CBMX Combimatrix Corp. (MM)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

x            QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For The Quarterly Period Ended March 31, 2013

OR

o               TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

N/A

(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 filing requirements for the past 90 days.      Yes x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).      Yes x No o

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

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

As of May 9, 2013, 3,586,191 shares of CombiMatrix Corporation common stock, $0.001 par value were issued and outstanding.

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COMBIMATRIX CORPORATION

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

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

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COMBIMATRIX CORPORATION

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COMBIMATRIX CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

Liquidity and Risks

We have a history of incurring net losses and net operating cash flow deficits.  We are also deploying new technologies and continue to develop new and improve existing commercial diagnostic testing services and related products.  At March 31, 2013, we had cash and cash equivalents of $3.4 million and anticipate that our cash and cash equivalent balances, combined with: (i) the $1.2 million of gross proceeds received on May 6, 2013 and the $1.2 million of gross proceeds expected to be received from the second closing of the recent Series C convertible preferred stock financing consummated on May 6, 2013; and (ii) the $520,000 of proceeds received from exercise of certain common stock warrants subsequent to March 31, 2013, (see Notes 4 and 6) will be sufficient to meet our cash requirements into the second quarter of 2014, assuming stockholders approve the second tranche of the Series C financing at our upcoming annual stockholders’ meeting.  In the event the Series C financing is not approved by stockholders and the second tranche closing does not occur, we believe we can meet our cash requirements into the first quarter of 2014.  However, the uncertainty regarding our ability to execute our business plan beyond this point raises substantial doubt about our ability to continue as a going concern.

In order for us to continue as a going concern beyond the first and second quarters of 2014 and ultimately to achieve profitability, we may be required to obtain capital from external sources, increase revenues and reduce operating costs.  However, there can be no assurance that our operations will become profitable or that external sources of financing, including the issuance of debt and/or equity securities, will be available at times and at terms acceptable to us, or at all.  The issuance of additional equity or convertible debt securities will also cause dilution to our stockholders.  If external financing sources are not available or are inadequate to fund our operations, we will be required to reduce operating costs, including research projects and personnel, which could jeopardize our future strategic initiatives and business plans.

Our business operations are also subject to certain risks and uncertainties, including:

·                   market acceptance of our products and services;

·                   technological advances that may make our products and services obsolete or less competitive;

·                   increases in operating costs, including costs for supplies, personnel and equipment;

·                   the availability and cost of capital;

·                   governmental regulation that may restrict our business.

Our services are concentrated in a highly competitive market that is characterized by rapid technological advances, frequent changes in customer requirements and evolving regulatory requirements and industry standards.  Failure to anticipate or respond adequately to technological advances, changes in customer requirements, changes in regulatory requirements or industry standards, or any significant delays in the development or introduction of planned products or services, could have a material adverse effect on our business and operating results.  The accompanying consolidated financial statements have been prepared assuming that we will continue as a going concern.  The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the matters discussed herein.

2.     SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Use of Estimates.  The preparation of financial statements in conformity with generally accepted accounting principles (“GAAP”) in the United States of America requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

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COMBIMATRIX CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

Principles of Consolidation .  The accompanying consolidated financial statements include the accounts of the Company and our wholly owned and majority-owned subsidiaries.  Investments for which we possess the power to direct or cause the direction of the management and policies, either through majority ownership or other means, are accounted for under the consolidation method.  Material intercompany transactions and balances have been eliminated in consolidation.  Investments in companies in which we maintain an ownership interest of 20% to 50% or exercise significant influence over operating and financial policies are accounted for under the equity method.  The cost method is used where we maintain ownership interests of less than 20% and do not exercise significant influence over the investee.

Revenue Recognition . We recognize revenue when (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred or services have been performed, (iii) amounts are fixed or determinable and (iv) collectability of amounts is reasonably assured.

Service revenues from providing diagnostic tests are recognized when the testing process is complete and test results are reported to the ordering physician or clinic.  These diagnostic services are billed to various payors, including commercial insurance companies, healthcare institutions, government payors including Medicare and Medicaid, and individuals.  We report revenues from contracted payors based on a contractual rate, or in the case of Medicare and Medicaid, published fee schedules for our tests.  We report revenues from non-contracted payors based on the amount expected to be collected.  The difference between the amount billed and the amount expected to be collected from non-contracted payors is recorded as a contractual allowance to arrive at net recognized revenues.  The expected revenues from non-contracted payors are based on the historical collection experience of each payor or payor group, as appropriate.  In each reporting period, we review our historical collection experience for non-contracted payors and adjust our expected revenues for current and subsequent periods accordingly.  We also recognize additional revenue from actual cash payments that exceed amounts initially recognized, in the period the payments are received.  For the three months ended March 31, 2013 and 2012, net positive revenue adjustments were $202,000 and $221,000, respectively.  Because a substantial portion of our revenues is from non-contracted third-party payors, it is likely that we will be required to make adjustments to accounting estimates with respect to contractual allowances in the future, which may positively or adversely affect our results of operations.  In all cases described above, we report revenues net of any applicable statutory taxes collected from customers, as applicable.

Clinical trials support services revenue is recognized when the related support services have been delivered to and accepted by the customer.  Royalty revenue is recognized in the period when earned.

Cash and Cash Equivalents .  We consider all highly liquid, short-term investments with original maturities of three months or less when purchased to be cash equivalents.

Fair Value Measurements.  We measure fair value as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.  As such, fair value is a market-based measurement that is determined based on assumptions that market participants would use in pricing an asset or liability.  We utilize a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows:

·                   Level 1:                Observable market inputs such as quoted prices in active markets;

·                     Level 2:            Observable market inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and

·                  Level 3:              Unobservable inputs where there is little or no market data, which require the reporting entity to develop its own assumptions.

Concentration of Credit Risks .  Cash equivalents are invested in deposits with certain financial institutions and may, at times, exceed federally insured limits.  We have not experienced any significant losses on our deposits of cash and cash equivalents.

Accounts Receivable and Allowance for Doubtful Accounts.   Accounts receivable are stated at principal amounts and are primarily comprised of amounts contractually due from customers for products and services.  An allowance for doubtful accounts is recorded for estimated uncollectible amounts due from various payor groups such as commercial insurance companies, healthcare institutions, government payors and individuals.  The process for estimating the allowance for doubtful accounts involves significant assumptions and judgments.  Specifically, the allowance for doubtful accounts is adjusted periodically and is principally based upon specific identification of past due or disputed accounts.

