Number of Shares			Exercise Price		Expiration Date
50,000			$    0.35		May 2011
2,500,000			$    0.35		November 2010
2,186,668			$    0.35		May 2012
1,000,000			$    0.50		August 2013
250,000			$    0.50		September 2013
250,000			$    0.50		October 2013
250,000			$    0.50		November 2013
250,000			$    0.50		December 2013
7,000,000			$    0.75		June 2011
50,000			$    1.00		May 2011
50,000			$    1.50		May 2011
50,000			$    2.00		May 2011
50,000			$    2.50		May 2011
410,400			$    2.50		April 2009
1,641,600			$    4.00		April 2009
15,988,668			$    0.99

G.         Stock-Based Compensation

Below is a summary of Aeolus stock option activity during the three-month period ended December 31, 2008:

		Shares			Weighted Average Exercise Price			Weighted Average Remaining Contractual Term		Aggregate Intrinsic Value
Outstanding at September 30, 2008			4,235,281		$	2.50		6.7 years	$	46
Granted			194,000		$	0.41
Exercised			---		$	---
Forfeited			---		$	---
Outstanding at December 31, 2008 (unaudited)			4,429,281		$	2.40		6.6 years	$	8
Exercisable at December 31, 2008 (unaudited)			4,081,114		$	2.58		6.3 years	$	4

 

 

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For the three months ended December 31, 2008 and 2007, all stock options were issued with an exercise price at or above the fair market value of the Company’s common stock on the date of grant.

The details of stock options outstanding at December 31, 2008 were as follows:

		Options Outstanding							Options Exercisable
Range of Exercise Prices		Number Outstanding at December 31, 2008		Weighted Average Exercise Price			Weighted Average Remaining Contractual Life		Number Exercisable at December 31, 2008		Weighted Average Exercise Price
$0.32 - 0.40		569,000		$	0.36		9.6 years		220,833		$	0.35
$0.44 - $0.60		526,050		$	0.55		8.4 years		526,050		$	0.55
$0.68 - $0.80		464,161		$	0.75		7.5 years		464,161		$	0.75
$0.81 - $0.90		780,085		$	0.88		7.4 years		780,085		$	0.88
$0.91 - $1.45		224,500		$	1.04		7.3 years		224,500		$	1.04
$1.50		1,256,015		$	1.50		4.6 years		1,256,015		$	1.50
$1.52 - $12.85		461,418		$	4.24		5.1 years		461,418		$	4.24
$14.50 - $31.88		99,253		$	25.97		1.9 years		99,253		$	25.97
$50.9375		2,999		$	50.94		1.3 years		2,999		$	50.94
$51.25		45,800		$	51.25		1.3 years		45,800		$	51.25
$0.32 - $51.25		4,429,281		$	2.40		6.6 years		4,081,114		$	2.58

Stock-based compensation expense recognized in the statement of operations is as follows (in thousands):

			For the three months December 31,
			2008			2007
Research and development expenses		$	22		$	20
General and administrative expenses			43			127
Total stock-based compensation expense		$	65		$	147

 

The total deferred compensation expense for outstanding and unvested stock options was $70,000 as of December 31, 2008.  The weighted average remaining recognition period for the total deferred compensation expense is four months. The fair value of the options associated with the above compensation expense was determined at the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions:

		For the three months December 31,
		2008		2007
Dividend yield		0%		0%
Expected volatility		200%– 201%		197%
Risk-free interest rate		2.6% - 3.8%		4.6%
Expected option life after shares are vested		10 years		10 years

H.           Commitments

The Company has acquired assets still in development and entered into research and development arrangements with third parties that may require milestone and royalty payments to the third party contingent upon the occurrence of certain future events linked to the success of the asset in development. Milestone payments may be required, contingent upon the successful achievement of an important point in the development life-cycle of the pharmaceutical product (e.g., approval of the product for marketing by a regulatory agency). If required by the arrangement, the Company may have to make royalty payments based upon a percentage of the sales of the pharmaceutical product in the event that regulatory approval for marketing is obtained.

