The accompanying discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements and the related disclosures, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts in our consolidated financial statements and accompanying notes. On an on-going basis, we evaluate our estimates, including those related to terms of revenue recognition, research and development expense, long-lived assets, warrant liabilities and share-based compensation. We base our estimates on historical experience and on various other market-specific and other relevant assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ significantly from these estimates.

Overview

We are a leader in the discovery, development and manufacture of therapeutic antibodies designed to treat inflammatory, autoimmune, infectious and oncological diseases. Our proprietary development pipeline includes XOMA 052, an anti-IL-1 beta antibody, XOMA 3AB, a biodefense anti-botulism antibody candidate, and five antibodies in preclinical development. Our proprietary development pipeline is funded by multiple revenue streams resulting from the licensing of our antibody technologies, product royalties, discovery and development collaborations and biodefense contracts, and sales of our common shares. Our technologies and experienced team have contributed to the success of marketed antibody products, including LUCENTIS® (ranibizumab injection) for
(wet) age-related macular degeneration and CIMZIA® (certolizumab pegol, CDP870) for Crohn's disease and rheumatoid arthritis.

We have a premier antibody discovery and development platform that includes six antibody phage display libraries and our proprietary Human Engineering™ and bacterial cell expression technologies. Our bacterial cell expression technology is a key biotechnology for the discovery and manufacturing of antibodies and other proteins. Thus far, more than 50 pharmaceutical and biotechnology companies have signed bacterial cell expression licenses with us. We are currently in discussions with multiple companies to license our antibody technologies.

In addition to developing our own potential products, we develop products for premier pharmaceutical companies including Novartis AG ("Novartis"), Takeda Pharmaceutical Company Limited ("Takeda") and Schering-Plough Research Institute ("SPRI"). We have a fully integrated product development infrastructure, extending from preclinical science to manufacturing.

Our ability to fund ongoing operations is dependent on the progress of our proprietary development pipeline, specifically XOMA 052 and XOMA 3AB. In October of 2009, we announced the initiation of our Phase 2 clinical program for XOMA 052 in Type 2 diabetes and cardiovascular disease. The clinical trials are designed to further evaluate the use of multiple dose regimens on the safety, pharmacodynamics and efficacy of XOMA 052 in cardiometabolic and other diseases, and based on positive results, select doses for pivotal Phase 3 studies. The initiation of the Phase 2 clinical program follows the announcement in July of 2009 of positive results from the U.S. Phase 1 trial, which continued to demonstrate that XOMA 052 is well tolerated in patients. Further, XOMA 052 showed clinically meaningful reductions in glycosylated hemoglobin, fasting blood glucose, high sensitivity C-reactive protein and erythrocyte sedimentation rate, a standard biomarker of systemic inflammation and cardiovascular risk. Generally, a more consistent response was seen across patients in the multiple dose regimen compared to single dose regimen. Pharmacokinetic results continue to support monthly or less frequent dosing.

We are in ongoing discussions with a number of companies offering to collaborate on development of XOMA 052 for Type 2 diabetes and now as a novel anti-inflammatory therapeutic for cardiovascular disease. We may complete a collaboration arrangement for XOMA 052 by the end of 2009 or it may take additional time to do so in order to, among other things, allow potential partners to include our new cardiovascular results in their analyses.

Our initial biodefense anti-botulism antibody candidate, XOMA 3AB, is a multi-antibody product that targets the most potent of the botulinum toxins, Type A. Our anti-botulism program was recently expanded to include additional product candidates and is the first of its kind to combine multiple human antibodies to target a broad spectrum of the most toxic botulinum toxins, including the three most toxic serotypes of botulism, Types A, B and E. The antibodies are designed to bind to each toxin and enhance the clearance of the toxin from the body. The use of multiple antibodies increases the likelihood of clearing the harmful toxins by providing specific protection against each toxin type. To date, we have been awarded three contracts, totaling nearly $100 million, from the National Institute of Allergy and Infectious Diseases ("NIAID"), a part of the National Institutes of Health ("NIH"), to support our ongoing development of XOMA 3AB and additional product candidates toward clinical trials in the treatment of botulism poisoning.

We also have the ability to generate revenues from funded research and development and other development activities. We are developing a number of products, both proprietary and under collaboration agreements with other companies and may enter into additional arrangements. Our objective in development collaborations is to leverage our existing development infrastructure to broaden and strengthen our proprietary product pipeline thereby diversifying our development risk and gaining financial support from our collaboration partners.

