EPICEPT CORP - EPCT Securities Registration Statement (S-1) MANAGEMENT'S DISCUSSION AND ANALYSIS

You should read the following discussion of our financial condition and results of operations in conjunction with our consolidated financial statements and the related notes included elsewhere in this prospectus. This discussion contains forward-looking statements that involve risks and uncertainties. As a result of many factors, including those set forth under the section entitled “Risk Factors” and elsewhere in this prospectus, our actual results may differ materially from those anticipated in these forward-looking statements.

We are a specialty pharmaceutical company focused on the development and commercialization of topically-delivered prescription pain management therapeutics. We have six product candidates in clinical development; three in late-stage development that are ready to enter, or have entered, Phase IIb or Phase III clinical trials, and three that have completed initial Phase II clinical trials. All of our product candidates target moderate-to-severe pain that is influenced, or mediated, by nerve receptors located just beneath the skin’s surface. Our product candidates utilize proprietary formulations and several topical delivery technologies to administer FDA-approved pain management therapeutics, or analgesics.

EpiCept NP-1, a prescription topical analgesic cream designed to provide effective, long-term relief from the pain of peripheral neuropathies;

LidoPAIN SP, a sterile prescription analgesic patch designed to provide sustained topical delivery of lidocaine to a post-surgical or post-traumatic sutured wound while also providing a sterile protective covering for the wound; and

LidoPAIN BP, a prescription analgesic non-sterile patch designed to provide sustained topical delivery of lidocaine for the treatment of acute or recurrent lower back pain.

Our objective is to address unmet medical needs in pain management by developing a broad portfolio of topically-delivered prescription analgesics for the treatment of moderate-to-severe pain where existing treatments are ineffective or cause significant adverse side effects. To achieve our objective, the three key elements of our strategy are to:

None of our product candidates has been approved by the FDA or any comparable foreign agencies. We have yet to generate revenues from product sales. Until 2003, we had not generated any significant revenues. During 2003, we entered into two agreements, the first in July with Adolor for the development and commercialization of certain products, including LidoPAIN SP in North America, and the second in December with Endo for the worldwide commercialization of certain products, including LidoPAIN BP. We received a total of $10.0 million in upfront license fees upon the closing of these license agreements. Under these relationships, we are eligible to receive an additional $102.5 million in milestone payments and, upon receipt of appropriate regulatory approvals, royalties based on net sales of products. There is no assurance that any of these milestones will be earned or any royalties paid. Our ability to generate additional revenue in the future will depend on our ability to meet development or regulatory milestones under our existing license agreements that trigger additional payments to us, to enter into new license agreements for other products or territories and to receive regulatory approvals for, and successfully commercialize, our product candidates either directly or through commercial partners.

Since our inception we have incurred significant net losses each year. Our net loss for the year ended December 31, 2003 and the nine months ended September 30, 2004 was $9.9 million and $4.7 million,

respectively. As of September 30, 2004, we had an accumulated deficit of $56.0 million. Our losses have resulted principally from costs incurred in connection with our development activities and from general and administrative expenses. Even if we succeed in developing and commercializing one or more of our product candidates, we may never become profitable. We expect to continue to incur increasing expenses over the next several years as we:

Our operations to date have been funded principally through the proceeds from the sales of common and preferred securities, debt, revenue from collaborative relationships, investment income earned on cash balances and short-term investments and the sales of a portion of its New Jersey net operating loss carry forwards.

As disclosed in Note 11 to our consolidated financial statements, our 2001 consolidated financial statements were restated to correct errors.

We have a 100%-owned subsidiary, EpiCept GmbH, based in Munich, Germany, which is engaged in research and development activities on our behalf. Historically, a significant amount of our debt was denominated in euros. Following this offering, more than half of our euro-denominated debt will either be repaid or converted into common stock.

Our revenues are limited to amounts earned under licenses and related development agreements. We have not generated any significant revenue from product sales or royalties, nor do we expect to generate such revenues in the near term. We are currently recognizing the payment of upfront license fees from our licensees as revenues on a straight-line basis over the anticipated development period for the respective product candidates. Licensing fees of $2.5 and $7.5 million were received in 2003 from Adolor and Endo, respectively, of which $2.3 million in the aggregate was recognized as revenue through September 30, 2004. We expect that any additional revenue we generate as a result of the timing and amount of milestone payments we may receive from our strategic relationships, as well as those we may receive upon the sale of our product candidates, to the extent any are successfully commercialized, will vary from quarter-to-quarter and from year-to-year.

Upon receipt of marketing approval and commencement of commercial sales, which may not occur for several years, we will owe royalties to licensors of certain patents. Under a royalty agreement with Dr. R. Douglas Cassel, we are obligated to pay a royalty based on net sales of any of our products for the treatment of pain associated with surgically closed wounds. Under a sublicense agreement with Epitome Pharmaceuticals Limited that relates to EpiCept NP-1, we are obligated to pay royalties based on annual net sales derived from the products incorporating the licensed technology. In each case, our royalty obligation expires upon the expiration of the last to expire related patent.

