News Column

STEMCELLS INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

August 12, 2014

This report contains forward looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act that involve substantial risks and uncertainties. Such statements include, without limitation, all statements as to expectation or belief and statements as to our future results of operations; the progress of our research, product development and clinical programs; the need for, and timing of, additional capital and capital expenditures; partnering prospects; costs of manufacture of products; the protection of, and the need for, additional intellectual property rights; effects of regulations; the need for additional facilities; and potential market opportunities. Our actual results may vary materially from those contained in such forward-looking statements because of risks to which we are subject, including the fact that additional trials will be required to confirm the safety and demonstrate the efficacy of our HuCNS-SC cells for the treatment of any disease or disorder; uncertainty as to whether the U.S. Food and Drug Administration (FDA), Swissmedic, Health Canada, or other regulatory authorities will permit us to proceed with clinical testing of proposed products despite the novel and unproven nature of our technologies; the risk that our clinical trials or studies could be substantially delayed beyond their expected dates or cause us to incur substantial unanticipated costs; uncertainties in our ability to obtain the capital resources needed to continue our current research and development operations and to conduct the research, preclinical development and clinical trials necessary for regulatory approvals; the uncertainty regarding our ability to obtain a corporate partner or partners, if needed, to support the development and commercialization of our potential cell-based therapeutics product; the uncertainty regarding the outcome of our clinical trials or studies we may conduct in the future; the uncertainty regarding the validity and enforceability of our issued patents; the risk that we may not be able to manufacture additional master and working cell banks when needed; the uncertainty whether any products that may be generated in our cell-based therapeutics programs will prove clinically safe and effective; the uncertainty whether we will achieve significant revenue from product sales or become profitable; obsolescence of our technologies; competition from third parties; intellectual property rights of third parties; litigation risks; and other risks to which we are subject. All forward-looking statements attributable to us or to persons acting on our behalf are expressly qualified in their entirety by the cautionary statements and risk factors set forth in "Risk Factors" in Part I, Item 1A of our Form 10-K for the year ended December 31, 2013.



Overview

The Company

We are engaged in researching, developing, and commercializing cell-based therapeutics and enabling tools and technologies for stem cell-based research and drug discovery and development. Our research and development (R&D) programs are primarily focused on identifying and developing potential cell-based therapeutics which can either restore or support organ function. In particular, since we relocated our operations to California in 1999, our R&D efforts have been directed at refining our methods for identifying, isolating, culturing, and purifying the human neural stem cell and developing this cell as potential cell-based therapeutics for the central nervous system (CNS). Our HuCNS-SC cells (purified human neural stem cells) are currently in clinical development for several indications - chronic spinal cord injury, dry age-related macular degeneration (AMD) and Pelizeaus-Merzbacher disease (PMD), which is a myelination disorder in the brain. We are also conducting preclinical research to evaluate HuCNS-SC cells in Alzheimer's disease. We are conducting a Phase I/II clinical trial for the treatment of chronic spinal cord injury, which represents the first time that neural stem cells have been transplanted as a potential therapeutic agent for spinal cord injury. To accelerate patient enrollment, we expanded this trial from a single-site, single-country study to a multi-site, multi-country program and in April 2014, we completed enrollment of the twelfth and final patient in this trial. This trial is being conducted in Switzerland and Canada. Data from the first three patients demonstrated a favorable safety profile and multi-segment gains in sensory function in two of the three patients twelve months after transplantation of HuCNS-SC cells compared to pre-transplant baselines; the third patient remained stable. Interim analysis of clinical data to date has shown significant post-transplant gains in sensory function in two additional patients and continue to confirm the favorable safety profile of the cells and the surgical implant procedure. Final results from this clinical study are expected to be released mid-2015. We plan to initiate, in the second half of 2014, a controlled Phase II efficacy study to further investigate our HuCNS-SC cells as a treatment for spinal cord injury. We also conducted a Phase I/II clinical trial in dry AMD at five trial sites in the United States, and in June 2014, based on positive interim results, we closed enrollment for this trial in order to focus our efforts on initiating a follow-on Phase II randomized, controlled proof-of-concept study, later this year. Interim results for the AMD Phase I/II trial showed a 70 percent reduction in the rate of geographic atrophy (GA) as compared to the control eye and a 65 percent reduction in the rate of GA as compared to the expected natural history of the disease following a single dose of our proprietary HuCNS-SC cells.



We plan to release additional interim clinical data on our spinal cord injury and dry AMD Phase I/II clinical trials later this year.