In September of 2009, we fully repaid our term loan facility with Goldman Sachs Specialty Lending Holdings, Inc. ("Goldman Sachs"). As previously disclosed, we were not in compliance with the requirements of the relevant provisions of this loan facility, due to the cessation of royalties from sales of RAPTIVA®, a product for the treatment of moderate-to-severe plaque psoriasis, related to its market withdrawal in the first half of 2009. Repayment of this loan facility discharged all of our obligations to the lenders. Refer to the Liquidity and Capital Resources - Goldman Sachs Term Loan section for additional details relating to this repayment.

In connection with the repayment of this loan, we sold our LUCENTIS ® royalty stream to Genentech, Inc., a wholly-owned member of the Roche Group (referred to herein as "Genentech"), in the third quarter of 2009 for a total of $25.0 million, which included the receipt of royalties of $2.7 million earned in the second quarter of 2009 and an additional one-time, non-refundable payment of $22.3 million. We will no longer receive royalties on sales of LUCENTIS®. We continue to receive royalties from UCB Celltech, a branch of UCB S.A., on sales of CIMZIA® for the treatment of Crohn's disease and moderate-to-severe rheumatoid arthritis.

Also in the third quarter of 2009, we raised approximately $26.4 million in two separate financing transactions, before deducting placement agent fees and estimated offering expenses of approximately $0.4 million, with Azimuth Opportunity Ltd. ("Azimuth"). We sold approximately 34.3 million common shares to Azimuth in these financing transactions. Refer to Liquidity and Capital Resources - Equity Line of Credit for additional disclosure relating to these equity financing transactions. The net proceeds from the first transaction, approximately $12.3 million, were used, together with other funds, to repay the Goldman Sachs term loan.

In January of 2009, we announced a workforce reduction of approximately 42%, or 144 employees, a majority of which were employed in manufacturing and related support functions. This decision was made based on the challenging economic conditions and a decline in forecasted manufacturing demand in 2009. We expected an annualized reduction of approximately $27 million in cash expenditures when changes are completed and are on track to achieve these savings. We remain staffed with approximately 190 employees to develop XOMA 052, develop and license proprietary products and technology, and continue fully funded antibody discovery and development activities with our pharmaceutical partners in collaborations and the U.S. government in biodefense. We recorded a charge in the first quarter of 2009 of $3.3 million for severance, other termination benefits and outplacement services in connection with the workforce reduction. In the second quarter of 2009, we recorded an adjustment of $0.2 million to reduce the outplacement services liability upon expiration of such services offered to the terminated employees.

Also, as a result of the workforce reduction, we significantly reduced operations in four leased buildings in the first quarter of 2009. In the second quarter of 2009, we resumed operations in one of these buildings and vacated another resulting in a restructuring charge of $0.5 million primarily related to the net present value of the future minimum lease payments, less the estimated future sublease income. We are currently seeking a sublease tenant. Our leases on the remaining two buildings expire in 2011 and 2013, and total minimum lease payments due from October 1, 2009 until expiration of the leases are $4.3 million. In addition, the net book value of fixed assets in these two buildings potentially subject to write-down is approximately $8.9 million as of September 30, 2009. We are pursuing multiple strategies to provide various options as to the future use of these leased spaces. We anticipate the potential for incurring further restructuring charges through the remainder of 2009 as we continue to evaluate our options as to the future use of our facilities.

In September of 2009, we received notice from the NASDAQ Stock Market that for the thirty consecutive business days preceding September 15, 2009, the bid price of our common shares closed below the minimum $1.00 per share requirement under Marketplace Rule 4450(a)(5) for continued inclusion on the NASDAQ Global Market. This notice has no effect on the listing of our common shares at this time, and we have an initial period of 180 calendar days to regain compliance with this requirement. If at any time before March 15, 2010, the bid price of our common shares closes at $1.00 per share or more for at least ten consecutive business days, NASDAQ will provide written notification that we have achieved compliance, although NASDAQ may require us to maintain a closing bid price for a longer period before determining that we have achieved compliance. If we do not regain compliance by March 15, 2010, NASDAQ would provide written notification that our common shares will be delisted, after which we may appeal to the NASDAQ Listing Qualifications Panel. Alternatively, we could apply to transfer our common shares to The NASDAQ Capital Market if we satisfy all of the requirements, other than the minimum bid price requirement, for initial listing on The NASDAQ Capital Market set forth in Marketplace Rule 5505. If we were to elect to apply for such transfer and if we satisfy the applicable requirements and our application is approved, we would have an additional 180 days to regain compliance with the minimum bid price rule while listed on The NASDAQ Capital Market. We are considering alternative strategies to address this issue if necessary.