Research and development expense consists of development work associated with product candidates, including employee compensation, costs of preclinical studies, clinical trials and clinical supplies, consultant fees and payments to our research partners. We are responsible for all of the research and development costs related to EpiCept NP-1 and LidoPAIN BP and for continuing and completing our European Phase III clinical trial for LidoPAIN SP that we anticipate will be used to support an application for marketing approval in Europe. As we commence more extensive development activities, including Phase III clinical trials and commercial scale-up, we expect research and development expense to increase substantially.

For the years ended December 31, 2003, 2002, and 2001, and the nine-month periods ended September 30, 2004 and 2003, we incurred the following research and development expense:

Direct expenses consist primarily of fees paid to vendors and consultants for services related to preclinical product development, clinical trials, and manufacturing of the respective products. We generally maintain few fixed commitments; therefore, we have flexibility with respect to the timing and magnitude of a significant portion of our direct expenses. Indirect expenses are those expenses we incur that are not allocated by project, which consist primarily of the salaries and benefits of our research and development staff.

Development timelines and costs are difficult to estimate and may vary significantly for each product and from quarter-to-quarter. The process of seeking regulatory approvals, and the subsequent compliance with applicable regulations, require the expenditure of substantial resources. We intend to advance our three late-stage product candidates into Phase IIb or Phase III clinical trials by the first half of 2005. You should read the risk factors contained elsewhere in this prospectus that relate to the risks inherent in our research and development programs.

General and administrative expense consists primarily of compensation for employees in executive and operational functions, including finance and accounting, business development and corporate development. Other significant costs include facilities costs and professional fees for accounting and legal services. After completion of this offering, we anticipate our general and administrative expenses to increase due to increased costs for insurance, professional fees, external reporting requirements, Sarbanes-Oxley compliance and investor relations associated with operating as a publicly-traded company. These increases will also likely include the hiring of additional personnel.

In connection with the grant of stock options to employees, we recorded deferred stock-based compensation as a component of stockholders’ deficit. Deferred stock compensation for options granted to employees is the difference between the fair value of our common stock on the date such options were granted and their exercise price. We amortize this stock-based compensation as charges to operations over the vesting periods of the options, generally 36 months.

We recorded $0.6 million in amortization of deferred stock-based compensation related to options granted to employees during the year ended December 31, 2003. There was a balance of $0.4 million of deferred stock-based compensation at December 31, 2003 which we expect to be substantially amortized in 2004 with the balance amortized in 2005. We also recorded $0.2 million of stock-based compensation expense related to options granted to non-employees during the year ended December 31, 2003. Stock-based compensation expense for non-employees is recorded based on the fair value method utilizing the Black-Scholes option pricing model. The value of the underlying option is periodically re-measured at each reporting date and income or expense is recognized during the vesting period. Stock-based compensation expense is classified as either research and development expense or general and administrative expense depending on the nature of the compensated services.

The amount of stock-based compensation expense we expect to incur in future periods may decrease if unvested options for which deferred compensation expense has been recorded are subsequently cancelled, or may increase if we make future option grants with exercise prices below the estimated fair market value of our common stock on the date of grant.

Other income (expense) consists of non-operating items, including interest income, interest expense and foreign exchange transaction gains or losses. Interest income is earned from funds on deposit. Interest expense is incurred from our various financing arrangements. A portion of our interest expense derives from non-cash charges for debt discount and beneficial conversion feature present in certain of our debt obligations. Foreign exchange transaction gains and losses are principally related to the payment of intercompany debt obligations denominated in foreign currencies.

Revenues. We recorded $1.9 million in revenue during the nine months ended September 30, 2004, representing the recognized portion of the deferred revenue from upfront licensing fees received from Adolor and Endo in 2003. In July 2003, we entered into a license agreement with Adolor relating to certain products, including LidoPAIN SP, which resulted in our receipt of a $2.5 million payment upon signing. This amount has been deferred and is being recognized as revenue on a straight-line basis over the three-year estimated development period of LidoPAIN SP. In December 2003, we signed a license agreement with Endo, which resulted in our receipt of a $7.5 million payment upon signing. This payment has also been deferred and is being recognized as revenue on a straight-line basis over the estimated 4.5 year development period of LidoPAIN BP.

Revenue in the first nine months of 2003 amounted to $0.2 million representing the recognized portion of the deferred revenue from the upfront licensing fee received from Adolor in July 2003.

Research and development expense. Research and development expense increased approximately 8% in the nine-month period ended September 30, 2004 to $1.3 million compared to $1.2 million during the nine-month period ended September 30, 2003. Primary research and development activity during the 2004 period included preparing for the commencement of the Phase III clinical trial of LidoPAIN SP in Germany, an End of Phase II meeting with the FDA for EpiCept NP-1, ongoing work with respect to the design of pivotal clinical trials for EpiCept NP-1 and LidoPAIN BP, and the selection of manufacturers for the commercial scale-up of our product candidates. Included in 2004 research and development expense was a $0.1 million maintenance fee payment relating to our license agreement for Epicept NP-1. We commenced enrollment of our Phase III trial in Germany of LidoPAIN SP in November 2004.