 

 

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These arrangements may be material individually, and in the unlikely event that milestones for multiple products covered by these arrangements were reached in the same period, the aggregate charge to expense could be material to the results of operations in any one period. In addition, these arrangements often give Aeolus the discretion to unilaterally terminate development of the product, which would allow Aeolus to avoid making the contingent payments; however, Aeolus is unlikely to cease development if the compound successfully achieves clinical testing objectives.

I.           Subsequent Events

On January 2, 2009, the Company exercised its rights under the Put Option and sold its four auction rate securities for their par value of $525,000 to UBS and upon settlement of the trade the Company paid in full the UBS Margin Loan.  In addition, the Company settled its arbitration claim against UBS Financial Services, Inc.

Item 2.                      Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Introduction

Unless otherwise noted, the terms “we,” “our” or “us” refer collectively to Aeolus Pharmaceuticals, Inc. and our wholly owned subsidiary, Aeolus Sciences, Inc.

This report contains, in addition to historical information, statements by us with respect to expectations about our business and future results which are “forward-looking” statements under the Private Securities Litigation Reform Act of 1995. These statements and other statements made elsewhere by us or by our representatives, which are identified or qualified by words such as “likely,” “will,” “suggests,” “expects,” “might,” “believe,” “could,” “should,” “may,” “estimates,” “potential,” “predict,” “continue,” “would,” “anticipates,” “plans,” or similar expressions, are based on a number of assumptions that are subject to risks and uncertainties. Such statements include, but are not limited to, those relating to Aeolus’ product candidates, as well as its proprietary technologies and uncertainties and other factors that may cause Aeolus’ actual results to be materially different from historical results or from any results expressed or implied by such forward-looking statements. Important factors that could cause results to differ include risks associated with uncertainties of progress and timing of clinical trials, scientific testing, obtaining regulatory approval, the need to obtain funding for pre-clinical and clinical trails and operations, the scope and validity of intellectual property protection for Aeolus’ product candidates, proprietary technologies and their uses, new accounting and SEC requirements and competition from other biopharmaceutical companies. Certain of these factors and others are more fully described in Aeolus’ filings with the SEC, including, but not limited to, Aeolus’ Annual Report on Form 10-K for the fiscal year ended September 30, 2008. All forward-looking statements are based on information available as of the date hereof, and we do not assume any obligation to update such forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof.

Operations Summary

We are developing a series of catalytic antioxidant molecules to protect against the damaging effects of reactive oxygen derived molecules, commonly referred to as free radicals.  Free radicals cause damage in a broad group of diseases and conditions.  Our initial target indications are as a protective agent against the effects of mustard gas exposure, as a protective agent against radiation exposure, cancer radiation therapy, as a protective agent against the effects of chlorine gas exposure and amyotrophic lateral sclerosis, also known as “ALS” or “Lou Gehrig’s disease.”  We have reported positive safety results from two Phase I clinical trials of AEOL 10150, our lead drug candidate, with no serious adverse events noted.  We also have a long-term clinical trial underway in a single patient with ALS to test the efficacy and further test the safety of AEOL 10150.  However, further development of AEOL 10150 for the treatment of ALS and cancer radiation therapy, if any, will be dependent upon future specific financing for this development or a partnership and the results of our ongoing studies of AEOL 10150 for the treatment of mustard gas exposure and chlorine gas exposure.

We do not have any revenue, other than grant income, and therefore we must rely on public or private equity offerings, debt financings, collaboration arrangements or grants to finance our operations.

Need for Additional Funds

We believe we have adequate financial resources to fund our operations into the third quarter of fiscal year 2009, but in order to fund on-going operating cash requirements beyond the third quarter of fiscal year 2009, or to accelerate or expand our programs, we will need to raise significant additional funds. Our need for additional financing is discussed under “Liquidity and Capital Resources.”

