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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

For the quarterly period ended September 30, 2007

OR

For the transition period from             to            

Commission file number: 001-33678

NOVABAY PHARMACEUTICALS, INC.

(Exact name of registrant as specified in its charter)

5980 Horton Street, Suite 550, Emeryville, CA 94608

(Address of principal executive office) (Zip Code)

(510) 899-8800

(Registrant’s telephone number, including area code)

Not applicable

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes   ¨     No   x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer   ¨     Accelerated Filer   ¨     Non-Accelerated Filer   x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes   ¨     No   x

As of November 13, 2007, 21,254,926 shares of the registrant’s common stock, $0.01 par value, were outstanding.

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NOVABAY PHARMACEUTICALS, INC.

QUARTERLY REPORT ON FORM 10-Q

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Unless the context requires otherwise, all references in this report to “we,” “our,” “us,” the “Company” and “NovaBay” refer to NovaBay Pharmaceuticals, Inc. and its subsidiaries.

NovaBay™, Aganocide™, AgaNase™ and NeutroPhase™ are our trademarks. All other trademarks and trade names appearing in this report are the property of their respective owners.

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PART I. FINANCIAL INFORMATION

NOVABAY PHARMACEUTICALS, INC.

(formerly NovaCal Pharmaceuticals, Inc.)

(a development stage company)

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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NOVABAY PHARMACEUTICALS, INC.

(formerly NovaCal Pharmaceuticals, Inc.)

(a development stage company)

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

(in thousands, except per share data)

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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NOVABAY PHARMACEUTICALS, INC.

(formerly NovaCal Pharmaceuticals, Inc.)

(a development stage company)

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(in thousands)

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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NOVABAY PHARMACEUTICALS, INC.

(formerly NovaCal Pharmaceuticals, Inc.)

(a development stage company)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. ORGANIZATION

NovaBay Pharmaceuticals, Inc. (the “Company”) is a biopharmaceutical company focused on developing innovative product candidates targeting the treatment or prevention of a wide range of infections in hospital and non-hospital environments. Many of these infections have become increasingly difficult to treat because of the rapid increase in infectious agents that have become resistant to current drugs.

We have developed a class of antimicrobial compounds, which we have named Aganocide compounds, that we believe could form a platform on which to create a variety of products to address differing needs in the antimicrobial area. Our antimicrobial compounds are based upon small molecules that are generated by white blood cells and that enable them to perform their function of defending the body against invading pathogens. In the body, these compounds are produced “on demand” and are transient. We have focused our efforts on understanding these molecules and finding ways, primarily by chemical modification, to impart qualities to allow them to be developed as therapeutic products.

Our current development efforts are focused on Aganocide compounds to treat patients with infections of the eye, ear and sinus, to create an improved environment for the healing of wounds, whether chronic or acute, and to prevent infections that either result from surgical or other hospital procedures, or that can be caused by the use of products, such as contact lens solutions, which can introduce an infection into the body. We operate in one business segment.

We were incorporated under the laws of the State of California on January 19, 2000 as NovaCal Pharmaceuticals, Inc. We had no operations until July 1, 2002, on which date we acquired all of the operating assets of NovaCal Pharmaceuticals, LLC (“LLC”), a California limited liability company, in exchange for the issuance of 3.9 million and 2.7 million shares of our common stock and Series A Convertible Preferred Stock, respectively. Additionally, we issued warrants to purchase an aggregate of 544,500 shares of our common stock to certain holders of common and preferred units of the LLC. Under this transaction, we acquired cash, property and equipment, and other current assets of $516,000, $9,000 and $2,000, respectively. The transaction was accounted for using the purchase method of accounting.

In February 2007, we changed our name from NovaCal Pharmaceuticals, Inc. to NovaBay Pharmaceuticals, Inc. In August 2007, we formed NovaBay Pharmaceuticals Canada, Inc., a wholly-owned subsidiary incorporated under the laws of British Columbia (Canada), and DermaBay, Inc., a wholly-owned U.S. subsidiary.

NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The condensed consolidated financial statements include our accounts and the accounts of our wholly owned subsidiaries. Intercompany transactions and balances have been eliminated. The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) and are expressed in U.S. dollars. The financial statements have been prepared under the guidelines of Statement of Financial Accounting Standard (“SFAS”) No. 7, “Accounting and Reporting by Development Stage Enterprises”. A development stage enterprise is one in which planned principal operations have not commenced, or if its operations have commenced, there have been no significant revenues therefrom. As of September 30, 2007, we had not commenced our planned principal operations.

The interim condensed consolidated financial statements as of September 30, 2007 and for the three and nine months ended September 30, 2006 and 2007 and the cumulative period from July 1, 2002 to September 30, 2007 are unaudited. The accompanying condensed consolidated financial statements should be read in conjunction with the audited financial statements and related notes for the year ended December 31, 2006 contained in our Registration Statement on Form S-1 (Registration No. 333-140714) initially filed on February 14, 2007, as amended. The unaudited interim condensed consolidated financial statements have been prepared on the same basis as the audited annual financial statements and, in our opinion, reflect all adjustments necessary for a fair statement of our consolidated financial position, results of operations, and cash flows. All adjustments are of a normal recurring nature. The results for the nine months ended September 30, 2007 are not necessarily indicative of the expected results for the year ending December 31, 2007.

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NOVABAY PHARMACEUTICALS, INC.

(formerly NovaCal Pharmaceuticals, Inc.)

(a development stage company)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

Certain amounts for prior periods have been reclassified to conform to the September 30, 2007 presentation.

Reverse Stock Split

On August 10, 2007, we filed an amendment to our articles of incorporation to effect a 1-for-2 reverse stock split of our common stock. All share and per share amounts relating to the common stock, stock options and warrants and the conversion ratios of preferred stock included in the financial statements and footnotes have been restated to reflect the reverse stock split.