We incurred negative cash flow from operations in four of the past five years and expect to remain in this position until sufficient cash flow can be generated from XOMA 052 partnering agreements, technology licensing, biodefense contracts with the government and various discovery and development collaboration arrangements, or until we achieve additional regulatory approvals and commence commercial sales of additional products. The timing and likelihood of additional approvals is uncertain and there can be no assurance that approvals will be granted or that cash flow from product sales will be sufficient to fully fund operations.

Results of Operations

Revenues

Total revenues for the three and nine months ended September 30, 2009, and 2008,
were as follows (in thousands):



                                         Three Months Ended       Nine Months Ended
                                           September 30,            September 30,
                                          2009         2008        2009        2008
      License and collaborative fees   $     1,421    $ 1,286   $   29,276   $  1,466
      Contract and other revenue             3,688      1,979       18,662     14,728
      Royalties                             22,314      4,629       28,895     14,873

      Total revenues                   $    27,423    $ 7,894   $   76,833   $ 31,067

License and collaborative fee revenue includes fees and milestone payments related to the out-licensing of our products and technologies. License and collaborative fee revenue increased by $0.1 million and $27.8 million for the three and nine months ended September 30, 2009, compared to the same periods of 2008. The increase in license and collaborative fee revenue for the three months ended September 30, 2009, compared to the same period of 2008, was due to $0.6 million in revenue recognized on the determination of final costs related to the expansion of our collaboration agreement with Takeda, which was entered into in the first quarter of 2009, partially offset by a decrease in new licensing revenues in the period.

The increase in license and collaborative fee revenue for the nine months ended September 30, 2009, compared to the same period of 2008, was primarily due to a total of $28.1 million in revenue recognized during the first and third quarters of 2009 related to the expansion of our collaboration agreement with Takeda, partially offset by a decrease in new licensing revenues in the period. The generation of future revenues related to license fees and other collaboration arrangements is dependent on our ability to attract new licensees to bacterial cell expression and other antibody technologies and new collaboration partners.

Contract and other revenue increased by $1.7 million and $3.9 million for the three and nine months ended September 30, 2009, compared to the same periods of 2008. These revenues include agreements where we provide contracted research and development and manufacturing services to our collaboration partners, including Takeda, SPRI and NIAID. The increases in contract and other revenue for the three and nine months ended September 30, 2009 are primarily related to work performed under our contracts with NIAID Contract No. HHSN272200800028C ("NIAID 3"), which was awarded in September of 2008, and Novartis, which was entered into in December of 2008. The work performed under our contract with Novartis was completed in the third quarter of 2009. Additionally, we accelerated the recognition of $2.6 million of unamortized deferred revenue in the second quarter of 2009 related to the termination of certain discovery and development programs under our collaboration with SPRI.

These increases in contract revenue were partially offset by a decrease in revenue recognized for research and development activities performed under our SPRI contract in 2009 as a result of the termination of these programs. In addition, contract and other revenue decreased related to our AVEO Pharmaceuticals, Inc. (now with SPRI and referred to herein together as "SPRI/AVEO") contract as a result of our nearing the end of the contracted service arrangement. Contract revenue in the third quarter of 2008 included an adjustment for NIAID Contract No. HHSN266200600008C/N01-A1-60008 ("NIAID 2") to decrease revenue by $2.7 million due to a change in billing rates. This resulted in a net increase in revenue recognized in 2009 on NIAID 2, despite nearing the end of the NIAID 2 contracted service arrangement.

In the third quarter of 2009, we began work on two biodefense subcontract awards from SRI International, including a $1.7 million award to develop novel antibody drugs against the virus that causes severe acute respiratory syndrome and a $2.2 million award to develop a novel antibody, known as F10, that has been shown to neutralize group 1 influenza A viruses, including the H1N1 and H5N1 strains. The subcontract awards are funded through NIAID. Revenue recognized through the third quarter of 2009 relating to these subcontracts was $0.1 million. Depending on whether and when we obtain new government and other contracts, we expect to experience a decline in contract revenues in the fourth quarter of 2009 as compared to 2008 levels.

