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

August 5, 2014

The following discussion should be read in conjunction with our financial statements and related notes contained in this report.

We are a clinical-stage biotechnology company engaged in the research and development of innovative cancer therapeutics. Our mission is to produce novel drugs with differentiated mechanisms of action that will extend the lives of our patients. These drugs target biological pathways implicated in a wide range of cancers. We employ technologies such as our ArQule Kinase Inhibitor Platform ("AKIPTM") to design and develop drugs that have the potential to fulfill this mission. Our product candidates and programs span a continuum of research and development ranging from drug discovery to advanced clinical testing. They are based on our understanding of biological processes that lead to the proliferation and metastasis of cancer cells, combined with our ability to generate product candidates possessing certain pre-selected, drug-like properties. We believe that these qualities, when present from the earliest stages of product development, increase the likelihood of producing safe, effective and marketable drugs. Our discovery and development efforts are also guided when possible by an understanding of the role of biomarkers, which are indicators of a particular biological condition or process and may predict the clinical benefit of our compounds in defined patient populations. Our lead product candidate is tivantinib (ARQ 197), an orally administered, small molecule inhibitor of the c-Met receptor tyrosine kinase ("c-MET" or "MET") and its biological pathway. C-MET is a promising target for cancer therapy, based on its multiple roles in cancerous cell proliferation, tumor spread, new blood vessel formation and resistance to certain drug therapies. We and our partners, Daiichi Sankyo Co., Ltd. ("Daiichi Sankyo") and Kyowa Hakko Kirin Co., Ltd. ("Kyowa Hakko Kirin"), are implementing a worldwide clinical development program designed to realize the broad potential of tivantinib. Our strategy is to focus on the most promising indications within our clinical programs based upon continually generated and updated clinical and pre-clinical data. Our lead indication is liver cancer ("hepatocellular carcinoma" or "HCC"). We have also completed earlier-stage combination therapy trials and pre-clinical experiments with tivantinib and other anti-cancer agents that may provide data to support trials in additional indications. Our most advanced ongoing clinical trial, the METIV-HCC trial, is a pivotal Phase 3 randomized, double-blind, controlled study of tivantinib as single agent therapy in previously treated patients with MET diagnostic-high, inoperable HCC conducted by Daiichi Sankyo and us. A dose reduction in the METIV-HCC trial from 240 mg twice daily ("BID") tablets to 120 mg BID tablets was implemented in September 2013 following the observation of a higher incidence of neutropenia in the initial phase of the METIV-HCC trial than was observed in the Phase 2 trial in the same patient population, which employed a 240 mg BID capsule dose, and in other trials with tivantinib. Certain enhanced patient monitoring procedures were temporarily instituted to confirm the safety profile of the lower dose. Following a review of data analyses from a predefined number of patients who received this lower dose, the DMC of the METIV-HCC trial recommended in January 2014 continuation of the ongoing trial, with patients receiving the lower dose. Pharmacokinetic analyses among a predefined number of patients treated with the 120 mg BID tablet dose showed that the incidence of neutropenia was reduced with this lower dose and that the plasma exposure of the lower dose was comparable to the 240 mg BID capsule dose in the Phase 2 trial with similar medians and overlapping ranges. Approximately 300 patients are planned to be enrolled in the METIV-HCC trial at approximately 120 clinical sites worldwide. Our current estimate of the time frame for completion of enrollment is mid-2016. This trial is being conducted under a Special Protocol Assessment ("SPA") agreement with the FDA. An SPA is an agreement establishing the design, endpoints and statistical analysis of a clinical trial intended to provide the necessary data, depending on the outcome of the trial, which could support the filing of a New Drug Application ("NDA"). Final marketing approval depends on the results of the trial. Because the METIV-HCC trial is enrolling patients with MET-diagnostic high HCC whom we believe are likely to benefit from treatment with tivantinib, the SPA also includes an immunohistochemistry ("IHC")-based companion diagnostic ("CDx") under development by a third party provider of such tests in collaboration with Daiichi Sankyo and ourselves. This CDx is being developed to enable the identification of the MET status of patients seeking to be enrolled in the trial. Our collaborator for this companion diagnostic test and our collaborator for a second test will each need to submit a Premarket Approval ("PMA") application to FDA that establishes the predictive value of the respective CDx in connection with the registration and commercialization of the drug in the U.S., and additional regulatory applications will need to be made in other