Research and development expenses in the first nine months of 2003 consisted primarily of salaries and benefits, payments to consultants and clinical trial expenses related to EpiCept NP-1 and LidoPAIN SP. We completed two Phase II clinical trials for EpiCept NP-1 and one Phase II clinical trial for LidoPAIN SP during the first quarter of 2003.

General and administrative expense. General and administrative expense increased $1.0 million to $3.1 million from $2.1 million for the nine months ended September 30, 2004 and 2003, respectively, primarily as a result of higher audit and legal expenses, additional staffing, higher employee compensation and increased consulting expenses in connection with business development activities.

Other income (expense). Other expense, net, decreased $1.5 million, to $2.1 million from $3.6 million for the nine months ended September 30, 2004 and 2003, respectively. Loan discount and beneficial conversion feature related to the convertible bridge loan taken in 2002 and early 2003 was fully accreted during the first half of 2004; as a result, interest expense for the nine-month period ended September 30, 2004 decreased to $2.3 million from $3.2 million for the nine-month period ended September 30, 2003, a decline of $0.9 million. Components of interest expense for the 2004 period were non-cash charges of $1.3 million related to the accretion of the discount on the convertible bridge loan, $0.8 million in coupon interest payable on loans, and $0.1 million each for increases in additional and contingent interest on certain debt obligations. Other expense, net, was also affected by net foreign exchange transaction gains related to intercompany debt recognized in 2004 of $0.1 million compared with net foreign exchange transaction losses recognized in 2003 of $0.4 million, a net improvement of $0.5 million. Since a portion of our transactions is denominated in euros, foreign exchange transaction gains and losses result from changes in the exchange rate between the U.S. dollar and the euro during the relevant period.

Warrant Deemed Dividend and Redeemable Convertible Preferred Stock Dividends. In addition to accrued redeemable convertible preferred stock dividends of $0.9 million relating to our Series B and C redeemable convertible preferred stock, we recorded a beneficial conversion charge of $0.2 million related to the exercise of warrants into Series A convertible preferred stock. A total of 74,259 warrants were exercised via a net share issuance of 53,225 shares of Series A convertible preferred stock.

Revenues. We recorded $0.4 million in revenue during the year ended December 31, 2003, representing the recognized portion of the deferred revenue from upfront licensing fees received from Adolor and Endo. In July 2003, we entered into a license agreement with Adolor relating to certain products, including LidoPAIN SP, which resulted in our receipt of a $2.5 million non-refundable payment upon signing. This amount has been deferred and is being recognized as revenue on a straight-line basis over the three-year estimated development period of LidoPAIN SP. In December 2003, we signed a license agreement with Endo, which resulted in our receipt of a non-refundable $7.5 million payment upon signing. This payment has also been deferred and is being recognized as revenue on a straight-line basis over the estimated four and one-half-year development period of LidoPAIN BP. We did not recognize any revenues in 2002 or 2001.

Research and development expense. Our research and development expenses were $1.6, $4.9 and $4.1 million for the years ended December 31, 2003, 2002 and 2001, respectively. In early 2003, we completed three clinical trials for two of our late-stage product candidates: one Phase II trial for LidoPAIN SP in Germany and two Phase II trials for EpiCept NP-1. We undertook no new significant clinical activity during the balance of the year, resulting in the reduction of expense from 2002 and 2001 as compared to 2003.

In 2002, we were conducting three clinical trials for two of our late stage product candidates, including two Phase II trials for EpiCept NP-1 that involved more than 25 centers in the United States and Canada. Direct expenses related to the EpiCept NP-1 clinical trial totaled $2.1 million, or 42%, of our total research and development expenses in 2002. A Phase II clinical trial for LidoPAIN SP at nine centers in Germany commenced in December 2001 and continued throughout 2002. Direct expenses for the LidoPAIN SP clinical trial totaled $0.8 million, or 17%, of total research and development expenses in 2002.

Research and development expenses for 2001 consisted primarily of the costs of non-clinical testing and clinical trial activity for our product candidates, payments to consultants and salaries and benefits.

General and administrative expense. General and administrative expenses were $3.4, $3.5 and $3.4 million for the years ended December 31, 2003, 2002, and 2001, respectively. In 2003, general and administrative expenses were affected by higher legal, audit and insurance expenses and increased business development efforts in connection with the negotiation and conclusion of our license agreements with Adolor and with Endo. This increase was offset by lower consulting and directors’ expenses. Increased staffing costs of $0.1 million primarily accounted for the increase in general and administrative expenses in 2002 from 2001.

General and administrative expense in 2001 consisted primarily of compensation for employees in executive and operational functions, facilities costs and professional fees for accounting and legal services, including patent maintenance.