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COMBIMATRIX CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

We also review the age of receivables by payor class to assess our allowance at each period end.  The payment realization cycle for certain governmental and commercial insurance payors can be lengthy, involving denial, appeal and adjudication processes, and is subject to periodic adjustments that may be significant.  Accounts receivable are periodically written off when identified as uncollectible and deducted from the allowance for doubtful accounts after appropriate collection efforts have been exhausted. Additions to the allowance for doubtful accounts are charged to bad debt expense as a component of general and administrative expenses in the consolidated statements of operations.  Collection of governmental, private health insurer, and client receivables are generally a function of providing complete and correct billing information to the insurers and clients within the filing deadlines required by each payor.  Collection of receivables due from patients and clients is generally subject to increased credit risk due to credit-worthiness or inability to pay.

Derivative Financial Instruments.  We evaluate financial instruments for freestanding or embedded derivatives.  Derivative instruments that do not qualify for permanent equity classification are recorded as liabilities at fair value, with changes in value recognized as other income (expense) in the consolidated statements of operations in the period of change.  Derivative liabilities are categorized as either short-term or long-term based upon management’s estimates as to when the derivative instrument may be realized or based upon the holder’s ability to realize the instrument.

Stock-Based Compensation .  The compensation cost for all stock-based awards is measured at the grant date, based on the fair value of the award, and is recognized as an expense, on a straight-line basis, over the employee’s requisite service period (generally the vesting period of the equity award) which is generally three years.  The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model.  Stock-based compensation expense is recognized only for those awards that are expected to vest using an estimated forfeiture rate.  We estimate pre-vesting option forfeitures at the time of grant and reflect the impact of estimated pre-vesting option forfeitures in compensation expense recognized.  Stock-based compensation expense for all periods presented attributable to our functional expense categories were as follows (in thousands):

Net Loss Per Share . Basic and diluted net loss per share has been computed by dividing the net loss by the weighted average number of common shares issued and outstanding during the periods presented. Options and warrants to purchase common stock as well as preferred stock convertible into shares of common stock are anti-dilutive and therefore are not included in the determination of the diluted net loss per share. The following table reflects the excluded dilutive securities:

Segments.   We have determined that we operate in one segment for financial reporting purposes.

Reclassifications .  Certain prior period amounts, including royalty revenues, have been reclassified to conform to the current period presentation.

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COMBIMATRIX CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

3.     FAIR VALUE MEASUREMENTS

The following table summarizes, for each major category of financial assets measured on a recurring basis, the respective fair value at March 31, 2013 and December 31, 2012 and the classification by level of input within the fair value hierarchy defined above (in thousands):

The following table is a reconciliation of financial liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three months ended March 31, 2013 (in thousands):

4.     STOCKHOLDERS’ EQUITY

Series A Convertible Preferred Stock Financing

On September 28, 2012 (the “Commitment Date”), we entered into a securities purchase agreement with certain accredited investors (the “Series A Investors”), pursuant to which we would sell and issue 1,050.70039 shares of newly created Series A 6% Convertible Preferred Stock (the “Series A Stock”) to the Series A Investors at a purchase price of $1,000 per share in an initial closing that occurred on October 1, 2012 (the “Series A First Closing”) and, subject to stockholder approval, would sell and issue 1,449.29961 additional shares of Series A Stock to the Series A Investors at a purchase price of $1,000 per share within five business days after such stockholder approval was obtained (the “Series A Second Closing”) (combined, the “Series A Financing”).  A special stockholders’ meeting was held on November 29, 2012 in which stockholder approval was obtained.  On December 6, 2012, the Series A Second Closing occurred.  After certain offering-related costs were incurred, the net proceeds received by us from the Series A Financing were $2.0 million.  As a result of the Series A Second Closing, the conversion price for the Series A Stock was set to $1.9995 per share, or the equivalent of 1.25 million shares of common stock issuable upon conversion of all Series A Stock.  We filed resale registration statements on Form S-3 related to the Series A financing, which have been declared effective by the SEC. Until all Series A Investors no longer hold Series A Stock or Series A warrants to purchase common stock: (i) we may not sell any variable rate securities or dilutive securities except for certain exempt issuances; (ii) if we enter into a subsequent financing on more favorable terms than the Series A Stock financing, then the agreements between us and the Series A Investors will be amended to include such more favorable terms; and (iii) we may not sell securities at an effective price per share less than $4.91 except for certain exempt issuances, unless waivers from the Series A Investors are obtained.  For a period of 12 months following the Series A First Closing, we have granted the Series A Investors a right of first offer on certain future issuances of securities.

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COMBIMATRIX CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

Holders of the Series A Stock were entitled to receive accruing dividends at the annual rate of 6%, payable semi-annually.  Upon conversion of Series A Stock into common stock, we paid to each holder of Series A Stock converting to common stock, as a “make-whole” payment in common stock, an amount equal to $118 per $1,000 of stated value of Series A Stock so converted, less the aggregate amount of dividends previously paid on such converting Series A Stock.  During December 2012, the Series A Investors converted 855.54814 shares of Series A Stock into 427,878 shares of common stock.  In addition, 12,871 shares of common stock were issued to the Series A Investors in payment of the make-whole dividends related to the Series A Stock conversions.  On January 4, 2013, accrued Series A dividends of $22,000 were paid by issuing 4,164 shares of common stock to the Series A Investors.  During the first quarter of 2013, the Series A Investors converted all of the remaining 1,644.45186 shares of Series A Stock into 822,421 shares of common stock.  In addition, 50,307 shares of common stock were issued to the Series A Investors in payment of the make-whole and accrued dividends related to the Series A Stock conversions.  The combination of make-whole and accrued dividends paid in shares of common stock for the quarter-ended March 31, 2013 was $247,000.