Use of Estimates

The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

Cash and Cash Equivalents and Short-Term Investments

We consider all highly liquid instruments with a stated maturity of three months or less to be cash and cash equivalents. Cash and cash equivalents are stated at cost, which approximates fair value, based on quoted market prices. Cash is deposited in institutions that are generally federally insured in limited amounts.

We classify all highly liquid investments with a stated maturity of greater than three months as short-term investments. We have classified our short-term investments as “available-for-sale”. We do not intend to hold securities with stated maturities greater than twelve months until maturity. In response to changes in the availability of and the yield on alternative investments as well as liquidity requirements, we occasionally sell these securities prior to their stated maturities. All short-term investments are recorded at fair value and unrealized gains and losses are recorded as a separate component of stockholders’ equity until realized. Realized gains and losses on sale of all such securities are reported in earnings, computed using the specific identification cost method.

Property and Equipment

Property and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation is calculated using the straight-line method over the estimated useful lives of the related assets of five to seven years for office and laboratory equipment, three years for software and seven years for furniture and fixtures. Leasehold improvements are depreciated on the shorter of seven years or the life of the lease term. Depreciation of assets recorded under capital leases is included in depreciation expense.

The costs of normal maintenance, repairs, and minor replacements are charged to operations when incurred.

Fair Value of Financial Instruments

The carrying values of financial instruments such as cash and cash equivalents, short-term investments, accounts payable and accrued liabilities approximate their fair values due to the short settlement period for these instruments.

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NOVABAY PHARMACEUTICALS, INC.

(formerly NovaCal Pharmaceuticals, Inc.)

(a development stage company)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

Impairment of Long-Lived Assets

We account for long-lived assets in accordance with SFAS No.144, “Accounting for the Impairment or Disposal of Long-Lived Assets and for Long-Lived Assets to be Disposed of”, which requires that companies consider whether events or changes in facts and circumstances, both internally and externally, may indicate that an impairment of long-lived assets held for use are present. Management periodically evaluates the carrying value of long-lived assets and has determined that there was no impairment as of all periods presented. Should there be impairment in the future, we would recognize the amount of the impairment based on the expected future cash flows from the impaired assets. The cash flow estimates would be based on management’s best estimates, using appropriate and customary assumptions and projections at the time.

Accumulated Other Comprehensive Income

Accumulated other comprehensive income consists of unrealized gains and losses on short-term investments classified as available-for-sale.

Revenue Recognition

License and collaboration revenue is primarily generated through agreements with strategic partners for the development and commercialization of our product candidates. The terms of the agreements typically include non-refundable upfront fees, funding of research and development activities, payments based upon achievement of certain milestones and royalties on net product sales. In accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables”, we analyze our multiple element arrangements to determine whether the elements can be separated. We perform our analysis at the inception of the arrangement and as each product or service is delivered. If a product or service is not separable, the combined deliverables are accounted for as a single unit of accounting and recognized over the performance obligation period. We recognize revenue in accordance with SEC Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements”, as amended by SAB No. 104 (together, “SAB 104”). In accordance with SAB 104, revenue is recognized when the following criteria have been met: persuasive evidence of an arrangement exists; delivery has occurred and risk of loss has passed; the seller’s price to the buyer is fixed or determinable and collectibility is reasonably assured.

Assuming the elements meet the EITF No. 00-21 criteria for separation and the SAB 104 requirements for recognition, the revenue recognition methodology prescribed for each unit of accounting is summarized below:

Upfront Fees—We defer recognition of non-refundable upfront fees if we have continuing performance obligations without which the technology licensed has no utility to the licensee. If we have continuing involvement through research and development services that are required because our know-how and expertise related to the technology is proprietary to us, or can only be performed by us, then such up-front fees are deferred and recognized over the period of continuing involvement.

Funded Research and Development—Revenue from research and development services is recognized during the period in which the services are performed and is based upon the number of full-time-equivalent personnel working on the specific project at the agreed-upon rate. Reimbursements from collaborative partners for agreed upon direct costs including direct materials and outsourced, or subcontracted, pre-clinical studies are classified as revenue in accordance with EITF Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent,” and recognized in the period the reimbursable expenses are incurred. Payments received in advance are recorded as deferred revenue until the research and development services are performed or costs are incurred.

Milestones—Substantive milestone payments are considered to be performance bonuses that are recognized upon achievement of the milestone only if all of the following conditions are met: the milestone payments are non-refundable; achievement of the milestone involves a degree of risk and was not reasonably assured at the inception of the arrangement; substantive effort is involved in achieving the milestone; the amount of the milestone is reasonable in relation to the effort expended or the risk associated with achievement of the milestone; and a reasonable amount of time passes between the up-front license payment and the first milestone payment as well as between each subsequent milestone payment. If any of these conditions are not met, the milestone payments are deferred and recognized as revenue over the term of the arrangement as we complete our performance obligations.

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NOVABAY PHARMACEUTICALS, INC.

(formerly NovaCal Pharmaceuticals, Inc.)

(a development stage company)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

Royalties—We recognize royalty revenues from licensed products upon the sale of the related products.

Advertising Costs

There were no advertising costs incurred for any of the periods presented.

Research and Development Costs

We charge research and development costs to expense as incurred. These costs consist of direct and indirect costs associated with specific projects, as well as fees paid to entities that perform research and clinical studies on our behalf.

Patent Costs

We expense patent costs, including legal expenses, in the period in which they are incurred. Patent expenses are included as general and administrative expenses in our statements of operations.