Other income (expense). Other income (expense), net, consisted of net other expense of $5.4, $1.5 and net other income of $0.2 million for the years ended December 31, 2003, 2002 and 2001, respectively. The increase in net expense in 2003 of $3.9 million was primarily attributable to an increase of $3.8 million in interest expense, principally due to the amortization of the debt discount and the beneficial conversion feature in connection with our convertible bridge loan that closed in tranches beginning November 2002. The discount is being accreted over the original scheduled term of the convertible bridge loan and totaled $2.6 million for the year ended December 31, 2003. The beneficial conversion feature of approximately $1.2 million was recorded in April 2003, of which $0.8 million was recognized in 2003.

The increase in other expense of $1.7 million in 2002 over 2001 was principally due to $0.7 million in net foreign exchange transaction losses recognized in 2002 compared with $0.3 million in net foreign exchange transaction gains recognized in 2001, as well as reduced interest income and increased interest expense as cash on hand declined while notes and loans payable increased.

Benefit for income taxes. Federal income tax expense for the year ended December 31, 2003 was approximately $31,000. State income benefit for the year ended December 31, 2003 was $(105,000). The state income tax benefit is comprised of current state income tax expense of $0.1 million offset by a state income tax benefit resulting from the sale of some state NOLs of $0.2 million.

During the years ended December 31, 2003 and 2002, we sold a portion of our state NOLs resulting in a state tax benefit of approximately $0.3 million in each of those years. The sales of cumulative net operating losses are a result of a New Jersey state law enacted January 1, 1999 allowing emerging technology and biotechnology companies to transfer or “sell” their unused New Jersey net operating loss carryforwards and New Jersey research and development tax credits to any profitable New Jersey company qualified to purchase them for cash. We received approval from the State of New Jersey to sell NOLs in November 2003 and November 2002 and entered into a contract with a third party to sell the NOLs at a discount for approximately $0.2 million in each December of the year.

In December 2003, we entered into a license agreement with Endo under which we granted Endo (and its affiliates) the exclusive (including as to us and our affiliates) worldwide right to commercialize LidoPAIN BP. We also granted Endo worldwide rights to certain of our other patents used by Endo in the development of certain Endo products, including Lidoderm, Endo’s topical lidocaine-containing patch, for the treatment of chronic lower back pain. We remain responsible for continuing and completing the development of LidoPAIN BP, including the conduct of all clinical trials and the supply of the clinical products necessary for those trials and the preparation and submission of the NDA in order to obtain regulatory approval for LidoPAIN BP. Upon the execution of the Endo agreement, we received a payment of $7.5 million, which has been deferred and is being recognized as revenue ratably over the estimated development period of LidoPAIN BP, and we may receive payments of up to $52.5 million upon the achievement of various milestones relating to product development, regulatory approval and commercial success for both our LidoPAIN BP product candidate and Endo’s own back pain product candidate, so long as, in the case of Endo’s product candidate, our patents provide protection thereof. We will also

receive royalties from Endo based on the net sales of LidoPAIN BP. These royalties are payable until generic equivalents of the LidoPAIN BP product candidate are available or until expiration of the patents covering LidoPAIN BP, whichever is sooner. We are also eligible to receive milestone payments from Endo of up to approximately $30.0 million upon the achievement of specified net sales milestones of covered Endo products, including Lidoderm, Endo’s chronic lower back pain product candidate, so long as our patents provide protection thereof. The total amount of upfront and milestone payments we are eligible to receive under the Endo agreement is $90.0 million. There is no certainty that any of these milestones will be achieved or any royalty earned.

In July 2003, we entered into a license agreement with Adolor under which we granted Adolor the exclusive right to commercialize, among other products, LidoPAIN SP throughout North America. Upon the execution of the Adolor agreement, we received a payment of $2.5 million, which has been deferred and will be recognized as revenue over the estimated development period of LidoPAIN SP. The agreement also requires Adolor to pay us up to $20.0 million upon reaching certain development, regulatory and commercial milestones and a royalty on sales of licensed products, including LidoPAIN SP. There is no certainty that any of these milestones will be achieved or any royalty earned.

We have devoted substantially all of our cash resources to research and development programs and general and administrative expenses. To date, we have not generated any meaningful revenues from the sale of products and we do not expect to generate any such revenues for a number of years, if at all. As a result, we have incurred an accumulated deficit of $50.4 and $56.0 million as of December 31, 2003 and September 30, 2004, respectively, and we expect to incur operating losses, potentially greater than losses in prior years, for a number of years in the future. The audit report from our independent registered public accounting firm states that our recurring losses from operations and our accumulated deficit raise substantial doubt about our ability to continue as a going concern. Our working capital deficit as of September 30, 2004 amounted to $3.1 million. Cash and cash equivalents were $3.0 million as of September 30, 2004. Since our inception through September 30, 2004, we have financed our operations through the proceeds from the sales of common and preferred securities, debt, revenue from collaborative relationships, investment income earned on cash balances and short-term investments and the sales of a portion of our New Jersey net operating loss carry forwards.