In addition to the issuance of the Series A Stock, at the Series A First Closing, we issued warrants to purchase 213,945 shares of common stock to the Series A Investors.  These warrants have a term of 5½ years and initially were to become exercisable six months from the Series A First Closing, with an initial exercise price of $9.50 per share.  At the Series A Second Closing, we issued warrants to purchase 724,825 shares of common stock to the Series A Investors.  These warrants have a term of 5½ years and initially were to become exercisable six months from the Series A Second Closing, with an initial exercise price of $2.364 per share (collectively, the “Series A Warrants”).  The exercise price of the Series A Warrants and the number of shares of common stock underlying the Series A Warrants are subject to full-ratchet anti-dilution adjustments in the event we issue securities, other than certain excepted issuances, at a price below the then current exercise price of the Series A Warrants.  On February 26, 2013, we entered into an agreement with the Series A Investors to modify the Series A Warrants such that they would become immediately exercisable as of February 22, 2013 (the “Modification Date”).  Since the Modification Date through March 31, 2013, 420,005 shares of common stock have been issued from exercise of the Series A Warrants, resulting in proceeds to the Company of $993,000.  Subsequent to March 31, 2013 though May 9, 2013, an additional 219,998 shares of common stock have been issued from exercise of the Series A Warrants, resulting in additional proceeds to the Company of $520,000.

We account for stock purchase warrants as either equity instruments or derivative liabilities depending on the specific terms of the warrant agreements.  Under applicable accounting guidance, stock warrants must be accounted for as derivative financial instruments if the warrants contain full-ratchet anti-dilution provisions, which preclude the warrants from being considered indexed to our own stock.  The Series A Warrants issued to Series A Investors contain such provisions, thus requiring us to treat them as derivative financial instruments, to be recorded at fair value at issuance and subsequently adjusted to fair value at each reporting date, with the corresponding adjustment reflected as a non-operating credit / charge in the consolidated statement of operations.  We valued the Series A Warrants using the Monte-Carlo simulation method using the following assumptions at March 31, 2013:  (i) closing stock price and Series A Warrant contractual exercise price; (ii) term to expiration commensurate with the individual Series A Warrant terms ranging from 5.0 years to 5.2 years; (iii) historical volatilities commensurate with the term of the Series A Warrants ranging from 114.5% to 116.0%; (iv) risk-free interest rates commensurate with the term of the Series A Warrants ranging from 0.7% to 0.8%; and (v) simulated anti-dilution impact assuming various probabilities that we will raise additional capital by issuing equity securities at prices above or below the current contractual Series A Warrant exercise prices during the Series A Warrant terms.  The result of these valuation simulations was to value the remaining Series A Warrants held by Series A Investors at $2.6 million, which was $1.8 million below their fair value as of December 31, 2012.  As a result, we recognized a $1.8 million non-operating, warrant derivative gain in our consolidated statement of operations for the period ended March 31, 2013.

Amortization of the deferred offering-related costs allocated to the Series A Warrants was $280,000 during the period ended March 31, 2013, and was recognized as a component of interest expense in the March 31, 2013 consolidated statement of operations.

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COMBIMATRIX CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

Series B Convertible Preferred Stock Financing

On March 19, 2013, we entered into a securities purchase agreement (the “Series B Purchase Agreement”) with an existing institutional investor (the “Series B Investor”) to purchase 130,000 shares of common stock at a price of $3.05 per share and approximately 1,610 units consisting of, in the aggregate, Series B 6% convertible preferred stock (the “Series B Stock”) and warrants to purchase up to 275,000 shares of common stock at an exercise price of $3.49 per share (the “Series B Warrants”) in a registered direct offering (the “Series B Financing”) of securities off of our existing shelf registration statement on Form S-3 (File No. 333-176372).  The Series B Financing closed on March 20, 2013 (the “Series B Closing”).  The Series B Stock and Series B Warrants were sold in multiples of fixed combinations, with each fixed combination consisting of one share of Series B Stock and a Series B Warrant to purchase approximately 171 shares of common stock.  Each fixed combination of Series B Stock and Series B Warrants was sold at a price of $1,000.  The Series B Stock is convertible into an aggregate of 528,000 shares of common stock at an initial conversion price of $3.05 per share.  The Series B Stock is not convertible into greater than 19.99% (when aggregated with the common shares purchased in the Series B Financing) of our outstanding common stock unless and until stockholder approval is obtained.  The Series B Warrants are not exercisable for six months from the Series B Closing, and the Series B Stock will accrue dividends at an annual rate of 6% beginning six months after the Series B Closing, assuming the Series B Stock has not been converted by that time.  Upon the Series B Closing, we received proceeds of $1.76 million, net of placement agent fees and other related paid and accrued costs.  Also, as a result of the Series B Financing, the exercise price of the Series A Warrants issued in the Series A First Closing automatically ratcheted down by their terms from their original exercise price of $9.50 per share to an adjusted exercise price of $3.05 per share, and the underlying shares exercisable were automatically increased from approximately 213,935 shares to approximately 666,375 shares.

Pursuant to the Certificate of Designation of Preferences, Rights and Limitations of Series B 6% Convertible Preferred Stock filed by the Company with the Delaware Secretary of State on March 19, 2013, the Series B Stock is non-voting (except to the extent required by law and except for certain consent rights relating to amending the certificate of incorporation or bylaws, and the like), but ranks senior to the common stock with respect to dividends and with respect to distributions upon a deemed dissolution, liquidation or winding-up of the Company.  Each share of Series B Stock carries a 6% per annum dividend that will begin accruing six months after the Series B Closing and will be payable only in cash.  Subject to certain exceptions, the conversion price of the Series B Stock is subject to full ratchet anti-dilution adjustment in the event we issue any convertible debt or equity below the then-current conversion price (subject to the limits imposed by General Instruction I.B.6. of Form S-3).  In the event we commit material and intentional fraud, we may be required to redeem the Series B Stock in exchange for the issuance of common stock valued at 130% of the stated value divided by 75% of the average of the preceding 10-day volume-weighted average price of the common stock, subject to the limits imposed by General Instruction I.B.6. of Form S-3.

The Series B Warrants have a 5 ½ year term as well as a cashless exercise provision in the event there is no effective registration statement covering the common stock issuable upon exercise of the Series B Warrants, and are not exercisable for the first six months following issuance.  The Series B Warrants are not subject to price anti-dilution protection.