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We previously completed a Phase I clinical trial in infantile and late infantile neuronal ceroid lipofuscinosis (NCL), which showed that our HuCNS-SC cells were well tolerated and non-tumorigenic, and that there was evidence of engraftment and long-term survival of the transplanted HuCNS-SC cells. In October 2013, the results of a four-year, long-term follow up study of the patients from the initial Phase I study showed there were no long-term safety or tolerability issues associated with the cells up to five years post-transplantation. In October 2012, we published in Science Translational Medicine, a peer-reviewed journal, the data from our four-patient Phase I clinical trial in PMD, which showed preliminary evidence of durable and progressive donor-derived myelination in all four patients. In addition, there were measurable gains in neurological function in three of the four patients, with the fourth patient clinically stable. For a brief description of our significant therapeutic research and development programs see Overview "Therapeutic Product Development Programs" in the Business Section of Part I, Item 1 of our Form 10-K for the year ended December 31, 2013. In April 2013, we entered into an agreement with the California Institute for Regenerative Medicine (CIRM) under which CIRM will provide up to approximately $19.3 million as a forgivable loan, in accordance with mutually agreed upon terms and conditions and CIRM regulations. The CIRM loan will help fund preclinical development of our HuCNS-SC cells for Alzheimer's disease. We received an initial disbursement of $3.8 million under the CIRM Loan Agreement in July 2013, and a subsequent disbursement of $3.8 million in January 2014. We are also engaged in developing and commercializing applications of our technologies to enable research, which we believe represent current and nearer-term commercial opportunities. Our portfolio of technologies includes cell technologies relating to embryonic stem cells, induced pluripotent stem (iPS) cells, and tissue-derived (adult) stem cells; expertise and infrastructure for providing cell-based assays for drug discovery; a cell culture products and antibody reagents business; and an intellectual property portfolio with claims relevant to cell processing, reprogramming and manipulation, as well as to gene targeting and insertion. Many of these enabling technologies were acquired in April 2009 as part of our acquisition of the operations of Stem Cell Sciences Plc (SCS). We have not derived any revenue or cash flows from the sale or commercialization of any products except for license revenue for certain of our patented technologies and sales of products for use in stem cell research. As a result, we have incurred annual operating losses since inception and expect to incur substantial operating losses in the future. Therefore, we are dependent upon external financing, such as from equity and debt offerings, to finance our operations. Before we can derive revenue or cash inflows from the commercialization of any of our therapeutic product candidates, we will need to: (i) conduct substantial in vitro testing and characterization of our proprietary cell types, (ii) undertake preclinical and clinical testing for specific disease indications; (iii) develop, validate and scale-up manufacturing processes to produce these cell-based therapeutics, and (iv) obtain required regulatory approvals. These steps are risky, expensive and time consuming. Overall, we expect our R&D expenses to be substantial and to increase for the foreseeable future as we continue the development and clinical investigation of our current and future product candidates. However, expenditures on R&D programs are subject to many uncertainties, including whether we develop our product candidates with a partner or independently. We cannot forecast with any degree of certainty which of our current product candidates will be subject to future collaboration, when such collaboration agreements will be secured, if at all, and to what degree such arrangements would affect our development plans and capital requirements. In addition, there are numerous factors associated with the successful commercialization of any of our cell-based therapeutics, including future trial design and regulatory requirements, many of which cannot be determined with accuracy at this time given the stage of our development and the novel nature of stem cell technologies. The regulatory pathways, both in the United States and internationally, are complex and fluid given the novel and, in general, clinically unproven nature of stem cell technologies. At this time, due to such uncertainties and inherent risks, we cannot estimate in a meaningful way the duration of, or the costs to complete, our R&D programs or whether, when or to what extent we will generate revenues or cash inflows from the commercialization and sale of any of our therapeutic product candidates. While we are currently focused on advancing each of our product development programs, our future R&D expenses will depend on the determinations we make as to the scientific and clinical prospects of each product candidate, as well as our ongoing assessment of the regulatory requirements and each product candidate's commercial potential. Given the early stage of development of our therapeutic product candidates, any estimates of when we may be able to commercialize one or more of these products would not be meaningful. Moreover, any estimate of the time and investment required to develop potential products based upon our proprietary HuCNS-SC technologies will change depending on the ultimate approach or approaches we take to pursue them, the results of preclinical and clinical studies, and the content and timing of decisions made by the FDA, Swissmedic, Health Canada, and other regulatory authorities. There can be no assurance that we will be able to develop any product successfully, or that we will be able to recover our development costs, whether upon commercialization of a developed product or otherwise. We cannot provide assurance that any of these programs will result in products that can be marketed or marketed profitably. If certain of our development-stage programs do not result in commercially viable products, our results of operations could be materially adversely affected. 22