Stock-Based Compensation

On January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123R, “Share-Based Payment”. SFAS No. 123R replaced SFAS No. 123 and superseded Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations. Under the fair value recognition provisions of SFAS No. 123R, stock-based compensation expense is measured at the grant date for all stock-based awards to employees and directors and is recognized as expense over the requisite service period, which is generally the vesting period. We were required to utilize the prospective application method prescribed by SFAS No. 123R, under which prior periods are not revised for comparative purposes. Under the prospective application transition method, non-public entities that previously used the minimum value method of SFAS No. 123 should continue to account for non-vested equity awards outstanding at the date of adoption of SFAS No. 123R in the same manner as they had been accounted for prior to adoption. SFAS No. 123R specifically prohibits pro forma disclosures for those awards valued using the minimum value method. The valuation and recognition provisions of SFAS No. 123R apply to new awards and to awards outstanding as of the adoption date that are subsequently modified.

Prior to the adoption of SFAS No. 123R, we accounted for stock-based compensation awards to employees using the intrinsic value method under the recognition and measurement principles of APB Opinion No. 25. Our application of APB Opinion No. 25 did not result in compensation expense because the exercise price of the stock-based awards was equal to the fair market value of the stock at the grant date.

We account for stock compensation arrangements with non-employees in accordance with SFAS No. 123R and EITF Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services”, using a fair value approach. For stock options granted to non-employees, the fair value of the stock options is estimated using a Black-Scholes-Merton valuation model.

The adoption of SFAS No.123R had a material effect on our financial position and results of operations. See Note 9 for further information regarding stock-based compensation expense and the assumptions used in estimating that expense.

Income Taxes

We account for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is recognized if it is more likely than not that some portion or all of the deferred tax asset will not be recognized.

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NOVABAY PHARMACEUTICALS, INC.

(formerly NovaCal Pharmaceuticals, Inc.)

(a development stage company)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

Net Income (Loss) per Share

We compute net income (loss) per share in accordance with SFAS No. 128, “Earnings per Share” which requires presentation of both basic and diluted earnings (loss) per share (“EPS”).

Basic EPS is computed by dividing net income (loss) available to common shareholders (numerator) by the weighted average number of common shares outstanding (denominator) during the period. Diluted EPS gives effect to all dilutive potential common shares outstanding during the period including stock options and stock warrants, using the treasury stock method, and convertible preferred stock, using the if-converted method. In computing diluted EPS, the average stock price for the period is used in determining the number of shares assumed to be purchased from the exercise of stock options or warrants. Potentially dilutive common share equivalents are excluded from the diluted EPS computation in net loss periods as their effect would be anti-dilutive. See Note 13 for further information regarding the calculation of net income (loss) per share.

Recently Issued Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”. SFAS No. 157 establishes a framework for measuring the fair value of assets and liabilities. This framework is intended to provide increased consistency in how fair value determinations are made under various existing accounting standards which permit, or in some cases require, estimates of fair market value. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Earlier application is encouraged, provided that the reporting entity has not yet issued financial statements for that fiscal year, including any financial statements for an interim period within that fiscal year. We are currently assessing the impact of SFAS No. 157 on our consolidated financial position and results of operations.

In February, 2007, the FASB issued SFAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 permits entities to choose to measure many financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We are currently assessing the impact of SFAS No. 159 on our consolidated financial position and results of operations.

In June 2007, the FASB issued EITF Issue No. 07-3, “Accounting for Nonrefundable Advance Payments for Goods or Services Received for Use in Future Research and Development Activities”. EITF No. 07-3 requires that nonrefundable advance payments for goods or services that will be used or rendered for future research and development activities be deferred and capitalized and recognized as an expense as the goods are delivered or the related services are performed. EITF No. 07-3 is effective, on a prospective basis, for fiscal years beginning after December 15, 2007. We are currently assessing the impact of EITF No. 07-3 on our consolidated financial position and results of operations.

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NOVABAY PHARMACEUTICALS, INC.

(formerly NovaCal Pharmaceuticals, Inc.)

(a development stage company)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

NOTE 3. SHORT-TERM INVESTMENTS

Short-term investments at September 30, 2007 consisted of the following:

Contractual maturities of short-term investments as of September 30, 2007 were as follows:

We recognized a net realized loss of $26,000 for both the three and nine months ended September 30, 2006, and a net realized gain of $22,000 and $88,000 for the three and nine months ended September 30, 2007, respectively. For the cumulative period from July 1, 2002 (date of development stage inception) to September 30, 2007, we recognized a net realized gain of $56,000.

NOTE 4. PROPERTY AND EQUIPMENT

Property and equipment consisted of the following:

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NOVABAY PHARMACEUTICALS, INC.

(formerly NovaCal Pharmaceuticals, Inc.)

(a development stage company)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

Depreciation expense was $18,000 and $48,000 for the three months ended September 30, 2006 and 2007, respectively, $50,000 and $128,000 for the nine months ended September 30, 2006 and 2007, respectively and $345,000 for the cumulative period from July 1, 2002 (date of development stage inception) to September 30, 2007.

NOTE 5. ACCRUED LIABILITIES

Accrued liabilities consisted of the following:

NOTE 6. CAPITAL LEASE OBLIGATION

During the first quarter of 2007, we commenced a lease for a portion of our laboratory equipment. This arrangement is being accounted for as a capital lease. Assets under capital leases that are included in property and equipment are as follows:

Future minimum lease payments under capital leases were as follows at September 30, 2007:

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NOVABAY PHARMACEUTICALS, INC.

(formerly NovaCal Pharmaceuticals, Inc.)

(a development stage company)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

NOTE 7. EQUIPMENT LOAN

During April 2007, we entered into a master security agreement to establish a $1.0 million equipment loan facility with General Electric Capital Corporation. The purpose of this loan is to finance equipment purchases, principally in the build-out of our laboratory facilities. Borrowings under the loan are secured by eligible equipment purchased from January 2006 through April 2008 and will be repaid over 40 months at an interest rate of 5.94% over the three year Treasury rate in effect at the time of funding. There are no loan covenants specified in the agreement.