Pursuant to the terms of the Series B Purchase Agreement, we have also agreed with the Series B Investor that while such Series B Investor holds Series B Preferred Stock or Series B Warrants, we will not effect or enter into an agreement to effect a “Variable Rate Transaction,” which means a transaction in which we: (i) issue or sell any convertible securities either (A) at a conversion, exercise or exchange rate or other price that is based upon and/or varies with the trading prices of, or quotations for, the shares of the common stock at any time after the initial issuance of such convertible securities, or (B) with a conversion, exercise or exchange price that is subject to being reset at some future date after the initial issuance of such convertible securities or upon the occurrence of specified or contingent events directly or indirectly related to our business; or (ii) enter into any agreement (including, without limitation, an equity line of credit) whereby we may sell securities at a future determined price.

We also agreed with the Series B Investor pursuant to the Series B Purchase Agreement that, except under certain permitted circumstances: (i) until the later of the date that is six months from the Series B Closing or 30 days following the date on which the Series B Stock is no longer outstanding we will not issue, or enter into any agreement to issue, any shares of common stock or equivalents thereof; (ii) until the time that less than 7.5% of the Series B Warrants remain outstanding, neither we nor our subsidiaries shall issue, or enter into any agreement to issue, common stock or equivalents thereof at a price below the exercise price of the Series B Warrants; (iii) so long as any shares of Series B Stock are outstanding, neither we nor our subsidiaries shall issue, or enter into any agreement to issue, common stock or equivalents at a price below the conversion price of the Series B Stock unless all shares of common stock underlying the Series B Stock (taking into consideration the effect of the full adjustment of the anti-dilution provisions from such dilutive issuance) are permitted by General Instruction I.B.6. of Form S-3 to be issued under the registration statement; (iv) if we issue securities within the nine months following the Series B Closing under the Series B Purchase Agreement, and subject to the preexisting rights of other security holders, the Series B Investor shall have the right to purchase all of the securities on the same terms, conditions and price provided for in the proposed issuance of securities; and (v) we will indemnify the Series B Investor against certain losses resulting from our breach of any of our representations, warranties, or covenants under agreements with the Series B Investor, as well as under certain other circumstances described in the Series B Purchase Agreement.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

The Series B Investor has agreed to be subject to a blocker that (i) would prevent its common stock ownership at any given time from exceeding 4.99% (which may be increased, but not above 9.99%) of our outstanding common stock; or (ii) would prevent us from issuing any shares of common stock to the Series B Investor upon the conversion by such Series B Investor of Series B Stock if the issuance of such shares to the Series B Investor, when aggregated with all other shares of common stock sold to the Series B Investor under the Series B Purchase Agreement together with all shares of common stock issued upon the conversion of Series B Stock, would result in the total issuance of common stock to exceed 19.99% of our outstanding common stock, without first obtaining the approval of our stockholders.  We have agreed to seek stockholder approval at our next annual stockholders’ meeting for the terms of the Series B Stock and the issuance and delivery in the aggregate of that number of shares of common stock exceeding 19.99% of the outstanding shares of common stock upon conversion of the Series B Stock.  Since the Series B Closing through the date of this report, the Series B Investor has converted 1,275.4 shares of Series B stock into 418,163 shares of common stock.

(1)          Prior to the anti-dilution adjustment which occurred on March 20, 2013, these warrants had an exercise price of $9.50 per share.

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(Unaudited)

5.     COMMITMENTS AND CONTINGENCIES

Executive Severance

We provide certain severance benefits such that if an executive officer of CombiMatrix Corporation is terminated for other than cause, death or disability, the executive will receive payments equal to three months’ base salary plus medical and dental benefits.  In addition, we have implemented a Restated Executive Change of Control Severance Plan (the “Severance Plan”) that affects certain of our senior management-level employees who are classified as “Section 16 Officers” of the Company.  Pursuant to the Severance Plan, if a participating employee is involuntarily terminated (other than for death, disability or for cause) or resigns for “good reason” (as defined in the Severance Plan) during the two-year period following a “change of control” (as defined in the Severance Plan) of the Company, then, subject to execution of a release of claims against the Company, the employee will be entitled to receive: (i) one-half times annual base salary; (ii) immediate vesting of outstanding compensatory equity awards; and (iii) payment of COBRA premiums for the participating employee and eligible dependants for a pre-determined period of time.  Payment of benefits under the Severance Plan will be limited by provisions contained in Section 409A of the U.S. Internal Revenue Code.  The Severance Plan is administered by a plan administrator, which initially is the Compensation Committee of the Board of Directors.  In order to participate in the Severance Plan, an eligible employee must waive any prior retention or severance agreements.

Litigation

In 2002, we entered into a settlement agreement with Nanogen, Inc. (“Nanogen”) to settle all pending litigation between the parties.  Pursuant to the terms of the settlement agreement, we agreed to make quarterly payments to Nanogen equal to 12.5% of total sales of products developed by us and our affiliates based on the patents that had been in dispute in the litigation, up to an annual maximum amount of $1.5 million.  The minimum quarterly payments under the settlement agreement are $25,000 per quarter until the patents expire in 2018.  Royalty expenses recognized under the agreement were $25,000 for each of the three months ended March 31, 2013 and 2012, respectively, and are included in patent amortization and royalties in the accompanying consolidated statements of operations.

On February 14, 2011, Relator Michael Strathmann (“Strathmann”) served us with a complaint (“the Complaint”) filed in the Superior Court of the State of California for the County of Orange.  The Complaint alleged that we submitted false and fraudulent insurance claims to National Union Fire Insurance Company of Pittsburgh, PA in connection with a prior lawsuit that was settled with Nanogen, Inc., thereby allegedly violating the California Insurance Fraud Prevention Act, and sought penalties and unspecified treble damages.  On May 4, 2011, the Superior Court dismissed the Complaint by ordering that it be stricken for violation of the California Anti-SLAPP statute, which prevents plaintiffs from filing abusive lawsuits against public policy.  On June 15, 2011, Strathmann filed a Notice of Appeal with the California Court of Appeals, appealing the granting of the Motion to Strike.  Subsequently, Strathmann filed a Notice of Appeal of the award of attorneys’ fees against him.  On October 24, 2012, the California Court of Appeals reversed the Superior Court’s dismissal, finding that the anti-SLAPP statute was not applicable and remanding the case to the Superior Court. Strathmann has filed an Amended Complaint, and we will be filing an Answer to that pleading.  No discovery has been served in the matter, and no trial date has been set.  We believe that there is no merit to Strathmann’s claims and intend to vigorously defend against it, but there can be no assurance that we will ultimately be successful.