Revenue from royalties increased by $17.7 million and $14.0 million for the three and nine months ended September 30, 2009, compared to the same periods of 2008, due to the sale of our LUCENTIS® royalty stream to Genentech for a total of $25.0 million, which included the receipt of royalties of $2.7 million recognized in the second quarter of 2009 and an additional one-time, non-refundable payment of $22.3 million in September of 2009. We recognized the payment of $22.3 million as royalty revenue in the third quarter of 2009, as the terms of the sale were fulfilled and no related continuing performance obligations exist. Royalties earned

from sales of LUCENTIS® for the first half of 2009 were $5.1 million. For the three and nine months ended September 30, 2008, royalties earned from sales of LUCENTIS® were $1.5 million and $5.7 million, respectively. We will not receive any further royalties on sales of LUCENTIS®.

The cessation of royalties earned from sales of RAPTIVA® in the second quarter of 2009 partially offsets these increases. RAPTIVA® was withdrawn from the market in the first half of 2009. Royalties earned from sales of RAPTIVA ® for the nine months ended September 30, 2009 were $1.2 million. Royalties earned from sales of RAPTIVA ® for the three and nine months ended September 30, 2008 were $3.1 million and $9.0 million.

During the three and nine months ended September 30, 2009, royalties received from sales of CIMZIA ® were $0.2 million and $0.3 million, respectively. Royalties received from sales of CIMZIA ® in 2008 were immaterial. CIMZIA® was approved by the U.S. Food and Drug Administration ("FDA") in May of 2009 for the treatment of moderate-to-severe rheumatoid arthritis in adults. We expect royalty revenues from sales of CIMZIA® to increase in the fourth quarter of 2009.

Research and Development Expenses

Biopharmaceutical development includes a series of steps, including in vitro and in vivo preclinical testing, and Phase 1, 2 and 3 clinical studies in humans. Each of these steps is typically more expensive than the previous step, but actual timing and the cost to us depends on the product being tested, the nature of the potential disease indication and the terms of any collaborative arrangements with other companies. After successful conclusion of all of these steps, regulatory filings for approval to market the products must be completed, including approval of manufacturing processes and facilities for the product. Our research and development expenses currently include costs of personnel, supplies, facilities and equipment, consultants, third party costs and other expenses related to preclinical and clinical testing.

Research and development expenses were $13.4 million and $43.5 million for the three and nine months ended September 30, 2009, compared with $19.7 million and $62.4 million for the three and nine months ended September 30, 2008. The decrease of $6.3 million and $18.9 million for the three and nine months ended September 30, 2009, as compared to the same periods in 2008, is primarily a result of our continuing focus on cost control. In addition, spending on NIAID 2, SPRI/AVEO and Novartis-related contract activities decreased in 2009 due to our nearing the end of contracted service arrangements, and spending on SPRI-related contract activities decreased in 2009 due to the termination of certain discovery and development programs under the collaboration. These decreases were partially offset by increased spending on the preclinical development of five antibodies, and on our contracts with NIAID 3 and Takeda. Spending on XOMA 052 decreased in the first nine months of 2009, as compared to same period of 2008, due to the completion of enrollment in our two Phase 1 clinical trials in April of 2009. However, spending on XOMA 052 increased for the three months ended September 30, 2009, as compared to the same period of 2008, due to the initiation of our Phase 2 clinical program for XOMA 052 in Type 2 diabetes and cardiovascular disease in October of 2009.

We recorded research and development salaries and employee-related expenses of $6.2 million for the three months ended September 30, 2009, compared with $9.3 million for the same period of 2008. The decrease of $3.1 million for the third quarter of 2009 was due to decreases in salaries and benefits of $3.1 million and accrued bonus expense of $0.1 million primarily due to the workforce reduction announced in January of 2009. Partially offsetting these decreases was an increase in share-based compensation expense of $0.1 million for the three months ended September 30, 2009, as compared to the same period of 2008. See Results of Operations: Share-Based Compensation for further discussion of our share-based compensation expense.