As of September 30, 2007, we had an outstanding equipment loan balance of $448,000 with a weighted-average interest rate of 10.65%. At September 30, 2007, there was $506,000 available for borrowing under this equipment loan facility.

Future minimum loan payments under equipment loans were as follows at September 30, 2007:

NOTE 8. COMMITMENTS AND CONTINGENCIES

Operating Leases

We lease laboratory facilities and office space under operating leases which expire at various dates through 2011. Rent expense was $72,000 and $130,000 for the three months ended September 30, 2006 and 2007, respectively, and $227,000 and $393,000 for the nine months ended September 30, 2006 and 2007, respectively. For the cumulative period from July 1, 2002 (date of development stage inception) to September 30, 2007, rent expense was $1,189,000.

The future minimum lease payments under non-cancellable operating leases were as follows as of September 30, 2007:

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NOVABAY PHARMACEUTICALS, INC.

(formerly NovaCal Pharmaceuticals, Inc.)

(a development stage company)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

Legal Matters

From time to time, we may be involved in various legal proceedings arising in the ordinary course of business. There are no matters at September 30, 2007 that, in the opinion of management, would have a material adverse effect on our financial position, results of operations or cash flows.

NOTE 9. STOCKHOLDERS’ EQUITY

Convertible Preferred Stock

In 2002 and 2003, we issued 3.2 million shares of Series A Convertible Preferred Stock for net proceeds of $647,000. In 2003 and 2004, we issued 6.9 million shares of Series B Convertible Preferred Stock for net proceeds of $3.0 million. In 2004 and 2005, we issued 6.7 million shares of Series C Convertible Preferred Stock for net proceeds of $5.4 million. In 2005 and 2006, we issued 2.5 million shares of Series D Convertible Preferred Stock for net proceeds of $3.6 million. Preferred shares authorized were 39 million at December 31, 2005 and 2006 and September 30, 2007.

All outstanding shares of preferred stock automatically converted into shares of common stock upon the closing of our initial public offering in October 2007. See Note 14 for additional information pertaining to the preferred stock conversion.

Common Stock

The holders of common stock are entitled to one vote per share on matters submitted to shareholders. The common stock carries dividends as declared by the board of directors. As of September 30, 2007, we have not declared any dividends to the holders of our common stock.

The following table summarizes the common shares available for issuance:

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NOVABAY PHARMACEUTICALS, INC.

(formerly NovaCal Pharmaceuticals, Inc.)

(a development stage company)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

Stock Option Plans

In June 2002, we adopted a stock option plan (“2002 Plan”) under which 1.25 million shares of common stock had been reserved for grants under the plan. In May 2003, the number of shares reserved under the 2002 Plan was increased to 2.25 million shares. In May 2005, we adopted an additional but substantially similar plan (“2005 Plan”) under which 1.24 million shares of common stock were reserved for grant under the plan. Under these plans, options that terminate or expire may be re-issued. In conjunction with the adoption of the 2005 Plan, the board of directors stipulated that no further options may be granted from the 2002 Plan and any option cancellations or expirations from the 2002 Plan may not be re-issued. At December 31, 2006 and September 30, 2007, there were 418,000 and 203,500 shares available for grant under the 2005 Plan, respectively.

The options typically expire ten years from the date of grant or three months from the end of an employee’s employment with the Company. Options granted to employees generally vest over four years while options granted to directors, advisory board members and consultants typically vest over two years or less, subject to continued service. Under the terms of these plans, the option exercise price may not be less than 100% of the fair market value of the common stock on the date of grant. The board of directors estimates the fair value of the common stock upon each grant of stock options. All of the options include early exercise provisions that allow for full exercise of the option prior to option vesting, subject to certain repurchase provisions.

In March and April 2007, our board of directors and our shareholders, respectively, approved the 2007 Omnibus Incentive Plan, which became effective in October 2007 upon the effective date of the registration statement for our initial public offering. Upon the effectiveness of this plan, no further awards will be granted under the 2005 Plan. See Note 14 for additional information pertaining to the new plan.

Comprehensive Loss

Comprehensive loss is comprised of net loss and unrealized gains and losses on short term investments classified as available-for-sale that are excluded from net loss and reported separately in stockholders’ equity. Comprehensive loss was $1.5 million and $4.2 million for the three and nine months ended September 30, 2006, respectively, and $1.5 million and $4.0 million for the three and nine months ended September 30, 2007, respectively.

Stock Option Activity

The following table summarizes our stock option activities:

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NOVABAY PHARMACEUTICALS, INC.

(formerly NovaCal Pharmaceuticals, Inc.)

(a development stage company)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

The following table summarizes information about options outstanding at September 30, 2007:

The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying stock option awards and the fair value of our common stock at the end of the reporting period. The aggregate intrinsic value of stock option awards exercised was $214,000 and $552,000 for the three and nine months ended September 30, 2007, respectively, as determined at the date of option exercise. We received cash payments in the amount of $32,000 and $99,000 for the exercise of stock options during the three and nine months ended September 30, 2007, respectively.

Valuation of Stock-Based Awards to Employees and Directors

We grant options to purchase common stock to some of our employees and directors at prices equal to or greater than the market value of the stock on the dates the options are granted. We have estimated the value of certain stock option awards as of the date of the grant by applying the Black-Scholes-Merton option pricing valuation model using the single-option valuation approach. The application of this valuation model involves assumptions that are judgmental and subjective in nature. See Note 2 for a description of the accounting policies that we applied to value our stock-based awards.

The weighted average key assumptions used in determining the value of options granted and a summary of the methodology applied to develop each assumption are as follows:

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NOVABAY PHARMACEUTICALS, INC.

(formerly NovaCal Pharmaceuticals, Inc.)