geographic areas. 15 In addition to METIV-HCC, a second Phase 3 clinical trial in HCC with tivantinib is ongoing in Japan. On February 4, 2014, Kyowa Hakko Kirin, our partner for the development of tivantinib in Asian territories, announced the initiation of this trial in Japanese patients with MET diagnostic-high, inoperable HCC treated with one prior therapy with sorafenib. The trial is a randomized, double-blind placebo-controlled study to compare PFS in patients treated with tivantinib with those treated with placebo. Kyowa Hakko Kirin plans to enroll approximately 160 patients in this study. There are no milestone payments associated with the initiation of this trial. On January 16, 2014, we reported that Kyowa Hakko Kirin provided us with top-line results of the amended Phase 3 randomized, double-blind ATTENTION clinical trial evaluating the combination of tivantinib and erlotinib in second-line patients with advanced or metastatic non-squamous non-small cell lung cancer ("NSCLC") with wild-type epidermal growth factor receptor ("EGFR") in Asia (Japan, Korea and Taiwan). Enrollment in ATTENTION had been originally planned at 460 patients. Recruitment of new patients was permanently suspended in October 2012 based on a recommendation by the trial's Safety Review Committee following an observed imbalance in interstitial lung disease ("ILD") cases as a drug-related adverse event. Patients who received treatment as of October 2012 were allowed to continue thereafter in the trial after being re-consented, and including such patients, 307 patients in total were included in the final analysis. In the intent to treat ("ITT") population of ATTENTION, OS favored the treatment arm of tivantinib plus erlotinib compared to the erlotinib only control arm, but it was not statistically significant (median OS of 12.9 months vs. 11.2 months, hazard ratio = 0.89, p = 0.4). PFS and overall response rate ("ORR") results also showed a trend toward improvement favoring the treatment arm. The safety profile observed in ATTENTION was in line with what was previously observed in other NSCLC trials with tivantinib, with the exception of ILD, which is a known adverse event observed in Japanese patients treated with EGFR inhibitors such as erlotinib. On September 30, 2013 at the European Cancer Congress, we and our partner Daichii Sankyo, presented final data from MARQUEE, a randomized, double-blind, controlled pivotal Phase 3 trial conducted under an SPA to evaluate tivantinib in combination with erlotinib, an approved anti-cancer agent, in previously treated patients with locally advanced or metastatic, non-squamous NSCLC. Of the 1048 patients in the trial, 445 were evaluable for MET status. Patients with MET-high NSCLC numbered 211, and the number with MET-low disease was 234. These data demonstrated clinical benefits in patients with non-squamous, NSCLC whose tumors expressed high levels of MET protein. The overall safety profile among patients receiving tivantinib (360 milligrams BID) and erlotinib (150 milligrams daily) was consistent with findings at a previous planned interim analysis announced on October 2, 2012. Unlike the ATTENTION trial, no imbalance was observed in the incidence of ILD between treatment and control arms, with one case (0.2%) reported in the treatment arm and four cases (0.8%) in the control arm. At the time of the interim analysis of MARQUEE, the independent DMC recommended that the study be discontinued early after concluding that it would not meet its primary endpoint of improved OS. Although the interim analysis showed a statistically significant improvement in PFS in the ITT population, this benefit did not carry over to OS. There were no safety concerns identified by the DMC during this analysis. We and our partners are evaluating data from the MARQUEE and ATTENTION trials to determine whether the potential exists for further trials in patient sub-populations within this disease category who may benefit from treatment that includes tivantinib. On January 11, 2013, we announced the top-line results of a randomized Phase 2 signal generation trial of tivantinib used in combination with irinotecan and cetuximab in patients with refractory or relapsed colorectal cancer ("CRC"). The trial did not meet its primary endpoint of PFS. The PFS and ORR results obtained in both the control arm and the treatment arm were longer than expected compared to previously published historical norms. Additional data and analyses from this trial were presented at the American Society of Clinical Oncology ("ASCO") Annual Meeting in June 2013, showing that the median PFS in the treatment arm was 8.3 months, compared with 7.3 months in the control arm. Median OS in the treatment arm was 19.8 months, compared with 16.9 months in the control arm. ORR in the treatment arm was 45 percent versus 33 percent in the control arm. Adverse events were reported at similar rates in the treatment and control arms of the trial, except for increased neutropenia observed in the treatment arm, with no discontinuations of treatment for this reason. Tivantinib was generally well tolerated in combination with the approved doses of irinotecan and cetuximab studied in this trial. We have licensed commercial rights to tivantinib for human cancer indications to Daiichi Sankyo in the U.S., Europe, South America and the rest of the world, excluding Japan and certain other Asian countries, where we have licensed commercial rights to Kyowa Hakko Kirin. Our agreements with these partners provide for possible future milestone payments, royalties on product sales, and development funding, in addition to significant payments that we have already received. During 2011, we received $25 million from Daiichi Sankyo resulting from the dosing of the first patient in the MARQUEE trial, and we received $10 million from Kyowa Hakko Kirin resulting from dosing of the first patient in the ATTENTION trial. The terms of our tivantinib licensing agreements with Daiichi Sankyo and Kyowa Hakko Kirin remain in effect following the recent developments in both of these trials. Our proprietary pipeline of product candidates is directed toward molecular targets and biological processes with demonstrated roles in the development of human cancers. Our priorities within this pipeline include ARQ 092, an Akt inhibitor, and ARQ 087, an inhibitor of fibroblast growth factor receptor. We are also supporting an ongoing investigator-sponsored trial with ARQ 761, which is being investigated as a potential NQ01 inhibitor. Our drug discovery efforts are focused primarily on AKIPTM, which we are using to generate novel kinase inhibitors that are potent and selective against their targets. We have assessed the potential of AKIPTM to target multiple kinases in oncology and other therapeutic areas, and we are generating and validating compounds that inhibit these kinase targets. We utilize our proprietary kinase-focused libraries that are enriched with chemical matter to enhance the efficiency and effectiveness of these efforts. During 2011, Daiichi Sankyo licensed ARQ 092, an inhibitor of the Akt protein kinase discovered under our AKIPTM oncology drug discovery collaboration that terminated in November 2012. ARQ 092 is the first clinical-stage compound to emerge from this collaboration. As a result of our license agreement for this compound, we received a $10 million payment from Daiichi Sankyo in November 2011. 16



We have a cumulative deficit of approximately $458 million from inception through June 30, 2014. We recorded a net loss for 2011, 2012 and 2013 and expect a net loss for 2014.