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The research markets served by our tools and technologies products are highly competitive, complex and dynamic. Technological advances and scientific discoveries have accelerated the pace of change in biological research, and stem cell technologies have been evolving particularly fast. We compete mainly by focusing on specialty media and antibody reagent products and human cell lines where we believe our expertise, intellectual property and reputation give us competitive advantage. We believe that, in this particular market niche, our products and technologies offer customers specific advantages over those offered by our competitors. We compete by offering innovative, quality-controlled products, consistently made and designed to produce reproducible results. For the first and second quarter of 2014, we generated in aggregate, revenues from the sale of specialty cell culture products of approximately $535,000. We can give no assurances that we will be able to continue to generate such revenues in the future. Significant Events In April 2014, we completed enrollment in our Phase I/II clinical trial in spinal cord injury. The multi-national, open-label, Phase I/II trial is evaluating both safety and preliminary efficacy of our proprietary HuCNS-SC platform technology as a treatment for chronic spinal cord injury. The trial enrolled twelve subjects with chest-level injury to the spinal cord. The trial enrolled seven patients with complete paralysis, no motor or sensory function below the point of injury, classified as complete (AIS A), according to the American Spinal Injury Association Impairment Scale, and five patients with no motor function and limited sensory function below the point of injury, classified as incomplete (AIS B). We plan to release additional clinical data from this landmark study later this year and final results are expected to be released mid-2015. In May 2014, the principal investigator, from our phase I/II trial in spinal cord injury presented an interim update from the trial at the Annual Meeting of the American Spinal Injury Association in San Antonio, Texas. Interim analysis of clinical data to date has shown that the significant post-transplant gains in sensory function first reported in two patients have now been observed in two additional patients. The presentation included the first data on AIS B subjects to be transplanted in the Phase I/II chronic spinal cord injury trial with our proprietary HuCNS-SC cells. The interim results also continue to confirm the favorable safety profile of the cells and the surgical implant procedure. The presentation included data from a total of five new subjects with a minimum six month follow up. In total, we have now reported clinical updates on a total of eight of the twelve patients enrolled in our Phase I/II clinical trial using our proprietary HuCNS-SC cells. In June 2014, we reported positive interim results from our 16-patient Phase I/II clinical trial for geographic atrophy of age related macular degeneration (AMD) at the 12th annual meeting of the International Society for Stem Cell Research in Vancouver, Canada. Based on positive interim results, we closed enrollment in this clinical trial in order to focus our efforts on a follow-on Phase II randomized, controlled proof-of-concept study, later this year. Interim results for the Phase I/II trial show a 70 percent reduction in the rate of geographic atrophy as compared to the control eye and a 65 percent reduction in the rate of GA as compared to the expected natural history of the disease following a single dose of our proprietary HuCNS-SC cells. In addition to these initial efficacy findings, the Phase I/II trial has also demonstrated a favorable safety profile for our proprietary HuCNS-SC cells as a treatment for dry AMD. Final results from this landmark study are expected to be released mid-2015. Also in June 2014, we strengthened our senior executive team. Stephen Huhn, M.D., F.A.C.S., F.A.A.P. was promoted to the newly created position of vice president, CNS clinical research and chief medical officer. Joel Naor, M.D., M.B.A., M.Sc., was hired as vice president, clinical development, ophthalmology; Naymisha Patel was hired as vice president, quality systems; and Mohammad A. El-Kalay, Ph.D. was hired as vice president, process development. In July 2014, we appointed Alan Trounson, Ph.D. to our Board of Directors. Dr. Trounson most recently served as President of The California Institute for Regenerative Medicine (CIRM), the largest scientific funding body for stem cell research in the world. In July 2014, we raised gross proceeds of $20,000,000 through the sale of 11,299,435 units to two institutional biotechnology investors, at an offering price of $1.77 per unit. Each unit consists of one share of our common stock and a warrant to purchase 0.85 of a share of our common stock. The warrants are exercisable six months from the date of issuance at an exercise price of $2.17. The Warrants are non-transferable and will expire thirteen months from the date of issuance. The shares were offered under our shelf registration statement previously filed with, and declared effective by, the SEC. 23



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Critical Accounting Policies and the Use of Estimates

The accompanying discussion and analysis of our financial condition and results of operations are based on our condensed consolidated financial statements and the related disclosures, which have been prepared in accordance with U.S. GAAP. The preparation of these condensed consolidated financial statements requires management to make estimates, assumptions, and judgments that affect the reported amounts in our condensed consolidated financial statements and accompanying notes. These estimates form the basis for making judgments about the carrying values of assets and liabilities. We base our estimates and judgments on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, and we have established internal controls related to the preparation of these estimates. Actual results and the timing of the results could differ materially from these estimates.



Stock-Based Compensation

U.S. GAAP requires us to recognize expense related to the fair value of our stock-based payment awards, including employee stock options and restricted stock units. Under the provisions of U.S. GAAP, the fair value of our employee stock-based payment awards is estimated at the date of grant using the Black-Scholes-Merton (Black-Scholes) option-pricing model and is recognized as expense ratably over the requisite service period. The Black-Scholes option-pricing model requires the use of certain assumptions, the most significant of which are our estimates of the expected volatility of the market price of our stock and the expected term of the award. Our estimate of the expected volatility is based on historical volatility. The expected term represents our estimated period during which our stock-based awards remain outstanding. We estimate the expected term based on historical experience of similar awards, giving consideration to the contractual terms of the awards, vesting requirements, and expectation of future employee behavior, including post-vesting terminations. We review our valuation assumptions at each grant date and, as a result, our assumptions in future periods may change. As of June 30, 2014, we expect to recognize approximately $3,713,000 of compensation expense related to unvested stock-based awards over a weighted-average period of 3.1 years. See also Note 5, "Stock-Based Compensation," in the notes to condensed consolidated financial statements of Part I, Item 1 of this Form 10-Q for further information.