From time to time, we are subject to other claims and legal actions that arise in the ordinary course of business.  We believe that the ultimate liability with respect to these other claims and legal actions, if any, will not have a material effect on our financial position, results of operations or cash flows.  Based on a distribution agreement executed between us and Acacia, it is expected that such claims and legal actions attributable to CombiMatrix Corporation prior to the Split-Off Date will remain with us subsequent to the Split-Off Date.  As of the date of this report and prior to such date, we are not aware of the existence of any such claims or legal actions.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

6.     SUBSEQUENT EVENT

On May 3, 2013, we entered into a securities purchase agreement (the “Series C Purchase Agreement”) with certain accredited investors (the “Series C Investors”), pursuant to which we sold and issued 1,200 shares of our newly created Series C 6% convertible preferred stock (the “Series C Stock”) to the Series C Investors (the “Series C Financing”) at a purchase price of $1,000 per share in an initial closing that occurred on May 6, 2013 (the “Series C First Closing”) and, subject to stockholder approval, will sell and issue 1,200 additional shares of Series C Stock to the Series C Investors at a purchase price of $1,000 per share within five business days after such stockholder approval is obtained (the “Series C Second Closing”). The $1,200,000 aggregate purchase price for the Series C Stock received at the First Closing was paid, and the $1,200,000 aggregate purchase price for the Series C Stock to be issued and sold in the Second Closing will be paid, in cash.

After stockholder approval, each share of Series C Stock will be convertible at any time at the holder’s option into shares of common stock at an initial conversion price of $3.05 per share of common stock.  The conversion price of the Series C Stock is subject to full-ratchet anti-dilution adjustment in the event we issue securities, other than certain excepted issuances, at a price below the then current conversion price.  The conversion price of the Series C Stock will be reduced to the lesser of the then-applicable conversion price or 90% of the three day volume weighted average price of one share of our common stock immediately prior to the Series C Second Closing date.  The conversion price of the Series C Stock also is subject to proportional adjustment for stock splits, stock dividends, recapitalizations and the like.  The Series C Stock is entitled to 6% annual dividends, which rate shall increase by 1% per year for as long as the Series C Stock is outstanding, up to a maximum rate of 10%. The dividends are payable semi-annually in cash or, subject to stockholder approval and to certain conditions and at our election, in shares of common stock. If the dividends are paid in shares of common stock, the number of shares of common stock comprising the dividend on each share of Series C Stock will be valued at a 20% discount to the average of the daily volume weighted average price for the five-day trading period immediately prior to the dividend payment date.

In addition to the issuance of the Series C Stock, at the Series C First Closing, we issued to each Series C Investor a warrant to purchase our common stock, initially exercisable for a number of shares of common stock equal to 125% of the number of shares of common stock issuable upon conversion at the initial conversion price of the Series C Stock acquired by such Series C Investor at the Series C First Closing.  We also agreed to issue substantially similar warrants to the Series C Investors at the Series C Second Closing, initially exercisable for a number of shares of Common Stock equal to 125% of the number of shares of common stock issuable upon conversation at the initial conversion price of the Series C Stock acquired at the Series C Second Closing (together with the warrants issued at the Series C First Closing, the “Series C Warrants”).  The exercise price of the Series C Warrants issued at the Series C First Closing was $3.77 per share, which equals 110% of the market value (as defined by Nasdaq rules) of one share of common stock on the date on which the parties entered into the Series C Purchase Agreement.  At the Series C Second Closing, the exercise price will be 110% of the market value (as defined by Nasdaq rules) of one share of common stock on the date of the Series C Second Closing. The Series C Warrants have a 5 1/2 year term, are not exercisable for the first six months following issuance and include a cash-less exercise provision which is only applicable if the common stock underlying the Series C Warrants is not subject to an effective registration statement or otherwise cannot be sold without restriction pursuant to Rule 144.

Until the date that is six months following the Series C Second Closing, we have granted the Series C Investors a right of first offer on certain future issuances of securities. We have also agreed to certain standstill provisions, pursuant to which we may not issue any equity securities (or securities convertible into equity) until the later of:  (i) September 20, 2013 and (ii) the date that is 30 days following the date on which no Series C Stock remains outstanding (except for certain exempt issuances).  If the Series C Second Closing does not occur, we also may not issue any equity securities (or securities convertible into equity) until all Series C Investors no longer hold Series C Stock or Series C Warrants, except for certain exempt issuances.  Until all Series C Investors no longer hold Series C Stock or Series C Warrants:  (i) we may not sell any variable rate securities except for certain exempt issuances; and (ii) if we enter into a subsequent financing on more favorable terms than the Series C Financing, then the agreements between us and the Series C Investors will be amended to include such more favorable terms.  In addition, until 7.5% or less of the Series C Warrants remain unexercised, we may not sell any dilutive securities, except for certain exempt issuances.

The Series C Stock is non-voting (except to the extent required by law and except for certain consent rights relating to amending the certificate of incorporation or bylaws, and the like), but ranks senior to the common stock and junior to the Series A Preferred Stock and Series B Preferred Stock with respect to dividends and with respect to distributions upon a deemed dissolution, liquidation or winding-up of the Company. The Series C Investors have agreed to be subject to a blocker that would prevent their common stock ownership at any given time from exceeding 4.99% (which may be increased, but not above 9.99%) of our outstanding common stock. In connection with the Series C Financing, our officers, directors and 10% or greater stockholders entered into a Voting Agreement pursuant to which the parties thereto have agreed to vote in favor of the Series C Financing at the next annual stockholders’ meeting.

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COMBIMATRIX CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

The common stock underlying the Series C Stock and Series C Warrants have not been registered under the Securities Act of 1933 and may not be offered or sold in the United States absent registration or an applicable exemption from registration requirements.  In connection with the Series C Financing, however, we entered into a registration rights agreement with the Series C Investors (the “Registration Rights Agreement”). The Registration Rights Agreement requires us, not later than 15 days after each closing, to file a registration statement with the SEC registering for resale:  (i) the shares of common stock issuable upon conversion of the Series C Stock; (ii) the shares of common stock issuable as dividends on the Series C Stock; (iii) the shares of common stock issuable upon exercise of the Series C Warrants; and (iv) any additional shares of common stock issuable in connection with any anti-dilution provisions associated with the Series C Stock.  We have agreed to cause the registration statements to be declared effective on or prior to the 90th day after the applicable closing, and have agreed to file additional registration statements if necessary.  Under the terms of the Registration Rights Agreement, we are obligated to maintain the effectiveness of the resale registration statements until all securities registered thereunder are sold or otherwise can be sold without restriction pursuant to Rule 144. The Registration Rights Agreement includes liquidated damages provisions in the event we fail to file or maintain the effectiveness of the registration statements. We do not plan, nor are we obligated, to register the Series C Stock or the Series C Warrants.