Our revenue consists primarily of development funding from our alliances with Daiichi Sankyo and Kyowa Hakko Kirin. Revenue and expenses fluctuate from quarter to quarter based upon a number of factors, notably the timing and extent of our cancer-related research and development activities together with the length and outcome of our clinical trials. On December 18, 2008, we entered into a license, co-development and co-commercialization agreement with Daiichi Sankyo to conduct research, clinical trials and commercialization of tivantinib in human cancer indications. The agreement provides for a $60 million cash upfront licensing payment from Daiichi Sankyo to us, which we received in December 2008, and an additional $560 million in potential development and sales milestone payments offset by our share of the Phase 3 costs. Upon commercialization, we will receive tiered, double-digit royalties from Daiichi Sankyo on net sales of tivantinib commensurate with the magnitude of the transaction. We retain the option to participate in the commercialization of tivantinib in the U.S. We and Daiichi Sankyo will share equally the costs of Phase 2 and Phase 3 clinical studies, with our share of Phase 3 costs payable solely from milestone and royalty payments by Daiichi Sankyo. The dosing of the first patient in the Phase 3 MARQUEE clinical trial of tivantinib in NSCLC, announced in January 2011, triggered the payment of a $25 million development milestone from Daiichi Sankyo that was received in February 2011. Revenue for this agreement is recognized using the contingency-adjusted performance model. Through September 30, 2012, revenue was recognized based upon an estimated development period through December 2013. As a result of the October 2012 decision to discontinue the MARQUEE trial, the development period as of October 1, 2012 was extended to June 2015. Commencing with the fourth quarter of 2012 and through the third quarter of 2013 revenue was recognized over that development period. In the fourth quarter of 2013, following a recommendation by the Data Monitoring Committee that the METIV-HCC trial continue with patients receiving a lower dose of tivantinib than the dose originally employed in the trial, we reviewed the estimated development period and extended it to June 2016. Under the terms of our tivantinib collaboration agreement with Daiichi Sankyo we share development costs equally with our share of Phase 3 costs funded solely from milestones and royalties. In each quarter the tivantinib collaboration costs we incur are compared with those of Daiichi Sankyo. If our costs for the quarter exceed Daiichi Sankyo's, we recognize revenue on the amounts due to us under the contingency adjusted performance model. Revenue is calculated on a pro-rata basis using the time elapsed from inception of the agreement over the estimated duration of the development period under the agreement. If our costs for the quarter are less than those of Daiichi Sankyo's, we report the amount due to Daiichi Sankyo as contra-revenue in that quarter. To the extent that our share of Phase 3 collaboration costs exceeds the amount of milestones and royalties received, that excess is netted against future milestones and royalties if and when earned and is not reported as contra-revenue. Our cumulative share of the Daiichi Sankyo Phase 3 costs through June 30, 2014, totaled $86.9 million. We received a milestone of $25 million in February 2011 upon enrolling the first patient in the MARQUEE trial, the cash proceeds of which were subsequently applied to our share of Phase 3 collaboration costs. On January 31, 2013, we announced that the first patient had been enrolled in the pivotal Phase 3 METIV trial of tivantinib, entitling us to a $15 million milestone. That $15 million milestone was also netted against our cumulative share of Phase 3 collaboration costs in 2013, and consequently we did not receive any cash proceeds from this milestone. Our cumulative share of Phase 3 collaboration costs has exceeded the amount of milestones received through June 30, 2014 by $46.9 million which will be netted against future milestones and royalties, if any, when earned and has not been reported as contra-revenue. For the quarter ended June 30, 2014, our non-Phase 3 tivantinib collaboration costs incurred exceeded those of Daiichi Sankyo's and we recognized $0.1 million as research and development revenue under the contingency adjusted performance model. For the six months ended June 30, 2014, no research and development revenue was recognized related to our non-Phase 3 tivantinib collaboration as our costs incurred were offset by an equal amount of contra-revenue. For the quarter ended June 30, 2013, our non-Phase 3 tivantinib collaboration costs incurred exceeded those of Daiichi Sankyo's and we recognized $0.3 million as research and development revenue under the contingency adjusted performance model. Through the six months ended June 30, 2013 we recognized a net of $0.1 million of research and development revenue related to our non-Phase 3 tivantinib collaboration costs which included contra-revenue of $0.2 million and $0.3 million of revenue. In November 2012, we completed our research collaboration with Daiichi Sankyo under a research collaboration, exclusive license and co-commercialization agreement entered into on November 7, 2008, that was focused on applications of our proprietary AKIPTM technology and know-how for the discovery of therapeutic compounds that selectively inhibit certain kinases in the field of oncology. The agreement provided for a $15 million upfront payment, which we received in November 2008, research support payments for the first two years of the collaboration (which was extended for an additional two years in 2010), licensing fees for compounds discovered as a result of this research, milestone payments related to clinical development, regulatory review and sales, and royalty payments on net sales of compounds from the collaboration. Daiichi Sankyo's obligation to provide further research funding to ArQule under this agreement terminated in November 2012. 17