(a development stage company)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

Expected Price Volatility — The computation of expected volatility was based on the historical volatility of comparable companies from a representative peer group selected based on industry and market capitalization data. An increase in the expected price volatility will increase the value of the option granted and the related compensation expense.

Expected Life — This is the period of time over which the options granted are expected to remain outstanding and is based on management’s estimate, taking into consideration vesting term, contractual term and historical actual lives. Options granted have a maximum term of ten years. An increase in the expected life will increase the value of the option granted and the related compensation expense.

Risk-Free Interest Rate — This is the U.S. Treasury rate for the week of the grant having a term approximating the expected life of the option. An increase in the risk-free interest rate will increase the value of the option granted and the related compensation expense.

Dividend Yield — We have not made any dividend payments nor do we have plans to pay dividends in the foreseeable future. An increase in the dividend yield will decrease the value of the option granted and the related compensation expense.

Under SFAS No.123R, forfeitures are estimated at the time of grant and reduce compensation expense ratably over the vesting period. This estimate is adjusted periodically based on the extent to which actual forfeitures differ, or are expected to differ, from the previous estimate. For the three and nine months ended September 30, 2006 and 2007, we applied an estimated forfeiture rate of 5% to employee grants and 0% to director grants.

Stock-Based Compensation Expense

For the three and nine months ended September 30, 2006 and 2007, we recognized stock-based compensation expense of $98,000, $238,000, $67,000 and $287,000, respectively. As of September 30, 2007, total unrecognized compensation cost related to unvested stock options granted or modified on or after January 1, 2006 was $401,000. This amount is expected to be recognized as stock-based compensation expense in our statements of operations over the remaining weighted average vesting period of 2.5 years.

NOTE 10. COLLABORATION AND LICENSE AGREEMENTS

Alcon Manufacturing, Ltd.

In August 2006, we entered into a collaboration and license agreement with Alcon Manufacturing, Ltd. (“Alcon”) to license to Alcon the exclusive rights to develop, manufacture and commercialize products incorporating the Aganocide compounds for application in connection with the eye, ear and sinus and for use in contact lens solution. Under the terms of the agreement, Alcon agreed to pay an up-front, non-refundable, non-creditable technology access fee of $10.0 million upon the effective date of the agreement. This up-front fee was recorded as deferred revenue and is being amortized into revenue on a straight-line basis over the four-year funding term of the agreement, through August 2010. Additionally, we will receive semi-annual payments to support on-going research and development activities over the four year funding term of the agreement. The research and development support payments include amounts to fund a specified number of personnel engaged in collaboration activities and to reimburse for qualified equipment, materials and contract study costs. Our obligation to perform research and development activities under the agreement expires at the end of the four year funding term. As product candidates are developed and proceed through clinical trials and approval, we will receive milestone payments. If the products are commercialized, we will also receive royalties on any sales of products containing the Aganocide compound. Alcon has the right to terminate the agreement in its entirety upon nine months’ notice, or terminate portions of the agreement upon 135 days’ notice, subject to certain provisions. Both parties have the right to terminate the agreement for breach upon 60 days’ notice.

For both the three and nine months ended September 30, 2006, we recognized revenue of $208,000 for amortization of the upfront technology access fee. There were no other amounts recognized as revenue during these 2006 periods in connection with the Alcon agreement. For the three and nine months ended September 30, 2007, we recognized revenue of

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NOVABAY PHARMACEUTICALS, INC.

(formerly NovaCal Pharmaceuticals, Inc.)

(a development stage company)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

$625,000 and $1.9 million, respectively, for amortization of the upfront technology access fee and $675,000 and $2.0 million, respectively, for the on-going research and development activities performed during these periods. During the three and nine months ended September 30, 2007, we recognized $84,000 and $427,000, respectively, for materials, equipment and contract study costs which have been or will be reimbursed by Alcon. In total, we recognized revenue of $1.4 million and $4.3 million for the three and nine months ended September 30, 2007, respectively, in connection with the Alcon collaboration and license agreement. At September 30, 2007, $97,000 of reimbursable expenses were recorded as a receivable and included in prepaid expenses and other current assets on our balance sheet. As of September 30, 2007, we had not earned or received any milestone or royalty payments under the Alcon agreement.

KCI International VOF GP

In June 2007, we entered into a license agreement with an affiliate of Kinetic Concepts, Inc., pursuant to which we granted to the Kinetic Concepts affiliate (“KCI”) the exclusive rights to develop, manufacture and commercialize NVC-101 (which we also refer to as NeutroPhase), a solution containing hypochlorous acid, as well as other products containing hypochlorous acid as the principal active ingredient, worldwide for use in wound care in humans, other than products or uses intended for the eye, ear or nose. Under the terms of the agreement, we received from KCI a non-refundable technology access fee of $200,000. The up-front technology access fee was recorded as deferred revenue and is being amortized into revenue on a straight-line basis over the 18-month performance obligation period, through December 2008. Under the agreement, we are also entitled to receive reimbursements for qualified consulting, materials and contract study costs. In addition, we are entitled to receive payments of up to $1.25 million if certain milestones are met. If products covered by the license are commercially launched, we will also receive royalty payments based on net revenues from sales by KCI of such products. KCI has the right to terminate the agreement without penalty upon 60 days’ notice. We have the right to terminate the agreement if KCI has not commercially launched a product incorporating NVC-101, or any other product containing hypochlorous acid , within 18 months of the date of the agreement. Both parties have the right to terminate the agreement for breach upon 60 days’ notice.

For the three and nine months ended September 30, 2007, we recognized revenue of $33,000 and $39,000, respectively, for amortization of the upfront technology access fee. For both the three and nine months ended September 30, 2007, we recognized $26,000 for consulting and materials costs which will be reimbursed by KCI. In total, we recognized revenue of $59,000 and $65,000 for the three and nine months ended September 30, 2007, respectively, in connection with the KCI agreement. At September 30, 2007, $26,000 of reimbursable expenses were recorded as a receivable and included in prepaid expenses and other current assets on our balance sheet. As of September 30, 2007, we had not earned or received any milestone or royalty payments under the KCI agreement.