For the nine months ended September 30, 2009, we recorded research and development salaries and employee-related expenses of $20.0 million, compared with $27.6 million for the same period of 2008. The decrease of $7.6 million for the nine months ended September 30, 2009 was due to decreases in salaries and benefits of $7.2 million and accrued bonus expense of $0.3 million primarily due to the workforce reduction announced in January of 2009. In addition, share-based compensation decreased by $0.1 million. See Results of Operations:
Share-Based Compensation for further discussion of our share-based compensation expense.

Our research and development activities can be divided into earlier stage programs and later stage programs. Earlier stage programs include molecular biology, process development, pilot-scale production and preclinical testing. Also included in earlier stage programs are costs related to excess manufacturing capacity, which we expect will continue to decrease in the fourth quarter of 2009 as we continue to consolidate facilities. Later stage programs include clinical testing, regulatory affairs and manufacturing clinical supplies. The costs associated with these programs approximate the following (in thousands):

                                     Three Months Ended       Nine Months Ended
                                       September 30,            September 30,
                                      2009         2008        2009        2008
          Earlier stage programs   $     9,492   $ 11,921   $   32,559   $ 36,932
          Later stage programs           3,952      7,793       10,913     25,512

          Total                    $    13,444   $ 19,714   $   43,472   $ 62,444

Our research and development activities can also be divided into those related to our internal projects and those projects related to collaborative and contract arrangements. The costs related to internal projects versus collaborative and contract arrangements approximate the following (in thousands):

                                              Three Months Ended       Nine Months Ended
                                                September 30,            September 30,
                                               2009         2008        2009        2008
  Internal projects                         $    10,869   $ 14,623   $   30,800   $ 44,398
  Collaborative and contract arrangements         2,575      5,091       12,672     18,046

  Total                                     $    13,444   $ 19,714   $   43,472   $ 62,444

For the three and nine months ended September 30, 2009, our largest development program (XOMA 052) accounted for more than 20% but less than 30% of our total research and development expense, and one development program (NIAID 3) accounted for more than 10% but less than 20% of our total research and development expense. No development program accounted for more than 30% of our total research and development expense for the three and nine months ended September 30, 2009. For the three and nine months ended September 30, 2008, our largest development program (XOMA 052) accounted for more than 20% but less than 30%, and no development program accounted for more than 30% of our total research and development expense.

We continue to expect our research and development spending in 2009 will be less than research and development spending in 2008. In October of 2009, we announced the initiation of our Phase 2 clinical program for XOMA 052 in Type 2 diabetes and cardiovascular disease. We are in ongoing discussions with a number of companies offering to collaborate on development of XOMA 052 for Type 2 diabetes and now as a novel anti-inflammatory therapeutic for cardiovascular disease. We may complete a collaboration arrangement for XOMA 052 by the end of 2009 or it may take additional time to do so in order to, among other things, allow potential partners to include our new cardiovascular results in their analyses.

Future research and development spending may be impacted by potential new licensing or collaboration arrangements, as well as the termination of existing agreements. Beyond this, the scope and magnitude of future research and development expenses are difficult to predict at this time.

Selling, General and Administrative Expenses

Selling, general and administrative expenses include salaries and related personnel costs, facilities costs and professional fees. Selling, general and administrative expenses were $7.2 million and $19.0 million for the three and nine months ended September 30, 2009, compared with $6.7 million and $19.0 million for the same periods of 2008. The $0.5 million increase for the three months ended September 30, 2009, as compared to the same period of 2008, primarily relates to $1.3 million in fees incurred in the third quarter of 2009 related to the restructuring negotiations and repayment of the Goldman Sachs term loan discussed in further detail below in the Liquidity and Capital Resources section. This increase was partially offset by a decrease in salaries and employee-related expenses in the third quarter of 2009 of $0.5 million, as discussed below, a decrease in professional fees of $0.2 million, and other decreases due to our continued focus on cost control.

Selling, general and administrative expenses remained the same for the nine months ended September 30, 2009, as compared to the same period of 2008. However, salaries and employee-related expenses decreased by $1.7 million in 2009 as compared to the same period of 2008, as discussed below. This decrease was offset by an increase in fees incurred for the nine months ended September 30, 2009, related to the restructuring negotiations and repayment of the Goldman Sachs term loan of $1.8 million.

We recorded salaries and employee-related expenses of $3.3 million for the three . . .