We have regained worldwide rights for the development and commercialization of ARQ 092 and all other compounds included under our Akt collaboration with Daiichi Sankyo pursuant to their formal notice to terminate our license and commercialization agreement received on March 26, 2013. Termination of this agreement was effective 90 days from our receipt of the formal notice from Daiichi Sankyo, following which we became responsible for funding the remainder of the ongoing Phase 1 trial with ARQ 092 beyond the contractual termination period, as well as any future clinical development and commercialization of this compound. The license agreement had provided exclusive rights to Daiichi Sankyo for the development, manufacturing and marketing of ARQ 092 on a worldwide basis. Under this agreement, we received a $10 million upfront fee from Daiichi Sankyo in November 2011. Following the termination of this agreement, ARQ 092 has become our proprietary asset, and Daiichi Sankyo has no further financial or other obligations or rights related to this program. On April 27, 2007, we entered into an exclusive license agreement with Kyowa Hakko Kirin to develop and commercialize tivantinib in Japan and parts of Asia. A $3 million portion of an upfront licensing fee was received by the Company under this agreement in the first quarter of 2007, and an additional $27 million in upfront licensing fees was received on May 7, 2007. The agreement includes $123 million in upfront and potential development milestone payments from Kyowa Hakko Kirin to ArQule, including the $30 million cash upfront licensing payments. In February 2008, we received a $3 million milestone payment from Kyowa Hakko Kirin, and in September 2010, we received a $5 million milestone payment. Upon commercialization, ArQule will receive tiered royalties in the mid-teen to low-twenty percent range from Kyowa Hakko Kirin on net sales of tivantinib. Kyowa Hakko Kirin will be responsible for all clinical development costs and commercialization of the compound in certain Asian countries, consisting of Japan, China (including Hong Kong), South Korea and Taiwan. In addition to the upfront and possible regulatory milestone payments totaling $123 million, the Company will be eligible for future milestone payments based on the achievement of certain levels of net sales. The Company will recognize the payments, if any, as revenue in accordance with its revenue recognition policies. As of June 30, 2014, the Company has not recognized any revenue from these potential sales milestone payments, and there can be no assurance that it will do so in the future. Revenue for this agreement is recognized using the contingency-adjusted performance model with an estimated development period through April 2016.



LIQUIDITY AND CAPITAL RESOURCES

June 30, December 31, Increase (decrease) 2014 2013 $ % (in millions)



Cash, cash equivalents and marketable securities-short term $ 63.2 $ 74.7 (11.5 )

(15 )% Marketable securities-long term 14.4 20.4

(6.0 ) (30 )% Notes payable 1.7 1.7 - - Working capital 43.4 53.9 (10.5 ) (19 )% Six Months Ended June 30, June 30, Increase 2014 2013 (decrease) (in millions) Cash flow from: Operating activities $ (17.0 )$ (18.4 )$ 1.4 Investing activities 12.6 17.1 (4.5 ) Financing activities 0.1 0.2 (0.1 ) Cash flow from operating activities. Our uses of cash for operating activities have primarily consisted of salaries and wages for our employees, facility and facility-related costs for our offices and laboratories, fees paid in connection with preclinical and clinical studies, laboratory supplies and materials, and professional fees. The sources of our cash flow from operating activities have consisted primarily of payments received from our collaborators for services performed or upfront payments for future services. For the six months ended June 30, 2014 and 2013, our net use of cash was primarily driven by our net loss and the difference between cash receipts from our collaborators and payments for operating expenses which resulted in net cash outflows of $17.0 million and $18.4 million, respectively. Cash flow from investing activities. Our net cash provided by investing activities of $12.6 million and $17.1 million for the six months ended June 30, 2014 and 2013, respectively, was comprised of net sales of marketable securities. The composition and mix of cash, cash equivalents and marketable securities may change frequently as a result of the Company's constant evaluation of conditions in financial markets, the maturity of specific investments, and our near term liquidity needs. 18 Our cash equivalents and marketable securities typically include U.S. Treasury bill funds, money market funds, commercial paper, and U.S. federal and state agency backed certificates, including auction rate securities that have investment grade ratings. Our cash equivalents and our portfolio of marketable securities are subject to market risk due to changes in interest rates. Fixed rate interest securities may have their market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectation due to changes in interest rates or we may suffer losses in principal if we are forced to sell securities that decline in market value due to changes in interest rates. ArQule's marketable securities portfolio includes $2.1 million (at cost) at June 30, 2014 and December 31, 2013, invested in auction rate securities.