During the nine months ended September 30, 2004, cash used in operating activities totaled $3.6 million, primarily due to our net loss of $4.7 million and a $1.9 million reduction in deferred revenue representing the amount we recorded as revenue during the period. Cash use was partially offset by a $1.1 million increase in accounts payable and $1.3 million for the accretion of loan discount on our convertible bridge loan. For the year ended December 31, 2003, net cash of $4.8 million was provided by operating activities primarily as a result of $10.0 million in deferred revenue that will be recognized in future periods, $3.4 million in accretion of discount on our convertible bridge loan, $0.8 million foreign exchange loss due to an unfavorable change in the exchange rate between the U.S. dollar and euro pertaining primarily to our loan interest payments and $0.8 million in stock-based compensation charges, which were partially offset by our $9.9 million net loss. Deferred revenue of $10.0 million represents the $10.0 million in non-refundable license fee payments we received from Adolor and Endo in 2003.

Cash used in investing activities totaled approximately $25,000 and $17,000 during the nine months ended September 30, 2004 and the year ended December 31, 2003, respectively, primarily for the purchase of office equipment. Future cash used in investing activities for property and equipment are not expected to be significant.

Cash used in financing activities totaled approximately $1.4 million during the nine months ended September 30, 2004 and consisted of $0.7 million of scheduled loan repayments and $0.7 million of costs related to our proposed initial public offering of common stock. Cash provided by financing activities totaled approximately $2.7 million for the year ended December 31, 2003, primarily related to the receipt of a portion of the proceeds from our convertible bridge loan.

We believe that our existing cash resources, the net proceeds of this offering, future payments from our strategic partners, future sales of our New Jersey net operating loss carry forwards and interest earned on cash balances and investments will be sufficient to meet our projected operating requirements for at least the next 24 months. However, we may need to raise additional capital or incur indebtedness to continue to fund our operations in the future.

Our future capital uses and requirements depend on numerous forward-looking factors. These factors include, but are not limited to, the following:

If, at any time, our prospects for financing our clinical development programs decline, we may decide to reduce research and development expenses by delaying, discontinuing or reducing our funding of development of one or more product candidates. Alternatively, we might raise funds through public or private financings, strategic relationships or other arrangements. We cannot assure you that the funding, if needed, will be available on attractive terms, or at all. Furthermore, any additional equity financing may be dilutive to stockholders and debt financing, if available, may involve restrictive covenants and increased interest expense. Similarly, financing obtained through future co-development arrangements may require us to forego certain commercial rights to future drug candidates. Our failure to raise capital as and when needed could have a negative impact on our financial condition and our ability to pursue our business strategy.

€ 1.5 Million Due 2007. In August 1997, our subsidiary, EpiCept GmbH entered into a 10-year non-amortizing loan in the amount of € 1.5 million with Technologie-Beteiligungs Gesellschaft mbH der Deutschen Ausgleichsbank, or “tbg.” Proceeds must be directed toward research, development, production and distribution of pharmaceutical products. The loan bears interest at 6% per annum. Tbg is also entitled to receive additional compensation equal to 9% of the annual surplus (income before taxes, as defined in the debt agreement) of EpiCept GmbH, reduced by any other compensation received from EpiCept GmbH by virtue of other loans to or investments in EpiCept GmbH provided that tbg is an equity investor in EpiCept GmbH during that time period. To date, EpiCept GmbH has had no annual surplus. We consider the additional compensation element based on the surplus of the EpiCept GmbH to

At the demand of tbg, additional amounts may be due at the end of the loan term up to 30% of the loan amount, plus 6% of the principal balance of the loan for each year after the expiration of the fifth complete year of the loan period, such payments to be offset by the cumulative amount of all payments made to tbg from the annual surplus of EpiCept GmbH. We are accruing these additional amounts as additional interest up to the maximum amount due over the term of the loan. Accrued interest attributable to these additional amounts totaled $0.3, $0.3 and $0.4 million at December 31, 2003 and 2002, and September 30, 2004, respectively. The effective rate of interest of this loan is 9.7%.

€ 2.0 Million Due 2007. In February 1998, EpiCept GmbH entered into a 10-year non-amortizing convertible term loan in the amount of € 2.0 million with tbg. The loan is non-interest bearing; however, the loan agreement provides for potential future annual payments from surplus of EpiCept GmbH up to 6% of the outstanding loan principal balance, not to exceed 9% of all payments made from surplus of EpiCept GmbH and limited to 7% of the total financing from tbg. To date, EpiCept GmbH has had no annual surplus. We consider the additional compensation element based on the surplus of the EpiCept GmbH to be a derivative. We have assigned no value to the derivative at each reporting period as no surplus of EpiCept GmbH is anticipated over the term of the agreement.

The loan is convertible into shares of our common stock at any time by tbg at a conversion price of $7.07 per share. We can require conversion upon a defined triggering event (such as a sale of substantially all our assets, a public offering of our securities, a sale of more than 50% of the voting power of our outstanding equity securities, a merger, etc.) at a calculated conversion price ranging between $2.02 and $7.07 based on the applicable triggering event’s proceed. We intend to require tbg to convert this loan upon consummation of this offering.