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Overview

For the three months ended March 31, 2013, our operating activities included the recognition of $1.6 million of total revenues, which increased by $342,000 from the comparable period in 2012 due primarily to increased volumes of molecular diagnostic tests performed.  Our net loss decreased over the comparable periods due partially to increased revenues and reduced operating expenses as a result of cost reduction efforts executed during the second quarter of 2012, but primarily due to a non-cash warrant derivative gain of $1.8 million that was recognized during the first quarter of 2013.

In addition, we completed financing activities in the first quarter of 2013, including a registered direct offering to an existing institutional investor of Series B convertible preferred stock, common stock and warrants to purchase common stock (the “Series B Financing”), resulting in net proceeds to us of $1.8 million.  The exercise of certain warrants from our Series A convertible preferred stock financing executed during the fourth quarter of 2012 (the “Series A Warrants”) resulted in additional proceeds of $993,000 through March 31, 2013, and additional proceeds of $402,000 in April 2013.

On May 3, 2013, we executed agreements to issue securities in a private placement transaction with certain accredited investors that, subject to stockholder approval, will result in gross proceeds to us totaling $2.4 million to be received in two tranches, with the first tranche having closed on May 6, 2013 and the second tranche expected to close in late June or early July 2013 following our annual stockholders’ meeting.  Such financing is through the sale of Series C convertible preferred stock (the “Series C Stock”) with the first tranche having an initial conversion price of $3.05 per share of common stock, subject to future adjustments, and 125% warrant coverage at an exercise price of $3.77 per share.  The Series C Stock also accrues an annual dividend of 6%, increasing by 1% per year that the Series C Stock remains outstanding but not to exceed 10%.  Upon closing of the first tranche, we received gross proceeds of $1.2 million from the investors and, pending stockholder approval, expect to receive the remaining $1.2 million within five business days after our annual stockholders’ meeting expected to occur in June 2013.

Critical Accounting Estimates

Our unaudited interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America.  Preparation of these statements requires management to make judgments and estimates.  Some accounting policies have a significant impact on amounts reported in these financial statements.  A summary of significant accounting policies and a description of accounting policies that are considered critical may be found in our Annual Report on Form 10-K for the year ended December 31, 2012, filed with the SEC on March 25, 2013, in the Notes to the Consolidated Financial Statements and the Critical Accounting Estimates sections.  In addition, refer to Note 2 to the consolidated interim financial statements included in Part I, Item 1 of this report .

Comparison of the Results of Operations for the Three Months Ended March 31, 2013 and 2012

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Diagnostic Services.   Diagnostic services revenues are generated from providing DNA-based genomic testing services primarily in the areas of prenatal and postnatal development disorders in children and, to a lesser extent, in oncology.  Total billable test volumes were 1,718 for the three months ended March 31, 2013, compared to 1,377 for the comparable period in 2012, representing an increase of 25%, while diagnostic services revenues were $1.6 million for the three months ended March 31, 2013, compared to $1.2 million for the comparable period in 2012, representing an increase of 27%.  The reason that diagnostic testing volumes have not increased by the same percentage as diagnostic services revenues is due to a shift in test mix during 2013 towards a higher concentration of microarray testing, particularly in the prenatal testing market.  During 2012, cytogenetic tests in this market, including FISH and chromosome analysis, represented 61% of total tests performed, whereas in 2013, FISH and chromosome analysis represented 49% of total prenatal testing.  These non-array tests are priced and reimbursed at lower rates than our array-based tests, which represented 39% of total tests performed in 2012 and 51% of total prenatal testing in 2013 .  As a result, our overall average revenue per test increased from $904 in 2012 to $923 in 2013.  In addition, decreases in oncology and pediatric testing volumes were offset by increases in prenatal testing, resulting in an overall increase in diagnostic services revenues year-over-year.  Diagnostic services revenues also includes adjustments relating to our revenue recognition policy of periodically adjusting our estimate for contractual allowances for revenues from non-contracted payors as well as from receiving cash payments in excess of amounts previously recognized for services revenues. For the three months ended March 31, 2013 and 2012, net positive revenue adjustments were $202,000 and $221,000, respectively.

Royalties.  In 2010, we entered into an exclusive licensing agreement with CustomArray, Inc. (“CA”), a private company located in Washington State, for certain of our patents and intellectual property developed as part of our prior microarray manufacturing business.  This agreement requires CA to pay us royalties as a percentage of their gross revenues, not less than $25,000 per quarter.  We received the minimum contractual amount for the three months ended March 31, 2013 and 2012.  It is uncertain whether in future periods, CA’s revenues will increase or continue at the minimum contractual amounts.

Cost of Services .  Cost of services relating to our diagnostic tests performed include direct materials such as array and laboratory costs, direct laboratory labor (wages and benefits), allocation of administrative overhead and stock-compensation expenses.   Increases in cost of services are due to increased volumes period-over-period.  For the three months ended March 31, 2013 and 2012, non-cash stock compensation expenses were not significant.

Research and Development .  These expenses include labor (wages and benefits), non-cash stock compensation expenses and laboratory supply costs associated with investigating and validating new tests, costs to maintain and improve our existing suite of diagnostic tests offered and process improvement projects.  Prior to launching a new test or modifying an existing test, appropriate clinical trials and extensive laboratory validations, consistent with the various regulations that govern our industry, must be performed.  These costs are classified as research and development for all periods presented.  For the three months ended March 31, 2013, research and development expenses decreased from the comparable 2012 period due primarily to reduced headcount as well as from lower supply and materials costs incurred.  For the three months ended March 31, 2013 and 2012, non-cash stock compensation expenses were not significant.

Sales and Marketing.   These expenses include salaries and wages associated with our sales force and marketing resources, sales commissions and other expenses associated with promotional and advertising efforts as well as non-cash stock compensation expenses.  For the three months ended March 31, 2013, sales and marketing expenses decreased from the comparable 2012 period due primarily to reduced headcount, travel and marketing expenses primarily as a result of our cost reduction efforts executed near the end of the second quarter of 2012.  For the three months ended March 31, 2013 and 2012, non-cash stock compensation expenses were not significant.