Cash flow from financing activities. Our net cash provided by financing activities for the six months ended June 30, 2014 and 2013 of $0.1 million and $0.2 million, respectively, was from employee stock plan purchases.

Our cash requirements may vary materially from those now planned depending upon the results of our drug discovery and development strategies, our ability to enter into additional corporate collaborations and the terms of such collaborations, results of research and development, unanticipated required capital expenditures, competitive and technological advances, acquisitions and other factors. We cannot guarantee that we will be able to develop any of our drug candidates into a commercial product. It is likely we will need to raise additional capital or incur indebtedness to continue to fund our operations in the future. Our ability to raise additional funds will depend on financial, economic and market conditions, and due to global capital and credit market conditions or for other reasons, we may be unable to raise capital when needed, or on terms favorable to us. If necessary funds are not available, we may have to delay, reduce the scope of, or eliminate some of our development programs, potentially delaying the time to market for any of our product candidates. In July 2013, we implemented a focused reduction in our workforce of 26 positions, resulting in a remaining workforce of approximately 68 employees. This action was intended to align human and financial resources with our primary focus on clinical-stage development, while retaining our core discovery capabilities. The costs associated with this action were comprised of severance payments of $422 thousand and benefits continuation costs of $89 thousand all of which were paid by December 31, 2013. We also incurred non-cash charges of $139 thousand in 2013 related to the modification of employee stock options. The restructuring actions for which charges were incurred in the year ended December 31, 2013 are expected to result in annual cost savings of approximately $3.5 to $4.0 million commencing in 2014. On July 30, 2014, the Company approved plans to restructure its operations to better align its human and financial resources with the Company's primary focus on clinical stage development programs and to extend the Company's cash runway beyond the anticipated time for achievement of key milestones, including the completion of the METIV-HCC trial. Commencing on August 4, 2014, the Company began to reduce its current workforce from 61 to approximately 40 employees by the end of the year. Most of this reduction will come from the Company's Discovery Group, which has been engaged primarily in early-stage, pre-clinical research. The Company estimates that the costs associated with this action will be comprised principally of severance payments of approximately $1.0 million and benefits continuation of approximately $100 thousand, all of which are expected to be paid by March 31, 2015. In addition, in the third quarter of 2014, the Company expects to incur non-cash charges of approximately $150 thousand related to the modification of employee stock options associated with the restructuring. We anticipate that our cash, cash equivalents and marketable securities on hand at June 30, 2014, financial support from our collaboration agreements, and savings from our workforce reductions described above, will be sufficient to finance our working capital and capital requirements into 2017. Our contractual obligations were comprised of the following as of June 30, 2014 (in thousands): Payment due by period Less than More than Contractual Obligations Total 1 year 1 - 3 years 3 - 5 years 5 years Note payable $ 1,700$ 1,700 $ - $ - $ - Operating lease obligations 2,673 2,673 - - - Purchase obligations 4,941 4,941 - - - Total $ 9,314$ 9,314 $ - $ - $ -

Purchase obligations are comprised primarily of outsourced preclinical and clinical trial expenses and payments to license certain intellectual property to support the Company's research efforts. Interest on notes payable is variable and is excluded from the table above. Notes payable currently bears interest at LIBOR plus 125 basis points. Under our tivantinib collaboration with Daiichi Sankyo, our share of Phase 3 costs are payable solely from future milestones and royalties. As of June 30, 2014 our portion of these costs was $46.9 million and is excluded from the table above. These costs are netted against any future milestones and royalties due to us. Daiichi Sankyo has the right to offset future milestone and royalty payments by this amount.



CRITICAL ACCOUNTING POLICIES AND ESTIMATES

A "critical accounting policy" is one which is both important to the portrayal of the Company's financial condition and results and requires management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. For additional information, please see the discussion of our significant accounting policies in Note 2 to the Financial Statements included in our Annual Report for the fiscal year ended December 31, 2013 on Form 10-K filed with the SEC on

March 5, 2014. 19 RESULTS OF OPERATIONS The following are the results of operations for the three and six months ended June 30, 2014 and 2013: Revenue Increase (decrease) 2014 2013 $ % (in millions) For the three months ended June 30: Research and development revenue $ 2.9$ 4.4$ (1.5 )



(35 )%

For the six months ended June 30: Research and development revenue $ 5.6$ 10.1$ (4.5 )