€ 2.6 Million Due 2006. In March 1998, EpiCept GmbH entered into a term loan in the amount of € 2.6 million with IKB Private Equity GmbH, or “IKB,” which we guaranteed. The interest rate on the loan varies and was 10.5% per annum from August 1, 2000 through March 31, 2001, 15% per annum through June 30, 2003 and 20% per annum thereafter. The loan was amended in December 2002 to extend the maturity to December 31, 2006 and incorporate a principal repayment schedule, which commenced April 30, 2004. The first 11 quarterly principal payments are € 0.2 million (approximately $0.2 million as of September 30, 2004), and the final quarterly principal payment will be approximately € 0.4 million (approximately $0.4 million as of September 30, 2004). The loan agreement provides for contingent interest of 4% per annum of the principal balance, becoming due only upon our realization of a profit and payable up to two years thereafter, as defined in the agreement. We have not realized a profit through September 30, 2004. We value the contingent interest as a derivative using the fair value method in accordance with SFAS 133. Changes in the fair value of the contingent interest are recorded as an adjustment to interest expense. The fair value of the contingent interest was approximately $0.5, $0.3 and $0.6 million as of December 31, 2003 and 2002, and September 30, 2004, respectively. We intend to repay this term loan with a portion of the proceeds of this offering.

Convertible Bridge Loan Due 2005. In November 2002, we entered into a convertible bridge loan with several of our shareholders in an aggregate amount of up to $5.0 million. At December 31, 2003, we had outstanding borrowings of $4.8 million. The convertible bridge loan bears interest at 8% per annum. The convertible bridge loan is convertible into the next round of preferred stock financing and also has provisions for optional conversion into preferred stock or common stock. The conversion rate is equal to the lowest price per share paid by any purchaser in a financing of the next round of preferred stock or at anti-dilutive conversion rates for optional conversion into preferred stock or common stock based upon the results of certain milestones. In addition, warrants to purchase preferred stock were issued to the lenders in connection with the convertible bridge loan. Such warrants were valued utilizing the Black-Scholes options pricing model and resulted in recording warrants at $3.6 million and a discount of $3.6 million to the convertible bridge loan. The discount was accreted over the original scheduled term of the loans. During the years ended December 31, 2003 and 2002 and the nine months ended September 30, 2004 and 2003, we recognized approximately $2.5, $0.2, $0.9 and $1.9 million, respectively, of non-cash interest expense

Our long-term commitments under operating leases shown above consist of payments relating to our facility leases in Englewood Cliffs, New Jersey, which expires in September 2005, and Munich, Germany, which expires in July 2009, but is cancelable at our option in July 2007 .

We have a number of research, consulting and license agreements that require us to make payments to the other party to the agreement upon us attaining certain milestones as defined in the agreements. In 2003, we made payments of approximately $1.5 million under these agreements, the majority of which were in connection with milestones relating to preclinical and clinical trials and manufacturing. As of December 31, 2003, we may be required to make future milestone payments, totaling approximately $4.1 million, under these agreements, depending upon the success and timing of future clinical trials and the attainment of other milestones as defined in the respective agreement. In 2004, we entered into an additional clinical research agreement totaling approximately $1.2 million in payments beginning in September 2004 through 2006. Under our agreement with Epitome, we are obligated to pay an annual maintenance fee that is equal to twice the fee paid in the previous year as long as no commercial product sales have occurred. We recorded a maintenance expense of $100,000 during the third quarter 2004. Our current estimate as to the timing of other research, development and license payments, assuming all related research and development work is successful, is listed in the table above in “Other long-term liabilities.”

We are also obligated to make future royalty payments to two of our collaborators under existing license agreements, one based on net sales of EpiCept NP-1 and the other based on net sales of LidoPAIN SP, to the extent revenues on such products are realized. We have not estimated the amount or timing of such royalty payments.

The financial currency of our German subsidiary is the euro. As a result, we are exposed to various foreign currency risks. First, our consolidated financial statements are in U.S. dollars, but a portion of our consolidated assets and liabilities is denominated in euros. Accordingly, changes in the exchange rate between the euro and the U.S. dollar will affect the translation of our German subsidiary’s financial results into U.S. dollars for purposes of reporting our consolidated financial results. We also bear the risk that interest on our euro-denominated debt, when translated from euros to U.S. dollars, will exceed our current estimates and that principal payments we make on those loans may be greater than those amounts currently reflected on our balance sheet. Historically, fluctuations in exchange rates resulting in transaction gains or losses have had a material effect on our consolidated financial results. We have not engaged in any hedging activities to minimize this exposure, although we may do so in the future.

Our exposure to interest rate risk is limited to interest income sensitivity, which is affected by changes in the general level of U.S. dollar interest rates, particularly as the majority of our investments are in short-term debt securities and bank deposits. The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive without significantly increasing risk. To minimize risk, we maintain our portfolio of cash and cash equivalents in a variety of interest-bearing instruments, including U.S. government and agency securities, high-grade U.S. corporate bonds, commercial paper and money market funds. Due to the nature of our short-term and restricted investments, we believe that we are not exposed to any material market risk.

