June 30, 2009 increased by $531,000 as compared to the three months ended June 30, 2008. The higher research and development expenses were principally attributable to an increase of $596,000 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 $3.2 million for the 2009 period, from $2.6 million for the 2008 period. The increase was primarily due to

costs associated with the conduct of the Phase 2b clinical trial of TC-5214 as an augmentation therapy for MDD, which we initiated in July 2008. The higher research and development expenses were also attributable to an increase of $215,000 in costs incurred for third-party research and development services in connection with our preclinical programs, primarily in the therapeutic focus areas of our alliance with GlaxoSmithKline, to $1.7 million for the 2009 period, from $1.4 million for the 2008 period. These increases were partially offset by a decrease of $280,000 in supply and other non-program specific research and development costs resulting from planned budget reductions.

The costs that we incurred for the three-month periods ended June 30, 2009 and 2008 for third-party research and development services in connection with clinical-stage product candidates are shown in the table below:

                                   Three months ended June 30,
                                    2009                2008          Change
                                               (in thousands)

           TC-5214             $         2,025     $         1,106   $    919
           TC-5619                         687                 614         73
           AZD3480 (TC-1734)               191                 133         58

In addition to the product candidates shown in the table above, for the three months ended June 30, 2009 and 2008, we incurred $254,000 and $707,000, respectively, in expenses for third-party research and development services in connection with TC-2696, TC-6499 and TC-2216, which are clinical-stage compounds for which we have either terminated development or are not currently progressing. AstraZeneca is responsible for funding all future development costs for AZD3480 and AZD1446.

General and Administrative Expenses

General and administrative expenses $ 1,377 $ 1,894 $ (517 )

General and administrative expenses for the three months ended June 30, 2009 decreased by $517,000 as compared to the three months ended June 30, 2008. The lower general and administrative expenses were principally attributable to decreases in professional fees, patent-related costs and travel-related expenses.

Interest Income and Interest Expense



                                  Three months ended June 30,
                                    2009              2008        Change
                                             (in thousands)

             Interest income    $         258     $         700   $  (442 )
             Interest expense              57                69       (12 )

Interest income for the three months ended June 30, 2009 decreased by $442,000 as compared to the three months ended June 30, 2008. The decrease was . . .