Business Combinations

The operating results of acquired companies or operations are included in our consolidated financial statements starting on the date of acquisition. Goodwill is recorded at the time of an acquisition and is calculated as the difference between the aggregate consideration paid for an acquisition and the fair value of the net tangible and intangible assets acquired. Accounting for acquisitions requires extensive use of accounting estimates and judgments to allocate the purchase price to the fair value of the net tangible and intangible assets acquired, including in-process research and development. Goodwill and intangible assets deemed to have indefinite lives are not amortized but are subject to annual impairment tests. If the assumptions and estimates used to allocate the purchase price are not correct, or if business conditions change, purchase price adjustments or future asset impairment charges could be required. We test goodwill for impairment on an annual basis or more frequently if we believe indicators of impairment exist. Impairment evaluations involve management estimates of asset useful lives and future cash flows. Significant management judgment is required in the forecasts of future operating results that are used in the evaluations. It is possible, however, that the plans and estimates used may be incorrect. If our actual results, or the plans and estimates used in future impairment analysis, are lower than the original estimates used to assess the recoverability of these assets, we could incur impairment charges in a future period. 24



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Warrant Liability

We account for our warrants in accordance with U.S. GAAP which defines how freestanding contracts that are indexed to and potentially settled in a company's own stock should be measured and classified. Authoritative accounting guidance prescribes that only warrants issued by us under contracts that cannot be net-cash settled, and are both indexed to and settled in our common stock, can be classified as equity. As part of both our November 2008 and November 2009 financings, we issued warrants with five year terms to purchase 1,034,483 and 400,000 shares of our common stock at $23.00 and $15.00 per share, respectively. The 1,034,483 warrants issued as part of the November 2008 financing, expired unexercised by their own terms in May 2014. As part of our December 2011 financing, we issued Series A Warrants with a five year term to purchase 8,000,000 shares at $1.40 per share and Series B Warrants with a ninety trading day term to purchase 8,000,000 units at $1.25 per unit. Each unit underlying the Series B Warrants consisted of one share of our common stock and one Series A Warrant. In the first and second quarter of 2012, an aggregate of 2,700,000 Series B Warrants were exercised. For the exercise of these warrants, we issued 2,700,000 shares of our common stock and 2,700,000 Series A Warrants. The remaining 5,300,000 Series B Warrants expired unexercised by their terms on May 2, 2012. As terms of the warrants issued in 2009 and the Series A warrants do not meet the specific conditions for equity classification, we are required to classify the fair value of these warrants as a liability, with subsequent changes in fair value to be recorded as income (loss) due to change in fair value of warrant liability. The fair value of the warrants issued in the 2009 financings is determined using the Black-Scholes-Merton (Black-Scholes) option pricing model and the fair value of the Series A Warrants is determined using a Monte Carlo simulation model (see Note 8, "Warrant Liability"). The fair value is affected by changes in inputs to these models including our stock price, expected stock price volatility, the contractual term, and the risk-free interest rate. The use of a Monte Carlo simulation model requires input of additional assumptions including the progress of our R&D programs and its affect on potential future financings. We will continue to classify the fair value of the warrants as a liability until the warrants are exercised, expire or are amended in a way that would no longer require these warrants to be classified as a liability. The estimated fair value of our warrant liability at June 30, 2014, was approximately $8,526,000.



Revenue Recognition

We currently recognize revenue resulting from the licensing and use of our technology and intellectual property, from government grants, from services provided to third parties, and from product sales. Licensing agreements may contain multiple elements, such as upfront fees, payments related to the achievement of particular milestones and royalties. Revenue from upfront fees for licensing agreements that contain multiple elements are generally deferred and recognized on a straight-line basis over the term of the agreement. Fees associated with substantive at risk performance-based milestones are recognized as revenue upon completion of the scientific or regulatory event specified in the agreement, and royalties received are recognized as earned. Revenue from licensing agreements is recognized net of a fixed percentage due to licensors as royalties. Grant revenue from government agencies are funds received to cover specific expenses and are recognized as earned upon either the incurring of reimbursable expenses directly related to the particular research plan or the completion of certain development milestones as defined within the terms of the relevant collaborative agreement or grant. Revenue from services provided to third parties is recognized when we have performed the agreed upon services. Revenue from product sales are recognized when the product is shipped and the order fulfilled. Results of Operations Our results of operations have varied significantly from year to year and quarter to quarter and may vary significantly in the future due to the occurrence of material recurring and nonrecurring events, including without limitation the receipt and payment of recurring and nonrecurring licensing payments, the initiation or termination of clinical studies, research collaborations and development programs for both cell-based therapeutic products and research tools, unpredictable or unanticipated manufacturing and supply costs, unanticipated capital expenditures necessary to support our business, developments in on-going patent prosecution and litigation, the on-going expenses to maintain our Rhode Island facilities, and the costs associated with operating our California and Cambridge, U.K. facilities.



We acquired the operations of SCS on April 1, 2009, and have consolidated such operations since that date.