We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not engage in trading activities involving non-exchange traded contracts. Therefore, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in these relationships. We do not have relationships or transactions with persons or entities that derive benefits from their non-independent relationship with our related parties or us.

Our discussion and analysis of our financial condition and results of operations are based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses and related disclosure of contingent assets and liabilities. We review our estimates on an ongoing basis. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in the notes to our financial statements included in this prospectus, we believe the following accounting policies to be critical to the judgments and estimates used in the preparation of our financial statements.

We recognize revenue relating to our collaboration agreements in accordance with the Securities and Exchange Commission’s Staff Accounting Bulletin (“SAB”) No. 101, Revenue Recognition in Financial Statements , SAB No. 104, Revenue Recognition , and Emerging Issues Task Force (“EITF”) Issue No. 00-21, Revenue Arrangements with Multiple Deliverables . Revenue under collaborative arrangements may include the receipt of non-refundable license fees, milestone payments and research and development payments.

We evaluate our collaboration agreements to determine units of accounting for revenue recognition purposes. Revenue is deemed earned when all of the following have occurred: all of our obligations relating to the revenue have been met and the earnings process is complete; the monies received or receivable are not refundable irrespective of research results; and there are neither future obligations nor milestones that we must meet with respect to such revenue. We recognize revenue from non-refundable, upfront licenses and related payments, not specifically tied to a separate earnings process, ratably over the development period in which we are obligated to participate on a continuing and substantial basis in the research and development activities outlined in each contract. We periodically review the estimated development period and, to the extent such estimates change, the impact of such change is recorded at the time. When payments are specifically tied to a separate earnings process, revenue will be recognized when the specific performance obligation associated with the payment has been satisfied. Performance obligations typically consist of contracted services or development milestones. Revenue from significant milestones in the development lifecycle of the related technology, including filing for and obtaining approvals with regulatory agencies, will be considered earned when the payer acknowledges the milestone achievement, generally by payment of amounts due.

As permitted by Statement No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), we account for employee stock-based compensation in accordance with Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), using intrinsic values with appropriate disclosures using the fair value based method. Accordingly, we have recorded stock-based compensation expense for stock options issued to employees in fixed amounts with exercise prices that are, for financial reporting purposes, deemed to be below fair market value on the measurement date — generally being the date of grant. In the notes to our consolidated financial statements, we provide pro forma disclosures required by SFAS No. 123 and related pronouncements. We account for stock-based transactions with non-employees in which services are received in exchange for the equity instruments based upon the fair value of the equity instruments issued, in accordance with SFAS No. 123 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.” The two factors that most affect charges or credits to operations related to stock-based compensation are the estimated fair market value of the common stock underlying stock options for which stock-based compensation is recorded and the estimated volatility of such fair market value.

Accounting for equity instruments granted by us requires fair value estimates of the equity instrument granted or sold. If our estimates of fair value of these equity instruments are too high or too low, it would

have the effect of overstating or understating expenses. When equity instruments are granted in exchange for the receipt of goods or services, we estimate the value of the equity instruments based upon consideration of factors that we deem to be relevant at the time using cost, market and/or income approaches to such valuations. Because shares of our common stock have not been publicly traded, market factors historically considered in valuing stock and stock option grants include comparative values of public companies discounted for the risk and limited liquidity provided for in the shares we are issuing, pricing of private sales of our convertible preferred stock, prior valuations of stock grants and the effect of events that have occurred between the time of such grants, economic trends, perspective provided by investment banks and the comparative rights and preferences of the security being granted compared to the rights and preferences of our other outstanding equity. As a result of these factors, some of which are subjective, changes in our estimates of fair market value and volatility could have a significant effect on the determination of stock-based compensation.

The fair value of our common stock for options granted during 2003, 2002 and 2001 and for the nine month period ending September 30, 2004 was determined contemporaneously at the time of the grant by our board of directors, with input from management. Prior to our entering into the Adolor license agreement in July 2003, we utilized the value paid for each of our series of preferred stock as an estimate of the fair value of our common stock. During the period October 1, 2003 through September 30, 2004, we did not grant any options to employees. During the nine month period ended September 30, 2003 and for the years ended December 31, 2002 and 2001, we granted options to employees at prices, which, for financial reporting purposes, were deemed to be below fair market value on the dates of grant. As a result, we recorded deferred compensation related to these grants for the difference between the deemed fair market value and the exercise price. We are amortizing this deferred compensation as a charge to operations over the vesting period of the options. In 2002 and 2001, we also granted options to non-employees for which we recorded stock-based compensation in the statements of operations based upon the fair market value of these options, as determined using the Black-Scholes model, over the service period, which is usually the vesting period. We did not grant any options to non-employees in 2003. Stock-based compensation for third parties is re-measured through the vesting period at fair value. The following weighted average assumptions were used for grants in 2003 and 2002: dividend yield of 0% percent, risk free interest rate from 2.79% to 4.74%, volatility of 101% and expected life of four to five years. As discussed above, these stock-based compensation charges will fluctuate based primarily on the volatility and fair value of our common stock.