(45 )%

Research and development revenue for the three and six months ended June 30, 2014 is comprised of revenue from the Daiichi Sankyo tivantinib development agreement and the Kyowa Hakka Kirin exclusive license agreement. Research and development revenue for the three and six months ended June 30, 2013 is comprised of revenue from the Daiichi Sankyo tivantinib development agreement, the license agreement with Daiichi Sankyo for the development of ARQ 092 that ended in June 2013, and the Kyowa Hakko Kirin exclusive license agreement. In addition, during the six months ended June 30, 2013 we completed a one- time research project and received a payment of $1.75 million which we recognized as revenue in the six months ended June 30, 2013. Under the terms of our tivantinib collaboration agreement with Daiichi Sankyo we share development costs equally with our share of Phase 3 costs funded solely from milestones and royalties. In each quarter the tivantinib collaboration costs that we incur are compared with those of Daiichi Sankyo. If our costs for the quarter exceed Daiichi Sankyo's, we recognize revenue on the amounts due to us under the contingency adjusted performance model. Revenue is calculated on a pro-rata basis using the time elapsed from inception of the agreement over the estimated duration of the development period under the agreement. If our costs for the quarter are less than those of Daiichi Sankyo's, we report the amount due to Daiichi Sankyo as contra-revenue in that quarter. To the extent that our share of Phase 3 collaboration costs exceeds the amount of milestones and royalties received, that excess is netted against future milestones and royalties if and when earned and is not reported as contra-revenue. Revenue for this agreement is recognized using the contingency-adjusted performance model. Through September 30, 2012, revenue was recognized based upon an estimated development period through December 2013. As a result of the October 2012 decision to discontinue the MARQUEE trial, the development period as of October 1, 2012 was extended to June 2015. Commencing with the fourth quarter of 2012 and through the third quarter of 2013 revenue was recognized over that development period. In the fourth quarter of 2013, following a recommendation by the Data Monitoring Committee that the METIV-HCC trial continue with patients receiving a lower dose of tivantinib than the dose originally employed in the trial, we reviewed the estimated development period and extended it to June 2016. Our cumulative share of the Daiichi Sankyo Phase 3 costs through June 30, 2014, totaled $86.9 million. We received a milestone of $25 million in February 2011 upon enrolling the first patient in the MARQUEE trial, the cash proceeds of which were subsequently applied to our share of Phase 3 collaboration costs. On January 31, 2013, we announced that the first patient had been enrolled in the pivotal Phase 3 METIV trial of tivantinib, entitling us to a $15 million milestone. That $15 million milestone was also netted against our cumulative share of Phase 3 collaboration costs in 2013, and consequently we did not receive any cash proceeds from this milestone. Our cumulative share of Phase 3 collaboration costs has exceeded the amount of milestones received through June 30, 2014 by $46.9 million which will be netted against future milestones and royalties, if any, when earned and has not been reported as contra-revenue. For the quarter ended June 30, 2014, our non-Phase 3 tivantinib collaboration costs incurred exceeded those of Daiichi Sankyo's and we recognized $0.1 million as research and development revenue under the contingency adjusted performance model. For the six months ended June 30, 2014, no research and development revenue was recognized related to our non-Phase 3 tivantinib collaboration as our costs incurred were offset by an equal amount of contra-revenue. For the quarter ended June 30, 2013, our non-Phase 3 tivantinib collaboration costs incurred exceeded those of Daiichi Sankyo's and we recognized $0.3 million as research and development revenue under the contingency adjusted performance model. Through the six months ended June 30, 2013 we recognized a net of $0.1 million of research and development revenue related to our non-Phase 3 tivantinib collaboration costs which included contra-revenue of $0.2 million and $0.3 million of revenue. 20 The $1.5 million revenue decrease in the three months ended June 30, 2014 is primarily due to revenue decreases of $0.9 million from our Daichii Sankyo tivantinib program and $0.6 million from our Daiichi Sankyo ARQ 092 agreement that ended in June 2013. The $0.9 million revenue decrease in the quarter ended June 30, 2014 from our Daichii Sankyo tivantinib program consisted of a $0.8 million decrease in revenue due to the changes in the estimated development period, and a $0.1 million decrease attributable to revenue recognized as research and development revenue under the contingency adjusted performance model from our non-Phase 3 tivantinib collaboration costs incurred that exceeded those of Daiichi Sankyo's.



The $4.5 million revenue decrease in the six months ended June 30, 2014 is primarily due to revenue decreases of $1.4 million from our Daichii Sankyo tivantinib program due to the changes in the estimated development period, $1.8 million of other revenue related to a one-time research project in the six months ended June 30, 2013 and $1.3 million from our Daiichi Sankyo ARQ 092 agreement that ended in June 2013.

Research and development Increase (decrease) 2014 2013 $ % (in millions) For the three months ended June 30: Research and development $ 6.2$ 8.1$ (1.9 )



(23 )%

For the six months ended June 30: Research and development $ 13.0$ 16.3$ (3.3 ) (20 )% Research and development expense in the three months ended June 30, 2014 decreased by $1.9 million primarily due to lower labor related costs of $0.3 million from employee attrition and $0.6 million from the July 2013 restructuring, reduced lab expenses of $0.3 million and other cost decreases of $0.7 million. Research and development expense in the six months ended June 30, 2014 decreased by $3.3 million primarily due to lower labor related costs of $0.8 million from employee attrition and $1.3 million from the July 2013 restructuring, reduced lab expenses of $0.7 million and other cost decreases of $0.5 million. At June 30, 2014 we had 41 employees dedicated to our research and development program compared to 69 at June 30, 2013.