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General and Administrative.   These expenses include compensation and benefit costs of our administrative staff, client billing and collections, information technology, executive management, human resources and accounting personnel, as well as facilities-related costs, insurance, legal, audit and other professional services.    For the three months ended March 31, 2013, general and administrative expenses decreased from the comparable 2012 period due primarily to reduced third-party billing fees and lower bad debt expenses, partially offset by increased salaries and benefits resulting from the hiring of our Chief Medical Officer during the second quarter of 2012.  Included in general and administrative expenses are non-cash stock-based compensation expenses, which were $68,000 and $155,000 for the three months ended March 31, 2013 and 2012, respectively.  The decreases were due primarily to prior stock option awards that were or became fully vested during recent periods, resulting in fewer option awards subject to vesting and related expenses during the current period as compared to the prior period.  See Note 2 to our consolidated interim financial statements included elsewhere in this report for a detailed description of the amounts of non-cash stock compensation expense recognized for the periods presented.

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Liquidity and Capital Resources

At March 31, 2013, cash and cash equivalents totaled $3.4 million, compared to $2.4 million at December 31, 2012. Cash is held primarily in general checking accounts as well as in money market mutual funds backed by U.S. government securities. Working capital at March 31, 2013 was $1.4 million, compared to a working capital deficit of $(1.4 million) at December 31, 2012. The change in working capital was due primarily to the impact of net cash flow activities as discussed below. The net change in cash and cash equivalents for the periods presented was comprised of the following (in thousands):

Operating Activities.   The decrease in net cash flows used in operating activities resulted primarily from lower cash reimbursement from customers, which was partially offset by decreased operating expenses described above.

Investing Activities.   The decrease in net cash flows used in investing activities was due to a decrease in capital expenditures.

Financing Activities.   The increase in net cash flows from financing activities was due primarily to the $1.8 million of net proceeds received from the Series B Financing coupled with $993,000 in proceeds from the exercise of certain Series A Warrants during the first quarter of 2013.  There were no such financing activities during the first quarter of 2012.

Future Liquidity.   We have a history of incurring net losses and net operating cash flow deficits.  We are also deploying new technologies and continue to develop commercial services.  We believe that our cash and cash equivalent balances at March 31, 2013, combined with: (i) $1.2 million of gross proceeds received on May 6, 2013 and $1.2 million of gross proceeds expected to be received from the recent Series C Financing described above; and (ii) $402,000 in proceeds from the exercise of certain Series A Warrants in April of 2013, will allow us to meet our cash requirements into the second quarter of 2014, assuming our stockholders approve the second tranche of the Series C Financing at our upcoming annual stockholders meeting.  In the event the Series C Financing is not approved by stockholders and the second tranche closing does not occur, we believe we can meet our cash requirements into the first quarter of 2014.

In order for us to continue as a going concern beyond this point and ultimately to achieve profitability, we will be required to obtain capital from external sources, increase revenues and reduce operating costs.  However, there can be no assurance that our operations will become profitable or that external sources of financing, including the issuance of debt and/or equity securities, will be available at times and at terms acceptable to us, or at all.  The issuance of additional equity or convertible debt securities will also cause dilution to our stockholders.  If external financing sources are not available or are inadequate to fund our operations, we will be required to reduce operating costs, including research projects and personnel, which could jeopardize our future strategic initiatives and business plans.  See Note 1 to the consolidated interim financial statements included elsewhere in this report for additional discussion of these matters.

Capital Requirements.   We may also encounter unforeseen difficulties that may deplete our capital resources more rapidly than anticipated.  As a result, we may be required to seek additional funding through equity, debt or other external financing, and there can be no assurance that additional funding will be available on favorable terms, in a timely fashion or at all.  At this time, we have no significant commitments for capital expenditures in 2013 or beyond.  However, our long-term capital requirements could be substantial and the adequacy of available funds will depend upon many factors, including:

·                   the costs of commercialization activities, including sales and marketing costs and capital equipment;

·                   competing technological developments;

·                   the creation and formation of strategic partnerships;

·                   the costs associated with leasing and improving our Irvine, California facility; and

·                   other factors that may not be within our control.

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Off-Balance Sheet Arrangements

As of March 31, 2013, we did not have any significant off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K promulgated by the SEC.  However, we have entered into an operating lease for our laboratory space and corporate offices, totaling approximately 12,200 square feet, expiring in January of 2014.  We have no significant commitments for capital expenditures for the remainder of 2013 or beyond.  We have executed twelve capital leases totaling $699,000 for certain laboratory and IT-related equipment, with lease payments continuing through 2017.

Recent Accounting Pronouncements

None that are expected to have a material impact to the Company’s consolidated financial statements.

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Exposure to possible litigation and legal liability may adversely affect our business, financial condition and results of operations.

In the past, we have been exposed to a variety of litigation claims and there can be no assurance that we will not be subject to other litigation in the future that may adversely affect our business, financial condition or results of operations. On February 14, 2011, Relator Michael Strathmann served us with a Complaint filed in the Superior Court of the State of California for the County of Orange. The Complaint alleged that we submitted false and fraudulent insurance claims to National Union Fire Insurance Company of Pittsburgh, PA in connection with a prior lawsuit that was settled with Nanogen, Inc., thereby allegedly violating the California Insurance Fraud Prevention Act, and sought penalties and unspecified treble damages. On May 4, 2011, the Superior Court dismissed the Complaint by ordering that it be stricken for violation of the California Anti-SLAPP statute, which prevents plaintiffs from filing abusive lawsuits against public policy. On June 15, 2011, Strathmann filed a Notice of Appeal with the California Court of Appeals, appealing the granting of the Motion to Strike. Subsequently, Strathmann filed a Notice of Appeal of the award of attorneys’ fees against him. On October 24, 2012, the California Court of Appeals reversed the Superior Court’s dismissal, finding that the anti-SLAPP statute was not applicable and remanding the case to the Superior Court. Strathmann has filed an Amended Complaint, and we will be filing an Answer to that pleading.  No discovery has been served in the matter, and no trial date has been set. Defense of this lawsuit could be time-consuming and expensive, and there can be no assurance that we will be successful in our defense.