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Revenue and Cost of Product Sales

Revenue for the three and six-month periods ended June 30, 2014, as compared with the same period in 2013, is summarized in the table below:

Three months ended, Six months ended, June 30 Change in 2014 versus 2013 June 30 Change in 2014 versus 2013 2014 2013 $ % 2014 2013 $ % Revenue:



Licensing agreements, grants and other $ 23,479$ 31,333 $

(7,854 ) (25 )% $ 47,063$ 106,975$ (59,912 ) (56 )% Product sales 218,725 250,364 (31,639 ) (13 )% 534,621 458,922 75,699 17 % Total revenue 242,204 281,697 (39,493 ) (14 )% 581,684 565,897 15,787 3 % Cost of product sales 78,097 77,573 (524 ) 1 % 165,373 144,414 (20,959 ) 15 % Gross profit $ 164,107$ 204,124$ (40,017 ) (20 )% $ 416,311$ 421,483 $ (5,172 ) (1 )% Second quarter ended June 30, 2014 versus second quarter ended June 30, 2013. Total revenue in the second quarter of 2014 was approximately $242,000, a decrease of 14% compared to the second quarter of 2013. Revenue from product sales were 13% lower, at approximately $219,000, in the second quarter of 2014 compared to the same period in 2013. This decrease was primarily attributable to decreased unit volumes in our SC Proven line of media and reagents. Licensing, grant and other revenue for the second quarters of 2014 and 2013 were not significant. Licensing, grant and other revenue in the second quarter of 2014 totaled approximately $23,000 compared to approximately $31,000 for the same period in 2013. Six-month period ended June 30, 2014 versus six-month period ended June 30, 2013. Total revenue in the six-month period ended June 30, 2014 was approximately $582,000, which was 3% higher than total revenue of approximately $566,000 for the same period of 2013. Revenue from product sales were 17% higher, at approximately $535,000, for the six-month period in 2014 compared to the same period in 2013. This increase was primarily attributable to increased unit volumes in our SC Proven line of media and reagents. Licensing, grant and other revenue for the first quarters of 2014 and 2013 were not significant. Licensing, grant and other revenue in the six-month period ended June, 30 2014 totaled approximately $47,000 compared to approximately $107,000 for the same period in 2013. Operating Expenses



Operating expenses for the three and six-month periods ended June 30, 2014, as compared with the same period in 2013, is summarized in the table below:

Three months ended, Six months ended, June 30 Change in 2014 versus 2013 June 30 Change in 2014 versus 2013 2014 2013 $ % 2014 2013 $ % Operating expenses: Research & development $ 6,092,284$ 4,804,890$ 1,287,394 27 % $ 10,996,578$ 9,368,780$ 1,627,798 17 %



Selling, general & administrative 2,175,797 1,581,521

594,276 38 % 4,423,397 3,469,278 954,119 28 % Wind-down expenses - 38,978 (38,978 ) (100 )% - 61,837 (61,837 ) (100 )% Total operating expenses $ 8,268,081$ 6,425,389$ 1,842,692 29 % $ 15,419,975$ 12,899,895$ 2,520,080 20 %



Research and Development Expenses

Our R&D expenses consist primarily of salaries and related personnel expenses, costs associated with clinical trials and regulatory submissions, costs associated with preclinical activities such as toxicology studies, costs associated with cell processing and process development, certain patent-related costs such as licensing, facilities related costs such as allocated rent and operating expenses, depreciation, lab equipment and supplies. Clinical trial expenses include payments to vendors such as clinical research organizations, contract manufacturers, clinical trial sites, laboratories for testing clinical samples and consultants. Cumulative R&D costs incurred since we refocused our activities on developing cell-based therapeutics (fiscal years 2000 through the six months ended June 30, 2014) were approximately $199 million. Over this period, the majority of these cumulative costs were related to: (i) characterization of our proprietary HuCNS-SC cells, (ii) expenditures for toxicology and other preclinical studies, preparation and submission of applications to regulatory agencies to conduct clinical trials and obtaining regulatory clearance to initiate such trials, all with respect to our proprietary HuCNS-SC cells, (iii) preclinical studies and development of our human liver engrafting cells, (iv) costs associated with cell processing and process development, and (v) costs associated with our clinical studies. 26



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We use and manage our R&D resources, including our employees and facilities, across various projects rather than on a project-by-project basis for the following reasons. The allocations of time and resources change as the needs and priorities of individual projects and programs change, and many of our researchers are assigned to more than one project at any given time. Furthermore, we are exploring multiple possible uses for each of our proprietary cell types, so much of our R&D effort is complementary to and supportive of each of these projects. Lastly, much of our R&D effort is focused on manufacturing processes, which can result in process improvements useful across cell types. We also use external service providers to assist in the conduct of our clinical trials, to manufacture certain of our product candidates and to provide various other R&D related products and services. Many of these costs and expenses are complementary to and supportive of each of our programs. Because we do not have a development collaborator for any of our product programs, we are currently responsible for all costs incurred with respect to our product candidates. Second quarter ended June 30, 2014 versus second quarter ended June 30, 2013. R&D expenses totaled approximately $6,092,000 in the second quarter of 2014 compared with $4,805,000 in the second quarter of 2013. The increase of approximately $1,287,000, or 27%, in 2014 compared to 2013, was primarily attributable to an increase of approximately $1,315,000 in expenses related to our clinical studies; primarily to initiate in the second-half of 2014, a controlled Phase II efficacy study to further investigate our HuCNS-SC cells as a treatment for spinal cord injury and our Phase I/II clinical trial in dry AMD. The increase was partially offset by a decrease of approximately $28,000 in net other operating expenses. Six-month period ended June 30, 2014 versus six-month period ended June 30, 2013. R&D expenses totaled approximately $10,997,000 in the six-month period ended June 30, 2014 compared with $9,369,000 for the same period in 2013. The increase of approximately $1,628,000, or 17%, in 2014 compared to 2013, was primarily attributable an increase of approximately $1,869,000 in expenses related to our clinical studies; (i) our Phase I/II clinical trial for the treatment of chronic spinal cord injury, (ii) our Phase I/II clinical trial in dry AMD, and (iii) expenses incurred to initiate in the second-half of 2014, a controlled Phase II efficacy study to further investigate our HuCNS-SC cells as a treatment for spinal cord injury. The increase was partially offset by a decrease of approximately $241,000 in net other operating expenses primarily external services related to preclinical studies of our proprietary HuCNS-SC cells.