 

 

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Results of Operations

Three months ended December 31, 2008 versus three months ended December 31, 2007

We had net losses attributable to common stockholders of $459,000 for the three months ended December 31, 2008, versus net losses attributable to common stockholders of $641,000 for the three months ended December 31, 2007.

Research and development (“R&D”) expenses decreased $129,000, or 51%, to $125,000 for the three months ended December 31, 2008 from $254,000 for the three months ended December 31, 2007.  R&D expenses were lower during the three months ended December 31, 2008 versus December 31, 2007 due to a decline in grant expenses. During the three months ended December 31, 2008, our development program was focused on the development of AEOL 10150 as a protective agent against chemical agents which were funded through grants from the National Institutes of Health CounterAct Program, whereas during the three months ended December 31, 2007 there were two studies underway which were funded by the Company in the amount of $110,000.

R&D expenses for our antioxidant program have totaled $34,636,000 from inception through December 31, 2008. Because of the uncertainty of our research and development and clinical studies, we are unable to predict the level of spending and the anticipated program completion date, if any.

General and administrative (“G&A”) expenses decreased $112,000, or 28%, to $283,000 for the three months ended December 31, 2008 from $395,000 for the three months ended December 31, 2007.  G&A expenses were lower during the three months ended December 31, 2008 versus December 31, 2007 due to a decline in stock based compensation expense and Board of Directors expense.   Stock compensation expense decreased by $84,000 as a result of the lower level of grant activity during the current quarter and an average lower valuation assigned to such grants in the current quarter when compared to the prior year quarter.  Board of Directors expense decreased by $34,000 as the Board of Directors adopted a stock based compensation plan in July 2008 whereas during the quarter ended December 31, 2007, the Board of Directors received cash and stock based compensation.

We incurred net interest expense of $100,000 for the three months ended December 31, 2008 compared to net interest income of $8,000 for the three months ended December 31, 2007.  The change reflects higher interest expense as a result of the issuance of the Senior Convertible Notes which bear interest at a rate of 7% as well as the related amortization of debt issuance costs and a note issuance discounts related to warrant issuances and beneficial conversion features.  Interest expense also increased as a result of a higher average balance of our note payable with Elan and the draws on our margin loan with UBS Financial Services, Inc.  Interest income on our investments also decreased due to a lower level of investable assets as well as a lower level of interest rates during the current quarter.

We recorded a gain of $49,000 related to the net increase in the market value of our trading securities during the three months ended December 31, 2008.

Liquidity and Capital Resources

We do not have any revenue and therefore we rely on investors, grants, collaborations and licensing of our compounds to finance our operations. At December 31, 2008, we had $169,000 of cash, a decrease of $230,000 from September 30, 2008. The decrease in cash was primarily due to the $408,000 loss from operations for the three months ended December 31, 2008.  We believe we have adequate financial resources to conduct operations into the third quarter of fiscal year 2009, but in order to fund on-going operating cash requirements beyond that point, or to further accelerate or expand our programs, we need to raise significant additional funds.

We incurred significant losses from operations of $408,000 and $2,517,000, and cash outflows from operations of $606,000 and $1,813,000, for the three months ended December 31, 2008 and for the fiscal year ended September 30, 2008, respectively. Our ongoing future cash requirements will depend on numerous factors, particularly the progress of our catalytic antioxidant program and clinical trials and our ability to negotiate and complete collaborative agreements or out-licensing arrangements. In order to help fund our on-going operating cash requirements, we intend to seek new collaborations for our antioxidant research program that include initial cash payments and on-going research support. In addition, we might sell additional shares of our stock and/or convertible debentures and explore other strategic and financial alternatives, including a merger with another company, the sale of stock and/or debt, the establishment of new collaborations for current research programs, that include initial cash payments and ongoing research support and the out-licensing of our compounds for development by a third party.