We comply with SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (“SFAS 149”). SFAS 149 clarifies under what circumstances a contract with an initial net investment meets the characteristics of a derivative as discussed in Statement No. 133. It also specifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. As a result of certain financings, derivative instruments were created that we measured at fair value and mark to market at each reporting period.

We have a 100%-owned subsidiary in Germany, EpiCept GmbH, that performs certain research and development activities on our behalf pursuant to a research collaboration agreement. EpiCept GmbH has been unprofitable since its inception. Its functional currency is the euro. The process by which EpiCept GmbH’s financial results are translated into U.S. dollars is as follows: income statement accounts are translated at average exchange rates for the period and balance sheet asset and liability accounts are translated at end of period exchange rates. Translation of the balance sheet in this manner affects the stockholders’ equity account, referred to as the cumulative translation adjustment account. This account exists only in EpiCept GmbH’s U.S. dollar balance sheet and is necessary to keep the foreign balance sheet stated in U.S. dollars in balance.

Several of our debt instruments, originally expressed in German deutsche marks, are now denominated in euros. Changes in the value of the euro relative to the value of the U.S. dollar could affect

the U.S. dollar value of our indebtedness at each reporting date as substantially all of our assets are held in U.S. dollars. These changes are recognized by us as a foreign currency transaction gain or loss, as applicable, and are reported in other expense or income in our consolidated statements of operations.

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 153, Exchanges of Nonmonetary Assets (“SFAS 153”). SFAS 153 amends Accounting Policy Board (“APB”) Opinion No. 29 (“APB 29”), Accounting for Nonmonetary Transactions, which requires that exchanges of nonmonetary assets be measured based on the fair value of the assets exchanged, but which includes certain exceptions to that principle. SFAS 153 eliminates the exception from APB 29 for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have a commercial substance. SFAS 153 is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of SFAS 153 is not expected to have a material impact on our consolidated financial position or results of operations.

In December 2004, the FASB issued a revision to SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123R”). SFAS 123R replaces SFAS 123 and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. SFAS 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions and is effective as of the beginning of the first reporting period that begins after June 15, 2005 for public entities that do not file as small business issuers. We have illustrated the effect on our earnings as if we had adopted the fair value method of accounting for stock-based compensation under SFAS 123 in Note 2 to our Consolidated Financial Statements for the years ended December 31, 2001, 2002, and 2003 and for the nine months ended September 30, 2004. The fair value-based method of SFAS 123 is similar in most respects to the fair value-based method under SFAS 123R, although the election of certain methods within the applicable transition rules of SFAS 123R may affect the impact on our consolidated financial position or results of operations. Such impact, if any, on our consolidated financial position or results of operations has not been determined.

In December 2003, the FASB issued Interpretation No. 46(R), Consolidation of Variable Interest Entities (“FIN 46R”), which is an interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements . FIN 46R requires that if an entity has a controlling interest in a variable interest entity, the assets, liabilities and results of activities of the variable interest entity should be included in the consolidated financial statements of the entity. FIN 46R is effective immediately for all new variable interest entities created or acquired after December 31, 2003. The adoption of FIN 46R is not expected to have a significant impact on our consolidated financial position or results of operations.

In May 2003, SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (“SFAS 150”) was issued. This statement establishes how a company classifies and measures certain financial instruments with characteristics of both liabilities and equity, including redeemable convertible preferred stock. This statement is effective for financial instruments entered into or modified after May 31, 2003 and otherwise effective at the beginning of the interim period commencing July 1, 2003, except for mandatorily redeemable financial instruments of nonpublic companies. The FASB has indefinitely deferred implementation of certain provisions of SFAS 150. The adoption of SFAS 150 did not have a significant impact on our consolidated financial position or results of operations.

In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (“SFAS 149”). SFAS 149 clarifies under what circumstances a contract with an initial net investment meets the characteristics of a derivative as discussed in Statement No. 133. It also specifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. SFAS 149 amends certain other existing pronouncements in order to improve consistency in reporting these types of transactions. The new guidance is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003.

In November 2002, the FASB issued Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (“FIN 45”). FIN 45 requires a guarantor to recognize, at the inception of certain guarantees, a liability for the fair value of the obligation undertaken in issuing the guarantee. The accounting provisions and new disclosure requirements of FIN 45 are required to be adopted for all guarantees issued or modified on or after January 1, 2003. The adoption of FIN 45 had no impact on our consolidated financial position or results of operations, as we do not enter into guarantees with third parties.

In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities (“SFAS 146”). SFAS 146 requires recognition of a liability for a cost associated with an exit or disposal activity when the liability is incurred, as opposed to when the entity commits to an exit plan under previous guidance. This statement is effective for exit or disposal activities initiated after December 31, 2002. The adoption of SFAS 146 did not have a significant impact on our consolidated financial position or results of operations.

In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations (“SFAS 143”). SFAS 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This statement requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. It applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or the normal operation of a long-lived asset, except for certain obligations of lessees. This statement is effective for financial statements issued for fiscal years beginning after June 15, 2002. The adoption of SFAS 143 did not have a significant impact on our consolidated financial position or results of operations.