Selling, General and Administrative Expenses

Selling, general and administrative (SG&A) expenses are primarily comprised of salaries, benefits and other staff related costs associated with sales and marketing, finance, legal, human resources, information technology, and other administrative personnel, allocated facilities and overhead costs, external legal and other external general and administrative services. Second quarter ended June 30, 2014 versus second quarter ended June 30, 2013. SG&A expenses totaled approximately $2,176,000 in the second quarter of 2014 compared with approximately $1,582,000 in the same period of 2013. The increase of approximately $594,000, or 38%, in 2014 compared to 2013, was primarily attributable to (i) an increase of approximately $316,000 in expenses related to external services; primarily attributable to an increase in legal fees, recruiting fees, and expenses related to our annual shareholders' meeting, (ii) an increase of approximately $221,000 in payroll expenses; primarily attributable to the addition of a role dedicated to scientific and strategic alliances towards the end of the second quarter of 2013 and increased personnel costs related to roles within the finance department, and (iii) an increase in net other expenses of approximately $57,000. Six-month period ended June 30, 2014 versus six-month period ended June 30, 2013. SG&A expenses totaled approximately $4,423,000 in the six-month period ended June 30, 2014 compared with approximately $3,469,000 in the same period of 2013. The increase of approximately $954,000, or 28%, in 2014 compared to 2013, was primarily attributable to (i) an increase of approximately $487,000 in expenses related to external services; primarily attributable to an increase in legal fees, recruiting fees, and expenses related to our annual shareholders' meeting, (ii) an increase of approximately $351,000 in payroll expenses; primarily attributable to the addition of a role dedicated to scientific and strategic alliances towards the end of the second quarter of 2013 and increased personnel costs related to roles within the finance department, and (iii) an increase in net other expenses of approximately $116,000.



Other Income (Expense)

Other expense totaled approximately $4,011,000 in the second quarter of 2014 compared with other income of approximately $353,000 in the same period of 2013, and other expense of approximately $4,732,000 for the six-month period ended June 30, 2014 compared with other expense of approximately $193,000 for the six-month period ended June 30, 2013. 27



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Table of Contents Three months ended, Change in 2014 versus Six months ended, Change in 2014 versus June 30 2013 June 30 2013 2014 2013 $ % 2014 2013 $ % Other income (expense): Change in fair value of warrant liability $ (3,654,470 )$ 757,688$ (4,412,158 ) * $ (3,981,094 )$ 569,081$ (4,550,175 ) * Interest income 1,689 1,790 (101 ) (6 )% 3,874 8,636 (4,762 ) (55 )% Interest expense (343,224 ) (392,855 ) 49,631 (13 )% (723,712 ) (403,003 ) (320,709 ) 80 % Other income (expense), net (15,245 ) (14,040 ) (1,205 ) 9 % (30,884 ) 18,569 (49,453



) (266 )%

Total other income (expense), net $ (4,011,250 )$ 352,583$ (4,363,833 ) * $ (4,731,816 )$ 193,283$ (4,925,099 ) *



Change in Fair Value of Warrant Liability

We record changes in fair value of warrant liability as income or loss in our Consolidated Statements of Operations. We have warrants outstanding which were issued as part of financing transactions in 2009 and 2011 and have classified the fair value of these warrants as a liability. The fair value of the outstanding warrants is determined using various option pricing models, such as the Black-Scholes-Merton (Black-Scholes) option pricing model and a Monte Carlo simulation model, and is affected by changes in inputs to the various models, including our stock price, expected stock price volatility, the contractual term and the risk-free interest rate. The use of a Monte Carlo simulation model requires input of additional subjective assumptions including the progress of our R&D programs and its affect on potential future financings. The fair value of the warrant liability is revalued at the end of each reporting period. See Note 8 "Warrant Liability" in the notes to condensed consolidated financial statements of Part I, Item 1 of this Form 10-Q for further information.



Interest Income

Interest income in three and six-month period ended June 30, 2014 and 2013 were not significant and is from the investment of our cash balances in money market accounts and short-term money market instruments that are highly liquid and that preserves capital. Interest Expense Interest expense was approximately $343,000 in the second quarter of 2014 compared with approximately $393,000 for the second quarter of 2013. Interest expense was approximately $724,000 in the six-month period ended June 30, 2014 compared with approximately $403,000 for the similar period in 2013. Interest expense is primarily interest due under a Loan Agreement with SVB. See Note 6 "Loan Payable," in the notes to condensed consolidated financial statements of Part I, Item 1 of this Form 10-Q for further information.