NOTE 11. EMPLOYEE BENEFIT PLAN

We have a 401(k) plan covering all eligible employees. We are not required to contribute to the plan and have made no contributions through September 30, 2007.

NOTE 12. INCOME TAXES

We have not recorded a provision for income taxes for any of the periods presented. The difference between the expected provision for income taxes, based on the United States federal statutory rate of 34%, from our actual provision for income taxes, an effective tax rate of 0%, is attributable to the net deferred tax assets offset by a full valuation allowance.

As of December 31, 2006, we recorded a full valuation allowance against our net deferred tax assets due to operating losses incurred since inception. Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, the net deferred tax assets were fully offset by a valuation allowance. If not utilized, the federal and state net operating loss and tax credit carryforwards will expire at various dates between 2015 and 2025. Under the Tax Reform Act of 1986, as amended, the amounts of and benefits from net operating loss and credit carryforwards may be impaired or limited in certain circumstances. Events that could cause limitations in the amount of net operating losses that we may utilize in any one year include, but are not limited to, a cumulative ownership change of more than 50%, as defined under the Tax Reform Act, that may occur, for example, as a result of our initial public offering completed in October 2007 aggregated with certain other sales of our stock before or after the initial public offering.

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NOVABAY PHARMACEUTICALS, INC.

(formerly NovaCal Pharmaceuticals, Inc.)

(a development stage company)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

NOTE 13. NET INCOME (LOSS) PER SHARE

The components of net income (loss) per share were as follows:

The following outstanding stock options and preferred stock were excluded from the diluted EPS computation as their effect would have been anti-dilutive.

Pro forma net loss per share for the three and nine months ended September 30, 2007 was computed using the weighted average number of shares of common stock outstanding, including the pro forma effects of the automatic conversion of the preferred stock into shares of common stock effective upon the closing of the offering as if such conversion occurred on the first day of the fiscal year, or at the date of the original issuance, if later.

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NOVABAY PHARMACEUTICALS, INC.

(formerly NovaCal Pharmaceuticals, Inc.)

(a development stage company)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

NOTE 14. SUBSEQUENT EVENTS

Initial Public Offering

In October 2007, we completed an initial public offering of our common stock (“IPO”) in which we sold and issued 5,000,000 shares of our common stock at a price to the public of $4.00 per share. We raised a total of $20.0 million from the IPO, or approximately $17.2 million in net proceeds after deducting underwriting discounts and commissions of $1.4 million and other offering costs of $1.4 million. Upon the closing of the IPO, all shares of convertible preferred stock outstanding automatically converted into 9,613,554 shares of common stock. In connection with the closing of IPO, we also issued warrants to the underwriters to purchase an aggregate of 350,000 shares of common stock at an exercise price of $4.00 per share. The warrants are exercisable on or after October 31, 2008 and expire on October 31, 2010.

2007 Omnibus Incentive Plan

In March and April 2007, our board of directors and our shareholders, respectively, approved the 2007 Omnibus Incentive Plan under which 2.0 million shares of our common stock were reserved for issuance as stock options and other stock-based awards. This plan became effective in October 2007 upon the effective date of the registration statement for our IPO. Upon the effectiveness of this plan, no further awards will be granted under the 2005 Plan.

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You should read the following discussion and analysis in conjunction with our condensed consolidated financial statements and the related notes thereto contained in Part I, Item 1 of this report. The information contained in this Quarterly Report on Form 10-Q is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this report and in our other filings with the SEC, before deciding to purchase, hold or sell our common stock.

This report contains forward-looking statements that are based on our management’s beliefs and assumptions and on information currently available to our management. These forward-looking statements include but are not limited to statements regarding our product candidates, market opportunities, competition, strategies, anticipated trends and challenges in our business and the markets in which we operate, and anticipated expenses and capital requirements. In some cases, you can identify forward-looking statements by terms such as “anticipates,” “believes,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “potential,” “predicts,” “projects,” “should,” “will,” “would” and similar expressions intended to identify forward-looking statements. Forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performances or achievements expressed or implied by the forward-looking statements. Factors that might cause or contribute to such differences include, but are not limited to, those discussed under the heading “Risk Factors” in Part II, Item 1A of this report. You should carefully review the risks described in this report and in other documents we file from time to time with the Securities and Exchange Commission, or the SEC. Given these uncertainties, you should not place undue reliance on these forward-looking statements, which speak only as of the date of this report. Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.

Overview

We are a biopharmaceutical company focused on developing innovative product candidates targeting the treatment or prevention of a wide range of infections in hospital and non-hospital environments. Many of these infections have become increasingly difficult to treat because of the rapid increase in infectious agents that have become resistant to current drugs.

We have discovered and are developing a class of antimicrobial compounds, which we have named Aganocide compounds, that we believe could form a platform on which to create a variety of products to address differing needs in the treatment and prevention of bacterial infections. Our antimicrobial compounds are based upon small molecules that are generated by white blood cells that defend the body against invading pathogens. In the body, these compounds are produced “on demand” and are transient. We have focused our efforts on understanding these molecules and finding ways, primarily by chemical modification, to impart qualities to them to allow them to be developed as therapeutic products.

Our current development efforts are focused on Aganocide compounds to treat patients with infections of the eye, ear and sinus, to create an improved environment for the healing of wounds, whether chronic or acute, and to prevent infections that result from surgical or other hospital procedures, or that can be caused by the use of products, such as contact lens solutions, which can introduce an infection into the body. We operate in one business segment.