Future sales or the potential for future sales of our securities in the public markets may cause the trading price of our common stock to decline and could impair our ability to raise capital through subsequent equity offerings.

Sales of a substantial number of shares of our common stock or other securities in the public markets, or the perception that these sales may occur, could cause the market price of our common stock or other securities to decline and could materially impair our ability to raise capital through the sale of additional securities. We have obligations to the holders of our Series C Stock that require us to register, on a registration statement, shares of common stock (i) underlying their issued and outstanding shares of Series C Stock, (ii) issuable as dividends on their issued and outstanding Series C Stock, (iii) issuable upon exercise of their Warrants issued at the Series C First Closing, (iv) underlying their shares of Series C Stock to be issued at the Series C Second Closing, (v) issuable as dividends on their Series C Stock to be issued at the Series C Second Closing, and (vi) issuable upon exercise of their Warrants issued at the Series C Second Closing. We have continuing obligations to the holders of our Series A Warrants to maintain the public registration of common stock underlying such Series A Warrants and to register shares of common stock underlying such Series A Warrants issuable pursuant to their anti-dilution provisions. The shares of common stock underlying the securities issued in our Series B Financing are freely tradable. We also have obligations to the investors in our April 2011 private placement that could require us to register shares of common stock held by them and shares issuable upon exercise of their warrants for resale on a registration statement. If we raise additional capital in the future through the use of our existing shelf registration statement or if we register existing, or agree to register future, privately placed shares for resale on a registration statement, such additional shares would be freely tradable, and, if significant in amount, such sales could further adversely affect the market price of our common stock. The sale of a large number of shares of our common stock also might make it more difficult for us to sell equity or equity-related securities in the future at a time and at the prices that we deem appropriate.

Our stock price could decline because of the potentially dilutive effect of future financings, preferred stock or warrant anti-dilution provisions or exercises of warrants and common stock options.

Assuming conversion of all of our convertible securities and exercise in full of all options and warrants outstanding as of March 31, 2013 (not taking into account any price-based or anti-dilution adjustments and not including dividend or redemption payments) plus conversions of the Series C Stock and exercise of the Series C Warrants (assuming stockholder approval is obtained, but not taking into account any price-based or anti-dilution adjustments and not including the payment of dividends), approximately 7.4 million shares of our common stock would be outstanding. Any additional equity or convertible debt financings in the future could result in further dilution to our stockholders.  Existing stockholders also will suffer significant dilution in ownership interests and voting rights and our stock price could decline as a result of potential future application of anti-dilution features of our Series A Warrants, our Series B Stock and our Series C Stock, redemption features of our Series B Stock or dividend features of our Series C Stock.

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Our Common Stock may be delisted from The Nasdaq Capital Market if we cannot satisfy Nasdaq’s continued listing requirements.

Among the conditions required for continued listing on The Nasdaq Capital Market, Nasdaq requires us to maintain at least $2.5 million in stockholders’ equity and to have a majority of independent directors. We have recently failed to comply with these requirements. Due to the stockholders’ equity deficiency reported in our Form 8-K filed on February 27, 2013, the Nasdaq Staff notified us that it was reviewing our eligibility for continued listing on The Nasdaq Capital Market. We have submitted a plan to regain and thereafter maintain compliance with the stockholders’ equity requirement, which plan is currently under consideration by the Nasdaq Staff. The Nasdaq Staff also notified us that we must achieve a majority of independent directors on our Board by September 11, 2013 (assuming our next annual stockholders’ meeting is held before that time). There are no assurances that Nasdaq will accept our plan to comply with the Nasdaq stockholders’ equity requirement. Although we raised gross proceeds of $1.2 million from the sale of Series C Stock in an initial closing subsequent to the submission of our initial compliance plan to the Nasdaq Staff, we believe the Nasdaq Staff’s review of our compliance plan is focusing on our ability to sustain long-term compliance with the Nasdaq stockholders’ equity requirement. The foregoing notwithstanding, there can be no assurance that our stockholders’ equity will remain above Nasdaq’s $2.5 million minimum or that we will be able to add another independent director to our Board. If we fail to timely comply with the applicable requirements, our stock may be delisted. In addition, even if we demonstrate compliance with the stockholders’ equity and board composition requirements, we will have to continue to meet other objective and subjective listing requirements to continue to be listed on The Nasdaq Capital Market. Delisting from The Nasdaq Capital Market could make trading our common stock more difficult for investors, potentially leading to declines in our share price and liquidity. Without a Nasdaq Capital Market listing, stockholders may have a difficult time getting a quote for the sale or purchase of our stock, the sale or purchase of our stock would likely be made more difficult and the trading volume and liquidity of our stock could decline. Delisting from The Nasdaq Capital Market could also result in negative publicity and could also make it more difficult for us to raise additional capital. The absence of such a listing may adversely affect the acceptance of our common stock as currency or the value accorded by other parties. Further, if we are delisted, we would also incur additional costs under state blue sky laws in connection with any sales of our securities. These requirements could severely limit the market liquidity of our common stock and the ability of our stockholders to sell our common stock in the secondary market. If our common stock is delisted by Nasdaq, our common stock may be eligible to trade on an over-the-counter quotation system, such as the OTCQB market, where an investor may find it more difficult to sell our stock or obtain accurate quotations as to the market value of our common stock. We cannot assure you that our common stock, if delisted from The Nasdaq Capital Market, will be listed on another national securities exchange or quoted on an over-the counter quotation system.

As a public company, we are subject to complex legal and accounting requirements that will require us to incur substantial expense and will expose us to risk of non-compliance.

As a public company, we are subject to numerous legal and accounting requirements that do not apply to private companies. The cost of compliance with many of these requirements is substantial, not only in absolute terms but, more importantly, in relation to the overall scope of the operations of a small company. Failure to comply with these requirements can have numerous material adverse consequences including, but not limited to, our inability to file required periodic reports on a timely basis, which would result in the loss of our eligibility to use Form S-3 for raising capital, loss of market confidence, delisting of our securities, governmental or private actions against us and/or liquidated damages payable to the holders of our Series A Warrants, Series C Stock and Series C Warrants. We cannot assure you that we will be able to comply with all of these requirements or that the cost of such compliance will not prove to be a substantial competitive disadvantage vis-à-vis our privately held and larger public competitors.

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