Other income (expense), net

Other expense of approximately $15,000 for the first quarter of 2014 and $14,000 for the similar period in 2013, were primarily related to state franchise taxes. Other expense of approximately $31,000 for the six-month period ended June 30, 2014 were primarily related to state franchise taxes. In comparison, other income of approximately $19,000 for the similar period in 2013 is primarily from a gain on sale of equipment offset by other expenses primarily related to state franchise taxes. * Calculation not meaningful 28



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Liquidity and Capital Resources

Since our inception, we have financed our operations through the sale of common and preferred stock, the issuance of long-term debt and capitalized lease obligations, credit facilities, revenue from collaborative agreements, research grants, license fees, and interest income. Change June 30, December 31, 2014 2013 $ % Cash and cash equivalents $ 17,847,097$ 30,585,424 12,738,327 (42 )%



In summary, our cash flows were:

Six months ended June 30, Change in 2014 versus 2013 2014 2013 $ % Net cash used in operating activities $ (14,277,185 )$ (10,430,088 )$ (3,847,097 ) 37 % Net cash provided by (used in) investing activities $ (362,873 )$ 9,994,467$ (10,357,340 ) (104 )% Net cash provided by financing activities $ 1,898,442$ 14,723,836



$ (12,825,394 ) (87 )%

Net Cash Used in Operating Activities

Net cash used in operating activities in the six-month period ended June 30, 2014 increased by approximately $3,847,000, or 37%, when compared to the same period of 2013. Cash used in operating activities is primarily driven by our net loss as adjusted for non-cash charges and differences in the timing of operating cash flows. The increase from 2013 to 2014 was primarily attributable to expenses incurred on our Phase I/II clinical trials for the treatment of chronic spinal cord injury and dry AMD; expenses incurred to initiate in the second-half of 2014, a controlled Phase II efficacy study to further investigate our HuCNS-SC cells as a treatment for spinal cord injury; an increase in legal fees, recruiting fees, and expenses related to our annual shareholders' meeting.



Net Cash Provided by (Used in) Investing Activities

Net cash used in investing activities in 2014 was primarily for the purchase of lab and office equipment. Net cash provided by investing activities for the similar period in 2013 was primarily attributable to net maturities of short-term marketable debt securities of approximately $12,476,000, offset by net capital expenditures of approximately $2,482,000.



Net Cash Provided by Financing Activities

In the six-month period ended June 30, 2014, we received approximately $3,820,000 as a part of a loan provided under the CIRM Loan Agreement. See Note 6, "Loan Payable" in the notes to condensed consolidated financial statements of Part I, Item 1 of this Form 10-Q for further information. There were no other significant financing transactions during this period. In July 2014, we raised gross proceeds of $20,000,000 through the sale of 11,299,435 units to two institutional biotechnology investors, at an offering price of $1.77 per unit. Each unit consists of one share of our common stock and a warrant to purchase 0.85 of a share of our common stock. The warrants are exercisable six months from the date of issuance at an exercise price of $2.17. The Warrants are non-transferable and will expire thirteen months from the date of issuance. The shares were offered under our shelf registration statement previously filed with, and declared effective by, the SEC. We have incurred significant operating losses and negative cash flows since inception. We have not achieved profitability and may not be able to realize sufficient revenue to achieve or sustain profitability in the future. We do not expect to be profitable in the next several years, but rather expect to incur additional operating losses. We have limited liquidity and capital resources and must obtain significant additional capital resources in order to sustain our product development efforts, for acquisition of technologies and intellectual property rights, for preclinical and clinical testing of our anticipated products, pursuit of regulatory approvals, acquisition of capital equipment, laboratory and office facilities, establishment of production capabilities, for selling, general and administrative expenses and other working capital requirements. We rely on cash balances and proceeds from equity and debt offerings, proceeds from the transfer or sale of our intellectual property rights, equipment, facilities or investments, and government grants and funding from collaborative arrangements, if obtainable, to fund our operations. We intend to pursue opportunities to obtain additional financing in the future through equity and debt financings, grants and collaborative research arrangements. In December 2013, we filed with the SEC, and the SEC declared effective, a universal shelf registration statement which permits us to issue up to $100 million worth of registered debt and equity securities. Under this effective 29



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shelf registration, we have the flexibility to issue registered securities, from time to time, in one or more separate offerings or other transactions with the size, price and terms to be determined at the time of issuance. Registered securities issued using this shelf may be used to raise additional capital to fund our working capital and other corporate needs, for future acquisitions of assets, programs or businesses, and for other corporate purposes. As of July 25, 2014, we had approximately $59 million under this universal shelf registration statement available for issuing debt or equity securities. The source, timing and availability of any future financing will depend principally upon market conditions, interest rates and, more specifically, on our progress in our exploratory, preclinical and future clinical development programs. Funding may not be available when needed - at all, or on terms acceptable to us. Lack of necessary funds may require us, among other things, to delay, scale back or eliminate some or all of our research and product development programs, planned clinical trials, and/or our capital expenditures or to license our potential products or technologies to third parties. In addition, a decline in economic activity, together with the deterioration of the credit and capital markets, could have an adverse impact on potential sources of future financing. Commitments



See Note 7, "Commitments and Contingencies" in the notes to condensed consolidated financial statements of Part I, Item 1 of this Form 10-Q for further information.