In August 2006, we entered into a collaboration and license agreement with Alcon Manufacturing Ltd. (“Alcon”) to license to Alcon the exclusive right to develop, manufacture and commercialize products incorporating the Aganocide compounds for application in connection with the eye, ear and sinus and for use in contact lens solutions. Under the terms of the agreement, Alcon agreed to pay an up-front, non-refundable technology access fee of $10.0 million in addition to semi-annual payments to support on-going research and development activities over the four year funding term of the agreement.

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In June 2007, we entered into a license agreement with an affiliate of Kinetic Concepts, Inc (“KCI”) under which we granted KCI the exclusive rights to develop, manufacture and commercialize NVC-101, or Neutrophase, as well as other products containing hypochlorous acid as the principal active ingredient, worldwide for use in wound care in humans, other than products or uses intended for the eye, ear or nose. Under the terms of the agreement, KCI paid to us a technology access fee of $200,000 and, if certain milestones are met, we are entitled to receive additional amounts of up to $1.25 million.

To date, we have generated no revenue from product sales, and we have financed our operations and internal growth primarily through the sale of our capital stock. We have also recently begun to generate revenue under our agreements with Alcon and KCI. We are a development stage company and have incurred significant losses since commencement of our operations in July 2002, as we have devoted substantially all of our resources to research and development. As of September 30, 2007, we had an accumulated deficit of $17.1 million. Our accumulated deficit resulted from research and development expenses and general and administrative expenses. We expect to continue to incur net losses over the next several years as we continue our clinical and research and development activities and as we apply for patents and regulatory approvals.

Recent Events

In August 2007, we filed an amendment to our articles of incorporation to effect a 1-for-2 reverse stock split of our common stock. All share and per share amounts relating to the common stock, stock options and warrants and the conversion ratios of the preferred stock included in the financial statements and footnotes have been restated to reflect the reverse stock split.

In March 2007, we filed an Investigational New Drug application, or IND, to initiate Phase I human clinical trials associated with our initial Aganocide compound, NVC-422 for our pre-surgical nasal preparation indication. The FDA cleared our IND in April 2007, and we began Phase I clinical trials in early May 2007. A total of 96 participants were enrolled in the clinical trials. The treatment phase of the trial was completed in September 2007 and the resultant clinical data is currently under analysis.

In April 2007, we submitted a 510(k) premarketing application to the FDA to permit the use of NVC-101 in wound management as a wound cleanser and debriding agent. We received clearance from the FDA in September 2007 for such indications of use.

In October 2007, we completed the initial public offering of our common stock in which we sold and issued 5,000,000 shares of our common stock, at an issue price of $4.00 per share. We raised a total of $20.0 million from the IPO, or approximately $17.2 million in net proceeds after deducting underwriting discounts and commissions of $1.4 million and other offering costs of $1.4 million. Upon the closing of the IPO, all shares of convertible preferred stock outstanding automatically converted into 9,613,554 shares of common stock. In connection with the closing of IPO, we also issued warrants to the underwriters to purchase an aggregate of 350,000 shares of common stock at an exercise price of $4.00 per share. The warrants are exercisable on or after October 31, 2008 and expire on October 31, 2010.

In March and April 2007, our board of directors and our shareholders, respectively, approved the 2007 Omnibus Incentive Plan under which 2.0 million shares of our common stock were reserved for issuance as stock options and other stock-based awards. This plan became effective in October 2007 upon the effective date of the registration statement for our IPO. In connection with the effectiveness of this plan, no further awards will be granted under the 2005 Stock Option Plan.

Critical Accounting Policies and Estimates

Our financial statements have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported revenues and expenses during the reporting periods. In preparing these financial statements, management has made its best estimates and judgments of certain amounts included in the financial statements giving due consideration to materiality. On an ongoing basis, we evaluate our estimates and

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judgments related to revenue recognition, income taxes, intangible assets, long-term service contracts and other contingencies. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

While our significant accounting policies are more fully described in Note 2 of the Notes to Condensed Consolidated Financial Statements, included in Part I, Item I of this report, we believe that the following accounting policies are most critical to aid you in fully understanding and evaluating our reported financial results.

Revenue Recognition

License and collaboration revenue is primarily generated through agreements with strategic partners for the development and commercialization of our product candidates. The terms of the agreements typically include non-refundable upfront fees, funding of research and development activities, payments based upon achievement of certain milestones and royalties on net product sales. In accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables”, we analyze our multiple element arrangements to determine whether the elements can be separated. We perform our analysis at the inception of the arrangement and as each product or service is delivered. If a product or service is not separable, the combined deliverables are accounted for as a single unit of accounting and recognized over the performance obligation period. We recognize revenue in accordance with SEC Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements”, as amended by SAB No. 104 (together, “SAB 104”). In accordance with SAB 104, revenue is recognized when the following criteria have been met: persuasive evidence of an arrangement exists; delivery has occurred and risk of loss has passed; the seller’s price to the buyer is fixed or determinable and collectibility is reasonably assured.

Assuming the elements meet the EITF No. 00-21 criteria for separation and the SAB 104 requirements for recognition, the revenue recognition methodology prescribed for each unit of accounting is summarized below:

Upfront Fees—We defer recognition of non-refundable upfront fees if we have continuing performance obligations without which the technology licensed has no utility to the licensee. If we have continuing involvement through research and development services that are required because our know-how and expertise related to the technology is proprietary to us, or can only be performed by us, then such up-front fees are deferred and recognized over the period of continuing involvement.

Funded Research and Development—Revenue from research and development services is recognized during the period in which the services are performed and is based upon the number of full-time-equivalent personnel working on the specific project at the agreed-upon rate. Reimbursements from collaborative partners for agreed upon direct costs including direct materials and outsourced, or subcontracted, pre-clinical studies are classified as revenue in accordance with EITF Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent,” and recognized in the period the reimbursable expenses are incurred. Payments received in advance are recorded as deferred revenue until the research and development services are performed or costs are incurred.