There are significant uncertainties as to our ability to access potential sources of capital. We may not be able to enter into any collaboration on terms acceptable to us, or at all, due to conditions in the pharmaceutical industry or in the economy in general or based on the prospects of our catalytic antioxidant program. Even if we are successful in obtaining a collaboration for our antioxidant program, we may have to relinquish rights to technologies, product candidates or markets that we might otherwise

 

 

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develop ourselves. These same risks apply to any attempt to out-license our compounds.

Similarly, due to market conditions, the illiquid nature of our stock and other possible limitations on equity offerings, we may not be able to sell additional securities or raise other funds on terms acceptable to us, if at all. Any additional equity financing, if available, would likely result in substantial dilution to existing stockholders.

Our forecast of the period of time through which our financial resources will be adequate to support our operations is forward-looking information, and actual results could vary.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

ITEM 3.                      Quantitative and Qualitative Disclosures About Market Risk.

Our exposure to market risk is presently limited to the interest rate sensitivity of our cash and cash equivalents, which is affected by changes in the general level of U.S. interest rates. However, we believe that we are not subject to any material market risk exposure and do not expect that changes in interest rates would have a material effect upon our financial position. A hypothetical 10% change in interest rates would not have a material effect on our Statement of Operations or Cash Flows for the three months ended December 31, 2008. We do not have any foreign currency or other derivative financial instruments. Our debt bears interest at a fixed rate.

ITEM 4.                      Controls and Procedures.

(a)                 As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s President and Chief Executive Officer (the Company’s Principal Executive Officer) and Chief Financial Officer (the Company’s Principal Financial and Accounting Officer), of the effectiveness of the Company’s disclosure controls and procedures required by Exchange Act Rule 13a-15.  Based upon that evaluation, the Company’s Principal Executive Officer and Principal Financial and Accounting Officer have concluded that the Company’s disclosure controls and procedures were not effective as of December 31, 2008 to provide reasonable assurance that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms because of the material weakness discussed below.

As a result of the lack of segregation of duties, management has determined that a material weakness in internal control over financial reporting related to the segregation of duties existed as of December 31, 2008, and based on the criteria set forth by by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), concluded that the Company’s internal control over financial reporting was not effective as of December 31, 2008.

A “material weakness,” as defined by the Public Company Accounting Oversight Board (PCAOB) is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis.  This material weakness has not resulted in an adjustment or misstatements to the financial statements.

To address the material weakness, management has established mitigating controls to minimize the potential for material misstatements in the financial statements.  Management has determined that given the Company’s size, level of operations and financial resources, it is not practicable for the Company to eliminate the segregation of controls weakness and therefore management has established mitigating controls to minimize the impact of the lack of segregation of duties.

(b)                 During the most recent fiscal quarter, there were no significant changes in the Company’s internal control over financial reporting or in other factors that materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting.

PART II. - OTHER INFORMATION

ITEM 1.                      Legal Proceedings.

None.

 

 

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ITEM 1A.                                                                                                                                                    Risk Factors.

None.

ITEM 2.                      Unregistered Sales of Equity Securities and Use of Proceeds.

None.

ITEM 3.                      Defaults Upon Senior Securities.

None.

 

ITEM 4.                      Submission of Matters to a Vote of Security Holders.

None.

ITEM 5.                      Other Information.

 

None.

ITEM 6.                      Exhibits

Exhibit #		Description
31.1		Certification of the Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a).
31.2		Certification of the Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a).
32.1		Certification by the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. §1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

AEOLUS PHARMACEUTICALS, INC.

Date:                         February 6, 2009	By:	/s/ John L. McManus
		John L. McManus President and Chief Executive Officer (Principal Executive Officer)
Date:                         February 6, 2009	By:	/s/ Michael P. McManus
		Michael P. McManus Chief Financial Officer, Treasurer and Secretary (Principal Financial and Accounting Officer)