Off-Balance Sheet Arrangements

We have certain contractual arrangements that create potential risk for us and are not recognized in our Consolidated Balance Sheets. Discussed below are those off-balance sheet arrangements that have or are reasonably likely to have a material current or future effect on our financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources.



Operating leases

We lease various real properties under operating leases that generally require us to pay taxes, insurance, maintenance, and minimum lease payments. Some of our leases have options to renew. Operating Leases - California In December 2010, we entered into a commercial lease agreement with BMR-Gateway Boulevard LLC (BMR), as landlord, for office and research space at BMR's Pacific Research Center in Newark, California. The initial term of the lease is approximately eleven and one-half years and includes escalating rent payments which we recognize as lease operating expense on a straight-line basis. We will pay approximately $17,869,000 in aggregate as rent over the term of the lease to BMR. Deferred rent for this facility was approximately $1,440,000 as of June 30, 2014, and approximately $1,434,000 as of December 31, 2013. In March 2013, we entered into a commercial lease agreement with Prologis, L.P. (Prologis), as landlord, for office and research space in Sunnyvale, California. The facility is for operations that support our clinical development activities. The initial term of the lease is ten years and includes escalating rent payments which we recognize as lease operating expense on a straight-line basis. We will pay approximately $3,497,000 in aggregate rent over the term of the lease. As part of the lease, Prologis has provided us financial allowances to build initial tenant improvements, subject to customary terms and conditions relating to landlord-funded tenant improvements. The tenant improvements are recorded as leasehold improvement assets and amortized over the term of the lease. The financial allowances are treated as a lease incentive and recorded as deferred rent which is amortized as reductions to lease expense over the lease term. Deferred rent for this facility was approximately$392,000 as of June 30, 2014, and approximately $391,000 as of December 31, 2013.



Operating Leases - United Kingdom

In January 2011, we amended the existing lease agreements of our wholly-owned subsidiary, Stem Cell Sciences (U.K.) Ltd, effectively reducing our leased office and lab space. The lease by its terms was extended to September 30, 2013. In October 2013, we signed a new three-year lease agreement for the leased space and expect to pay rent of approximately GBP 53,000 per annum. StemCells, Inc. is the guarantor of Stem Cell Sciences (U.K.) Ltd.'s obligations under the existing lease. The lease includes an option for early termination of the lease agreement. 30



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With the exception of the operating leases discussed above, we have not entered into any significant off balance sheet financial arrangements and have not established any special purpose entities. We have not guaranteed any debts or commitments of other entities or entered into any options on non-financial assets.



Contractual Obligations

In the table below, we set forth our legally binding and enforceable contractual cash obligations at June 30, 2014:

Total Payable in Obligations Payable in (July to 2019 at June 30, December) Payable in Payable in Payable in Payable in and 2014 2014 2015 2016 2017 2018



Beyond

Operating lease payments(1) $ 17,110,968 $



957,416 $ 1,912,217$ 1,968,459$ 2,014,706$ 2,061,260

$ 8,196,910 Capital lease payment (equipment) 43,187 12,142 21,591 9,454 - - - Loan Payable (principal & interest)(2) 7,923,730 2,161,017 4,322,035 1,440,678 - - - Bonds Payable (principal & interest)(3) 19,193 19,193 - - - - -



Total contractual cash obligations $ 25,097,078 $ 3,149,768 $ 6,255,843$ 3,418,591$ 2,014,706$ 2,061,260$ 8,196,910

(1) See Note 7, "Commitments and Contingencies" in the notes to condensed

consolidated financial statements of Part I, Item 1 of this Form 10-Q for

further information.

(2) See Note 6, "Loan Payable" in the notes to condensed consolidated financial

statements of Part I, Item 1 of this Form 10-Q for further information.

(3) See Note 7, "Commitments and Contingencies" in the notes to condensed

consolidated financial statements of Part I, Item 1 of this Form 10-Q for

further information.

We periodically enter into licensing agreements with third parties to obtain exclusive or non-exclusive licenses for certain technologies. The terms of certain of these agreements require us to pay future milestone payments based upon achievement of certain developmental, regulatory or commercial milestones. We do not anticipate making any milestone payments under any of our licensing agreements for 2014. Milestone payments beyond fiscal year 2014 cannot be predicted or estimated, due to the uncertainty of achieving the required developmental, regulatory or commercial milestones.



We do not have any material unconditional purchase obligations or commercial commitments related to capital expenditures, clinical development, clinical manufacturing, or other external services contracts at June 30, 2014.

Recent Accounting Pronouncements

In May 2014, the FASB issued Accounting Standards Update ("ASU") 2014-09, Revenue from Contracts with Customers, which outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. This ASU requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The guidance in this ASU affects any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This ASU is effective for interim and annual periods beginning after December 15, 2016 and early adoption is not permitted. We do not expect this new guidance will have a material effect on our consolidated financial statements.


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