Overview

Our research and development expense consists primarily of salaries and related expenses for personnel, costs of contract manufacturing services, costs of facilities and equipment, fees paid to professional service providers in conjunction with our clinical trials, fees paid to research organizations in conjunction with pre-clinical animal studies, costs of materials used in research and development, consulting, license, and sponsored research fees paid to third parties and depreciation of associated laboratory equipment. We expect that our research and development expense will remain significant as we continue to develop our portfolio of oncology programs. We have not accumulated and tracked our internal historical research and development costs or our personnel and personnel-related costs on a program-by-program basis. Our employee and infrastructure resources are allocated across several projects, and many of our costs are directed to broadly applicable research endeavors. As a result, we cannot state the costs incurred for each of our oncology programs on a program-by-program basis.



The expenses incurred by us to third parties for pre-clinical and clinical trials in the current quarter and since inception of our lead clinical stage program were as follows (in millions):

Six Months Ended Oncology program Current status June 30, 2014 Program-to-date c-Met program-tivantinib Phase 3 $ 1.4 $ 83.5 Under the terms of our tivantinib collaboration agreement with Daiichi Sankyo we share development costs equally with our share of Phase 3 costs funded solely from milestones and royalties. Our cumulative share of Phase 3 collaboration costs has exceeded the amount of milestones received through June 30, 2014 by $46.9 million and is not reflected in the above table. Our future research and development expenses in support of our current and future oncology programs will be subject to numerous uncertainties in timing and cost to completion. We test potential products in numerous pre-clinical studies for safety, toxicology, and efficacy. We may conduct multiple clinical trials for each product. As we obtain results from trials, we may elect to discontinue or delay clinical trials for certain products in order to focus our resources on more promising products. Completion of clinical trials may take several years or more, and the length of time generally varies substantially according to the type, complexity, novelty, and intended use of a product. It is not unusual for the pre-clinical and clinical development of each of these types of products to take nine years or more, and for total development costs to exceed $500 million for each product. 21



We estimate that clinical trials of the type generally needed to secure new drug approval are typically completed over the following timelines:

Estimated Completion Clinical Phase Period Phase 1 1 - 2 years Phase 2 2 - 3 years Phase 3 2 - 4 years



The duration and the cost of clinical trials may vary significantly over the life of a project as a result of differences arising during clinical development, including, among others, the following:

? the number of clinical sites included in the trials; ? the length of time required to enroll suitable patients; ? the number of patients that ultimately participate in the trials; ? the duration of patient follow-up to ensure the absence of long-term product-related adverse events; and ? the efficacy and safety profile of the product. An element of our business strategy is to pursue the research and development of a broad pipeline of products. This is intended to allow us to diversify the risks associated with our research and development expenditures. As a result, we believe our future capital requirements and future financial success do not substantially depend on any one product. To the extent we are unable to build and maintain a broad pipeline of products, our dependence on the success of one or a few products increases. Our strategy includes entering into alliance arrangements with third parties to participate in the development and commercialization of our products, such as our collaboration agreements with Daiichi Sankyo and Kyowa Hakko Kirin. In the event that third parties have control over the clinical trial process for a product, the estimated completion date would be under control of that third party rather than under our control. We cannot forecast with any degree of certainty whether our products will be subject to future collaborative arrangements or how such arrangements would affect our development plans or capital requirements. As a result of the uncertainties discussed above, we make significant estimates in determining the duration and completion costs of our oncology programs or when and to what extent we will receive cash inflows from the commercialization and sale of a product. Our inability to complete our oncology programs in a timely manner or our failure to enter into appropriate collaborative agreements could significantly increase our capital requirements and could adversely impact our liquidity. These uncertainties could force us to seek additional, external sources of financing from time-to-time in order to continue with our product development strategy. Our inability to raise additional capital, or to do so on terms reasonably acceptable to us, would jeopardize the future success of our business. General and administrative Increase (decrease) 2014 2013 $ % (in millions) For the three months ended June 30: General and administrative $ 3.1$ 3.2$ (0.1 )



(4 )%

For the six months ended June 30: General and administrative $ 6.3$ 6.6$ (0.3 ) (4 )%



General and administrative expense decreased in the three months ended June 30, 2014 principally due to lower non-cash stock compensation costs.

General and administrative expense decreased in the six months ended June 30, 2014 principally due to lower non-cash stock compensation costs. General and administrative headcount was 20 at June 30, 2014, compared to 25 at June 30, 2013. 22



Interest income, interest expense and other income (expense)

Increase (decrease) 2014 2013 $ % (in thousands) For the three months ended June 30: Interest income $ 76$ 132$ (56 ) (42 )% Interest expense (10 ) (6 ) 4 67 % Other income (expense) 1 (68 ) 69 101 % For the six months ended June 30: Interest income $ 171$ 283$ (112 ) (40 )% Interest expense (17 ) (10 ) 7 70 % Other income (expense) 77 (70 ) 147 210 %

Interest income is derived from our portfolio of cash, cash equivalents and investments and decreased in the three and six month periods ended June 30, 2014 primarily due to a decrease in our portfolio balance. Interest expense was incurred on our notes payable. Other income (expense) in the three and six month periods ended June 30, 2014 includes a gain of $1 thousand and a gain of $77 thousand, from the increase in fair value of our auction rate securities, respectively. Other income (expense) in the three and six month periods ended June 30, 2013 includes a loss of $68 thousand and a loss of $70 thousand, from the decrease in fair value of our auction rate securities, respectively