Milestones—Substantive milestone payments are considered to be performance bonuses that are recognized upon achievement of the milestone only if all of the following conditions are met: the milestone payments are non-refundable; achievement of the milestone involves a degree of risk and was not reasonably assured at the inception of the arrangement; substantive effort is involved in achieving the milestone; the amount of the milestone is reasonable in relation to the effort expended or the risk associated with achievement of the milestone; and a reasonable amount of time passes between the up-front license payment and the first milestone payment as well as between each subsequent milestone payment. If any of these conditions are not met, the milestone payments are deferred and recognized as revenue over the term of the arrangement as we complete our performance obligations.

Royalties—We recognize royalty revenues from licensed products upon the sale of the related products.

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Research and Development Costs

We charge research and development costs to expense as incurred. These costs consist of direct and indirect costs associated with specific projects, as well as fees paid to entities that perform research and clinical studies on our behalf.

Patent Costs

We expense patent costs, including legal expenses, in the period in which they are incurred. Patent expenses are included as general and administrative expenses in our statements of operations.

Stock-Based Compensation

On January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123R, “Share-Based Payment”. SFAS No. 123R replaced SFAS No. 123 and superseded Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations. Under the fair value recognition provisions of SFAS No. 123R, stock-based compensation expense is measured at the grant date for all stock-based awards to employees and directors and is recognized as expense over the requisite service period, which is generally the vesting period. We were required to utilize the prospective application method prescribed by SFAS No. 123R, under which prior periods are not revised for comparative purposes. Under the prospective application transition method, non-public entities that previously used the minimum value method of SFAS No. 123 should continue to account for non-vested equity awards outstanding at the date of adoption of SFAS No. 123R in the same manner as they had been accounted for prior to adoption. SFAS No. 123R specifically prohibits pro forma disclosures for those awards valued using the minimum value method. The valuation and recognition provisions of SFAS No. 123R apply to new awards and to awards outstanding as of the adoption date that are subsequently modified.

Prior to the adoption of SFAS No. 123R, we accounted for stock-based compensation awards to employees using the intrinsic value method under the recognition and measurement principles of APB Opinion No. 25. Our application of APB Opinion No. 25 did not result in compensation expense because the exercise price of the stock-based awards was equal to the fair market value of the stock at the grant date.

We account for stock compensation arrangements with non-employees in accordance with SFAS No. 123R and EITF Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services”, using a fair value approach. For stock options granted to non-employees, the fair value of the stock options is estimated using a Black-Scholes-Merton valuation model.

The adoption of SFAS No.123R had a material effect on our financial position and results of operations. See Note 9 of the Notes to Condensed Consolidated Financial Statements, included in Part I, Item I of this report, for further information regarding stock-based compensation expense and the assumptions used in estimating that expense.

Income Taxes

We account for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is recognized if it is more likely than not that some portion or all of the deferred tax asset will not be recognized.

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Recently Issued Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”. SFAS No. 157 establishes a framework for measuring the fair value of assets and liabilities. This framework is intended to provide increased consistency in how fair value determinations are made under various existing accounting standards which permit, or in some cases require, estimates of fair market value. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Earlier application is encouraged, provided that the reporting entity has not yet issued financial statements for that fiscal year, including any financial statements for an interim period within that fiscal year. We are currently assessing the impact of SFAS No. 157 on our consolidated financial position and results of operations.

In February, 2007, the FASB issued SFAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 permits entities to choose to measure many financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We are currently assessing the impact of SFAS No. 159 on our consolidated financial position and results of operations.

In June 2007, the FASB issued EITF Issue No. 07-3, “Accounting for Nonrefundable Advance Payments for Goods or Services Received for Use in Future Research and Development Activities”. EITF No. 07-3 requires that nonrefundable advance payments for goods or services that will be used or rendered for future research and development activities be deferred and capitalized and recognized as an expense as the goods are delivered or the related services are performed. EITF No. 07-3 is effective, on a prospective basis, for fiscal years beginning after December 15, 2007. We are currently assessing the impact of EITF No. 07-3 on our consolidated financial position and results of operations.

Results of Operations

Comparison of Three and Nine Months Ended September 30, 2006 and September 30, 2007

License and Collaboration Revenue

Total license and collaboration revenue was $208,000 for both the three and nine months ended September 30, 2006, compared to $1.4 million and $4.4 million for the three and nine months ended September 30, 2007. License and collaboration revenue consisted of amounts earned under the license and collaboration agreements with Alcon and KCI for amortization of the upfront technology access fees and amounts that have been or will be reimbursed for the funding of research and development activities performed during the period. The increase in revenue during the 2007 periods over the comparable 2006 periods is attributable to the timing of the Alcon and KCI agreements, which were entered into in August 2006 and June 2007, respectively.

The upfront technology access fee of $10.0 million from Alcon will be amortized into revenue on a straight-line basis over the four year funding term of the agreement, through August 2010. The upfront technology access fee from KCI of $200,000 will be amortized on a straight-line basis over 18 months through December 2008.

Research and Development

Research and development expenses increased by 83% to $2.1 million for the three months ended September 30, 2007 from $1.1 million for the three months ended September 30, 2006. This increase was due in part to an increase in salary and benefits expense of $328,000, as the number of research and development personnel grew by 63% from September 30, 2006 to September 30, 2007, and included the hiring of several senior personnel. Also, during the second and third quarters of 2007, we conducted Phase I clinical studies for the pre-surgical nasal preparation indication of NVC-422, which caused our clinical expenses to increase by $444,000 over the corresponding third quarter in 2006. Additionally, during the three months ended September 30, 2007, we accrued $92,000 for estimated amounts that we may pay to research and development personnel for annual bonuses. No such accrual was made during 2006.