RECENT ACCOUNTING PRONOUNCEMENTS

From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board ("FASB") or other standard setting bodies that are adopted by the Company as of the specified effective date. Unless otherwise discussed, we believe that the impact of recently issued standards that are not yet effective will not have a material impact on our financial position or results of operations upon adoption. In June 2014, the FASB issued ASU No. 2014-12, "Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period."This ASU requires a reporting entity to treat a performance target that affects vesting and that could be achieved after the requisite service period as a performance condition, and apply existing guidance under the Stock Compensation Topic of the ASC as it relates to awards with performance conditions that affect vesting to account for such awards. The provisions of this ASU are effective for interim and annual periods beginning after December 15, 2015. We are currently evaluating the potential impact this ASU may have on our financial position and results of operations. During the quarter ended June 30, 2014, the FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers" (Topic 606), which supersedes all existing revenue recognition requirements, including most industry-specific guidance. The new standard requires a company to recognize revenue when it transfers goods or services to customers in an amount that reflects the consideration that the company expects to receive for those goods or services. The new standard will be effective for us on January 1, 2017. We are currently evaluating the potential impact this ASU may have on our financial position and results of operations. In July 2013, the FASB issued an update, which is intended to eliminate the diversity that is in practice with regard to the financial statement presentation of unrecognized tax benefits when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. The guidance was effective for our interim period ending March 31, 2014. We adopted this standard in the first quarter of fiscal year 2014. The adoption of this standard did not have a material impact on our financial condition or results of operations. FORWARD LOOKING STATEMENTS

In addition to historical information, this report contains forward-looking statements. You can identify these forward-looking statements by their use of words such as "anticipate," "assume," "believe," "estimate," "expect," "forecast," "intend," "may," "plan," "project," "target," "will" and other words and terms of similar meaning. You also can identify them by the fact that they do not relate strictly to historical or current facts. All statements which address operating performance, events or developments that the Company expects or anticipates will occur in the future, such as projections about its future results of operations, its financial condition, research, development and commercialization of its products and anticipated trends in its business are forward-looking statements. In this report we make forward-looking statements regarding our drug development pipeline and our clinical trials involving tivantinib. Additional forward-looking statements relate to our agreements with Kyowa Hakko Kirin and Daiichi Sankyo, including potential future milestones and royalty payments that could result from the future development of tivantinib. 23 Drug development involves a high degree of risk. Only a small number of research and development programs result in the commercialization of a product. For example, pre-clinical efforts associated with our product pipeline may fail or prove disappointing because our technology platform did not produce candidates with the desired characteristics. Animal xenograft pre-clinical studies may be unpredictive of human response. Positive information about early stage clinical trial results will not ensure that later stage or larger scale clinical trials will be successful. Furthermore, our drugs may not demonstrate promising therapeutic effects; in addition, they may not demonstrate appropriate safety profiles in ongoing or later stage or larger scale clinical trials as a result of known or as yet unidentified side effects. The results achieved in later stage trials may not be sufficient to meet applicable regulatory standards. Problems or delays may arise during clinical trials or in the course of developing, testing or manufacturing our drugs that could lead us or our partner to discontinue development. Even if later stage clinical trials are successful, the risk exists that unexpected concerns may arise from analysis of data or from additional data or that obstacles may arise or issues be identified in connection with review of clinical data with regulatory authorities or that regulatory authorities may disagree with the Company's view of the data or require additional data or information or additional studies. Also, the planned timing of initiation of clinical trials and the duration and conclusion of such trials for our drugs are subject to the ability of the company to enroll patients, enter into agreements with clinical trial sites and investigators, and other technical hurdles and issues that may not be resolved. We also make forward-looking statements regarding the adequacy of our financial resources. Our capital resources may not be adequate because our cash requirements may vary materially from those now planned depending upon the results of our drug discovery and development strategies, the outcomes of our clinical trials, our ability to enter into additional corporate collaborations in the future and the terms of such collaborations, results of research and development, the need for currently unanticipated capital expenditures, competitive and technological advances, acquisitions, financial market conditions, our ability to liquidate our investments in auction rate securities and other factors. Additionally, our corporate collaborators may terminate their agreements with us, thereby eliminating that source of funding, because we may fail to satisfy the prescribed terms of the collaborations or for other reasons. We cannot guarantee that we will be able to develop any of our drug candidates into a commercial product generating revenues. If we experience increased losses, we may have to seek additional financing from public and private sales of our securities, including equity securities. There can be no assurance that additional funding will be available when needed or on acceptable terms. The factors, risks and uncertainties referred to above and others are more fully described under the heading "Risk Factors" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 filed with the SEC on March 5, 2014, as updated from time to time in our subsequent Quarterly Reports on Form 10-Q and Current Reports on Form 8-K. The forward-looking statements contained herein represent the judgment of the Company as of the date of this report. We are not under any obligation, and we expressly disclaim any obligation, to update or alter any forward-looking statements, whether as a result of new information, future events or otherwise, except to the extent required by law.


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